What’s your cybersecurity stock of choice?

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SIMON BROWN: I’m chatting now with Keith McLachlan. You’ll him of course at Element Investment Managers. Keith, appreciate the early morning time. CrowdStrike AA – CrowdStrike has been my cybersecurity stock of choice. I bought it almost exactly three years ago. Back then it was $40; it’s now $220. So I’m a happy man about that. Less happy, perhaps, 30 times price-to-sales, 5% stock-based compensation.

You and I have spoken about stock-based compensation before. It’s immensely expensive, the short answer. It’s just expensive, which got me thinking there’s something else out there.

You and I have chatted before. You have different angles on the cybersecurity, different stocks in your in your quiver. What’s your thinking around the space?

KEITH McLACHLAN: Absolutely. Morning, Simon. Perhaps stand back and the sectoral view here is really simple. More and more of the economy and our lives are shifting digital. And that means that there is more potential attack surface and more at risk, and therefore not just is the information technology growing faster than GDP, but in fact, ICT, the security of that data, that access – and everything growing faster.

It’s an incredibly resilient and long-term tailwind in the sector. So there are some really great growth stories from – and you touched on them – a CrowdStrike, Palo Alto, Zscaler, Fortinet.

All of them are top tier, really good growing vectors in the global markets. Locally, we have Datatec. And then don’t forget Microsoft has got a division of it.

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But all of them, great top-line growth stories. Here’s the thing – not all of them are great bottom-line growth stories. Some of these companies are basically, in my slightly jaded opinion, actually listed compensation schemes that exist to make the employees and the insiders rich, but shareholders get absolutely nothing.

CrowdStrike – you touched on the share-based compensation, which is really part of the payroll, and instead of paying cash for a salary, for some of your salary I’m going to give you shares, which is even more expensive than cash, because they tend to linger around.

And CrowdStrike, 21% of its revenue is share-based compensation. Is that a lot or a little? Well, it’s really part of payroll; 80% of its free cash flow is, and in fact, almost 100% of its profits – 80%, 87%, rounded up to 90%.

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SIMON BROWN: Yes.

KEITH McLACHLAN: So really, Zscaler is even more toxic, where 120% of its profit is share-based compensation, shareholders getting absolutely nothing. So you’re taking all the risk, but you’re getting nothing, none of the economic benefits are flowing to you as a shareholder.

And if a valuation is nothing more than expected future cash flows attributable to you, are these things really worth anything?

That’s where I think Fortinet stands out as the gold standard, where they’ve got really, really beautiful, beautiful economics, and it does flow to the shareholders.

SIMON BROWN: And that’s the point. To be clear, the share price is up, so I’m a happy shareholder, but of course ultimately there needs to be something underpinning that. And that’s what’s missing there. I’m assuming Fortinet which you suggest – they’re in the space but not sort of paying everything back to staff. They’re actually giving some real return and some real growth to shareholders.

And it is a stock – I’m pulling up the chart – that’s doing excellently well as well.

KEITH McLACHLAN: Absolutely. Fortinet, you look at those ratios, and about 14-15% of free cash flow and profits is paid in share-based compensation, which means that you’re getting the majority of it and all is in there, because in a controlled basis share-based compensation aligns employees with the outcome that shareholders are getting. That is a good thing, that’s not a bad thing.

But abused to the maximum, it just means that shareholders get nothing and employees get all of the upside but none of the downside.

Fortinet has a beautiful balance, and it’s because its founder still runs it and still has a large equity position; so he’s actually aligned with the rest of us. Really strong free cash flows.

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All of these guys – we can get sucked into the slightly different business models and where they’re positioned in terms of the IT security market, but ultimately, if you’re not getting the benefits, it doesn’t matter. And with Fortinet, you really are. Those benefits are accruing to the shareholders, and it’s reflected in reasonable valuations. Somewhat expensive. You’re going to be hard-pressed to find cheap in this market.

But that’s really a symptom – that’s such a long-term, resilient, inelastic tailwind IT security in that all of these companies are growing at high double digits, and expected to continue growing for years like that.

SIMON BROWN: Yes, absolutely. And to be clear, Fortinet, I’ve got an EV/Sales [enterprise vale-to-sales] here for the current financial year of around 16; that compares with 40 on CrowdStrike. To your point, there’s no cheap here, but there is certainly relative, and I think that’s perhaps that’s what we’re looking for.

We’ll leave it there. Keith McLachlan from Element Investment Managers, appreciate the early morning time.

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