Outlook 2024 - Security & Space: Cyber threats strike back

Security: cybersecurity is back under the spotlight 

Cyberthreats strike back

Forget the post-SolarWinds hangover: cybersecurity is back with a vengeance! The perennial structural drivers that we had identified at the time remain unchanged, and notably the clear need to upgrade cybersecurity infrastructures in order to address new emerging threats after years of underinvestment.

But the sector is now benefiting from the resurgence of such threats, as exemplified by the recent high-profile hack of MGM. This revival also comes after a period during which new-generation players have focused on their cost structure while still generating substantial growth compared to legacy ones: the multiple compression that occurred in the past few quarters, therefore, appears less and less justified, and a simple return to a historical forward P/S for leading non-legacy players (e.g., Zscaler Inc) implies upside in the 70-80% zone. Last but not least, executives now know they are responsible for hacks in front of their investors, as exemplified by the SEC suing SolarWinds’s CISO: facing the risk of potential jail time, we think C-level executives will prefer untying the purse strings to invest into cyberinfrastructure.

For all these reasons, we stand firmly on our ground: cybersecurity faces secular growth tailwinds, which will inevitably boost the segment's addressable market in a durable fashion. Most of the bad news appears priced-in already, multiples are relatively attractive (12m forward P/S showing a ~30% discount to historical value for the top half of our cybersecurity allocation), and the sector appears relatively protected from a potential recession.

We favor new-generation players with a clear technological edge over legacy players, which we see faltering due to them losing touch with the most recent technology: as an example, one just needs to look at the difference in growth dynamics in the endpoint security segment between CrowdStrike Holdings Inc (~30% 2023-26e revenue CAGR) and Gen Digital (~8%) to infer which category of player will lead what is expected to be a $350bn market by 2027. Most importantly, we believe the momentum is slowly shifting towards platform players after favoring a best-of-breed approach, hence a focus on players with a widening integrated approach such as Palo Alto Networks Inc.

AI to accelerate in the security landscape

Artificial intelligence (AI) has been a hot topic in 2023, something we discuss in our Artificial Intelligence and Robotics outlook. The technology already has substantial implications in the Security & Space theme. As a matter of fact, it is already largely employed in the cybersecurity industry: Machine Learning (ML) algorithms have indeed powered a transformational leap in endpoint security, allowing the transition from reactive security (based on signature detection) to preventive one (based on behavioral analytics). We have no doubt that the ongoing progress in AI will turbocharge applications in this field as well.

AI will also have concrete applications in the physical world. We see the most notable one being in the surveillance segment. The most recent generations of cameras are already equipped with some visual recognition technology, but the recent progress in AI will take it to an entirely new level. It will, for one, give surveillance devices the ability to analyze a scene and deliver potentially critical information much faster than if this analysis had to be run by a human operator in the loop, who generally has to monitor several cameras at the same time. However, such devices will have to comply with privacy regulations, as they have the potential to turn our daily lives into a truly Orwellian hellscape. Still, we see a significant business opportunity, as traditional surveillance technology is already an easy answer for authorities facing the growing anxiety of aging societies.

Space: a clear lack of thrust

Maximum pressure

The space segment has been experiencing almost as many headwinds as could have been imagined, leading to complicated performances this far, to say the least. The SPAC bubble has definitely imploded, with the narrative shifting to other sectors and the hype not resisting the (widely expected) succession of quarterly losses. More worrying but not unexpected, the sector is experiencing a funding crisis aggravated by high interest rates.

Some prominent companies have already fallen victim to this credit crunch (e.g., Virgin Orbit), which we expect will claim the existence of several other early-stage players. A consolidation wave has started for the more mature companies, something clearly visible among legacy satellite operators.

This downcycle is not necessarily a bad thing. Low-interest rates had enabled the rise of players making up in storytelling what they were lacking in technology and execution. Only the players with a differentiating positioning and solid perspectives (e.g., innovative imagery platforms such as Planet Labs and Iceye) can expect to make it through and receive enough funding to survive in what remains a capex-intensive industry. These players, which we believe will come from the so-called “New Space” movement, will become the market leaders once the cycle swings up again.

The moment of truth approaches for commercial constellations

We have long touted the constellation approach as game-changing for the entire supply chain. Until recently, although this approach was no longer purely theoretical it still remained largely a technological proof-of-concept rather than a solid business case. This period of uncertainty is approaching its end, as according to recent news SpaceX’s Starlink is supposedly at cash flow breakeven.

Although some doubts about such news can be legitimate due to the company being private and benefiting from its own launch infrastructure, Amazon.com Inc will soon proceed with the rollout of its Kuiper constellation and, being a public compan, will not be able to hide potential setbacks. Other constellation projects are also in the pipeline, and much more will emerge if the technology is economically viable. In such a scenario, constellations will enable nothing short of a revolution, bringing high-speed connectivity everywhere across the world. 

Considering the incoming mass to launch, the current launch infrastructure is critically lacking, especially with the retirement of older generations of boosters and the delay in producing new ones. This gap creates a void in which some players will have a major card to play. Apart from the inevitable SpaceX, our favorite player remains Rocket Lab, which has demonstrated focus, vision, and execution, and is developing a new booster precisely targeting this market, with a maiden flight expected in 2024.

Do not forget the dream

The monetization of space was historically not a given, as it was first a strategic playground for governments. In some sense, this remains the case, as they are critical enablers of many space programs through defense budgets and high-visibility missions. One of those, the return to the Moon, is expected to reach important milestones next year with several test launches of SpaceX’s Starship, on which the lunar lander will be based.

If successful, NASA may have no choice but to discard its white elephant SLS. This would free a substantial budget to allocate to other missions, such as contracts with private space station developers, which would benefit the entire ecosystem. Such stations would enable fully-private space-based ecosystems and act as motherships for further developments, and their timeline is not that distant: the International Space Station will meet its demise by the early 2030s. But most importantly, the Starship developments would clearly accelerate the space ecosystem's timeline, providing something very potent in stock markets: a powerful narrative.

Defense: the wake-up call

Continuous lessons from the Ukraine invasion

We do not invest directly in weaponry suppliers for ESG reasons, but it is nevertheless interesting to have a look into the Defense vertical due to implications for the main other areas in the theme. After all, defense is a form of security, and many of the innovations from the space sector were originally developed with military use in mind. In this regard, a defining event occurred in 2022 with the invasion of Ukraine by Russia.

Geopolitical consequences are still unfolding, as the conflict is still ongoing, but military operations will be transformational for the defense sector for the decades to come. It is not an exaggeration on our part: this war is the first 21st-century high-intensity conflict opposing what was previously considered cutting-edge equipment, and has already provided some major lessons.

The most important one, in our view, is the importance of data and communications to level gaps in manpower and quantity of equipment and weaponry. The more data, the better the situational awareness, which can make the difference between victory and defeat. This implies high-speed datalinks, which were, in this case, critically provided by SpaceX’s Starlink constellation: we can therefore expect many additional military constellations to launch in the next few years, which will be a driver for the launch segment as well as for the satellite manufacturing supply chain. And technologies used in these constellations will also be applied, ultimately, to civilian applications.

The second one is the importance of drones, which is co-dependent on the existence of good communication networks. This war shows every day that such drones are used to gather intelligence, but also to attack, either by dropping explosives or with kamikaze missions. In essence, this war shows us that future conflicts will be fought with swarms of killer drones, something to which armies will have to adapt to. For the non-military market, this may lead the security market to become increasingly automated, but also accelerate innovation in adjacent sectors such as drone-based delivery and autonomous vehicles.

AI will gain importance

For the moment, such drones are controlled by human operators in a close decision loop, but some tactical decisions could in the future be delegated to AI. This will, of course, be the subject of intense scrutiny for obvious ethical reasons, and we think humans will remain in the loop for important decisions such as opening fire. Still, progress in AI could offer more autonomy and flexibility to unmanned vehicles, something quite valuable on battlefields, which makes us believe that it is rather a matter of when rather than if - especially with the first tests of AI-controlled unmanned vehicles already happening. Be ready for security robots!

On the other hand, AI is likely to make a huge difference in intelligence collection and data analytics in the short term. Players such as Palantir Technologies Inc have already built data platforms targeting the military, offering the possibility to accelerate and enlighten the decision process with obvious advantages in conflictual situations. This implies the implementation of a consistent data infrastructure and, therefore, the digitization of equipment and armies. Manpower will remain important of course, but warfare is inevitably becoming digital and network-centric.

This will benefit the entire theme and open investment opportunities without having to invest directly in weaponry suppliers. In addition, innovations born in the military sector almost always find their way into the civilian world. In this regard, the defense segment is more than ever a bellwether for future trends in the security and space sectors, making those two critically interlinked. Considering recent developments, we can therefore expect no shortage of innovation, which guarantees exciting times ahead for savvy investors.

Catalysts

• Major hacks. Seismic cyberattacks often act as a wake-up call to invest in cyber defenses. Increasingly profitable, there is no reason to believe their frequency will decrease. 

• New launchers. New generations of launchers are entering or about to enter the testing phase. They promise lower cost, potentially triggering an acceleration of the space economy. 

• Extension of conflicts. The persistence of current conflicts and the occurrence of new ones would boost defense budgets, and accelerate the transition towards technology-centric warfare.

Risks

• Credit crunch. Many subsegments of the theme are capex-intensive, especially on the space side. A persisting period of credit tightening could lead to major development slowdown, or even failures. 

• Unfavorable technology breakthrough. Although unlikely, any sudden breakthrough would render the current defensive infrastructure useless and force players to adapt. 

• Regulation. Regulation has been positive up to now, but security businesses are highly sensitive. In the event of major tensions, regulation could be tightened extremely fast and hamper business development.