Splunk (NASDAQ:SPLK) is a leader in data monitoring and security. Their mission is to help enterprises turn “data into doing” through dashboard visualizations and machine learning. The company was founded in 2003 and had their IPO in 2012. Since then, the share price has been volatile for investors, it increased by 145% up until 2014 and rose to $93 per share. However, there has been major volatility and multiple declines over the past few years. In 2020, the stock price went on a major bull run and increased to ~$200/share. However, the stock price has now slid down by 54% thanks to increasing losses and rising interest rates, which is negatively affecting the valuation for growth stocks.
The good news is the company is poised to benefit from three major macro tailwinds. The first is the abundance of “Big data” which has been called the “new oil” and is a market forecasted to grow from $162 billion in 2021 to $273 billion by 2026, registering a CAGR of 11%. While enterprise IT software spending is expected to grow at 9.8% this year, reaching a value of $674.9 billion. Big data isn’t going away, and neither is the need to gain visibility into this data and ensure it’s secure. The rise of remote working and the increasing use of cloud applications means the “attack surface” is even greater for hackers. Thus the global Cybersecurity Market was valued at $133 billion in 2021, and is forecasted to grow at a rapid CAGR of 14.1% from 2022 to 2027.
Splunk is poised to ride these industry trends, they have increased R&D spending substantially and free cash flow turned positive in 2021, which could be an early indicator of their new business model is gaining traction. The company also has a high customer retention rate (132%) which indicates customers are staying with their product and spending more. Given these factors the stock is now trading at the lowest price to multiple sales (PS = 5.6) relative to history and is intrinsically undervalued. Let’s dive into the business model, financials, and valuation to find out more.
Transition Business Model
Splunk is a leader in data monitoring and security. Enterprises are producing a vast amount of different data types from an array of sources. These include public clouds, on premises data centers and the network edge. This data is often kept in “silos” and thus isolated and not utilized effectively. Splunk’s mission is to turn this “data into doing”, by helping companies to observe, track, analyze and secure the data. Splunk’s platform dashboard has two main functions “Observability” and “Security”. The data captured can be observed via dashboards and visualizations. While machine learning can be utilized to spot anomalies and help to stop cybersecurity threats.
The company is currently going through a major business model transition, to a “workload based” or data usage pricing model. Basically, the more data a company analyzes and uses the more they will be charged, similar too many other cloud services such as AWS. This will be a step change from the previous “premium pricing” the company was known for in the industry. Splunk’s offering is highly regarded in the industry, three branches of government and all four branches of the US Military have deployed it. A unique part of Splunk’s offering is the vast number (2400+) of “Splunkbase Apps” which have been built by the community. These apps range from extra visualization and security tools to database connectors and those to help with PCI compliance, which is vital for the financial/card payments industry.
Splunk’s revenue has jumped from $2.2 billion in 2020 to $2.6 billion in 2021, which is a rapid increase of 18%. However, it should be noted that this revenue is only up to 13% over the past 2 years, which could be one reason the company is changing their business model.
They invested $1 billion into R&D in FY2021, representing a substantial increase of 42% from the previous year. While S&G expenses have also increased by 25% to an eye watering $2 billion as they invest for future growth. Thus for FY2021, they racked up a heavy operating loss of $1.1 billion.
The company’s gross and operating margin have declined slightly (above chart), but the gross margin is still high at 72%, which is a benefit of a SaaS based business model.
Relative to competitors and industry peers (chart below), Splunk’s 73% gross margin is closest to SolarWinds (SWI) also at 73%. While other companies such as PagerDuty (PD) and Dynatrace (DT) have higher gross margins at the ~82% level.
The good news is the most important metric, “Free cash flow” has been trending positively from an eye watering -$400 million in mid-2020 to -$242 million by the end of that year. For FY2021, free cash flow came in at a positive $108 million. This is a great sign of an improved business model and could be an early indication of a bounce back.
If I compare the company’s free cash flow to competitors, it is clear to see Splunk is producing less free cash flow than most peers and this could be one reason the stock is trading cheap. SolarWinds definitely seems most similar from a financial point of view and generated $156 million in free cash flow.
Splunk has an extremely high net dollar retention rate of 132%, up a couple of percentage points from prior quarters. This means customers are staying with the company and spending more.
On the balance sheet, the company has $1.4 billion in cash and $286 million in short-term investments with long-term debt of $3.1 billion. This is fairly high for a “growth” company but at least their short-term debt (due in the next 2 years in minimal, current ratio = 1.56.
In order to value Splunk, I have plugged the latest financials into my valuation model, which uses the discounted cash flow method of valuation. I have been very conservative with revenue growth estimates, forecasted 16% for the next 2 to 5 years, which is actually less than the most recent years growth of 18%.
I am forecasting a substantial increase in Splunk’s operating margin from -27.46% to 30% in the next four years, at the top end of the software industry average.
In order to improve the accuracy of the valuation I have also capitalized their Research & Development expenses. Such as the $1 billion investment in FY2021 and $791 million in FY2020.
Given these factors and computing all the financial data I get a fair value of $97 per share which means the stock is fairly valued at the current level. It was undervalued when I began writing this post but has since risen 10%. The company is also trading at the lowest Price to Sales Ratio relative to history with PS = 5. As market predictions of increasing interest rates have compressed PS multiples, we shall look at the relative price to sales multiples for a better indication of value.
Splunk is currently trading at a forward price to sales ratio = 4.5. This is the 2nd lowest in the industry, just above SolarWinds which trades a forward PS = 2.4. PagerDuty trades at a higher level with a PS (forward) = 5.6 and Dynatrace trades at a PS (forward) = 8. The company is also often compared to Datadog (DDOG) although they do different things and DDOG is growing much faster and thus has a much higher valuation with PS (forward) = 19.
As mentioned previously there is a vast amount of competition in the “data monitoring” industry. With companies such as SolarWinds, PagerDuty and Dynatrace. There is also competition from large incumbents such as Cisco (CSCO) with their AppDynamics and even Microsoft with their Azure Network Watcher. Increasing competition could keep growth mutated for the company.
Rising Interest Rates
Morgan Stanley has forecasted at least 6 interest rate hikes in 2022, as the Fed tries to control the high inflation. A higher interest rate means higher discount rates and a compression in multiple valuations for growth stocks. This is the biggest threat to all growth stocks right now and is keeping them at depressed levels. Higher interest rates also raise the cost of servicing none fixed rate debt and thus Splunk’s $3.1 billion in long term debt could become more expensive to service. On the plus side high inflation devalues debt so it is really two forces acting out.
There are plenty of opportunities in the market right now in blue-chip tech names which are immensely profitable (unlike Splunk) but also had major declines. These include many of the FANG stocks, but mostly Meta (FB), Netflix (NFLX) and Amazon (AMZN).
Splunk is a fantastic company and was a true pioneer in the data monitoring industry. Their new focus on subscriptions and a usage-based model seems like a great strategy moving forward and should give the company more mass appeal. They have increased their R&D and sales expenses substantially which have come into operating profit, but free cash flow is positive and has shown a large uptick. The competition in the industry is fierce from the aforementioned competitors. In general, the stock is fairly valued intrinsically and relatively undervalued. They are releasing earnings in just a couple of weeks so I expect further volatility around that point.