2023-09-25 11:01:20 ET
Summary
- As you likely know, Cisco recently offered $157/share for Splunk.
- Generally speaking, I think the offer is fair. Considering my bullishness over the last six months or so, I'm happy to see something close to Splunk's intrinsic value recognized.
- That said, irrespective of whether the deal goes through, there's upside to Splunk at these levels.
- To this end, I will review the Splunk thesis as well as its Q2 2023, within which I will share my reasonable to conservative valuation model for the company.
- In short, I still like Splunk at $144/share, with or without Cisco.
Heating Up
I recently provided an update on my ownership of Splunk ( SPLK ). If you've not already, I would strongly encourage you to read that update before you continue reading today. It also includes a link to my original work on the company published in late 2020.
Therein I discussed my ownership of Splunk since 2020.
As you know, it's been quite a ride, though all great businesses will invariably experience the cycle of life, death, and resurrection (there's a reason billions of humans predicate their existences on the cycle).
And, indeed, Splunk has gone through its cycle of life, death, and resurrection over the last decade, and, as of today, we appear to be thoroughly through the death part of the cycle. In fact, I would say Splunk now operates from its greatest position of strength in easily the last five years, and its new leadership seems to be performing phenomenally. We will touch on this later today.
Exiting the death part of the cycle, Splunk has begun its resurrection and ascension, both figuratively and literally.
Splunk Began Its Ascension Before The Potential Cisco Deal Was Announced
In my prior update regarding Splunk, I highlighted that the business had finally, at long last, fully completed its transition to principally a SaaS business, and this completion entailed the newfound production of robust free cash flow.
Our Road To Free Cash Flow: Now More Robust Than Ever
As we can see, and as you know, it's been a long, treacherous road to this day, but we've finally arrived, and, even at $145/share, 1) we're still below Cisco's ( CSCO ) perceived value of the business as measured by its offer and 2) we're still below what I believe to be Splunk's fair value, which would be closer to $200/share.
We will value the company near the concluding portion of this note.
Broadly speaking, upstream of this free cash flow generation, the business produced simply stellar Q2 2023 results (fiscal year is different for Splunk).
Splunk Reported Very Healthy Metrics Across The Board And At Massive Scale
Let's parse each of these components together and conclude with a valuation exercise today.
Annual Recurring Revenue Grows At A Healthy Rate
Considering the median software growth rate, as well as the economic climate that I've detailed for you quantitatively over the last month or so (contextualizing resources linked below), 16% ARR growth is actually positively brilliant.
27% cloud ARR growth is also likewise positively brilliant.
Notably, Splunk grew net new ARR sequentially for the first time in a couple years, indicating that, despite an abysmal software industry overall, the turnaround for Splunk is proceeding well.
For the "alleged dying company" that is Splunk, which I have consistently rebutted, noting that it's still larger than all of its public market peers combined, 16% and 27% growth is fantastic. Incredible really.
Software Growth Rates Collapse
Clouded Judgment
Bradley Sills: Great to hear, Gary. One more, if I may, please. If you could just remind us how the macro has impacted the business. Are you talking about elongated sales cycles, smaller deal sizes to get deals through. And coming out of the macro, could we potentially see some acceleration as those things come back?
Gary Steele: Yes. So I would say the macro environment has been largely consistent this entire year. And what that means to us has been we've seen choppiness in cloud migrations, meaning customers, cloud migrations, they will defer them if they can because it represents an incremental project. There continues to be a lot of deal scrutiny, meaning additional sign-ups, etc. I think, though, having said all that, as we described earlier, I think our team has done a really good job of navigating through that. And so I think we've been able to deal with it reasonably well.
Notwithstanding this collapse for the broad software market, Splunk continues to grow at elevated rates, despite being seen by some as an outmoded, legacy software vendor.
Splunk Accelerates Growth Of Net New ARR
In fact, growth accelerated sequentially in Q2, bucking the trend of the software industry overall.
Splunk's Cloud Growth Continues To Grow At Healthy Rates At Giant Scale
Matt Hedberg: Gary and the whole team, congrats on the results. Really, really good to see the momentum on both the top line and certainly the bottom line. It looks to me like you grew net new ARR really for the first time in a couple of years. Obviously, great to see. When you think about momentum in the second half and even next year, how do you expect to build on this success? And I guess specifically, outside of macro (impacts), which remain - it feels like it's stable here, what are the most important things that we should think about that could perhaps apply further acceleration as we look out into the second half into next year?
Gary Steele: Yes. Yes, great question, Matt. So when we look at the business today, we continue to see tremendous strength in our security offerings and people are modernizing their stacks. Thinking differently about how they want to run their stack, and we're playing an integral role there. New capabilities like Attack Analyzer things like that have been really well received by our customers and by prospects. And then more broadly, the advantage that we have, bringing security and observability together, we're giving our customers this opportunity to standardize on a single platform and save money in what has been a challenging economic time for folks.
(Platform consolidation has been a theme for FTNT and PANW in cybersecurity, where there's immense, very strong competition, but, interestingly, this theme, at least within the hivemind of the market, has not been present in SIEM, APM, and Observability. This has likely been the case because Splunk's leadership team was gutted, and it's taken time for Mr. Steele and his CFO to get up and running. However, I believe they are hitting their stride today, and Splunk's results, against a difficult macro-environment, reflect as much.)
So I think we're well positioned. What we saw in the quarter, we think, continues through the second half and into the coming year. And as we described before, we're excited about growth opportunities outside the U.S., and you heard it in a lot of the prepared remarks with the customers that we close, we're seeing very good traction in markets where we're relatively new. And so we feel like we have a lot of good momentum coming out of this quarter going into the second half, and we think it's a good setup as we contemplate next year.
While I did not include much language from Splunk's new CEO and CFO in today's review, I did listen to the entire call, and I must say they are both impressive.
I do not think Splunk's accelerating net new ARR is a coincidence in any sense.
I do not believe Splunk's expanding operating leverage while sustaining fantastic growth is a coincidence. I believe it's directly attributable to the decisions the Splunk board made in installing Mr. Steele (the CEO) and Mr. Roberts (the CFO).
Splunk Demonstrates Exceptional Operating Leverage While Sustaining Elevated Growth
Valuation Analysis
Before we begin a valuation analysis, I'd like to share a snapshot of Splunk's recent financial performance, which buttresses the assumptions I will share just below.
Splunk's Expanding Free Cash Flow and Operating Margins
As we can see, Splunk, despite a collapsing software growth environment and despite operating at giant scale (~4B in annualized run rate is larger than all of Splunk's pure play public market peers combined), grew at a very healthy rate, while expanding free cash flow margins.
With solid brand and embedding moats, I believe the following assumptions are reasonable to conservative.
I believe, barring a Great Recession-like scenario akin to '08-'09, '73-'75, or '29-'32, there could be upside to these assumptions (suggesting they are indeed conservative).
- Assumptions
TTM revenue [A] | $3.9 billion |
Long Run Free Cash Flow Margin [B] | 25% |
Average diluted shares outstanding [C] | ~167 million |
Free cash flow per share [ D = (A * B) / C ] | $5.83 |
Free cash flow per share growth rate (reasonable) | 12.5% |
Terminal growth rate | 3% |
Years of elevated growth | 10 |
Total years to stimulate | 100 |
Discount Rate (Our "Next Best Alternative") | 9.8% |
With Splunk's new management and momentum, I think 12.5% annualized returns are well within reach, and, again, there could be upside to this, especially if Splunk begins repurchasing shares in a disciplined fashion in the decade ahead.
And, of course, there's a small amount of upside should the Cisco deal actually go through, which it may not.
Concluding Thoughts: New Management and New Logos
Over the last few years, the common bearish thesis I've heard has revolved around these key points:
- Splunk is outmoded, but so were PANW, MSFT, and FTNT for the last decade until vendor consolidation became the theme, from which Splunk has benefited.
- Splunk has no leadership. Fair, but now it does.
- Splunk can't win new logos. Again, fair, but this may begin changing with new leadership and new momentum, and the data suggests that the change is currently underway.
The way we look at it, new customers continue to drive growth. From an ARR perspective, new customers generally account for roughly 20% of net new ARR on a trailing 12-month basis, and we were pleased that in Q2, this metric increased year-over-year.
Notably, when Mr. Roberts stated this, there was an audible murmuring of surprise from the analyst. A little "wow" was uttered through the line as Mr. Roberts continued his train of thought.
On the subject of Mr. Roberts, like Mr. Steele, I have been impressed by his work at Splunk. I find this articulation of the financials of Splunk heartening, as he is direct, comprehensive, and transparent. To wit:
Let's move to cash flow. In Q3, we expect to generate $75 million of free cash flow. This implies free cash flow of $834 million for the 12 months ending Oct. 31, 2023, which is nearly triple the $287 million of free cash flow for the 12 months ending Oct. 31, 2022. We then expect to generate approximately $300 million of free cash flow in Q4. Again, for the full year, we expect free cash flow of between $855 million and $875 million, which is an increase of $50 million compared to our guidance range provided last quarter.
(Clear, concise articulation of free cash flow and the trends thereof, which is all that matters ultimately for shareholders.)
Let's move to equity. As I mentioned last quarter, we're taking deliberate steps to reduce equity dilution. In fiscal '24, we expect to meaningfully reduce equity burn relative to fiscal '23, and this will benefit future SBC expense since it’s a lagging indicator. In terms of what we can control in Q2, we reduced equity usage by approximately 50% versus the year ago period.
(Clear, concise articulation of the "share" component of "free cash flow per share," which is all that matters for shareholders.)
Finally, let me spend a moment on capital allocation. We ended Q2 with over $2.4 billion of cash, cash equivalents and short-term investments. We have elected to redeem the 2023 convertible notes in cash next month. But on a pro forma basis, we will continue to have significant liquidity. We will share more details of our capital allocation strategy at our Investor and Analyst Day in January.
(Clear, concise articulation of balance sheet health, which impacts the growth rate of free cash flow per share.)
For those that study my work, you will see clearly that he understands what drives value creation in the stock market.
Those were his concise, concluding remarks, and, on some level, that's all we need to know, and he understands that reality.
This is very heartening to me.
In closing, I have never felt better about Splunk. I shared recently that it could have 100% upside from $100/share.
I believe Splunk is an interesting "deep value" technology investment that could appreciate ~100% in the decade ahead from valuation multiple expansion alone. - Rising From The Ashes
I still believe there's upside here. Should the Cisco deal go through, of course, there would be a bit of upside. Should it not, over the long run, I still believe there's upside at about $144/share.
For further details see:
Splunk: Still A Solid Buy Following The Cisco News