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Darktrace
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== ARR growth tied to new customer acquisition == A significant portion of Darktrace’s total addressable market opportunity depends on the company’s ability to grow its ARR independent of new customer acquisition. However, despite reporting higher platform adoption stats in the last couple of years, the company has not reported any meaningful uptick in average contract ARR (Dec- 21 level approx. flat vs. Jun-19). This is partly explained by Darktrace’s focus on acquiring new customers, SMB/mid-market skew in customer base and impact from new product launches. It remains to be seen whether Darktrace can decouple ARR growth from new customer acquisition, which JP Morgan believes will only get tougher with high competition and growing enterprise awareness of competing vendors. Unless the quality (in terms of stickiness) of the customer base acquired is high, focus on new customer acquisition will not translate to sustainable profitable growth, in JP Morgan's view, even though the company may deliver healthy growth in the near term. Darktrace sees its total addressable market to be ~$41bn. The company calculates this TAM using a bottom-up approach by multiplying its 2021 ARR of $343m (FY ending in Jun) by the following factors: * 27x – to reflect 150k addressable customers (27x installed base as of Jun-21); Darktrace considers any company in any region excluding Russia and China, industry and of any size (> 250 employees) as an addressable customer; * 2x to reflect the cross-sell opportunity within Darktrace’s existing product offering; * 1.5x to reflect the up-sell opportunity to deploy Darktrace’s products across the entire digital estate of its customers; and * 1.5x to reflect the potential adoption of planned future product offerings (including ‘Prevent’ and ‘Heal’ product families). While Darktrace’s addressable opportunity seems sizable, the company continues to grow its ARR primarily via new customer additions, with limited contribution from average contract ARR uplift. Darktrace reported constant currency (cc) ARR of $427m as of Dec-21, up from $177m as of Jun-19 (~140% over this period). ARR growth during this period was primarily driven by new customer acquisition, which grew ~140% from 2,731 as of Jun-19 to 6,531 as of Dec-21. === Limited uptick in average contract ARR despite higher platform adoption === Average contract ARR (defined as period-end ARR divided by period-end number of customers) stood at $65k as of Dec-21 and is roughly flat vs. the level as of Jun-19. The limited increase in average contract ARR over this period is despite the higher platform adoption the company has delivered in recent years (number of customers purchasing more than one product up from 47% in 2019 to 88% in 1H22). According to Darktrace, the limited increase in average contract ARR is driven by the following factors: * Impact of new product cycles on average contract ARR; * Limited uplift in net ARR retention rate. ==== Impact from new product cycles ==== SMB/mid-market customers (with shorter sales cycles) tend to adopt new products first, causing a temporary dip in average contract ARR; this is followed by a gradual increase in ARR as larger enterprise deals are closed – the dip in average contract ARR during 2019-1H21 (see Figure 20) is explained by the roll-out of new product modules (Cyber AI analyst, Antigena Email, etc.) in 2019. With Darktrace expected to roll out the ‘Prevent’ product suite around Jun-22, the company expects average contract ARR to go through a similar transition (dip followed by gradual increase) from early FY23. ==== Limited uplift in net retention rate ==== Darktrace reported net ARR retention rate of 105.1% as of Dec-21, up from 99.9% as of Dec-20 and 101.7% as of Jun-19. The improvement in net ARR retention rate is a function of stabilizing 1-yr gross ARR churn (which declined to 6.4% as of Dec-21, from 8% as of Dec-20 and 8.8% as of Jun-19) and some higher upsell and cross-sell across Darktrace’s installed customer base. These results are driven by a recovery in Darktrace’s SMB/mid-market customer base post pandemic and the positive impact from the scaling of customer success function (created in 2H20). Having said this, Darktrace does not expect net ARR retention rate to move up significantly from the current level – this is due to: * Darktrace’s SMB/mid-market heavy customer base (~85% of Darktrace customers generate sub-$100k in contract ARR) that is characterized by relatively higher churn vs. larger enterprise customers; Darktrace sees normalized 1-yr gross ARR churn at ~6% level; * A significant portion of the platform being sold upfront, leaving limited room for upsells and cross-sells; and * The company’s focus on acquiring new customers to capture the sizable addressable opportunity (150k+ potential addressable customers) – i.e. higher emphasis on “land, land, land” over “land & expand”. '''Figure 19: Evolution of period-end constant currency ARR ($, m)<ref>Source: Company data; rates established at the start of each year; for FY22, constant currency rates were 1.3835 and 1.1878 for GBP and EUR, respectively; FY ends in Jun.</ref>''' [[File:Figure 19.png]] '''Figure 20: Period-end cc average contract ARR ($, '000s)<ref>Source: Based on company data; calculated as period-end cc ARR divided by period-end number of customers; FY ends in Jun.</ref>''' [[File:Figure 20.png]] '''Figure 21: One-year gross cc ARR churn (%)<ref>Source: Company data; FY ends in Jun.</ref>''' [[File:Figure 21.png]] '''Figure 22: Net ARR retention rate (%)<ref>Source: Company data; FY ends in Jun.</ref><br />'''[[File:Figure 22.png]] While JP Morgan acknowledges the skew in Darktrace’s customer base towards SMB/mid- market enterprises, the above factors do not entirely explain why the company has not delivered any significant uplift in average contract ARR. Darktrace operates in a highly competitive market with broadly similar offerings available from competing vendors. This likely limits the company’s ability to price its products at a premium and increases retention costs. This could partly explain why the company has not seen a meaningful contract ARR uplift despite selling more product modules to its customer base (additional features bundled together to drive retention). This will not impact gross margin necessarily as providing a new product module such as AI analyst or Antigena autonomous response does not require shipping an additional appliance (for on-premises deployments) and may not result in a commensurate increase in hosting costs for cloud-delivered solutions. In addition, JP Morgan believes that larger enterprises that have well-resourced security teams and know-how are less likely to use Darktrace solutions as a replacement for a standalone EDR, SIEM or network security solutions; these enterprises will likely continue to stitch together best-of-breed point security solutions or license additional modules from existing XDR vendors to add specific network visibility / threat analytics use-cases. Broader Darktrace platform adoption is more likely across price- conscious and budget-constrained SMB/mid-market customers characterized by lower deal values. These factors may likely limit the increase in average contract ARR values, in JP Morgan's view. JP Morgan acknowledges that it is likely too early to judge the success of Darktrace’s cross- sell strategy as the company continues to prioritize new customer acquisition and has a relatively young customer success function. However, in the absence of data that demonstrates the company’s strong up-sell and cross-sell potential, JP Morgan continues to model a modest increase in average contract ARR going forward. Thus, ARR growth, in JP Morgan's view, will continue to be driven by new customer acquisition. JP Morgan believes that high competition in the markets Darktrace operates in will likely make new customer acquisition and retention tougher going forward. This will likely result in either higher gross logo/ARR churn or higher customer incentives needed (to drive retention) and continued high spend on sales and marketing expenses to hunt for new customers to offset churn. === Near-term customer acquisition will likely remain healthy driven by salesforce hiring and new product launch === JP Morgan models constant currency ARR to grow 39% to $498m in 2022 (fiscal-year ends in Jun), in-line with the midpoint of company guidance. JP Morgan models constant currency ARR (measured as of July-21 exchange rates) growth to slow to 29%/25% in 2023/24, respectively. JP Morgan's estimates are underpinned by the following assumptions. * The roll-out of new ‘Prevent’ product suite around mid-CY22, strong enterprise demand for AI-driven network and email threat detection and response tools and increase in salesforce hiring will likely translate to healthy new customer acquisition in the near term, in JP Morgan's view. Having said this, high competition in the markets Darktrace operates in will make new customer acquisition and retention tougher going forward, in JP Morgan's view. Taking these two factors into account, JP Morgan models a modest increase (up ~2% p.a.) in net new customer adds in 2023/24 from a base of ~7.5k customers exiting Jun-22. * JP Morgan models a slight decline in average contract ARR per net new customer added during 1Q-3Q23 (impacted by early uptake by SMB/mid-market customers following the roll-out of the ‘Prevent’ product suite), followed by a gradual increase during 4Q23-4Q24. * JP Morgan estimates net ARR retention rate to remain constant at 105% throughout JP Morgan's forecast horizon. '''Figure 23: Period-end constant-currency ARR ($, m): 2019-24E'''<ref>Source: Company data, J.P. Morgan estimates. Constant currency rates: 1.3835 and 1.1878 for the British Pound and the Euro, respectively; FY ends in Jun.</ref> [[File:Figure 23.png]] '''Figure 24: Period-end number of customers and net new customers added: 2019-24E'''<ref>Source: Company data, J.P. Morgan estimates; FY ends in Jun.</ref> [[File:Figure 24.png]] Darktrace generates revenue almost exclusively (99%+) from subscription contracts (with an average contract term of ~3 years). Revenue from these subscription contracts is recognized ratably over the contract period. Darktrace has high revenue visibility, with ~80% of annual revenue underpinned by the backlog at the beginning of the period. Based on JP Morgan's ARR assumptions highlighted above, JP Morgan models revenue to grow 48% YoY to $415m in 2022; JP Morgan's revenue growth estimate of 48% stands slightly above Darktrace’s guided range of 44.5%-46.5%. JP Morgan models revenue growth to slow to 32%/28% in 2023/24, mimicking the trend in ARR growth during these periods. '''Figure 25: Revenue ($, m): 1H20-2H24E'''<ref name=":4">Source: Company data, J.P. Morgan estimates; FY ends in Jun.</ref> [[File:Figure 25.png]] '''Figure 26: Revenue ($, m): 2018-24E'''<ref name=":4" /> [[File:Figure 26.png]]
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