Data breaches have become almost commonplace in recent years. Over the last two years, high-profile cases of cyber hacks have increased the demand for sophisticated software and security products. Companies across the globe are growing more aware of the potential threat, which is leading to a greater allocation of resources towards companies that help mitigate such risks. The Nasdaq CEA Cybersecurity Index is designed to track the performance of companies engaged in the Cyber security sector that provide protection of the data integrity and network operations. The Nasdaq CEA Cybersecurity Index is the underlying index for the First Trust Nasdaq CEA Cybersecurity ETF (CIBR).
Growing Demand
The increasing complexity of cyber-attacks is driving the growth of companies that detect and offer protection from such breaches. Cybersecurity is a unique area of technology that has garnered the attention not only of investors, but governments and corporate boardrooms alike. Over the last few years, major cyber-attacks have shaken the corporate world impacting names like Target, Home Depot, and Sony Pictures. Cyber-attacks go far beyond impacting the bottom line of a company; they can also harm the reputation, brand, and customer base.
The impact of such threats has grabbed the attention of the White House, where President Obama has deemed cybercrime to be one of the biggest issues facing national security. In addition, the President’s 2016 budget is proposing to allocate $14 billion1 in spending to fund critical initiatives and research in the cybersecurity space.
In the boardroom, a recent study conducted by Piper Jaffray indicated that cybersecurity spending is among one of the top priorities in 2015 for Chief Information Officers of major corporations, with 75% of respondents expecting to increase spending on these initiatives in 2015.2
On the investment front, major data breaches have gathered more than just the attention of major venture capital firms. Over the last two years, venture capital firms have poured $4.6 billion into cybersecurity startups.3
Source: CB Insights
In public markets, retail and institutional investors alike have also been attracted to the space as witnessed by the steady increase of assets in exchange-traded products (ETPs) tracking the cybersecurity sector.
Nasdaq CEA Cyber Security Index
The Nasdaq CEA Cyber Security Index is designed to provide investors an index that tracks companies actively involved in the cybersecurity sector and well positioned to benefit from the positive trends unfolding in the space.
To be included in the index a security must:
1. Be classified as a Cybersecurity company as determined by Consumer Electronics Association (CEA);
2. Have a worldwide market capitalization of $250 million, have a minimum three-month average daily dollar trading volume of $1 million, and have a minimum free float of 20%.
A unique characteristic of the Nasdaq CEA Cyber Security Index is its emphasis on constituent liquidity. The Index employs a modified liquidity weighting methodology, focusing on the average daily dollar trading volume.
In addition, the $250 million market capitalization threshold ensures that more mature and established companies are included in the index. When compared to the ISE Cyber Security Index, the average market capitalization of the Nasdaq CEA Cybersecurity index is $11.9 Billion versus an average market cap of only $8.6 Billion of the ISE Cyber Security Index.
Top Line Growth
The increased allocation of resources towards cybersecurity companies is evidenced by the explosive sales growth experienced over the past three years.
As of 6/30/15
On average, constituents in the Nasdaq CEA Cybersecurity Index have seen revenues grow by 85% over the trailing three years. When compared to the ISE Cybersecurity Index and the more traditional S&P 500 Information Technology Index, the Nasdaq index includes companies that have displayed more favorable growth characteristics. Currently eight of the top 10 index constituents in the Nasdaq CEA Cybersecurity Index have experienced sales growth of 50% or more over the past three years.
Free Cash Flow
In addition to just the top line, it is essential to analyze a company’s ability to generate cash; after all, as the old mantra says: cash is king.
Given the relatively young age of the cybersecurity industry and the increasing demand for their services, companies in this space have a necessary focus to reinvest cash back into the business in forms of research and development, human capital, and asset purchases. The price-to-earnings ratio, although a useful valuation metric, may not be best suited as a metric in such a high growth sector. The price-to-free-cash ratio is a more appropriate metric in analyzing these names because it gauges a company’s operating cash flow, after it has invested capital back into the business.
The Nasdaq CEA Cybersecurity Index is currently trading at 43 times free cash flow, meaning that investors would be willing to pay $43 for every $1 of free cash flow generated by the companies in that index. Comparatively, the Nasdaq CEA Cybersecurity Index is displaying a more attractive price-to-cash-flow ratio than the ISE Cybersecurity Index, which has a ratio of 56.
One may argue that the ISE Cybersecurity Index is at a higher cash flow multiple because the constituents in that index are investing more heavily into their businesses relative to the Nasdaq Index. Data dictates that is not the case as witnessed by the percentage of sales that are allocated to research and development. On average, the constituents of the Nasdaq CEA Cybersecurity Index invest almost an equal amount as the names in the ISE Cybersecurity Index.
The Nasdaq CEA Cybersecurity Index contains companies that not only exhibit greater revenue growth, but also trade at more attractive valuations when compared to the ISE Cybersecurity Index.
Index Performance
*Prior to June 23, 2015 is back tested data
The Nasdaq CEA Cybersecurity Index has demonstrated very strong cumulative return over the historical period beginning December 31, 2010. Over the last three years, the Nasdaq CEA Cybersecurity Index is up over 85%.
Summary
The Nasdaq CEA Cybersecurity Index was created to provide investors a benchmark for the rapid growing cybersecurity sector. Over the last few years, high profile data breaches have increased awareness of the need to protect the information of governments, corporations, and individuals globally. The increased awareness and allocation of capital toward cybersecurity names has made this sector poised for future growth.
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Footnotes
2http://blogs.wsj.com/cio/2 015/01/07/piper-jaffray-security-again-the-top-cio-spending-priority/
3https://www.cbinsights.com/blog/cybersecurity-industry-startup-funding-trends/
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