Splunk: Baby Dumped With The Bathwater, Buy Now

Summary

• Splunk shares have pulled back more than 30% following its pre-announcement and the departure of its CEO. Investors were concerned that Splunk might lower its FY2023 guidance.
• Splunk beat F3Q estimates and guided F4Q revenue below estimates due to accelerating cloud transition. But Total F3Q and FY2023 ARR guidance was ahead of estimates, providing a significant relief.
• Splunk's position within the industry is solid; the growth drivers are intact, and the company is in a better position than the valuation reflects.
• Splunk is cheap on most metrics we care about when compared to its peer group. Adjusting for growth makes Splunk even more compelling.
• We urge investors to buy shares here. A new CEO will be a positive catalyst as well as continued beat and raises we expect.

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Since the news of the CEO's departure, the shares of Splunk (NASDAQ:SPLK) have underperformed significantly. The shares have been down more than 30% since mid-November news. Investors were concerned that the CEO was forced out on slowing momentum in the business leading to a sell-off in shares. Following F3Q results, Splunk's management reiterated its 4Q total ARR guidance and provided initial FY2023 ARR guidance mostly in line with prior consensus estimates. Splunk reiterating its FY2023 guidance will be viewed positively by investors. Due to lower contract duration and faster than expected cloud transition, Splunk guided revenue to be lower than prior consensus estimates. The quicker than expected cloud transition will be viewed positively by investors. In addition, shorter contract duration is good for business prospects. The company can engage with its customers once every year versus once every three years, allowing it to upsell more. Splunk's shares are trading at 5.4x EV/C2023 sales, versus the peer group trading at 12.3x. Splunk is growing in line with the peer group, yet it is trading at less than half the multiple. We believe Splunk's business is intact. We hear from our industry contacts that they continue to double down on their Splunk infrastructure. Given our confidence in the story, we urge investors to be patient and buy shares in bulk.

The new CEO will be a much-needed catalyst

Splunk has cast a wide net to hire a seasoned executive who understands the technology and can scale the company to the next level. With Silverlake keeping a hawk eye over the hiring process, we expect Splunk to hire someone who knows the software business, can scale it and has credibility with investors. We expect Splunk to announce a new CEO sometime in the new year, providing momentum for the stock.

Splunk operates in a very important, growing, and complex niche of the technology stack. The observability and log analytics IT niche is large and growing. With applications now deployed in hybrid cloud architecture, the complexity of the IT infrastructure has exploded. Making sense and troubleshooting through the complexity is challenging. Hence, we believe there will be multiple winners in the market. We expect Splunk to get its fair share of the market. We believe the upside in shares is significant due to compelling valuation, product depth, technology moat, and a large roster of enterprise customers. We will not be surprised to see shares trade at near $200 levels by mid-June next year. Therefore, we urge investors to buy these shares here.

Valuation

Splunk is trading at a discount to its peer group and is not warranted. Splunk is trading at its 52-week low. Splunk is cheap on all metrics we care about – EV/Sales, Price/Sales, and EV/Sales adjusted for growth. Splunk is trading at 5.4x EV/C2023 sales of $3.6 billion, compared to its monitoring tools peer group. With the cloud transition in full swing, the revenue continues to be depressed, making the valuation even more compelling. Compared to the perpetual license model based on a three-year contract, every $1 in perpetual revenue translates to around $0.33 revenue recognized every year. Hence the revenue growth appears to be lower than its peer group average. On a growth-adjusted basis, Splunk is trading at 0.26x versus 0.54x for the peer group. We expect Splunk's outlook continues to improve from here. The news of a good CEO hire would be the first catalyst. We expect the multiple to expand rapidly on incremental positive news over the next couple of quarters. The following chart illustrates valuation relative to the peer group.

What to do with the stock

Splunk has a lot going for it – large and expanding markets, deep technology moat, the large install base of marquee enterprise customers, easy-to-use product, sticky technology platform, and compelling valuation. The company also boasts high retention rates, with DBNRR consistently above 125% for several quarters. Splunk has also completed much of the hard work from being a predominantly on-prem vendor to a cloud-first company. The company also rolled out its newer pricing models that make it much more competitive with other players in the space, including Datadog (DDOG) and Elastic (ESTC).

Enterprise customers, we speak to love Splunk's products and the ease of use of its platform when compared to other open-source solutions. Many enterprises have standardized on Splunk for collecting and analyzing the logs. Enterprises use APIs to write applications that run on top of the Splunk platform, and many of these applications are mission-critical. Splunk's Cloud First strategy resonates with its customers, and we expect many of them to adopt the Splunk cloud platform.

Splunk stock is trading at around $118, near its 52-week lows, and the stock is well off its all-time high of about $220. Therefore, given compelling valuation, conservative estimates, the impending arrival of a new CEO that can scale the business, and overly negative sentiment that is likely to become positive, we would be buying shares here aggressively. We are highly confident our faith in Splunk's story will be paid off amply, but investors need to remain patient. We expect the stock to rise as the company continues to report beat and raise quarters. Therefore, we urge investors to back up the truck and buy shares aggressively here.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of SPLK either through stock ownership, options, or other derivatives. 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.