Darktrace (LON: DARK) found itself the target of a shortselling report from Quintessential Capital Management and the shares dropped 20% and more in a day – to largely regain their losses it is true. The problem here is that whether the allegations about the accounting are true or not doesn’t really matter.
Well, of course Darktrace accounting matters, but a lot less than we might think. What actually matters is what the rest of the market believes about Darktrace’s accounting. That’s a problem that doesn’t go away whatever the truth of the matter. Or, to be even-handed, something that might go away but only over considerable time.
The net effect of this is that Darktrace is going to be undervalued by any of the conventional metrics regarding its reported accounting numbers. That discount might be unfair, might not be, but it’s going to be there and only time will erode it.
The Darktrace Business Is a Fine Enough Idea
The basic offer at Darktrace is just fine – good even. It’s security against incursions into a corporate network. And obvious point is that if there are hackers, or other forms of unwanted outsiders, then there will be unusual activity across said network. Someone trying to down load 5 TB of all the company’s data, say. Artificial Intelligence, AI, is good at pattern recognition. In fact, that’s what AI does, pattern recognition. So, train an AI on what the traffic across the corporate network should look like, then set it to watching for the unusual. At which point alerts go off, maybe there’s an intruder? The logic is just fine and as far as anyone knows the implementation works just fine too.
This is then sold on a repeating subscription base – getting into that market-loved SaaS space with repeating revenues – and Bobbi’s your parental sibling of choice.
But Some Don’t Believe Darktrace
Except – the problem at Darktrace. The guiding light behind Darktrace is Mike Lynch. Who has been accused of – there have been allegations of – games with revenue recognition in an earlier company, Autonomy. Lynch stoutly denies all such. American courts have been unwilling to wholly believe such insistences. Well, OK, that’s all for the courts and the legal system.
What matters to us as investors is that this belief exists in some corners of the market. That perhaps some of those claimed – alleged – behaviours at Autonomy exist in Darktrace. Whether the belief is true or not isn’t, for our purposes here, quite the point. The beliefs exist and we must deal with their existence.
That they do exist means that Darktrade trades cheaper than we’d expect a company in this business, showing these numbers, should do. It also means that the Darktrace share price is subject to such shortselling reports. Almost, but not quite, anyone can put out a report making such claims and the DARK share price will fall.
The Implications of That Sad Lack of Belief In Darktrace
We can also go on to say some other things. As with this time around that Darktrace share price might well recover quickly enough. A week on from the release of this latest report the shares are back up 15% and only a shade off their starting point. So that’s our first trading observation – if another report comes along making much the same points then wait for the wobbles to cease and buy for the recovery. Assuming, obviously, that the new report is simply a rehash of the old concerns.
The second and much more important point is that at some point this uncertainty over the accounts will resolve. Whatever the truth over channel stuffing, hardware and software sales, these are things that cannot be run through the accounts forever. They have natural limits that is. My expectation is that these are not happening and there will come a point when the rest of the market agrees. Which is when there will be a rerating of Darktrace shares. That point will be when it becomes obvious that they’re not happening for if they were they would be obvious – as I say, these things cannot happen for the long term.
Now, when that will be is something for each of us to decide. As is the base logic that is being put forward there.
How To Trade the Market Beliefs About Darktrace
But this is what the trade in Darktrace is. Or the two trades if preferred. We note that the market is worried about the quality of revenues being reported. This makes the DARK share price fragile to allegations. Assuming that we think those allegations are untrue each fresh set of attempted revelations can be met by a buy-in for the coming recovery. Then, over time, that fragility and the associated under-rating will disappear. Simply because all do know that such games cannot persist over long periods of time. Therefore, over some long period of time the conclusion will be reached by the market more generally that such games are not being undertaken.
This is, of course, all predicated on the idea of us not believing the short selling reports.
