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This is unfair, but it is
It’s entirely possible that there’s a vibrant and useful business within Darktrace PLC (OTCPK:DRKTF) (LON: DARK). It’s also true that we’re not going to see the share price reflecting that for some time given other events going on.
So, whether there is that good business in there or not isn’t the point given that the share price isn’t going to reflect it for some time even if it is. Any consideration of what the stock price is going to do from here has to be based upon those factors that are going to actually influence it.
The Darktrace idea
I have to admit that I like the basic idea of Darktrace itself, the base technological story. We’re all not paranoid enough about network security these days and tightening up would be a jolly good idea. Especially what with bitcoin ransoms being demanded and all that.
The technological solution – at least the idea of it – is to map out what the network should be. What connects where, where are the connections to the outside world, what do usual traffic patterns look like? Then set up an AI system to look for variances from those normal patterns.
No, this works – this is what AIs are good at, excellent at, pattern recognition. No one is asking them to think here, they’re being asked to monitor patterns and report on changes. Excellent.
So, I do buy that basic logical structure. I know Cambridge is packed to the brim with clever software and hardware folk, I’ve worked with a few. So I’ve no problem with the basic story.
Ah, but history
This is where the Darktrace problem is. The founding investor – and until resignation last week – still influential adviser is Mike Lynch. Who was also the founder of Autonomy.
Which is a bit of a problem. Autonomy was bought by HP in some vast megadeal for $11 billion and a little later HP wrote off $8 billion and change of that. And since then has been trying to sue Mike Lynch for misrepresentation, possibly fraud and so on. The corporate accountant has been jailed in the US.
In this fight I’ve long had some sympathy for Lynch – it’s an English case about an English business to be decided in England under English law. HP disagrees and wants a trial in the US. This is what the extradition fight has been about – and last week Lynch lost that. The Home Secretary – which is it really, barring some truly Hail Mary appeal – has signed off on it.
He also had a ruling in a fraud case go against him. And that’s really where the problem is, not actually the extradition or American case.
Because now that ruling has come down people in the stock market are talking about Autonomy as it was. Not allegations that HP is making about how they were dinged, but investors in the market, at the time Autonomy was traded, talking about how they didn’t like the stock.
I’m old enough to have been around then, indeed I’m old enough to have talked to the company before it even floated. And I’ve done a lot of work in tech journalism in Britain too and absorbed a lot from that quarter.
The thing is, however good the idea at Autonomy was – and like the Darktrace one, it made perfect logical sense from the outside – no one really raved about the product itself, or even thought it was all that much cop. Nor was anyone on the stock market all that greatly enamored of it.
From the market side it was perhaps too aggressive in revenue recognition, there was too much of a target hitting sales environment about it. Rather than what folk thought they might want to buy into, a bunch of Cambridge eggheads with a brilliant product.
This might be a rather English mindset – actually it is – but there was a definite feeling that Autonomy was trying too hard. If the product was as good as they said it was then there just didn’t have to be that hard sell to it.
OK, so, all very British and cultural. But reading people within their own culture does work this way. I’m not going to comment at all on what the allegations from HP are – they’re easy enough to find – but they really revolved around this trying too hard to hit sales targets, being too aggressive on revenue recognition and so on. Not all that far away from what the vague unease in the market was at the time.
Now, as I say, I was around back then and that was the general view. The end of this recent fraud trial means that others – actual market names people might have heard of – are now going public with exactly their concerns and worries from this time.
Autonomy isn’t Darktrace of course
Sure it isn’t. But it wouldn’t surprise anyone at all the founder of a hugely aggressive software company, when he founded a second time, founded a hugely aggressive software company. We might even expect the internal culture to be similar.
Which is what the worry is with Darktrace. That’s it, the whole uneasiness. That’s also why the stock has declined so badly since the recent flotation and the following bounce. The Mike Lynch story has been coming to fruition in terms of trials and extradition so attention is being focused on that last company, Autonomy.
To give a direct example of what I mean. In conversation with a contact we talked about the churn rate of 24%. That’s people who try the Darktrace product but then drop out of using it. The implication of that is that you’ve got to replace a quarter of your customer base every period in order to just stand still, let alone expand.
Now, a 24% churn rate could mean nothing very much. Generous terms to try out the product perhaps. Or maybe it just doesn’t meet some needs. Or perhaps it’s a very aggressive sales force closing hard and then finding the client base drops out after real paid work.
If the market were in favor of Darktrace then we might well ascribe that first story to them. But that conversation – the second story is being talked of. It’s proof of the hard sell as with Autonomy. Whether it’s true or not isn’t the point. The market is valuing the stock as if it is.
That Darktrace problem
The problem is simply the hangover from the Autonomy story. It might well be true that there’s no link at all. But that’s not how Darktrace is going to get valued in these months ahead. Simply because stock markets don’t work that way.
All and any claims of revenue recognition – anything beyond actual receipt of cash – are going to be discounted by that Autonomy discount. This is going to continue until the Mike Lynch case – or cases – pass out of the current media window. Or, longer perhaps, when the market can see several periods of results where actual cashflow matches, exactly, with revenue recognition. And none of this interesting business with hardware sales either.
My view
I’m perfectly willing to believe that Darktrace is a fine, entirely wonderful, business. That’s just not the way it’s going to get valued by the market in this immediate future.
The investor view
This is where it gets interesting. And it’s a decision that has to be made. Is the current Darktrace price because the Lynch effect is real? That there is aggressive revenue recognition, that that churn rate is a result of hard selling of a product? Or is that effect simply a hangover from Autonomy and there is no relationship to the current business and its accounting?
I agree, we’d often like to have more analysis of the numbers here but that’s the entire point of this piece. It’s not what numbers are being reported that matters here, it’s who believes them?
There’s a price at which this doesn’t matter but I think it’s lower than the current one. At £2 (the London stock is currently £3.80 -ish) then I’d buy the story whatever the issues over Lynch or accounting. Above that, just not sure enough.
