2023-11-23 07:00:00 ET
Summary
- Splunk is set to be acquired by Cisco for $157 per share.
- The deal is being made in cash and does not require external funding.
- Investors should monitor Splunk's ongoing prospects as a stand-alone entity and its ability to generate strong near-term cash flows.
Investment Thesis
Splunk Inc. ( SPLK ) is about to be acquired by Cisco Systems, Inc. ( CSCO ) for $157 per share. Here I explain how investors should think about their holding now and why I've turned neutral on Splunk.
Rapid Recap
In my bullish analysis back in August I said,
Splunk is not a high-growth business. My investment thesis has never been about that. I'm an inflection investor.
As such, I'm seeking a change in the underlying story, from where investors' expectations are, to where I believe the company is able to move towards.
Accordingly, here's why I argue that Splunk offers investors a good risk-reward and why paying 17x forward free cash flow for Splunk makes it attractive.
What you see above is that I wasn't always bullish on Splunk, but I became bullish when I believed the risk-reward was promising.
What's important in investing is not finding the cheapest stocks or the best company in the world. What you are trying to invest in are stocks where there's a mispricing in expectations.
You are trying to do only one thing when you are investing, to retain purchasing power. You are deploying your hard-earned capital today, so that in the future that capital has as much buying power as it holds today.
And only after that, comes your upside potential. But you should not think about your upside until you've satisfied yourself with your downside on a stock.
As an inflection investor, I saw that there was a change in the underlying narrative coming from Splunk. Fundamentally, I saw that the business had the potential to be a lot more profitable than investors realized, but I'll come to that in a moment. Before that, let's discuss the details of the Cisco deal.
Details of the Deal With Cisco
The expiration of the antitrust period took place a few weeks ago, this means that there's an added chance that this deal will not fall apart due to regulatory matters .
The deal is being made in cash. That means that investors don't have to stick around to get 3% on their cash here. The current share price is $152, while the acquisition is coming at $157 per share. The deal could take a while to be finalized and of course, there's always the risk that this deal could fall through.
Cisco is not having to take on any debt to finance this deal. Splunk is being acquired for $28 billion in cash and Cisco has $26 billion of cash on its balance sheet, plus making approximately $4 billion of free cash flow per quarter. This implies that there's no need for external funding that should increase the odds that this deal goes through.
But, what happens in the unlikely scenario where the deal falls through?
Splunk's Ongoing Prospects As a Stand-Alone
Here I'll explain what I saw as an inflection investor and what I'm expecting to hear in Splunk's fiscal Q3 2024 earnings call.
What I'm looking forward to hearing is confirmation of the catalyst I saw back in August. An update on the surprising news that came out of Splunk last quarter, that its non-cloud business was picking up momentum again.
This is incredibly important because Splunk's on-premise business oozes free cash flow. And Splunk's management team hadn't been aggressively investing in its on-premise business because the market was infatuated and rewarding companies for having an alluring cloud-growth story.
But with interest rates higher for longer, the market is rewarding businesses that generate strong free cash flows more. The times of ''growth at any cost'' are now in the rear-view mirror and unlikely to return any time soon unless interest rates once again drop to abnormally low as we saw in 2020.
As you can see above, starting in 2019 into 2020 rates were massive tailwinds towards growth stocks. But going forward, if long-term interest rates stabilize around 3.5% to 4%, there will be a regime change.
Going forward investors will be rewarding businesses' near-term cash flows rather than colorful promising stories of the future. And not a lot of investors have understood this change that's underway.
For now, many investors are stuck buying the dip on growth stocks waiting for them to rip back up, but that's not what the market will be rewarding. The market is going to reward profitable growth. Not growth stories that will become profitable, but businesses that are resilient and able to deliver strong cash flows.
The Bottom Line
In conclusion, my neutral stance on Splunk reflects a measured assessment of the highly likely imminent acquisition by Cisco.
While the deal presents potential gains for investors, uncertainties linger, especially considering the dynamic landscape of the market.
Additionally, as an inflection investor, I emphasize the importance of monitoring Splunk's ongoing prospects as a stand-alone entity, particularly its ability to adapt to shifting market preferences for strong near-term cash flows.
If the deal doesn't go through, the forthcoming fiscal Q3 2024 earnings call is pivotal in confirming the anticipated catalysts and shedding light on Splunk's resilience and profitability amid changing market dynamics.
Given that I assume the deal will go through, I'm now neutral on this stock.
For further details see:
Splunk: Why This Inflection Investor Is Calling It A Day Here