Splunk: An Undervalued Software Category Leader

Splunk remains a competitively advantaged, sticky software suite that will only grow in importance as the data economy grows and large corporations' digital infrastructure expands

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Aug 16, 2022
Summary
  • Splunk defends its data market leader position with existing enterprise customers’ stickiness and expansion to cloud offering.
  • Splunk’s revenue is back on growth trajectory as its cloud transition, workload-based pricing and licenses transition stabilize.
  • Splunk is at the crossroads to achieve breakaway momentum on its cloud transition.
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Splunk Inc. (

SPLK, Financial) provides software that collects data from IT infrastructure and software applications, allowing enterprises to collect, operationalize, search and analyze data delivered from any type of digital device or systems. The company divides its offerings into three general categories: Splunk Cybersecurity, Slunk IT systems and Splunk Observability Cloud.

Despite category leadership, the company currently trades at a massive discount to the sector, which could be due to misperceptions of its financials and confusion around not one but several transitions the company is making simultaneously.

Splunk’s busy three years led to its unique cheap price

Splunk had three eventful years with multiple transitions, many of which are still ongoing, including:

  • Perpetual licenses to subscriptions, which affects revenue.
  • Complete term billing to annual invoicing, which affects not only revenue but also cash collection and operating cash flow.
  • On-premise to cloud-first, including the development of its observability suite with the help of several tuck-in acquisitions.
  • Fixed subscription to workload-based pricing.

The transition from perpetual licenses to subscriptions caused a pause in Splunk’s revenue trajectory, which actually went negative in fiscal 2021 (-5.5% year-over-year), but has begun returning to growth (20% in fiscal 2022). Operating cash flow went negative (-$191 million in fiscal 2021), but bottomed around the middle of last year and is steadily recovering ($128 million in fiscal 2022 and $143 million in fiscal Q1 2023)

Even though financial results have turned a corner and are heading towards a normalization, Splunk’s revenue is still tracking below its annualized recurring revenue (ARR) - trailing 12-month revenue is $2.85 billion vs. current ARR of $3.21billion. ARR is really how investors should think about the company’s top-line trajectory during the transition.

Aside from the confusing financials, Splunk may be suffering from the perception that cloud-native competitors may be eating into its market share. Additionally, the entire SaaS sector's stock valuation mutliples are suffering due to higher inflation and interest rates. Splunk fell again along with the sector as general economic pessimism and uncertainty has mounted.

As a result, its stock price has become truly dislocated after a series of unfortunate events.

Why is Spunk a compelling opportunity?

It’s true that competitors like Datadog (

DDOG, Financial), a “cloud-first” competitor, are growing much faster than Splunk, and investors still seem inclined to favor “cloud-first” tech companies that have disrupted legacy tech companies in other verticals.

However, Splunk’s case is a little different. It primarily focuses on large enterprises and has claimed and retained over 90 of the Fortune 100 companies, even during the bumpy transition. Datadog, on the other hand, is mostly geared towards small and medium-sized businesses.

Furthermore, Splunk trades at a massive discount to its peers and is nearly 50% off its all-time highs from mid-2020. Here’s how Splunk stacks up against some of its closer peers, based on current revenue growth and enterprise-value-to-sales ratios:

Company

EV / Sales (TTM)

Revenue Growth (Quarterly YoY Growth)

Datadog (

DDOG, Financial)

53.1

74%

Dynatrace (

DT, Financial)

21.1

32%

Elastic (

ESTC, Financial)

15.2

42%

Splunk (

SPLK, Financial)

6.32

34%

The above players are not perfect comps as they have slightly different (if overlapping) product portfolios and customer bases; however, each has revenue and ARR more or less in line with each other, and EV-to-sales seems to correlate with revenue growth. If Splunk were to be valued in the same ballpark as Dynatrance or Elastic – whose revenue growth most closely resembles Splunk’s ARR growth - its EV-to-sales ratio could reach the same ballpark of 15 to 22. That would mean a two to three-fold increase in the stock price.

Tying the total available market in can shed light on the likelihood of these target prices occurring. Splunk taps a total addressable market of $114 billion, compared with $80 billion in 2020. Note that Splunk's fiscal 2021 revenue represented 2.9% of the total share of the category. Keeping this share of total revenue constant for Splunk, it would imply that Splunk's revenue could potentially reach $3.28 billion in five years conservatively ($114 billion TAM * 2.9% = $3.28 billion). Taking a discounted EV-to-sales ratio with the benchmark data above, let’s say a very conservative 11, I get a current fair value estimate of $224, much lower than the current price of $107.

Conclusion

Given a “perfect storm” of events over the past few years, a very pessimistic scenario is being priced into Splunk that has de-risked the stock in a normally highly-priced sector. At the same time, the growth of data and the digitization of the enterprise gives Splunk very favorable long-term growth prospects. The stock could potentially double over the next two years by my estimates, which would be a terrific feat for this undervalued category leader.

Disclosures

I am/we currently own positions in the stocks mentioned, and have NO plans to sell some or all of the positions in the stocks mentioned over the next 72 hours. Click for the complete disclosure
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