2023-06-25 09:09:36 ET
Summary
- Splunk, a machine-data software company, has potential for growth due to its unique focus on machine data analytics and increasing demand for automation and AI.
- Total ARR growth is sustaining in the double digits, while cloud ARR is growing nearly 30% y/y.
- Splunk's valuation remains attractive, with its revenue multiple at <5x FY24 revenue guidance.
- Careful expense management is also helping Splunk achieve its target of nearly doubling FCF in FY24.
Amid double-digit gains in the stock market this year, many investors may be thinking: is there still room to rally higher? In my view, the answer is yes, but careful stock selection is the key.
Splunk ( SPLK ) is a great name to look into. This machine-data software company is up ~15% year to date, on par with the S&P 500 but lagging behind many small/mid-cap software companies that have seen sharp rallies since the start of the year. In my view, there's plenty of rope - especially from a valuation standpoint - for Splunk to charge higher.
I continue to be bullish on Splunk. On top of making short-term trades for quick gains (Splunk has been volatile on a day-to-day basis over the past month), I am still holding onto a good chunk of Splunk stock in my portfolio. In my view, the company continues to build up an impressive ARR base, and as companies continue to focus on the advantages of automation and AI, Splunk's focus on mining machine data for actionable insights will continue to enjoy secular tailwinds.
Here is the full long-term bull case for Splunk:
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The use cases for Splunk are infinite. In its early days, Splunk's machine data-mining capabilities were often used for security purposes to flag and respond to anomalies within corporate systems. But as Splunk has evolved, the company's machine data capabilities are applicable across virtually any industry and across many functions.
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Usage-based pricing. Some of the most successful software stocks are usage-based, meaning that revenue climbs proportionally to a customer's usage of the product. Splunk's platform is charged on a data volumes/computing power basis. As data volumes continue to explode and companies push the boundaries of how they integrate data into operations and decision-making, Splunk has a tremendous opportunity to derive growth from within its install base.
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Splunk isn't without competitors, but the company's focus on machine data is unique. It's also the largest company in the space . The company's closest large/public peers are the monitoring companies like Datadog ( DDOG ) and New Relic ( NEWR ), which primarily focus on monitoring the performance and uptime of applications and infrastructure. Splunk focuses on visualizing and analyzing machine data (information passively generated by computers, phones, and other endpoints within networks). We note as well that Splunk's ~$4 billion annual revenue scale makes it twice as large as its next-closest competitor, Datadog.
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Industry-wide recognition - More to the point above, it's fine to have competition when Splunk also is widely considered the best-in-breed vendor for machine data analytics. Gartner, the software industry's leading analyst and reviewer, has bestowed the "Leader" designation to Splunk in the security information and event management space, and also named it as the vendor with the highest ability to execute. These commendations don't come lightly to IT buyers when making a purchase decision.
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Significant international expansion opportunity - Splunk has become a global brand name, and it's time for Splunk to chase more opportunities overseas. Currently, only about ~35% of its revenue base comes from international markets (and an even smaller ~20% slice of the cloud business is overseas). I see significant opportunity for Splunk to expand its presence outside of the U.S.
Splunk's valuation remains a core reason to be bullish on the stock. At current share prices near $100, the company trades at a market cap of $16.72 billion, and after netting off the $2.51 billion of cash and $3.88 billion of debt on the company's most recent balance sheet, Splunk's resulting enterprise value is $18.09 billion.
Meanwhile, Splunk has guided to $3.90 billion in revenue, revising its range for the year to the upper end of its prior guidance and representing 7% y/y growth:
Note as well that the company has also taken up its FCF guidance to $805-$825 million, representing a 21% FCF margin and >90% growth relative to just $427 million in FCF in FY23.
This puts Splunk's valuation multiples at:
- 4.6x EV/FY24 revenue
- 22x EV/FY24 FCF
My updated year-end price target on Splunk is $121 , representing a 5.5x EV/FY24 revenue multiple and 20% upside from current levels.
Stay long here: I'd recommend holding a long-term position and wait to let go until Splunk hits the ~$120s, and selling puts on dips to capture short-term gains if desired.
Q1 download
Let's now review Splunk's latest quarterly results in greater detail. The Q1 earnings summary is shown below:
Splunk's revenue grew 11% y/y to $751.5 million, beating Wall Street's expectations of $727.2 million (+8% y/y) by a three-point margin. Optically, this revenue showed a massive deceleration from 39% y/y growth in Q4, but that's due to A) tougher comps from lapping Splunk's subscription transition and B) timing of contract renewals that disproportionately benefited the fourth quarter.
Splunk's total ARR grew 16% y/y to $3.72 billion, while cloud ARR jumped 29% y/y to $1.82 billion:
The company notes that the macro environment has spurred greater scrutiny on deals and delayed cloud migrations, which is similar commentary to what other software companies (especially large complex software products that require lengthy integrations like Splunk) have made during the past two quarters. And amid this slower demand environment, the company has turned its focus to expense management. Per CFO Brian Roberts' prepared remarks on the Q1 earnings call :
So, let's move to expenses and the impact on free cash flow. It's important to understand that in addition to looking for opportunities to leverage expenses, we will also make fiscal '24 investments that we expect can accelerate growth during the economic recovery and beyond. Our objective is to drive long-term ARR and free cash flow growth.
We made solid progress in Q1 on our expense structure, and looking forward, we remain extremely focused on increasing our operating efficiency. As a result, we are updating our annual expense outlook as we now expect to manage annual non-GAAP OpEx growth below this prior 7% outlook. We expect that we can hold non-GAAP OpEx growth to roughly between 5% and 6%, a reduction of 100 to 200 basis points from our prior outlook. It's worth noting that in the second half of the fiscal year, we will face more challenging OpEx growth comparisons as we begin to comp the cost actions we took last year."
As a result of cost-cutting, Splunk notes that its new pro forma operating margin target of 18.0-18.5% is a 100-150bps boost from its original FY24 guidance. Note as well that Splunk is doing well against its target to nearly double free cash flow this year: Q1 FCF of $486.3 million already achieves more than half of its annual target, and grew more than 3x y/y:
Key takeaways
With double-digit ARR growth and plans for significant operating profit and FXF expansion this year, there's a lot to like about Splunk, especially at a <5x forward revenue multiple. The only key risk I see here is a protracted recession that continues to dampen demand for Splunk's software, but I think that's more than priced into the current bargain valuation multiple. Stay long here.
For further details see:
Splunk: ARR And Margin Expansion Will Fuel Rally