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Our increased connectivity has widened the attack surface for hackers and brought a huge boost to cyber attacks. In fact, Cybercrime is expected to cost the world $10.5 trillion by 2025. With the average ransomware breach costing a company $4.54 million. Given this fact, it is not a surprise, that the global cyber security market will be worth $155.8 billion by 2022. It is predicted to grow at a rapid 13.4% compound annual growth rate [CAGR] and reach $376.3 billion by 2029.
SecureWorks (NASDAQ:SCWX) is a cybersecurity company poised to ride the growth in this industry. The company has had an interesting history, founded in 1999, it has developed a strong reputation among Fortune 100 companies for its Managed Security Services [MSS]. Then in 2011, Dell acquired the company before taking the company public again in 2016. Today, Dell still maintains a large ownership stake that gives the company a “mothership” to operate from. Since 2019, the business has focused on its Software as a Service [SaaS] solution that has gained strong traction in the market. However, over the past few years, finances have been declining for its legacy businesses as they undergo this transition. Management believes fiscal year 2023 is an “inflection” point and strong growth in its SaaS product supports this. The company recently beat revenue and earnings estimates, so it has all the ingredients of a “turnaround”. SecureWorks estimates its total addressable market to be worth $98 Billion by 2025, so there’s plenty of runway ahead. In this post, I’ll break down its business model, financials, and valuation, let’s dive in.
Secure Business Model
Many companies have gradually built their cybersecurity technology stack with a series of single-point solutions. This may include solutions for Identity Access Management (usernames/passwords) such as Okta, an endpoint protection platform, Network firewall from Palo Alto Networks, and more. The issue here is that many of these different solutions don’t “talk to each other”. In addition, Security analysts can spend up to 30 minutes investigating each individual alert which is labor intensive.
Siled Solutions (SecureWorks)
The SecureWorks solution creates an extended detection and response platform [XDR] called “Taegis” which brings many tools on one platform. It provides a “single pane of glass” for security consultants and IT admins, allowing them to act more quickly. The platform also seamlessly integrates all security data and alerts from cloud apps, endpoints (employee PCs), and the network. It does this through a “Centralized Data Lake” that allows insights to be gained using artificial intelligence and security alerts to be prioritized.
SecureWorks Platform (investor presentation)
Similar to CrowdStrike (CRWD), the platform also integrates with Human Intelligence through their SecureWorks Counter Threat Unit. This enables the team of IT Security experts to prioritize, “hunt” and ultimately defeat hackers. For example, the company outlines the story of a customer who contacted the Counter Threat Unit, because they had detected a “Network Scan” on their system. This is usually not a major issue in itself, but can be used by a hacker looking for gaps in a system. In this case, that was true and the hackers stole every password in the entire company. Typically, these hacker groups will hold passwords “hostage” until a sum of money is paid as a “ransom”. In this case, SecureWorks prevented that by eliminating the hackers and all of its ransomware in less than 6 hours. For Chief Financial Officers [CFOs] typically part of the buying committee in large organizations, SecureWorks boasts a payback period of less than 3 months. In addition, the platform is designed for automation and integrates with popular SaaS platforms such as ServiceNow, Zendesk, PagerDuty, and Jira. It also has a live chat function that gives customers direct access to security experts.
SecureWorks is a leader in managed threat detection and response with a 4.6 out of 5-star Gartner rating. Additionally, they have a 4.5 out of 5 star rating on G2. It’s great, but there are bigger, higher-ranked competitors like CrowdStrike, I’ll describe this later in the “Risks” section.
Solid Finances
SecureWorks generated solid financial results for the second quarter of fiscal year 2023. Revenue was $116 million, which was above analyst estimates by $79,000, but down 13% year over year. This revenue decline has become a historic trend as the company transitions to a new business model, which will focus on its Taegis platform.
The good news is that Taegis is a major revenue driver bringing in $43 million in revenue and growing at a rapid 131% year over year. Annual Recurring Income [ARR] which is a key metric for SaaS companies, increased to $201 million for its Taegis product alone, which now accounts for 56% of total ARR. Management is also on track for Taegis to generate ~75% of ARR by the end of this financial year. This is good to see and means that over time the previous trends in declining income should start to reverse.
ARR (Investor Presentation)
The Taegis product also added 800 new customers which is up 114% year over year.
The company generated earnings per share of minus $0.39 which beat analyst expectations by $0.04. When I dive into the income statement, I see that despite the losses, the investment is going in the right place. For example, the business invested $39.3 million in Sales & Marketing, which was up 16.8% year over year. This helped to drive the aggressive growth of its relatively new product/business line Taegis. In addition, R&D increased 7.4% year over year to $31 million, as the company improves its product. It is great to see that the General and Administrative Expenses decreased by 7.8% reflecting the improved efficiency of its operation.
Income Statement (Q323)
The company has a solid balance sheet with cash and short-term investments of $167.5 million. In addition to total debt of just $14.3 million which is substantial given the rising interest rate environment.
Guidance – FX Headwinds
Going forward Taegis faces FX headwinds from a strong dollar impacting international earnings. Thus, they expect lower professional services revenue than previously expected, in the range of $458 million to $465 million. The good news is that ARR guidance for its Taegis product is still the same and they expect more than $265 million for FY 2023. Management expects sales to accelerate in the second half of the year as the business benefits from its investment.
Advanced Valuation
To value SecureWorks, I plug the latest financials into my advanced valuation model that uses the discounted cash flow method of valuation. I predict revenues will continue to decline by 10% for the next year as the company changes its business model. However, for years 2 to 5 I predict a return to earnings as Taegis’ fast-growing product makes up a larger portion of the total. I predict a steady 10% growth rate per year between years 2 to 5.
SecureWorks (created by author Ben at Motivation 2 Invest)
I predict that the company’s operating margin will increase to 17% in 8 years, which is still below the 23% average for the software industry. I expect this to be driven by the SaaS platform generating a larger percentage of revenue and decreasing G&A costs as per the current trend. In addition, I expect FX headwinds to improve and thus allow margins to breathe. In addition, I increased R&D costs to increase the accuracy of the assessment.
SecureWorks stock valuation (created by author Ben at Motivation 2 Invest)
Given these factors I get a fair value of $12.55 per share, the stock is trading at $9 per share at the time of writing and is thus 28% undervalued.
As an additional data point, SecureWorks is trading at a forward Price to Sales ratio = 1.67. This is significantly cheaper than competitors such as SentinelOne (S) trading at PS = 18.79, CrowdStrike PS = 18.68 and even Rapid7 (RPD) trading at PS = 4.5.
Risks
Competition
I believe SecureWorks is doing the right thing in changing its business model and the market agrees with its product gaining significant traction. However, it should be noted that there are larger and more established players in the extended detection and response market such as market leader CrowdStrike, Rapid7 and even SentinelOne. So the company doesn’t really have a moat or competitive advantage which could be an issue in the long run.
Recession/Decreasing IT Spending
The high inflation and rising interest rate environment caused many analysts to predict a recession. This can cause businesses to delay IT spending until more economic certainty is provided. The good news is that I believe this is only a temporary issue and the long-term trend in security spending is upward.
Final Thoughts
SecureWorks has a great product and is undergoing a business model change. Its revenue is still falling but analyst expectations are still higher. Management predicts that the majority of the transition will be complete by the end of FY23 and thus given the stock’s cheap valuation, a turnaround is likely in the long run.