splunk (NASDAQ:SPLK) is a leader in data monitoring and security. Their mission is to help companies turn data into action through dashboard visualizations and machine learning. The company was founded in 2003 and had their IPO in 2012. Since then, the The share price was volatile for investors, rising 145% through 2014 and rising to $93 per share. However, recent years have seen significant volatility and multiple declines. In 2020, the stock price had a major bull run and rose to ~$200/share. However, the share price has now fallen by 54% thanks to mounting losses and rising interest rates, negatively affecting the valuation of growth stocks.
The good news is that the company is poised to take advantage of three key macroeconomic factors. The first is the plethora of “Big data,” which has been dubbed the “new oil” and is a market projected to grow from $162 billion in 2021 to $273 billion in 2026, at a CAGR of 11%. While enterprise IT software spending is expected to grow 9.8% this year, reaching a value of $674.9 billion. Big data is not going away, and there is no need to understand this data and make sure it is safe. With the rise of remote working and the increasing use of cloud applications, the “attack surface” for hackers is even greater. For example, the global cybersecurity market was valued at $133 billion in 2021 and is expected to grow at a rapid CAGR of 14.1% from 2022 to 2027.
Splunk is poised to follow these industry trends, they have significantly increased R&D spending and free cash flow turned positive in 2021, which could be an early indicator that their new business model is gaining momentum. The company also has a high customer retention rate (132%), indicating that customers stick with their product and spend more. Given these factors, the stock now trades at its lowest to sell multiple (PS = 5.6) history and is intrinsically undervalued. Let’s dive into the business model, financials and valuation to learn more.
Transitional business model
Splunk is a leader in data monitoring and security. Enterprises produce a vast amount of different data types from a range 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 used effectively. Splunk’s mission is to turn this “data into doing” by helping companies observe, track, analyze and secure the data. Splunk’s platform dashboard has two main functions “Observability” and “Security”. The captured data can be viewed through dashboards and visualizations. While machine learning can be used to detect anomalies and stop cybersecurity threats.
The company is currently undergoing a major business model transition to a “workload-based” or data usage pricing model. In short, the more data a company analyzes and uses, the more it charges, similar to too many other cloud services like 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 sheer number (2400+) “Splunkbase Apps” built by the community. These apps range from additional visualization and security tools to database connectors and apps to assist with PCI compliance, which is vital for the financial industry/card payments.
Splunk’s revenue has increased from $2.2 billion in 2020 to $2.6 billion in 2021, a rapid 18% increase. However, it should be noted that this revenue has only increased by 13% in the past 2 years, which may be one reason why the company is changing its business model.
They invested $1 billion in R&D in FY2021, a significant increase of 42% from the prior year. While S&G spending has also increased 25% to a dazzling $2 billion as they invest for future growth. So for FY2021, they posted a heavy operating loss of $1.1 billion.
The company’s gross and operating margin have declined slightly (above the chart), but the gross margin is still high at 72%, which is an advantage 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 like PagerDuty (PD) and Dynatrace (DT) have higher gross margins at the ~82% level.
The good news is the most important statistic: “Free cash flow” has progressed positively from a dazzling -$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 can be an early indication of a recovery.
When I compare the company’s free cash flow with that of competitors, it is clear that Splunk produces less free cash flow than most competitors and this could be one reason why the stock is trading cheaply. SolarWinds is definitely the most similar from a financial standpoint, generating $156 million in free cash flow.
Splunk has an extremely high net dollar retention rate of 132%, a few percentage points higher than in previous quarters. This means customers stay with the company and spend 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 quite high for a “growth” company, but at least their short term debt (maturing in the next 2 years in minimum, current ratio = 1.56.
To value Splunk, I connected the latest financial data to my valuation model, which uses the discounted cash flow valuation method. I’ve been very conservative with revenue growth estimates, forecasting 16% for the next 2 to 5 years, which is actually less than the most recent year’s growth of 18%.
I predict a substantial increase in Splunk’s operating margin from -27.46% to 30% over the next four years, at the high end of the software industry average.
To improve the accuracy of the valuation, I also capitalized their research and development costs. Like the $1 billion investment in FY2021 and $791 million in FY2020.
Given these factors and calculating all of the financials, I get a fair value of $97 per share, meaning the stock is fairly valued at its current level. It was undervalued when I started writing this post but has since risen by 10%. The company also trades at the lowest price-to-sale ratio in history with PS = 5. As market predictions of rising interest rates have compressed PS multiples, we’ll look at relative price versus sales multiples for a better indication of value.
Splunk is currently trading at a forward price to sell ratio = 4.5. This is the second lowest in the industry, just above SolarWinds trading a forward PS = 2.4. PagerDuty trades at a higher level with a PS (forward) = 5.6 and Dynatrace trades with a PS (forward) = 8. The company is also often compared to Datadog (DDOG) although they do other things and DDOG is growing much faster and so has a much higher rating with PS (forward) = 19.
As mentioned before, there is a huge 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 can dampen growth for the company.
Rising interest rates
Morgan Stanley has forecast at least 6 rate hikes in 2022 as the Fed tries to contain high inflation. Higher interest rates mean higher discount rates and a compression of valuation multiples for growth stocks. This is currently the biggest threat to all growth stocks and keeps them low. Higher interest rates also increase the cost of paying off debt without a fixed rate and so Splunk’s $3.1 billion in long-term debt could become more expensive to pay off. On the plus side, high inflation devalues debt, so it’s actually two forces acting.
There are currently plenty of opportunities in the market in blue-chip tech names that are hugely profitable (unlike Splunk) but also experienced major declines. These include many of the FANG stocks, but most notably 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 going forward and should give the company more appeal. They have significantly increased their R&D and selling costs, which has been at the expense of operating profit, but free cash flow is positive and has shown a large increase. The competition in the industry is fierce from the above competitors. In general, the stock is intrinsically valued fairly and relatively undervalued. They will publish the gains in just a few weeks, so I expect further volatility around that point.