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As much of the tech industry resets after years of hypergrowth, investors are searching for areas of continued growth and future potential. One sector that shows such promise is cyber, which is growing at 10% per annum. (Fig 1)
As a result, growth is currently the most critical factor in cyber value generation. But this is a moving target — what's driving stock market value today may not hold steady for the next six months or a year. Here's a look at how cybertech leaders and investors can make the most of this evolving value landscape.
Current market observations
Unlike many sectors within tech, growth continues to trump profitability in the cyber market. Several midsize industry players with growth rates between 50% and 110% CAGR command 20x to 30x revenue multiples. (Fig 2) Newer companies are also realizing substantial multiples, linked to higher revenue growth rates. These newer players are achieving this growth through their success in addressing critical cyber problems, like data security and privacy. It is interesting to note that some of the lift to revenues came from Work From Home tailwinds that drove increased need for security products, but how much of the tailwind came from this Covid impact is unclear.
Higher EBITDA margins, meanwhile, are not currently associated with higher market values. In fact, many firms seeing substantive multiples are not meeting the Rule of 40. (Fig 3)
Taken together, current market preferences prioritize growth above profit. Given the rapid rise of technology adoption and the speed of innovation, it makes sense: While many highly-valued companies may not currently show a profit, the downstream need for their digital solutions should lead to an eventual stabilization of value, revenue, and multiples.
Drivers of cyber performance
There are several drivers of this cyber performance landscape.
First are investments across areas such as research and development (R&D) and sales and marketing. While these efforts contribute to rapid growth, they also drive negative EBITDA, meaning they are most likely temporary rather than permanent industry characteristics. It's also worth noting that the majority of R&D investment is organic, especially given the current trend of scaling back M&A deal activity. This organic approach can potentially drive even greater value if companies bring products or services to market that address specific industry challenges.
Given the supremacy of great product in cyber it will be challenging for Tech leaders to drive overall cost reductions in R&D while maintaining the growth that the market values. If anything, recent trends, including Artificial intelligence will exert upward pressure on technology spend.
Labor costs also play a role in value generation. For example, best cost country (BCC) utilization has been correlated with increased Rule of 40 performance up to BCC levels between 15% and 20%. (Fig 4) Companies also need to find a balance between cost and quality. While lower-cost labor is available across multiple geographic markets, costs that are too low can spook investors who are concerned about output quality. On the high-quality, high-caliber side, Israel remains one of the top choices for talent.
Implications for value generation
All of these factors carry several implications for value generation. The first is volatility. While stock markets and analysts currently prioritize growth over profitability, even to the point of a negative correlation between higher EBITDA margins and higher market values, this could quickly change as market forces shift. For companies, this requires preparation to pivot on demand if the value landscape shifts.
At a high level, there are three implications for cybertech firms and their investors.
- Ensure liquidity for the next 18-24 months
Liquidity allows companies to react as needed to changing market forces. Too much investment, too soon, can put organizations in a challenging position if growth and revenue don’t materialize. In practice, this means optimizing investments in R&D etc. to ensure they’re commensurate with returns. In addition, look out for transient opportunities to acquire cutting-edge technology or research as some companies — possibly older firms or newer companies that spent too much, too fast — fall out of favor.
2. Enhance operating models to enable faster growth
The right operating model can help foster improved growth. One of the most influential models is "as-a-service" (aaS). By adopting aaS software, platform, infrastructure, security, or analytics (to name a few), organizations can enhance overall interoperability and accelerate onboarding, in turn increasing profitability.
AI is already an important topic on the product side, for example to differentiate actual threats from noise in threat detection. Cyber firms should not stop there. AI can help drive efficiency across the enterprise, perhaps consider building a center of excellence that can help drive best practices across the enterprise in a prioritized fashion
BCC up to 20% also allows companies to increase their potentially available workforce and improve margins at scale. Given the specialized nature of the work, we’d encourage those cyber firms new to utilizing offshore labor to start with India or Israel, Indian due to the sheer scale of the available tech talent and Israel due to the large amount of existing cyber talent.
3. Improve public and investor relations around new products
Employees and customers drive value growth. As a result, public relations (PR) around new products and developments are now essential to generate positive word of mouth, keep customers engaged, and potentially attract new talent. This means keeping audiences in the know about recent advancements across the industry and speaking directly to work being done within the company. Expectations need to be managed, as public markets are fickle and there are several recent examples where good performance that was slightly lower that expectations contributed to large share price declines. If businesses can excite investors and buyers about what comes next, they can encourage more reliable cash flow and better market valuation.
Steady as she goes: Managing a moving target
Current market forces put growth above profitability in cyber. We don’t view this as a sustainable situation. Over time, companies and investors must be prepared to demonstrate profitable growth better aligned with the Rule of 40.
Consider new, high-growth firms. While new solutions to old problems or innovative approaches to current operations have seen them generate massive value, especially in organic R&D, these companies will eventually need to demonstrate a profitable business model. If outcomes don't match expectations, the resulting fall could be problematic for business leaders and investors. We have notices several high performing cyber firms are already having more substantive discussions on growth versus margin.
As a result, companies should be ready for high valuations to contract and trigger potential consolidation. In order words, while value targets are moving, cybertech companies are best served by staying the course. Armed with the knowledge of current market forces and likely industry outcomes, a steady-as-she-goes approach can help firms better manage to moving targets.
