Last Thursday Splunk (SPLK) reported second quarter results, which were met with enthusiasm by analysts and investors, resulting in a 12.79% rise in share price of $34.40 on Friday, after having posted a top of $36.12 earlier on the day.
While the results were better than generally expected by the analysts, I would like to throw in a few notes of caution amidst the party.
Basically I adhere to this earlier Seeking Alpha article by Stone Fox Capital: Splunk: Huge Growth, But Ultimately Price Matters More. My first note is that Stone Fox Capital picked up a piece of information from the conference call that in my belief was overlooked:
"Our weighted average share count was 95.5 million shares at the end of Q2, and we don't expect any meaningful changes this quarter. However, as Q4 is traditionally our most profitable quarter of the year, we're expecting non-GAAP operating margin to be positive in Q4. As such, it's important to remember to use our fully diluted weighted average share count of approximately 116 million shares when calculating EPS in Q4, or any profitable period for that matter."
These extra 20.5 million shares are reserved for stock based compensations to Splunk employees. So they are not to be counted yet. But with the current valuation, in fact with any valuation above the IPO price of $19, you may take it to the bank that these options are going to be exercised eagerly by the executives that have them. Which means we must take into account a dilution of 20% as soon as quarter 4, which is only 6 months away.
I would argue that this more than wipes out all the good news of the earnings report.
Let me emphasize that I am not saying that Splunk is not a good company, I am merely saying that Splunk's current valuation has yet to be earned, that it is way ahead of itself and that investors are carried away. I am only pointing out the massive valuation and the risk of entering here.
I would even argue that the "Huge Growth" as mentioned in Stone Fox's title is a bit over the top. Compared with the year ago quarter (which was very low at 26 M) the revenue growth was 70% indeed. But compared to last quarter (37M) the growth was 20%, and compared to 2 quarters ago (43M), the growth was near zero. Anyone can check these figures here.
Let's face it, the company has never turned a profit and is forecasting another loss for this year. Yet it is valued at almost 20 times forward revenues. Even more with the future share count of 116 million shares, which basically dilutes everything by 20%. Mind you, if that share count were applied today, it would raise the market cap with a massive $700 million (4 times annual revenues).
The simple version of Splunk's message is this:
"We made 4 million more revenue than expected but we will keep losing money over the next 12 months. And by the way, we are going to dilute our share count by 20%, so you will have to share our results with 20% more shareholders, being our Splunk executives. Basically our executives employees are the main competitors for our shareholders."
Overvalued stocks like these fall harder in a market correction. If the market falls 10-20%, this is likely to drop 20-40%.
The markets are high from a historic point of view, defying the economic reality. Potential triggers for a sell-off are not hard to find these days. I would say the odds for a severe market correction or even a crash, over the next 12 months are at least 50%.
Take also into account that the lockup ends in October, while insiders have already shown their eagerness to sell in a follow-up offering with no proceeds to the company. I don't blame them for selling at these prices (by the way, 20% below the current price), as they are cashing whopping profits.
Another red flag is that the company focuses on non-GAAP results, excluding stock based compensations that keep diluting the shareholder. This is the same politics that many Seeking Alpha authors question on Salesforce.com (CRM). Some people, including me, say that reporting non-GAAP results in conference calls should be outlawed, as they are by the SEC (for good reasons). Moreover, the company is not specific about its future profitability, they did not even give an estimate on the EPS for this year, only that it will stay negative. I find it remarkable that no analyst asked a question on that. As if profits don't matter anymore for investors.
Of course the stock rose on earnings cheered by the analysts, some of whom have a vested direct or indirect interest in the company. But if you put that into perspective, the revenue beat was only 4 million with a promise to remain unprofitable for the year. Yet this added a whopping 400 million to the already lofty market cap! That is more than 2 times annual revenues. Revenues that won't be profitable this year. So a 4 million beat was rewarded with a 400 million valuation rise, a factor of 100. That is simply irrational exuberance, of which you could (and should) question its sustainability.
I have not even mentioned the risk of upcoming competitors from big established firms like or IBM and EMC. Or smaller upcoming firms. Three more of the latter category are filing for an IPO, Cloudera, Tableau and Sumo Logic: see Three More Big Data IPO's Following Splunk.
It may be prudent for overenthusiastic investors to consider the downward risks.