Splunk: Time To Go Long
Summary
- Splunk’s short-term price weakness is good for long-term investors to pick up shares at lower prices in a company that is estimated to grow ARR ~40% through 2023.
- Weak third-quarter results and fourth-quarter guidance will pressure near-term price action.
- Expanding Total Addressable Market should provide further growth. 81B TAM in 2020 increasing to 114B by 2023.
- Product value driving customer retention & expansion - ~131% Net Retention Rate.
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Investment Thesis
Splunk (NASDAQ:SPLK) has lagged other cloud stocks in performance over the past year and guided for less revenue, but its long-term outlook still looks very compelling, and it is poised to deliver double-digit growth over the coming years. This should provide significant gains for investors who are willing to hold it for the long term.
Splunk's stock price may be range-bound for some time unless its transition to cloud based revenue is completed and investors have more confidence in its ability to execute on its growth plan. The short-term revenue declines that are seen now and that will be seen for a few quarters will reduce investor confidence, but this is the time to consider it when it's down and trading at discount valuations. There are other better cloud stocks that can be invested in right now but they are trading at premium valuations to Splunk and thus makes it a better choice. At the end of the day investors should be willing to buy stocks in the cheap to realize a higher gain on their investments.
Business Outlook
Splunk prides itself as a Data-to-Everything platform and helps customers analyze the vast amounts of data to get meaningful insights. Considering data usage will grow at a solid pace, Splunk should be able to market its mission-critical solutions to customers easily and continue to increase its market share.
Splunk has three focus areas and has a leading position in all of them. Its solutions include data analytics, threat detection, incident response, application performance monitoring, IT Infrastructure monitoring and other features. These help customers to improve the efficiency of their business operations, make more use of the data generated while doing it securely over the cloud.
Source: Splunk
Competitive Advantage
Morningstar Research provides Splunk with a Narrow moat due to the high switching costs and network effects associated with its products. The switching costs are due to the mission-critical function played by Splunk's products and how entrenched they are in their customers' day to day activities. Any change in vendors brings several risks like operational disruptions, lost productivity, time to implementation and additional overhead costs. This moat should help it fend off competition & achieve higher return on investments.
Splunk is a leader in Security Information & Event Management (SIEM) and a visionary in Application Performance Monitoring as per Gartner Research. Investments in current products will help it maintain this lead and also improve the value provided by its other solutions.
Splunk counts 92 of the Fortune 100 as customers and has consistently increased the amount of customers with ARR>$1M. This testifies to the importance of Splunk's products to large organizations which should help bring in more customers over time and entrench itself in many of the critical functions of several organizations.
Source: Splunk
Splunk has several high profile competitors such as Elastic (ESTC), Datadog (DDOG), and Dynatrace (DT), but its leadership position in several of the areas of focus and its position in its customers' critical businesses make it a formidable company. Its competitors will make headways into its business, but Splunk should be able to hold them at bay with its solutions and increase its market share. Elastic especially has a lot of products similar to Splunk, but I believe the total addressable market is larger for several players to grow significantly in the coming years due to the digital transformation that is taking place around the world.
Revenue Growth
Total revenues have been down Y/Y for the past two quarters due to the shift to subscription model and uncertain market conditions brought about by the pandemic which in turn caused some customers to delay committing to long-term contracts, but its cloud revenue has been growing significantly.
As we reached the end of October, we saw a much lower-than-normal close rate among our largest deals, which caused us to fall short of our bookings target. Overall, our third quarter did not meet our expectations. Despite these near-term headwinds and our Q3 performance, Splunk remains one of the fastest-growing enterprise software companies in history. As we outlined at our Investor and Analyst Day, we're early in the penetration of our $81 billion TAM.
- Doug Merritt, CEO
Source: Splunk
The revenue declines are attributed to the change in realizing revenue upfront once signed versus a period of time as in subscription revenues. But the declines are still a concern, and Splunk's stock price will be judged based on these metrics for some time unless the transition is completed and we see actual year over year revenue growth projections from management.
Even though total revenues were down, the Annual Recurring Revenue (ARR) has been growing at a solid pace over the past few quarters with cloud ARR growing much faster. I view this as the metric that investors should be focused on to get the direction in which the company is moving towards.
Source: Splunk
Management expects ARR to grow at ~40% CAGR through Fiscal Year 23. This is a big testament to its growth and Splunk's stock price will eventually follow this trajectory to sustained gains for investors. It will be prudent for investors to start a position here before the transition is completed and the stock price becomes expensive.
Source: Splunk
Shift to Cloud
Splunk is shaping itself to be a cloud first company and the majority of its software bookings now come from the cloud. Although Cloud ARR makes a small portion today, its growth rate is higher and has a larger runway for growth.
Source: Splunk
The shift to cloud provides several advantages to Splunk as it helps it drive innovation faster and accelerate its digital transformation to bring more value for its customers.
Cloud contribution to software bookings is estimated to be greater than 80% of total software bookings by Fiscal Year 2023 from 53% today. Customer expansion is usually faster when they shift to the cloud, with the average ARR growth increasing 2.6 times in the first year of a cloud purchase and 5.4 times after 3 years.
Source: Splunk
Net Retention Rate
Splunk's Dollar Based Net Retention Rate (the amount of revenue growth from existing customers) has been consistently high and seems to be sustainable due to the value proposition of its solutions and the accelerated move to cloud based solutions that we are seeing in general. The pandemic has proven to be a tailwind for this acceleration.
Source: Splunk
Splunk should be able to retain its existing customers, get more business from them and add new customers due to network effects. A net retention rate greater than 130% is no small feat and is usually seen in smaller cloud companies, not one with over 550M in quarterly revenue. This makes it one of the exciting cloud companies to be invested in for the long term.
Total Addressable Market
Splunk has a large and increasing Total Addressable Market for its products. The Total Addressable Market is expected to reach 114B by 2023 as per management from 81B today.
Source: Splunk
Splunk's current ARR is ~2% of this and thus has tremendous opportunities to grow and expand its revenues in the future.
Acquisitions and new product introductions should increase the TAM and contribute to further growth. Splunk's previous acquisitions are a testament to this growth. Recent acquisitions of SignalFx, Streamlio, Plumbr, Rigor and Flowmill have cemented its leadership position and complemented its existing solutions. Splunk will look to acquire more companies in the future that helps it execute its vision of being the go-to platform for everything data-related.
Valuation
Splunk has a lower valuation in terms of Price/Sales compared to its direct peers and also to other cloud companies. This is one of the centerpieces to recommending the stock at this time before its revenue transition is completed, at which time it could trade at higher premiums similar to its peers and command higher prices. Its Total ARR is still increasing north of 40% for several quarters and is therefore considered very cheap relative to its Price/Sales.
Company | Price/Sales | Market Cap (B) | Revenue (TTM) (B) |
Splunk | 11.82 | 27.49 | 2.28 |
Elastic | 26.61 | 14.25 | 0.51 |
Datadog | 55.21 | 30.40 | 0.54 |
Dynatrace | 19.75 | 12.21 | 0.62 |
Source: Yahoo Finance
Conclusion
There are several tailwinds and headwinds that will affect Splunk over the coming quarters. Tailwinds include transition to cloud, growing renewal base, global expansion, increasing TAM and cheaper valuation compared to other cloud companies. The headwinds include revenue decline in the short term due to shift to cloud based subscription model from the prior perpetual license based model, competitive pressures from other vendors, uncertainty due to the pandemic causing delay in some big contracts and execution risks.
Make no doubt, the revenue declines are a concern and a big negative but we should view it in its entire context before making the assumption that it's a bad business and these declines are going to last forever. That is not the case with Splunk as seen with its increasing recurring revenue and once its revenues are back on track, it would be a good company to be invested in for the long haul. This might not be the best investment for investors looking to make quick bucks within a short time frame, but it will prove fruitful for long-term investors if the recent price declines are taken advantage of.
Overall the tailwinds look more compelling than the headwinds, which makes Splunk a stock to hold for the long term. Even though it doesn't look appealing due to the Revenue guidance in the short term, investors should be willing to pick up shares if they trend lower considering the higher growth and recurring revenue mix once its transition to a cloud based subscription model is completed in a few quarters.
This article was written by
Disclosure: I am/we are long SPLK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.