2023-06-26 16:04:36 ET
Summary
- Splunk Inc. focuses on improving efficiency and cost optimization, with management initiatives aiming to get the company back on track to approach the software "rule of 40".
- Despite a revenue slowdown, SPLK's cloud transition, FCF profile, and discounted P/S ratio make it an attractive long-term investment opportunity, particularly within the AI thematic trend.
- Splunk's solutions demonstrate strong stickiness among its enterprise customer base, with a high customer renewal rate and longer contract duration over the past quarters.
- Given SPLK's YTD return of 16%, significantly lower than the NASDAQ's 37%, I view this as a potential buying opportunity for long-term investors.
Investment Thesis
During the 2023 Global Technology Conference , the management of Splunk Inc. ( SPLK ) primarily focused on two important metrics: annual recurring revenue ((ARR)) and the FCF profile. I'm pleased to see that the company is prioritizing both its top and bottom lines. In the last earnings release, SPLK impressed investors by surpassing all metrics and raising its forward outlook for FY2024. As a leader in machine log analytics, the company has faced pressure due to its decelerating growth in recent years. The current stock price level is slightly below the pandemic low, which has resulted in a discounted valuation.
However, thanks to recent management initiatives, I believe SPLK has an opportunity to regain momentum and approach the software "rule of 40," potentially catalyzing an expansion of its valuation multiple. Given the stock's YTD return of 16%, which is significantly underperforming the Nasdaq's 37%, I'm optimistic on SPLK and recommend it as a buy. My recommendation is based on the expectation that the ongoing AI thematic trend will generate long-term growth opportunities for the company. In the following analysis, I will discuss several key takeaways from the recent conference and earnings release.
Cloud Transition is On Track
Although the management acknowledged that cloud migrations faced challenges in the current macro environment, we can see SPLK's revenue mix has been leaning towards the cloud segment in recent years. This is highlighted by the 62% CAGR of cloud ARR growth, compared to the 21% CAGR of non-cloud ARR growth. In 1Q FY2024, the cloud ARR accounted for 55% of the revenue mix. It's important to understand that during this transition to the cloud, the company will inevitably experience near-term revenue headwinds as the previous upfront revenue stream will be recognized gradually, negatively impacting overall revenue growth momentum. However, I believe this shift in the revenue mix is well-positioned to help SPLK capitalize on the potential higher demand within the current backdrop of AI's secular growth trend.
Improving Efficiency
The management is currently working to make SPLK more efficient and reduce costs. They are hiring people in less expensive locations, which will help improve their profit margins over time. The company is particularly focused on cutting operating expenses, especially in sales and marketing, which will help them improve their margins in the long term.
We can see a significant improvement in SPLK's profitability in 1Q FY2024 compared to the same period last year. Their non-GAAP operating margin went from -8.5% to 3.3%. Additionally, the company expects their non-GAAP operating margin to be between 18% and 18.5%, which is higher than their previous estimate of 16.5% to 17.5%. During the conference meeting, the CFO stated:
"If you look at our outlook, we thought at the beginning of the year, that OpEx would grow 7%. We updated that on the most recent call, we now think it's between 5% and 6% OpEx growth. So less than half of ARR growth."
Even though there has been a slowdown in revenue growth, prioritizing margin expansion and profitability can bring benefits to shareholders. By focusing on improving margins, I believe the company can become more resilient during economic downturns.
Alternative "Rule of 40"
As I mentioned in my previous articles, the 40-rule is a very useful metric used to evaluate the performance of SaaS (Software-as-a-Service) companies. It combines the growth rate of revenue with profit margin to provide a better assessment of a company's performance.
In addition to the traditional approach of using net profit margin, McKinsey research , suggests replacing it with FCF margin as another popular metric. However, due to the ASC 606 accounting rule, which impacts revenue recognition, SPLK's management believes that using ARR to measure top-line growth can help reduce volatility compared to total revenue.
Therefore, as shown in the chart, the company calculates the rule of 40 based on the growth rate of ARR and the FCF margin. In FY2024, SPLK is expected to achieve a combined ARR growth and FCF margin of 33.4%, which represents an improvement from the previous outlook of 31.8%. This indicates that the company is making progress in balancing its growth and profitability, which I believe can positively impact its valuation. Regarding the company's FCF trajectory, the CFO in the meeting added:
Free cash flow during the business transformation was -- it went negative. Hard for sort of that -- and now we're coming out of this. And I think, again, we've said publicly, we expect healthy growth next year in free cash flow.
The management plans to reveal the company's long-term ARR target, as well as the expenses as a percentage of ARR and FCF margin, during the Analyst Day later this year. Until those details are disclosed, I believe there are sufficient short-term catalysts to sustain the current momentum of the stock.
Customers Engagement
Although the Net Revenue Retention (NRR) remains undisclosed, we can see there is a positive trend in the average cloud contract duration. SPLK's management has highlighted its exceptional capability to handle large volumes of data, distinguishing it in the market. Over the past few quarters, the duration of cloud contracts has slightly increased and remained stable. This is an encouraging sign, especially during the current macro headwinds. It indicates that customers are not only maintaining their contract durations but potentially even extending them, demonstrating a strong level of customer engagement and satisfaction with SPLK's offerings.
Valuation
SPLK recently achieved non-GAAP earnings breakeven in FY2023 and currently has a P/E TTM of 32.2x. While the current multiple may not appear to be a bargain, I believe that as earnings continue to grow, the P/E is likely to decrease over time. This suggests that the stock's valuation may become more attractive.
In terms of the company's FCF profile, it has shown some volatility in recent years. The stock currently is trading at a P/FCF of 21.5x based on the TTM number of $776 million in Q1 FY2024. However, if we consider the company's forward FCF outlook of $815 million for FY2024, the P/FCF drops to 20.4x. Despite an expected 5% YoY growth in FCF, SPLK has consistently maintained a positive FCF growth in post-pandemic, which is a positive indicator.
Looking at the chart below, SPLK is currently trading at P/S TTM of 4.5x. The multiple is nearly 50% lower than its 5-year average of 10x. This suggests that not only is the company relatively cheaper compared to its own historical valuation, but it also appears attractive when considering its 13% YoY growth in ARR projected for FY2024.
Considering this context, despite the ongoing revenue slowdown, I don't think SPLK's valuation is overstretched. The stock's lower P/S indicates that it may be undervalued in relation to its potential growth prospects when its cloud transition is completed.
Conclusion
In sum, SPLK demonstrates several positive indicators such as stable cloud ARR growth, cost optimization, FCF profile, and strong customer engagement. The company's focus on margin expansion, along with a high customer renewal rate and expertise in handling large data volumes, contributes to its overall strength. While the P/E may not initially appear as a bargain, considering the company's growth prospects and discounted P/S, the stock offers an appealing long-term investment opportunity. Based on the impressive earnings results in the recent quarter and the management's positive initiatives during the 2023 Global Technology Conference, my outlook on the stock remains optimistic.
For further details see:
Splunk: Cloud Transition Impacts Revenue Growth, But Still On Track