Splunk stock is poised to rebound on big data tailwinds (NASDAQ:SPLK)

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Splunk (NASDAQ: SPLK) is a leader in data surveillance and security. Their mission is to help businesses turn “data into action” through dashboard visualizations and machine learning. The company was founded in 2003 and went public in 2012. Since then, the the stock price has been volatile for investors, rising 145% through 2014 to $93 per share. However, there has been great volatility and multiple declines over the past few years. In 2020, the stock price had a strong rally and rose to ~$200/share. However, the share price has now fallen 54% on the back of mounting losses and rising interest rates, negatively affecting the valuation of growth stocks.

Splunk stock price

Splunk Stock Price (YCharts)

The good news is that society is poised to benefit from three major macroeconomic tailwinds. The first is the abundance of “Big data” which has been called the “new oil” and which is a market is expected to grow from $162 billion in 2021 to $273 billion by 2026, registering a CAGR of 11%. While business computer software expenses is expected to grow by 9.8% this year, reaching a value of $674.9 billion. Big data isn’t going away, nor is there a need to gain visibility into that data and ensure it’s secure. The rise of remote working and the growing use of cloud applications means that the “attack surface” is even greater for hackers. Thus, global cybersecurity Market was valued at $133 billion in 2021 and is expected to grow at a rapid CAGR of 14.1% from 2022 to 2027.

Splunk is poised to follow these industry trends, they have significantly increased their R&D spending and free cash flow turned positive in 2021, which could be an early indicator that their new business model is gaining traction. The company also has a high customer retention rate (132%), indicating that customers stay loyal to their product and spend more. Given these factors, the stock is now trading at the lowest price to multiple sells (PS=5.6) on record and is inherently undervalued. Let’s dive into the business model, finance and valuation to learn more.

Business model in transition

Splunk is a leader in data monitoring and security. Companies produce a large amount of different types of data from a variety of sources. These include public clouds, on-premises data centers, and the network edge. This data is often kept in “silos” and therefore isolated and not used effectively. Splunk’s mission is to turn this “data into action”, helping companies to observe, track, analyze and secure data. Splunk’s platform dashboard has two main functions “Observability” and “Security”. Captured data can be observed through dashboards and visualizations. While machine learning can be used to detect anomalies and help stop cybersecurity threats.

Splunk Platform

Splunk Platform (Splunk website)

The company is currently going through a major business model transition, towards a “based on workloador data usage pricing model. Basically, the more data a company analyzes and uses, the more it will be charged, similar to too many other cloud services such as AWS. This will be a sea change from compared to the company’s previous “premium pricing” Splunk’s offering is highly regarded in the industry, three branches of government and all four branches of the U.S. military have deployed it. A unique part of Splunk’s offering is the large number (over 2400) of “Splunkbase apps” that have been created by the community. These applications range from additional visualization and security tools to database connectors and those to help with PCI conformity, which is vital for the card/financial payment industry.

Splunk Dashboard

Splunk Dashboard (Splunk Website)

Growing finances

Splunk’s revenue grew from $2.2 billion in 2020 to $2.6 billion in 2021, a rapid increase of 18%. However, it should be noted that these revenues have only increased by 13% in the last 2 years, which could be one of the reasons why the company is changing its business model.

Splunk Revenue

Splunk Revenue (YCharts)

They invested $1 billion in R&D in fiscal 2021, which is a substantial 42% increase from the previous year. While S&G’s spending also rose 25% to $2 billion as they invest for future growth. So, for fiscal year 2021, they racked up a heavy operating loss of $1.1 billion.

Splunk Margins

Splunk Margins (YCharts)

The company’s gross margin and operating margin declined slightly (chart above), but gross margin is still high at 72%, which is a benefit of a SaaS-based business model.

Compared to competitors and industry peers (chart below), Splunk’s gross margin of 73% is closest to SolarWinds (SWI) also at 73%. While other companies such as PagerDuty (PD) and Dynatrace (DT) have higher gross margins at the level of around 82%.

Splunk Peer Gross Margin

Splunk Peer Gross Margin (created by author YCharts)

The good news is the most important metric, “free cash flow” has trended positively from -$400 million in mid-2020 to -$242 million at the end of this year. For fiscal 2021, free cash flow was $108 million. This is a great sign of an improved trading pattern and could be an early indication of a rebound.

Free Cash Flow Stock Splunk

Splunk Free Cash Flow (YCharts)

If I compare the company’s free cash flow to its competitors, it’s clear that Splunk produces less free cash flow than most peers and that could be one of the reasons the stock is trading lower. low price. SolarWinds, certainly looks the most similar from a financial standpoint and generated $156 million in free cash flow.

Free movement of capital

Free cash flow (Splunk)

Splunk has an extreme high net dollar retention rate of 132%, up a few percentage points from previous quarters. This means customers stay with the business and spend more.

Splunk Retention

Splunk high retention (investor presentation)

On the balance sheet, the company has $1.4 billion in cash and $286 million in short-term investments with long-term debt of $3.1 billion. That’s quite high for a “growth” company but at least their short-term debt (maturity in the next 2 years in minimal, current ratio = 1.56.

Splunk review

Splunk Balance Sheet (YCharts)

Evaluation

In order to value Splunk, I incorporated the latest financial data into my valuation model, which uses the discounted cash flow valuation method. I have been very cautious with the revenue growth estimates, projected at 16% for the next 2-5 years, which is actually lower than the 18% growth of the most recent years.

Splunk Stock Valuation

Splunk Stock Valuation (created by author Ben at Motivation 2 invest)

I expect Splunk’s operating margin to grow substantially from -27.46% to 30% over the next four years, to the top of the software industry average.

R&D expenses

R&D expenses (created by author)

In order to improve the accuracy of the valuation, I also capitalized their research and development expenses. Like the investment of $1 billion for fiscal year 2021 and $791 million for fiscal year 2020.

Assessment model

Valuation model (created by the author at motivation 2 invest)

Considering these factors and calculating all the financials, I get a fair value of $97 per share, which means the stock is fairly valued at the current level. It was undervalued when I started writing this article, but it has since increased by 10%. The company is also trading at the lowest price-to-sales ratio on record with PS=5. Like the market predictions of rising interest rates have compressed PS multiples, we will look at relative price versus sell multiples for a better indication of value.

Splunk is currently trading at a futures price to sales ratio = 4.5. This is the 2nd lowest in the industry, just above SolarWinds which trades a forward PS=2.4. PagerDuty trades at a higher level with a PS(forward)=5.6 and Dynatrace trades at a PS(forward)=8. The company is also often compared to Datadog (DDOG) although they do different things and that DDOG grows much faster and therefore has a much higher valuation with PS (forward) = 19.

Price/sales ratio Brothers of Splunk

Splunk peer price to sales ratio (created by YCharts author)

Risks

Competition

As mentioned earlier, there is a large amount of competition in the “data monitoring” industry. With companies such as SolarWinds, PagerDuty and Dynatrace. There is also competition from large incumbents such as Cisco (CSCO) with their AppDynamics and even Microsoft with their Azure Network Watcher. Increased competition could hamper the growth of the business.

Rising interest rates

Morgan Stanley has planned at least 6 interests rate hikes in 2022 as the Fed attempts to control high inflation. A higher interest rate means higher discount rates and compression of valuation multiples for growth stocks. It’s the biggest threat to all growth stocks right now and keeps them at depressed levels. Higher interest rates also increase the cost of servicing non-fixed rate debt, and as a result, Splunk’s $3.1 billion in long-term debt could become more expensive to service. On the positive side, high inflation devalues ​​debt, so it’s really two forces at work.

Opportunity cost

There are currently many opportunities in the market in blue chip tech names that are extremely profitable (unlike Splunk), but have also seen significant declines. These include many FANG stocks, but mainly Meta (FB), Netflix (NFLX) and Amazon (AMZN).

Final Thoughts

Splunk is a fantastic company and has been a true pioneer in the data monitoring industry. Their new focus on subscriptions and a usage-based model seems like a great strategy moving forward and should give the company greater appeal. They have significantly increased R&D and sales spending, which has weighed on operating profit, but free cash flow is positive and has risen sharply. The competition in the industry is fierce from the aforementioned competitors. In general, the stock is quite intrinsically valued and relatively undervalued. They are posting earnings in just a few weeks, so I expect more volatility around that point.