Splunk (NASDAQ:SPLK) plays at the intersection of favorable tech trends that will drive sustainable growth. It has executed its strategy effectively despite growing competition and unfavorable macro developments. Having done the bulk of the heavy lifting, investors will only be worried about occasional earnings volatility as it completes the transition to cloud subscriptions. Splunk’s valuation offers more potential due to the unique combination of its offerings. The current valuation is also attractive as Splunk as a lot of industry-leading cloud products that compete favorably with offerings by cloud-native competitors.
Splunk is a commendable innovator that plays into multiple fast-growing segments in the tech space. Splunk plays in the IT operations, security operations, and the DevOps space. All three segments are growing at a fast pace. By market share, Splunk is a leader in the IT operations management space. It is a visionary in the APM (application performance monitoring) space. Given that its offerings are cloud-native, it is easily a leader in the market for enterprises that are geared towards adopting cloud-based APMs. Its SIEM (security information and event management) solution is also ranked as one of the best.
Splunk has been able to diversify into multiple tech verticals using a combination of internal innovation and strategic acquisitions. Like most tech platforms, Splunk is currently transitioning from a licensing model to a subscription billing model. This transition has masked top-line growth metrics like revenue and billings. Going forward, I expect the transition to continue to drive growth volatility. This will impact its momentum factor as the market continues to digest the transition.
Like most tech platforms, Splunk is expanding the breadth of its capabilities. Playing in multiple tech segments represents an attractive value proposition. Splunk’s presence in ITOps, SecOps, DevOps, and AIOps is brilliant as these fields complement each other. This is also aided by its platform business model. The advantage of this platform strategy is the ease of consumption of offerings across these segments. Having an all in one platform for multiple departments to adopt tech resources comes with advantages in data aggregation and cost savings.
More users are adopting Splunk’s cloud subscription offering compared to its licensing offering. This means metrics like annual recurring revenue, dollar net expansion rate, and remaining performance obligation will serve as the best yardstick to measure growth. ARR has been growing at a fast pace in recent quarters. DBNER is one of the highest out there at 130%. COVID-19 has slightly impacted Splunk’s growth rate in recent quarters. It has also improved the visibility of cloud platforms like Splunk.
For companies with strong cash flows and easy access to cheap capital, managing working capital won’t be an issue. For Splunk, the situation is slightly different. Currently, Splunk has two mandates, which explains why its cost of capital is slightly above its competitors.
Firstly, it needs to manage the migration to cloud subscription to position itself as a cloud platform. Most cloud platforms are driving a new wave of innovation; as such, the market is rewarding them with attractive valuation multiples. This makes sense if you are leading the market into a new innovation cycle. Splunk’s second mandate requires huge investment in sales and innovation to grow market share. This is important due to the rise of cloud-native platforms like Datadog (DDOG) and Elastic (ESTC). These tasks explain why margins have been volatile in recent quarters.
Currently, Splunk appears to be managing its new reality successfully. It has acquired leading players in ITOps and DevOps to complement its SecOps offerings. Its SIEM solution is currently rated as one of the best out there. SignalFx also positions Splunk as a visionary in the DevOps space. It only needs to improve its DevOps capabilities in areas like business analytics to complete its competitive parity. To differentiate itself from competitors, Splunk acquired VictorOps, a leading ITOps solution. Most DevOps players don’t have ITOps offerings. Splunk is also pulling ahead of its competitors by offering AIOps and data science capabilities. This is enabled due to its superior capabilities in data management via its logging and search solutions. As such, I expect these capabilities to drive sustainable double-digit growth in the long term. EPS will remain volatile until cloud ARR and the subscription shift becomes the biggest driver of revenue. I also expect COVID-19-related headwinds to wane. This will drive favorable working capital as Splunk’s investments to grow its new offerings have been a major headwind to operating cash flows. Splunk will also benefit from its presence across all business segments. Its strength with large enterprises points to the potential for large deals and renewals to drive operating cash flows. As such, I believe it is highly plausible that Spunk surpasses its FY’2023 FCF target of $1b, given the breadth of its capabilities.
Splunk sits in the middle of the cloud evolution with a fair blend of cloud subscription revenue growing at a fast pace and license revenue declining due to more cloud billings. The market is valuing Splunk for sustainable double-digit growth. The potential to expand margins in the long term is also attractive, as demonstrated by its current dollar net expansion rate. Therefore, I expect Splunk to trade in line with other cloud platforms with solid growth factors.
In the bullish scenario, I am projecting double-digit growth and a 20% CAGR over the next 10 years. I see strong potential for Splunk to dominate competitors using its experience in melding SecOps and DevOps capabilities to drive solutions that will lead to huge cost savings for enterprises. Therefore, Splunk is expected to experience massive margins expansion as it scales its cloud revenue. This will drive FCF margin in excess of 30%. If COVID-19 persists, more demand for remote working solutions and the usage of cloud platforms will drive down the risk premium of cloud stocks. Therefore, I expect multiples to expand to 20x TTM revenue.
In the base scenario, I am projecting mid-teens growth over the next ten years. I expect growth to be driven by usage growth and cross-sell. I expect Splunk to continue to trade in line with other tech platforms, making a transition to cloud subscription. This will drive occasional billings volatility and valuation corrections. I also expect the world to shake off the COVID-19 restrictions. This will cause tech players to spend more on sales and marketing, which will result in a headwind to margins expansion.
In the bear case, I expect competitors to evolve cloud-native solutions at a faster pace. I also expect public cloud platforms to evolve more capabilities to play in the DevOps and SecOps segments. This will raise customer acquisition costs. This will also impact the IRR of its cloud bets.
Splunk is well-positioned to capture market share in a lot of fast-evolving segments. It has the resources to keep executing, and the future roadmap is promising. I expect the market to be nervy as Splunk continues its cloud transition. This will result in occasional corrections and entry opportunities for investors seeking growth at a reasonable price.
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.