2023-03-07 14:20:05 ET
Summary
- Splunk is a Gartner-ranked leader in IT observability and events management.
- The company reported strong financial results for Q4 FY23 as it beat both revenue and earnings growth expectations.
- Its stock is undervalued intrinsically according to my discounted valuation model and forecasts for growth.
Splunk (SPLK) is a software company that provides an IT Observability platform. Its platform basically enables a CISO or Chief Information Security Officer at an organization to track all the IT logs, alerts, and activities. This is an essential process in order to ensure the efficient and secure running of operations. This is especially important given there was a reported 38% increase in Cyber-attacks in 2022, according to Check Point research. In addition, the Hybrid cloud industry is forecast to grow at an 18.4% compounded annual growth rate [CAGR], driven by tailwinds across digital transformation. Splunk is poised to benefit from these trends and was ranked number one in the Security Information and Event Management industry by both Gartner and IDC. In Q4 FY23, Splunk continued to execute tremendously and reported a beat on both top and bottom-line growth expectations. In this post, I'm going to break down its financial report before diving into my valuation model and forecasts for the stock, let's dive in.
Strong Financials
Splunk reported strong financial results for the fourth quarter of the fiscal year 2023. Its revenue was $1.25 billion, which beat analyst expectations by $177 million and increased by a rapid 38.84% year over year. Annual Recurring Revenue [ARR] also increased by a steady 15.5% year over year. This was driven by strong Cloud ARR growth, which increased by 33% to $1.778 billion. This wasn't a surprise to me, given the forecasted growth in the cloud industry, which was expected to be worth $1.2 trillion by 2027. Splunk also offers an extensive "migration guide " to help those on-premises customers move to the cloud version of the platform. However, as the industry stands, a Hybrid cloud environment is prevalent as is on-premises. Therefore, it was great to see Splunk continues to offer support for multiple deployments and its Non-Cloud ARR still makes up a substantial (~50%) of the total. This is also important because management has reported a slowdown in cloud migrations in Q4, driven by the "macro environment".
Splunk has also continued to grow its larger customer base, which generated over $1 million in ARR each. This increased by 17% year over year or 115 new customers to 790 while its Cloud ARR (>$1m) customers have been growing at an even faster rate of 33% year over year to 422 customers. This is a positive sign in my mind, as it means despite the macroeconomic environment, larger customers are still happy to adopt Splunk's platform. I believe this is for a couple of reasons. Firstly, security and observability are essential for organizations, due to the cyber trends mentioned in the introduction. In addition, this is possibly even more so during uncertain economic times. Secondly, from my experience in the IT industry, I know Splunk is often seen as the ideal platform to "consolidate" a variety of security and observability tools. This of course then reduces the complexity for CISOs (Chief Information Security Officers) and potentially even cost. The adoption by larger organizations paying (>$1m ARR) also means its customers are finding immense value in the product, which is likely to be more "sticky" (due to the complexities of enterprises). In addition, larger organizations tend to have a greater number of account expansion opportunities.
Notable customer wins in the quarter included the Department of the U.S. federal government, which signed a multimillion-dollar contract "expansion" agreement to increase the usage of Splunk's products. Government agencies are an incredibly lucrative customer base, as new product purchases are likely to be even more "sticky" than enterprises.
Splunk's switch from "ingest-based pricing" which analyzes data consumption to "workload" based pricing offers customers more flexibility and cost efficiency. This more "straightforward" pricing also encouraged a larger Norwegian Bank and energy business in Asia to sign multi-year security deals with Splunk in Q4 FY23. Splunk also won a deal with a large financial services provider in Asia, which provides greater visibility across its variety of cloud-based "microservices".
Margins and Balance Sheet
Splunk reported a super non-GAAP operating margin of 38%, which surpassed management's expectations of between 23% and 26%. Its GAAP Earnings Per Share [EPS] was $1.44, which beat analyst forecasts by $1.31.
This fantastic result was driven by operating efficiency improvements as its operating expenses increased by just 2% year over year, despite a much larger (~39%) increase in revenue. The improving operating leverage is forecast to continue with total expenses expected to grow by 11% between FY22 and FY24, while revenue is forecast to grow by a solid 33% (see the below chart for details).
Splunk has also massively scaled its free cash flow with $427 million reported in FY23, up by nearly four times over the $108 million reported in FY22. Moving into FY24, cash flow is again forecast to increase by a blistering 81% year over year.
Splunk also has a strong balance sheet with cash and short-term investments of $2 billion. The company does have a fairly high total debt of ~$4 billion, but the vast majority of this (~$3 billion) is long-term debt and thus manageable.
Valuation & Forecasts
In order to value Splunk, I have plugged its latest financial data into my discounted cash flow valuation model. Management has forecast ARR of between $4.125 billion and $4.175 billion, which implies a 12.39% YoY growth rate with a net new ARR of between $450 million and $500 million. At the bottom end of the management forecast, this is a slightly slower ARR growth than the ~15% reported in Q4 FY23. I have also scaled down real revenue growth proportionally with ~18% growth forecast for "next year" or the next four quarters in my model. This is mainly driven by the macroeconomic climate, which is fairly uncertain at this time. In years 2 to 5, I have forecast a faster growth rate of 22% per year, as I forecast economic conditions to recover, in addition to cloud migrations.
Splunk stock valuation 1 (Created by author Deep Tech Insights)
To increase the accuracy of my valuation model, I have capitalized R&D expenses which has boosted net income. I have forecast a pre-tax operating margin of 23% over the next 10 years, which is the average operating margin in the software industry, according to NYU data. I forecast this to be driven by improvements in operating leverage as per the current trend.
Splunk stock valuation 2 (Created by author Deep Tech Insights)
Given these factors, I get a fair value of $127 per share. The stock is trading at ~$100.75 per share at the time of writing and thus is just under 21% undervalued intrinsically, according to my valuation model and forecasts.
As an extra data point, Splunk trades at a price-to-sales [P/S] ratio = 4.23, which is over 50% cheaper than its 5-year average. The stock also trades cheaper than industry peers such as Dynatrace ( DT ) and Datadog ( DDOG ).
Risks
Recession/Longer Sales Cycles
Many analysts have forecast a recession in 2023. A third of economists surveyed believe a recession will start within the April and June quarter, while one-fifth believe it will start in the July to September quarter, later than originally expected. Therefore, I expect longer sales cycles for Splunk and lower cloud migrations, as decision-makers "wait and see" what happens.
Final Thoughts
Splunk is an innovative technology company that has continued to execute well. Managements increasing focus on profitability, cash flow, and improving the operating leverage is a positive sign, especially given the macro climate. The company is poised to benefit from industry growth across the hybrid cloud, observability, and cybersecurity. Given my valuation model and forecasts indicate the stock is undervalued intrinsically at the time of writing, the stock could be a great long-term investment.
For further details see:
Splunk: Outstanding Execution And Undervalued Intrinsically