Splunk: The Unstoppable Firecracker

Summary

• Splunk shares rose >10% and broke $100 for the first time after reporting Q4 earnings.
• Revenue growth accelerated yet again to 37% y/y, up from 34% y/y in Q3 (which in itself was already an acceleration from Q2).
• Cash flow also saw healthy growth, and the company smashed earnings and guidance targets.
• Demand for data and data services is ramping and doesn't look like it will taper down anytime soon.
• Despite all the positive signals, shares look fairly valued at 8x forward revenues.

I learned a lesson the hard way when I let go of my Splunk (NASDAQ: SPLK) shares in the fall of last year, missing out on a broad rally that could have taken my position 30-40% higher. And as I looked at Splunk's Q4 report, I'm kicking myself even more as the stock raced ahead to $100. There's no doubt about it: this company has emerged into the spotlight this year as a huge winner.

The bullish story is very evident in Splunk's growth numbers. For some context - Splunk is guiding to a midpoint of $1.625 billion in revenues for the next year, a huge scale that precious few software companies ever reach (I'll caveat this by saying that Splunk is still primarily a license company versus pure SaaS, so it's not exactly an apples-to-apples comparison with the other high-growing software companies in the market). At Splunk's current scale, it's within spitting distance of other software heavyweights like Autodesk (NASDAQ: ADSK) at ~$2 billion in revenues and ServiceNow (NASDAQ: NOW) with ~$2.6 billion. This is, for sure, the upper echelon of software companies that have "made it" into the big leagues.

And despite this scale, Splunk is still growing well north of 30% and accelerating revenues quarter after quarter. Nothing else says success like posting these kinds of numbers.

Furthermore, the demand backdrop for Splunk's services is extremely robust. Companies are scrambling to make themselves more data-driven (or at least appear that way in front of their customers and shareholders). Some companies pay hefty subscription license fees to the likes of Twitter (NASDAQ: TWTR) for access to their data feeds. What Splunk allows you to do is much better - it gives you access to your own data (the "machine data" generated automatically by all your connected endpoints), which is much more relevant and hits closer to home than a third-party data source. Even if it took Splunk a while to capitalize on this mass-market shift toward intensive data consumption, it's certainly benefiting from the enterprise world's data-hungry trends now.

All this strength - a fantastic narrative plus the actual quarterly results to back it - has been strong justification in seeing Splunk's stock nearly double over the last year. And certainly, looking at Splunk's above-consensus guidance for FY19, the company shows no signs of slowing down.

But at this point, investors do have to ask themselves if Splunk's valuation can hold. With the stock trading at ~8x forward revenues, it's not the most expensive software stock in the market (Adobe (NASDAQ: ADBE) and Workday (NYSE: WDAY) still trade 1-2 turns higher), but it doesn't have much more room on the upside either.

SPLK EV to Revenues (Forward) data by YCharts

At current levels, Splunk is a hold. Investors might also want to consider locking in gains. It's nearly without question that the company will continue to outperform against Wall Street's targets, but whether or not the stock can continue to outperform the broader market when it's already been such a steady riser over the past year remains to be seen.

Q4 download: acceleration, yet again

The biggest takeaway from Splunk's fourth-quarter results (see earnings summary below) goes no further than the headline number. Revenues accelerated once again, growing a mind-boggling 37% y/y to $419.7 million. This stacks up extremely well against analyst consensus of $390.9 million, or 28% y/y growth, with a nine-point beat to expectations.

Figure 1. Splunk Q4 results

Source: Splunk earnings press release

When a company gets to this size, the earnings surprises and the beat margins naturally tend to condense into smaller numbers. You can see that with the likes of software giants like Salesforce (NYSE: CRM) - it has beat almost every quarter that it's been a public company, but as Salesforce moves to the ~$10 billion scale (about 6x Splunk's size), its quarterly beat margins have gotten slimmer. Part of this is because analysts have gotten used to what to expect from the company, and part of it is because it becomes progressively harder to chase growth once you approach saturation in your market.

That also leads to a second point - the fact that Splunk accelerated growth atop this massive scale is truly impressive - not just in this quarter, but last quarter as well. When a big company like Splunk shows acceleration on the top line, Wall Street's models (which always bake in deceleration) get thrown off course, causing high estimate revisions and an ensuing rally in the stock.

So certainly, the growth is there. The primary argument in this thesis, however, is that at 8x revenues, that outperformance is likely already baked in. On the converse side of this situation, if Splunk were ever to miss expectations, its high valuation would take a nasty tumble.

Splunk has also done an excellent job at trimming its losses, with GAAP operating loss slimming down to a mere -$23.9 million (a -5.7% operating margin, basically breakeven) versus an operating margin of -23% in 4Q17.

What I especially liked seeing was the fact that the company's general and administrative costs actually went down despite the company's growth, with Splunk shaving off ~$5 million of its cost structure to end at $47.6 million in general overhead for Q4. When companies are growing, executives usually tend to use that as a wide permit for freewheeling headcount additions and excess luxuries. The general and administrative spend as a percentage of revenues will tick down by a few points year over year, but won't really move the needle by much. And unlike spending on R&D or sales and marketing, general and administrative spending has little correlation with actual growth. With Splunk, however, it showed immense discipline to down its percentage of general and administrative spending to just 11% of revenues, down from 17% in 4Q17.

This, combined with additional efficiencies realized in sales and marketing, were the major drivers behind the huge margin improvements. The company's pro forma EPS of $0.37 also beat analyst expectations of $0.33 by a healthy (>10%) amount. Based on the upside guidance for FY19, even though Splunk doesn't specifically guide to the bottom line for the full year, we could see Splunk hit breakeven on a GAAP basis at some point in FY19.

Cash flow, as usual, was another big plus for Splunk. The company's operating cash flows grew 42% y/y to $173.5 million for the fourth quarter. Netting out $6.6 million of capex, Splunk's free cash flow was $166.9 million, nearly doubling from $84.4 million in the prior year (though the last-year comp was colored by a seemingly accelerated capex schedule). All told, though Splunk generates a highly respectable 20% FCF margin - though we do also note that as a license company that bills a lot upfront, it's not a perfect comparison against software companies that have a more spread-out subscription billings schedule.

Key takeaways

Splunk's growth engine is undeniable, and the coming years will see even greater tailwinds for Splunk as it capitalizes on strong demand for data-oriented infrastructure software. Application software names like Salesforce and Workday are still showing robust growth, but they play in much more competitive circles than Splunk does. Within machine data, Splunk is nearly the only game in town.

All this, however, seems to be fully baked into Splunk's stock price at >$100, leaving little room for value-conscious investors to find a bargain in the stock. Wall Street may sing its praises for Splunk, but valuation does place a real ceiling on hot stocks like this. At best, Splunk is a hold - this is not a name I would chase as it's going up.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.