Splunk: A Heavily Undervalued – GuruFocus.com

Introduction

Splunk Inc. (SPLK, Financial) is a competitively advantaged, sticky software suite that will only grow in importance as the data economy grows and large corporations’ digital infrastructure needs increase. The company provides software that collects data from IT infrastructure and software applications, allowing enterprises to collect, operationalize, search and analyze their data for productivity, security, profitability and competitiveness. The Splunk platform has three primary categories of offerings:

• Splunk Security: Allows enterprises to modernize their security operations with advanced data, analytics and operations to guard against online threats.
• Splunk IT Operations: Helps enterprises minimize outages with a full stack IT management solution with monitoring, predictive analytics and troubleshooting.
• Splunk Observability: An all-in-one monitoring solution for problem detection and resolution, with infrastructure monitoring, log analytics, incident response and more.

Splunk counts 92 companies out of the Fortune 100 as customers. However, despite being a category leader, the company currently trades at a massive discount to the sector due to misperceptions of its financials and a high degree of confusion and uncertainty around the sweeping transitions the company is currently undergoing.

A new way to measure

A core aspect of these changes is the company’s complete overhaul of its revenue model. Over the past two years, Splunk has:

• Switched from perpetual licenses to subscriptions, affecting measurement of revenue.
• Completed the transition from term billing to annual invoicing, which affects not only revenue but also cash collection and operating cash flows.
• Moved from a fixed subscription cost to workload-based pricing.

The effects of the transition from perpetual licenses to subscriptions has caused a pause in Splunk’s revenue trajectory, which was negative in fiscal 2021 (the company’s fiscal year ends in January). There has, however, been a steady return to growth. Operating cash flows went negative, but bottomed out around the middle of 2021 and are steadily recovering.

Although financial results have turned a corner and are heading toward normalization, Splunk’s revenue is still tracking below its annualized recurring revenue. The company’s trailing 12-month revenue stands at $2.51 billion versus current ARR of $2.83 billion, which is really how investors should be thinking about the company’s top-line trajectory during this revenue model transition.

A massive discount

Splunk trades at a massive discount to its peers and is nearly 50% off its all-time highs from mid 2020, when revenue growth went negative, which forced management to pull guidance amid looming uncertainties. For comparison, here’s how Splunk stacks up against other peers in the infrastructure and system analytics space:

Companies	EV / Revenues (TTM)	Revenue Growth (Quarterly YoY Growth)
Datadog (DDOG, Financial)	48.2x	74.9%
Dynatrace (DT, Financial)	15.1x	31.6%
Elastic (ESTC, Financial)	10.4x	42.2%
Average	24.6x	49.6%
Splunk	7.9x	19.0%

Splunk’s revenue growth numbers underrate ARR growth, which is up 37% year over year versus the 19% growth from the most recent quarter.

Catalysts for 2022

With all of the changes to the business model and billing processes, it is likely the ongoing resolution of these issues could be catalysts for growth in 2022. It is also possible the new workload-based pricing implemented over the past year will lead to much greater usage. The precedent for this assumption is the high growth rates posted by data warehouse company Snowflake (SNOW, Financial), which has been wildly successful with that billing model. As Splunk Chief Financial Officer Jason Child noted, when clients move to workload-based pricing, data volume in the cloud goes up between 1.5 times to 2 times as customers become less worried about over-provisioning. He also noted the company has never had any attrition off workload-based pricing.

There are also multiple precedents for stocks becoming wildly successful on the back of a pivot from perpetual licenses sold on premise to cloud-delivered subscriptions. Most famously, Adobe (ADBE, Financial) did so between 2013 and 2015, and Autodesk (ADSK, Financial) pulled off a similar transition between 2016 and 2018.

In addition to the new workload-based pricing and the tandem transition to cloud and subscription, even non-cloud term licenses, which went from full-term billing to annual billing a few years ago, is coming up on the third year of that transition and should also normalize. Contract term lengths have traditionally been between two and three years, but are now getting shorter as customers continue to shorten term lengths as they navigate their moves to the cloud. As Splunk laps the length of these expiring contracts, even the non-cloud portion of the business should see steadier growth rates.

Valuation

Using a crude back-of-the-envelope calculation – if Splunk were to be valued in the same ballpark as Dynatrace or Elastic, whose revenue growth most closely resembles Splunk’s ARR growth, then Splunk’s enterprise value-to-revenue should also be falling in the same 10 to 15 times ballpark. Based on that alone, one can expect a 1.5 to 2 times increase in the stock price.

Since Splunk is larger, older and more established (founded in 2003), with more than 3 times the revenue of these cloud native upstarts, it suffers from the unfair reputation of being viewed as “legacy” tech. This reputation may warrant some discounting of the stock price.

Despite these perceptions, there is clearly a large enough gap wherein Splunk can easily find itself doubling in the next few years as the gap between revenue and ARR continues to close and its currently diverging, helter-skelter financial metrics begin to fall in line with one another.