Let’s be clear, cybersecurity stocks faced a challenging 2022. Interest rate hikes triggered a broad selloff that saw long duration (rate-sensitive) technology names particularly decline in value. But cybersecurity is just one aspect of technology and has its own dynamics that may have been overlooked by investors. In this piece we discuss the followings:
- What have been the challenges for technology stocks including cybersecurity names
- What are the relative growth opportunities for cybersecurity investors
- Why high revenue purity can optimize exposure to future cybersecurity growth
1. What have been the challenges for technology stocks?
Slowing demand has led to concerns over revenue growth
When companies announce mass layoffs, it’s usually a response to concerns of a slowing economy and consumers pushing back. Half way through 2022 we started hearing about layoffs in the technology sector which have since intensified. This trend has been so widespread that one website, Crunchbase, has launched a layoff tracker for the technology sector. According to their tracker, and at the time of writing we are only six weeks into 2023, there have been over 70,000 workers laid off in the technology sector including 6650 job cuts at Dell alone.[1] One immediate observation, and we will touch on this later, is the limited share of cybersecurity companies in the tracker.
We’ve heard a number of companies in recent months talk about slowing expectations for consumer spending. In the cybersecurity realm, F5 Networks recently announced their Q1 FY2023 results and said that they are seeing broader economic uncertainty, pervasive budget scrutiny and spending caution and that their multi-year subscription businesses were most affected.[2] They had expected revenue growth from their global services to be soft and revealed growth of 5% year-over-year, and software revenue growth came in at 3%. That said, analysts expect these to grow to 6% and 15% respectively in Q2 2023. Headline revenue of $700m in Q1 (2% YoY growth) was exactly what was forecast by analysts although F5 said it expects 9% to 11% revenue growth for 2023.
Microsoft recently weighed in pretty much the same saying that organizations are exercising caution given macroeconomic uncertainty. It also announced 10,000 layoffs on 18th January 2023. So, understandably, all of this is raising concern over revenue forecasts for the coming quarters.
Interest Rates
Interest rates have been hiked since the beginning of 2022. In the pandemic era it seemed as if fundamentals went out the window, and unprofitable and speculative growth stocks soared in value. We are now in the monetary-tightening stage of the economic cycle. With a Fed funds rate that’s currently between 450 and 475 basis points and poised to go higher, it means that if companies do refinance their debt, they are likely going to be at higher interest expense levels. This potentially elongates the road to profitability for unprofitable names, and for profitable names it raises the cost of capital to fund future growth.
The above factors have contributed to challenges for revenues and earnings in the technology sector. In March 2022, the technology sector was expected to grow 8.6% in 2023.[3] As we moved through the year, this figure declined. In June it had fallen to 7.9% and by the end of the year it was 3.7%. We now have around 3.5% of EPS growth forecast for the broad technology sector in 2023 but crucially we have to remember that cybersecurity is just a small part of this.
2. What are the relative growth opportunities for cybersecurity investors?
Cybersecurity has been somewhat immune to the large number of layoffs seen in broader tech
If we look at Microsoft’s guidance from its latest earnings, they’re looking for revenue to be relatively flat due to declines in the PC and Cloud markets but they continue to see their security business growing year over year. Furthermore, Microsoft’s 10,000 recent layoffs did not include their cyber security headcount. IBM announced on February 25th that they’re going to lay off some 3900 workers but they’re going to continue to invest in higher growth areas including cybersecurity. We also haven’t heard anything about cybersecurity layoffs at other companies whether it’s Alphabet or Meta platforms or others.
Most cybersecurity companies have not been laying off in 2022. In fact if you look through most of 2022 the average company in the Foxberry Tematica Research Cybersecurity & Data Privacy basket actually increased head count by roughly 21 year over year.[4] Why is this? As the market for cyber-attacks continues to rapidly expand, cybersecurity names must continue to invest and innovate to provide solutions to the increasingly sophisticated attacks of the future and therefore maintain a competitive advantage.
Cybersecurity revenue growth has slowed but deferred revenue has increased
In 2022, whilst many firms continued to grow revenues and earnings in double-digit and sometimes triple-digit figures, the overall rate of growth declined. Wall Street estimates for cybersecurity growth had been highly optimistic and as a result some companies were not quite able to live up to these expectations. Investors were therefore worried that falling revenue growth reflected falling expenditure on cybersecurity, but this wasn’t necessarily the case.
What we’ve actually seen is companies looking at new ways to optimise their cybersecurity expenditure to improve cash flows. For example, when CrowdStrike published its 2022 Q3 results, CEO George Kurtz commented that the company had to delay recognition of certain revenue until future quarters due to “elongated sales cycles with smaller customers and… larger customers [pursuing] multiphase subscription start dates”[5] resulting from the prevailing macroeconomic headwinds. As a result, an interesting trend we’ve seen is deferred revenue across companies in the Foxberry Tematica Research Cybersecurity & Data Privacy basket move higher in 2022. In the first quarter, we saw deferred revenue grow 3% quarter-over-quarter. In Q2, this jumped to 8% and in Q3 it was not only up another 6% but up 19% year over year.
This speaks to the notion that not only has cybersecurity continued to grow as companies have to thwart existing attacks and get ready for new attacks, it says that more dollars are being spent and that really alleviates concerns over declining spending on cybersecurity where deferred revenue continues to move higher.
As we move through 2023 we expect these trends to continue and we’re going to see this this disconnect start to fall as deferred revenue supports the revenue for the Foxberry Tematica Research Cybersecurity & Data Privacy basket that’s expected to hit in aggregate for the index around $USD 44.7 billion this year. That’s up from $33.2 billion in 2021.[6] We have also begun to see more bold decision making from CEOs as well. For example, Cloudflare decided to raise their prices in Q3 for the first time in 12 years which, according to CEO Matthew Prince, had a negligible effect on customer retention and in fact surprised clients who wondered why the company hadn’t done it sooner
Dollar strength unwinds
USD headwinds have impacted cyber stocks especially in the second half of 2022 when the dollar peaked. The dollar peaked in late September 2022 and continued to decline in the last quarter of 2022 and this trend has continued so far this year. The weakening dollar makes the companies in the Foxberry Tematica Research Cybersecurity & Data Privacy basket considerably more competitive and if the dollar continues to fall based on the trajectory that it’s on then that’s a positive tailwind for the competitive landscape in the basket. The index is roughly 74% US-listed equities so a weakening dollar has the potential to turn a headwind last year into a tailwind this year.
3. Why high revenue purity can optimize exposure to future cybersecurity growth
We’ve argued that cybersecurity has been caught up in a broad technology selloff and markets perhaps haven’t spotted the nuances between the prospects of the industry and broader technology. You may take the view that cybersecurity is a theme that is poised to continue growing – and we haven’t even touched on the megatrends in this piece such as the explosive growth of internet of things expanding the attack surface and driving expenditure on cybersecurity. If you take this view then you may want to consider gaining more focused exposure to cybersecurity and avoiding a higher correlation to broader technology. This is why we designed the Foxberry Tematica Research Cybersecurity & Data Privacy basket index to use revenue-purity weighting which maximises exposure to pure-plays and companies that derive a higher proportion of their revenues from cybersecurity companies. It avoids exposure to non-pure-plays or companies that have less than 20% of revenues attributable to cybersecurity. It is therefore one option in the market to optimize exposure to the cybersecurity theme rather than just providing a broad technology exposure.
Related ETF
CYBR: Rize Cybersecurity and Data Privacy UCITS ETF
References:
[1] Crunchbase, “Tech Layoffs: U.S. Companies That Have Cut Jobs In 2022 and 2023”, March 2023. Available at: https://news.crunchbase.com/startups/tech-layoffs/
[2] F5 Networks, “F5 Reports 2% Revenue Growth in its First Quarter of Fiscal Year 2023”, January 2023. Available at: https://investors.f5.com/media/document/ca784611-3a67-41dc-8bfe-2ab56babf3ce/assets/Q123%20Earnings%20PR%20(1-24-23).pdf?disposition=inline
[3] FactSet, Tematica Research, February 2023
[4] Ibid
[5] CNBC, “CrowdStrike shares tumble on weaker-than-expected growth in new revenue”, November 2022. Available at: https://www.cnbc.com/2022/11/29/crowdstrike-shares-drop-on-weaker-than-expected-growth-in-new-revenue.html
[6] Ibid
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