Darktrace PLC

LSE:DARK

Earnings Call Transcript 2022-Q2

[Poppy Gustafsson]

Welcome to all of those joining us today. It's a pleasure to be back in front of you today and to be giving you another positive update. I want to start by saying that we are saddened to read about the evolving tragic situation in Ukraine. At the same time, as the devastating on the ground war is unfolding, we are once again seeing the use of malicious cyber activity as a means of causing damage, disruption and the spread of misinformation. These attacks threaten Ukraine as well as supply chains and national security globally. Technology companies have an important role in making the world a safer place and democratizing defense. This is something that I'll come back to you later. But turning to our results, I can tell you that we have delivered a strong performance in the first half of the fiscal year and have continued to outperform against all of our key metrics.

If I can draw out some highlights, we have delivered strong constant currency ARR growth of 45.5% and of growing year-over-year revenue by 52.3%. We added over 900 new customers during the period taking our customer base to over 6,500 which represents 39.6% year-over-year growth. Our global workforce has continued to grow and is now more than 1,700 globally, up from 1,441 at the 31st of December, 2020. We have grown our development team by 63% period-over-period and have continued to invest in building our R&D team in Cambridge. This team boasts over 20 doctorates and almost 60 master's degrees bringing together the world's leading experts to self-learning AI. We've also grown our adjusted EBITDA by 124.6%. This is a really key metric for us as it indicates our ability to generate cash while stripping out non-cash items and is therefore a helpful guide to our profitability. We have again raised our guidance on our adjusted EBITDA margin for the full year to between 10% and 12% reflecting the strength and profitability of our underlying business model.

We are incredibly proud of what we do. Within our 6,500 strong customer base, we're protecting some of the society's most important organizations; organizations that are for the first time able to regain the upper hand in the battle against ever evolving cyber-attacks and this battle is a very real one for almost every organization that exists today. In 77% of companies where we install our AI, we find serious threats that have got through perimeter defenses. Attackers are innovative and are constantly looking for weaknesses and finding new creative methods of exploiting those weaknesses. This is compounded by a widening attack surface as we shift to a completely digitized society.

The reality is that every organization has vulnerabilities, but at Darktrace we do not believe that being vulnerable equates to being a victim. Our technology is able to stop the threats before it causes disruption or escalates into a crisis. And before that organization becomes a victim, indeed our new product line Prevent will create some even stronger defense in depth by hardening existing defenses against vulnerabilities before their security teams are even aware that they're there. All of this is possible, thanks to our self-learning AI. Instead of learning from past threats, we learn from the business. Our technology is constantly building and updating its understanding of the unique digital fingerprint of an organization, which in turn allows it to understand what is normal and what is not. Based on this understanding, it can rapidly and autonomously spot and stop attacks which have never been seen before, reprogramming that business' digital defenses before the breach escalates into a crisis. With this capability, every second of every day, Darktrace's self-learning AI is catching in-progress cyber-attacks which have got past existing defenses and are already inside a business. Every second of every day, our technology stops an organization from becoming a victim.

There's no other cyber vendor that has this range of capability from detection to investigation to autonomous response and there is no other cyber vendor that is capable of defending the breadth of environments that we can. Digital businesses are complex from Internet connected machinery on the factory floor to email to employee laptops to SaaS applications. All of this data makes up our digital DNA and Darktrace protects it all. Sitting at the heart of our organization and driving the innovation behind our breakthrough technology is our brilliant R&D team in Cambridge and they have been very busy at the period. The development team has grown by 63% and our AI Research Center has started to publish for the first time research on some of the most pressing questions in cybersecurity. For almost a decade, our powerhouse of mathematicians, scientists and cyber experts has been examining the fundamental challenges of securing the world's diverse business communities, publishing papers on areas such as

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(00:05:01) AI and social engineering and self-healing systems. This is an exciting step forward and our aim is that by sharing these insights, we will set a new standard in taking a collaborative approach to research that benefits the wider community. The hard work of the team is also reflected in our growing patent number. Today, we have over 90 patents granted all pending for AI and machine learning concepts. Our product set is also expanding. We recently announced our market leading autonomous response technology now takes action on the endpoint. And we also shipped the first module of Prevent the early adopters in December as planned. Prevent will form the next component of our vision for continuous AI loop, which brings me nicely to the final exciting development I once talked about.

Many of you will have seen that last week we made the announcement. We have agreed to acquire Cybersprint; an attack surface management company based in the Netherlands whose product provides continuous real-time insights from outside in perspective to eliminate blind spots and detect risks. I'm pleased to say that we completed the acquisition earlier this week from the 1st of March as planned. Combining this outside in perspective with Darktrace's unique capability in understanding organizations from the inside out is very powerful. We are particularly excited to welcome Cybersprint's impressive team of AI experts and engineers to Darktrace, many of whom have helped to shape the cybersecurity industry. Like our, Cybersprint is research business and we are delighted to have them on board.

As well as working on new innovations and developing offering for existing customers, we have added over 900 new customers to our roster over the period. We closed a number of very large deals in the first half with organizations across a huge range of sectors from the aviation industry through to investment banks, car manufacturers and telecommunications giants. Each and every win is a step forward in capturing the significant total addressable market ahead of us which I'll come back to later on. But we didn't only add new customers. We also invested in our existing ones. We have continued to grow our customer success team, which is reflected in an increase in our net retention rate which improved by 5.2 percentage points from the prior period end. A recent survey of our customer base by Berenberg Bank's equity research team produced really encouraging results and customers having a positive experience with us and an appetite for investing further in our technology in the future. You can see some of the key findings here. 100% of customers surveyed were very satisfied or satisfied. And 94% are open to buying one of our new products. Customer satisfaction is also reflected in our overall score in Gartner, the independent global research firm, which comprehensively tracks the whole cybersecurity sector. We are proud to have an overall customer satisfaction score of 4.7 or 94%.

I'll pass over to a very happy customer, Willem Lock, at Boardriders who we recently helped to defend against a ransomware attack.

[Video Presentation] (00:07:59-00:10:14)

[Poppy Gustafsson]

Thanks to William for that. Now, we've also been investing in our people who are, of course, the driving force behind Darktrace and have brought us to where we are today. We are focused on offering careers not just jobs to our employees and I've gathered feedback from a company-wide survey to understand how we can offer more to those working for us to ensure they are fulfilled in their roles and are able to develop the skills they need to progress their careers. I'm pleased to say that not only was engagement with the survey very high, it was 80% right at the top of the benchmark bracket for employee surveys, but then we got an overall score of 7.8 out of 10, ahead of the benchmark. Perhaps there is always room for improvement. And the key area for feedback was in personal growth and training. I should note that both of these still scored a 7.1 out of 10, reflecting the fact that our scores were generally good across the board. So we have taken steps to expand and formalize our training and development programs for employees supporting them to build on their skill sets in an industry where skills are in short supply.

I'll now show you a short clip of Lizzie Martin, one of our senior technical managers who is helping to drive up people related initiatives.

[Lizzie Martin]

Hi, I'm Lizzie Martin and I'm a Senior Technical Manager here at Darktrace. After five years at Darktrace I'm delighted to be the employee representative for all people-related initiatives. I've been working with Darktrace since we were only around 300 people strong. So it's been amazing to see the team grow to over 1,700 people today across the globe. I've been working with our employees to ensure we are driving forward initiatives that will make Darktrace an exceptional place to work. Today, I want to quickly run you through what we've been doing to strengthen our training and personal development offering in particular. We launched a pilot leadership development program which we've delivered alongside an external coaching partner to support our teammates in maximizing their own potential and that of their teams. We knew there was strong appetite for professional coaching program, so we formalized the scheme matching the first cohort of 70 people with coaches from within Darktrace. The feedback from the session so far has been really positive.

In addition to this, we launched a new online trading portal in 2021, where employees can access materials and resources. The portal will provide ongoing training opportunities for all Darktrace staff as their careers progress. Our goal is for these programs and opportunities to enrich the experience of Darktrace employees and ensure they can flourish whatever their role. Alongside our training and development programs, I've been focusing on initiatives around employee wellbeing, charitable giving and equality and diversity which is a list we expect to grow, but I'll leave it there for today. Most importantly, we understand that it's crucial to make this an ongoing and open dialog so we can best meet the needs of our people and ensure they are shaping what the future looks like here at Darktrace. I'm looking forward to working with more colleagues in 2022 to understand how we can go even further to make this a special place to work.

[Poppy Gustafsson]

Thank you, Lizzie. And finally, I wanted to give you an update on the progress that we have made on the evolution of our sales team structure, which I mentioned in our last results. As a reminder, historically, Darktrace salespeople have had the latitude to sell any kind of business in that region. We outlined plans to segment the sales team according to the size of our customer's organization, which will provide us with another lever for growth. We started to do this in October as planned, and I can confirm that the process is going well and will be complete by the end of the fiscal year. As a reminder, this is not about changing the profile of our customer base, but about building an optionality as we scale up the company to go after the 150,000 potential Darktrace customers out there.

Darktrace is here to help strengthen the organizations on which we all depend on in our daily lives to empower employees, to focus on what they do best and to enable executives to bring in exciting technologies while remaining safe and secure. Our focus on this mission is only sharpened by the global context we face today. The current geopolitical situation has heightened the urgency for our businesses, our public bodies and our governments to improve cyber resilience. The threat of nation state attack looms larger than ever and the consequences of this kind of mass scale cyber conflict and disruption are felt broadly. It is during periods like this when the next wave of cyber offensive capabilities take shape, adversaries are innovating and it is only a matter of time before the results of that trickle down into the hands of commodity criminals on the dark web. So for us the priority is to continue to outpace the attacker, delivering best-in-class technology into the hands of our customers whether that's a local business with 50 employees or a global corporation because there is not one organization that does not face the potential impact from a situation today or from the attacks tomorrow. As we look ahead, we would be building on a solid start to the year and we'll come back later to talk about our priorities in both the short and longer-term, but for now over to Cathy to go to the financial review.

[Catherine A. Graham]

Thanks, Poppy. I'm pleased to be here sharing both our first half results and further increases to our FY 2022 expectations. For the first half, Darktrace continued to deliver strong growth across our customer base, ARR and revenue as well as strengthening our key customer and contract metrics. Moreover, we delivered these results while moving further along the path towards sustainable profitability. At $192.6 million, first half revenue grew by 52.3% over the prior year. More than 99% of our revenue continues to come from subscription sales, which combined with our multi-year contract structure, creates significant RPO or contracted backlog. With RPO of $877 million up 43.2% over the prior year, we maintain a high recurring revenue base and significant revenue visibility.

To drive continuing top line growth, we remain laser focused on expanding constant currency ARR. During the first six months of FY 2022, we saw net ARR added of $69.9 million, 48.7% greater than in the prior year. This increased our ARR by 45.5% year-over-year to $427.3 million at the end of the first half. Growth in our ARR measures continue to be driven primarily by the addition of new customers. Year-over-year, we added 1,854 net new customers, a 39.6% year-over-year increase and 926 of these were added in the first six months of this financial year. We also saw movement in other contract metrics; both for new and existing customers that helped drive ARR growth through the period. Year-over-year, the average ARR of our new customer contracts increased by more than 15% and the average ARR uplift per existing customer more than tripled. In combination, this resulted in a 4.2% year-over-year increase in average contract ARR across our customer base. We continue to sell across a broad range of customer and contract sizes. However, driven by the period-over-period increase in average contract ARR, our account distribution shifted upward slightly. At the end of our first half, 49% of ARR was from the 16% of customers with ARR of more than $100,000. This represented a 1 percentage point year-over-year shift to above $108,000 ARR contracts within our customer base. Also key to this shift was the continued deepening of product penetration across both new and existing customers.

Darktrace currently has a 10-product platform and most of our customers buy multiple products from us. At the end of our first half, 66.1% of our customers had three or more products and 43.4% of customers had four or more. This reflected a year-over-year shift towards three-plus and four-plus products of 11.6 percentage points and 11.4 percentage points, respectively. While our customers still buy most of their products from us upfront, we've strengthened our upsell focus and it's showing results. We're looking forward to the general release of our first Prevent module and to bringing Cybersprint's external facing attack surface management capabilities to our product set. These developments should further support both upfront and upsell product penetration across our customer base.

Since IPO, we've been telling you that one year gross churn and net ARR retention rates might improve. As the smaller end of our customer base stabilized after early pandemic impacts, our customer success team reached the scale of maturity to influence results and we continue to focus on upsell activity. I'm pleased to say that is what we're now reporting. At the end of our first half, one year constant currency gross ARR churn was 6.4%; a year-over-year improvement of 1.6 percentage points. Over the past six months to nine months, we've seen retention improve amongst our smaller customers as they've adapted to changes in their operating environments and as we've expanded our ability to manage and demonstrate value in those relationships. With one year churn now in the 6s, we think we're in a reasonable operating range given the profile of our customer base. Remember that while a ubiquitous platform gives us a large addressable market and long sales runway, the resulting smaller average customer size means that our gross ARR churn will naturally be a bit higher than vendors and target larger enterprises.

In addition to improving churn, we're now maintaining a steady focus on upsell activities. This resulted in a net ARR retention rate at the end of our first half of 105.1%, a 5.2 percentage point year-over-year improvement. While our primary focus remains on new customer acquisition, our customer base is now large enough that increasingly attention we paid to existing customer product adoption makes sense and the results are showing you the existing customer contract ARR uplift which I'll remind you just tripled compared to the prior year. We've already talked about revenue. So now let's focus on the cost side of our business and its impact on profitability.

For the first half, gross margin stayed within our expected range, but declined by 0.9% versus prior year. This was largely driven by an increase in hosting costs as we expand and drive sales of our cloud-based offerings. We are continuously looking for technical efficiencies of our deployment costs and we have negotiated volume-based arrangements that will allow us to take advantage of unit cost efficiencies as we grow. In aggregate, first half operating expenses remained below our expectations, largely because of three factors. First, travel and entertainment expense was slower to return than we had forecasted. Second, the return of employees to our offices has been delayed for long than we predicted. And finally, while we have continued to hire at a rapid rate, we remained below planned staffing levels for much of the first half. Well, T&E and office costs are expected to return over the intermediate term and we are still getting back to a normal cadence for hiring an employment cost increases, we are also seeing offsetting levels of scale efficiencies.

Within our operating costs, we pay close attention to recurring non-T&E operating costs. This eliminates the impact of currently volatile travel and share-based payment costs and allows us to more readily assess whether our recurring cost movements align with our goals. In sales and marketing, these non-TNE operating costs, which made up 92% and 94% of total category expense in 1H 2022 and 1H 2021, respectively, remain a bit lower than we typically expect as we catch up on hiring. But while the exact amount of that impact is hard to quantify, this was not a major driver of the 13 percentage point reduction in these costs as a percent of revenue. As we continue to leverage our expanding customer base and multi-year contracts, the economies of scale we're driving in customer acquisition costs are real. In R&D, these non-T&E operating costs which made up 92% and 62% of total category expense in 1H 2022 and 1H 2021, respectively, increased by 2.3 percentage points as a percent of revenue between the periods. This resulted from us executing against our stated plan to expand product development capacity. We continue to hire into our core development and broader R&D teams and the development team we're adding as part of Cybersprint acquisition represents a significant step-function in our R&D expansion journey.

In other administrative expenses, these non-T&E operating costs which made up 72% and 82% of total category expense in 1H 2022 and 1H 2021 respectively, increased by 1 percentage point as a percent of revenue period-over-period. This increase was expected and it was driven by a combination of new public company costs and continued hiring, largely in our customer success function. As we only formalized this function into late-FY 2020, that team is still scaling disproportionately though we're also looking for this to settle into a more regular cadence over the next year.

Relative to the prior year, share-based payment charges generally increased, largely reflecting a full period of costs for private to public transition schemes put in place at the IPO. The exception is in R&D where the costs recognized during the period declined. This doesn't indicate any change in our use of equity within the R&D employee base. What it does reflect is our decision to begin capitalizing these costs as a part of our other development labor cost capitalization since these costs are now becoming material. In the first half, we capitalized $2.7 million in R&D SBP charges, but only $300,000 was related to the period. The additional $2.4 million was a catch up adjustment for prior periods and it was offset by $1.4 million in related catch up amortization. No catch up amounts were material to any prior period. For the first half of our financial year, we reported a net profit of $5.9 million; a $54.3 million improvement from the net loss reported in the same period of the prior year. While economies of scale were key to this shift, the biggest factor was a $41.7 million reduction in finance costs between the two periods. In the first half of FY 2021, we recognized non-cash finance costs related to $163 million in convertible notes, the proceeds of which were primarily used to buy back shares as a part of restructuring our ownership before listing.

These notes converted upon IPO and the related costs stopped. So in the first half of that FY 2022, we had only a normal level of bank charges, letter of credit fees and other operating finance costs. Additionally, for anyone who wants to dig in deeper to our cost trends, we've provided the schedule showing additional cost breakdowns and their period-over-period movements in the appendix to this presentation. One of the core features underlying our business model is that multi-year contracts deliver increasing levels of committed revenue backlog. This has continued to underpin the scale efficiencies with both year-over-year improvement across all our earnings measures and is evident in our EBITDA and adjusted EBITDA measures. Period-over-period, adjusted EBITDA increased by 124.6% to $46.7 million, largely driven by key costs growing more slowly than revenue. We continue to see economies of scale, particularly in sales and marketing, as we recognize continuing value from prior period contracts where a significant portion of the cost of acquisition was incurred in those prior periods.

With respect to the add-backs, we've already discussed the one change from prior periods and that's the capitalization of appropriate share based payment charges in R&D beginning in 1H 2022. We have this and other adjusting items detailed here by cost category. With our first half review now complete and based largely on that performance, we're again raising our expectations for FY 2022. We now expect year-over-year growth in constant currency ARR of between 38.5% and 40% up from the 37% to 38.5% we guided to in our January trading update. This implies year-over-year growth in net constant currency ARR added of between 24% and 29% up from the previous implied range of 19% and 24%. We have also incorporated our expectations for Cybersprint, and while we don't believe this will have a material impact on financial statement results for FY 2022, it does add to our expectations for ARR measures approximately 1 percentage point of the increase in expected year-over-year ARR growth and approximately 3.5 percentage points of the increase in expected net ARR added related to our 1 March acquisition of Cybersprint.

As a reminder, our business has significant net ARR added seasonality across the financial year. Especially for our organic ARR growth, you should consider our normal patterns including typically softer third quarter sales within the second half. Also keep in mind that we're still planning for potential temporary sales productivity impacts that could result from evolving our sales structure. We started this process early in the second quarter and are pleased with the progress so far. However, as new customer sales in that second quarter were generally underway by the time we started to make changes, it is in this second half where we would expect to see any impacts. Additionally, as we continue to catch up from pandemic related sales hiring delays, we'll continue to have a sales force with lower than expected average tenure and therefore lower sales capacity for some time to come. Driven in part by the organic increases in our ARR expectations, we now expect year-over-year revenue growth of between 44.5% and 46.5% up from a previous range of 42% to 44%. This increase is also partly driven by reducing our expectations for foreign exchange headwinds from previous predictions based on recent experience. This accelerates the conversion of constant currency ARR to US dollar denominated revenue in our forecasts.

Turning to profitability, and as we've said before, we expect that our cost structure will increase as a percent of revenue for the second half. This expected increase is driven by several factors including the return of travel and entertainment where a significant step up in activity during November and December have led us to forecast a steeper ramp in second half costs. Also late in the first half, we saw an acceleration in employees returning to offices. In some key locations, we're now moving to larger spaces to accommodate additional employees we've hired over the past two years. And in smaller locations, we're re-contracting for office space we let go over the pandemic. Overall, we're expecting a significant increase in our facilities and office costs for the second half. And finally, we've continued to hire at a rapid rate, both to catch up on sales capacity and more broadly to support our continuing growth trajectory.

The second half of this year will carry the full impact of compensation costs for people we hired in the first half, but where we only have them for a portion of that period. But while T&E and office cost are expected to return over the intermediate term and we are still getting back to a normal cadence for hiring employment cost increases, this steeper trajectory in cost increases is temporary as we return to a more normal operating environment. Further, we're seeing offsetting levels and scale efficiencies and modeling these forward, they clearly support our expectations for longer-term steady state margins. The steady state margin framework is also available for you in the appendix to this presentation. Combining first half results and our increased cost expectations for the rest of the year, we now expect an adjusted EBITDA margin for FY 2022 of between 10% and 12%, up from our previous 3% to 6% range. We've considered the impact of Cybersprint, but given the size and timing of the acquisition we don't believe it will be material to our FY 2022 adjusted EBITDA expectations. To wrap up, our first half delivered continued strong growth, both in revenue and the ARR and RPO measures that form the basis of a continuing growth trajectory. We saw positive trends in our customer and contract metrics and with economies of scale continuing to develop, we moved further along the path to sustainable profitability. At a very positive outlook to those results and I'm feeling happy with our prospects. Poppy?

[Poppy Gustafsson]

Thank you, Cathy. Now I want to turn to the future and give you a sense of what we are expecting as we look ahead. Under Jack Stockdale's leadership of our R&D team in Cambridge, we have set out the most ambitious technology vision in cybersecurity state which will transform the way that we protect our customers. And on a short life is the company so far, we have developed the capability through self-learning AI to detect, investigate and respond to cyber threats, to handle the parts of cybersecurity that are not only labor intensive for humans, but go beyond human capabilities such as responding to an in-progress attacks at machine speed. These capabilities are crucial for any business defending against today's cyber-attacks, but we want to go even further on this. Our ambition is to create an AI-driven feedback loop that autonomously optimizes digital business to mitigate cyber risk. This is where our research has been focused and we've made exciting progress to bring us closer to this goal since our last update.

Let me start with Prevent, which will be a family of products designed to autonomously identify and mitigate against vulnerabilities before an organization is even aware that they're attacked. Based on the understanding of

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(00:36:07) business, Prevent gets into the mindset of an attacker looking at how they would exploit vulnerabilities and find the quickest routes to crown jewels. It does this using attack path modeling technology, which continuously tests the security risks and identifies pathways, hardening defenses and ultimately making attackers task as difficult as possible. We're creating a new market which will save security team's time and money and what is currently an expensive and resource-heavy process of attacking themselves and trying to work out where their weaknesses are. As I mentioned, we shipped first module of Prevent to a select group of early adopter customers in December 2020 and are currently collecting feedback.

The fourth component of the loop is Heal. This is all about the remediation process and the aftermath of an attack. An attack, once thwarted, needs to have all the tendrils of infection removed. This is a human intensive task that is prone to human error and insufficient vigilance. Imagine a future where this was handled by artificial intelligence that is personalized. Using its understanding of the unique fingerprint of the business as well as its understanding of how the attack happened, it can return that organization to its normal as if the attack was never there.

Taken together, these four components can create continuously underpinned by self-learning AI; a virtuous circle where each AI brain feeds into the next, reinforcing each other. Darktrace's self-learning technology is what sets it apart from not only every other cybersecurity solution on the market today, but also from other approaches to artificial intelligence which learn from past threats rather than from the organization. So the task ahead of us is to get that technology into the hands of as many organizations as possible and there are plenty of them. There're over 150,000 companies that could benefit from our AI, 20 times our current customer base. This large addressable market will remain our number one driver of revenue growth for many years to come. The beauty of Darktrace's AI as it can be applied to companies of almost all sizes across all sectors and geographies and is complementary to traditional security solutions. So our priority remains for the time being to win as many new customers as we can and to land as much to the platform from day one as possible. This is not your typical land and expand model. Our focus remains land, land, land.

To summarize, we have delivered a strong performance in the first half and have made tangible progress across all of our strategic focus areas. Over last six months, we've added over 900 organizations to our customer community. We've grown our workforce to over 1,700 employees, and we have continued work on the development of breakthrough technologies, which brings us closer to achieving a continuous AI driven loop. We are increasing expectations for FY 2022 again and we are focused on delivering another strong performance against all of our key metrics as we head into the second half. Innovations that's at the heart of everything that we do and that we will continue to drive us forward as we look ahead. Thank you.