The past two months haven’t been kind to the software-as-a-service sector, as inflation and interest rate fears have caused a rapid and violent sell-off in these juicy, overpriced stocks.
However, could the sell-off have opened up bargain opportunities? Accelerating digital transformation amid COVID-19 is still in full swing. Rosenblatt analyst Blair Abernathy recently wrote that digital transformation stocks should continue to see strong growth for at least the next few years, on a recent bullish note.
This is why my SaaS stock of choice for 2022 is a key player in enabling and protecting those large-scale cloud transformations for large enterprises. However, due to some misconceptions about the stock, it is trading at a bargain lower price when compared to the rest of its expensive peers.
Splunk is submerged in 2021
Splink (NASDAQ: SPLK) It is a competitively privileged suite of installed software that collects data from IT infrastructure and software applications, allowing organizations to operate, research, and analyze data produced by any digital device or system. Splunk divides its offerings into three general categories: Splunk Cybersecurity, Slunk IT Systems, and Splunk Observability cloud.
Despite its category leadership, the company is currently trading at a massive discount to the segment, due to uncertainty about not one but several moves the company makes simultaneously.
2 busy years
The most significant transition is the company’s transition from an on-premises software company to a cloud-first company. However, there are actually many changes happening under the hood in addition to the cloud transition, including:
- Perpetual licenses for subscriptions, which impact revenue in the near term as prepayments are replaced by monthly or annual subscriptions.
- Full-term billing for annual bills, which affects not only revenue but also cash collection and operating cash flow.
- From on-premises to the cloud, including developing its own monitoring capability suite with the help of multiple real-time acquisitions.
- Fixed subscription pricing based on workload.
- Recent CEO resignation (announced November 15), with no successor selected yet.
The transition from perpetual licenses to subscriptions put a pause in Splunk’s revenue growth trajectory, which turned negative in fiscal year 2021 (Splunk’s fiscal year ends in January). However, revenue is starting to return to growth this year. Operating cash flow has also declined negatively, but bottomed out in the middle of last year and is steadily recovering:
Even though financial results have taken a turn and are heading toward normalization, Splunk’s post revenue of $2.51 billion still tracks below its $2.83 billion annual recurring revenue (ARR), which is what investors should really consider about the company’s trajectory. Up until the transition is complete.
Trading at a big discount
Splunk is trading at a massive discount to its peers and is down nearly 50% from its all-time highs since mid-2020, when revenue growth turned negative and management withdrew guidance amid uncertainty. Here’s how Splunk stacks up against its closest peers, based on revenue growth and EV-to-sales ratios:
Despite being cheap, the above numbers overvalue Splunk based on ARR (it currently trades at an EV to ARR of about 7 pairs, against 7.9 times revenue), while underestimating its ARR growth (37% vs. 19% of revenue (growth in the last quarter).
These competitors are not, of course, perfect companies, because they have a little different though overlapping product portfolios and customer bases; However, as they move forward in the cloud, or belong to the original cloud, they each have revenue and ARR that are more or less aligned with each other. The EV-to-sales ratios appear to correlate with revenue growth.
Very rudely, if Splunk is evaluated in the same ballpark as dynatrans (NYSE: DT) or flex (NYSE: ESTC) — whose revenue growth is very similar to Splunk’s 37% ARR growth, the EV to revenue ratio should be in the same ballpark of 15 to 22. That means a two to threefold increase in the stock price.
Amid confusing financial data, Splunk may struggle with the perception that original competitors in the cloud are consuming market share. The recent resignation of CEO Doug Merritt after six years in the job has also increased uncertainty about the company’s leadership.
Refuting these fears
There is still little evidence to suggest that Splunk is losing market share to competitors. Yes, datadog (NASDAQ: DDOG) It is growing faster and is a “cloud first” competitor. However, Datadog, for all its success, is mostly geared towards small and medium-sized businesses, while Splunk is really geared toward large organizations. Splunk has acquired more than 90 luck 100 companies and this has not changed, even during the bumpy transition.
Furthermore, Splunk has continued to publish metrics for net dollar retention (DBNRR) on cloud subscriptions at 130%, and this number has been pretty flat over the past two years. This means, on average, that Splunk’s existing cloud customers are spending 30% more this year than they did last year. In the third quarter of fiscal 2020, the DBNRR was 133%; Two years later, in the third quarter of fiscal 2022, that number was 130%, which is a slight slowdown from the past two years from a much larger base, and in fact an acceleration from 129% in the previous quarter. This seems to indicate that Splunk customers continue to buy more services and not flock to competitors.
It is also likely that large companies will be reluctant to move away from Splunk, because most large companies will always maintain some IT infrastructure on premises and will require hybrid Splunk offerings. Management said its business will eventually reach 80%-90% cloud, with the rest deployed locally.
Finally, the mission-critical nature of Splunk software, which is widely deployed in large organizations with diverse data sources and infrastructure, makes it a very “stable” product.
Recent financial metrics seem to support this
In the past quarter, cloud ARR growth accelerated to an average of 75% to just over $1.1 billion, making up 39% of total ARR. Cloud should soon exceed non-cloud ARR within quarters. Cloud bookings already exceeded 50% of total bookings in Q4 last year for the first time, and jumped solidly from 54% to 68% in one quarter in Q3.
Faster-than-expected cloud growth is likely underpinned by two new major cloud appointments from Amazon (NASDAQ: AMZN) earlier this year. In April, Splunk appointed Amazon Web Services (AWS) veteran Teresa Carlson as its head of growth. In June, Splunk appointed Shawn Bice, also of AWS, as Head of Products and Technology. The two employees show that Splunk has the potential to lure top talent away from a place like AWS—not exactly the suffering of an old company losing out to faster, more agile competitors.
Shortly after those appointments, Splunk attracted $1 billion in investment from Silver Lake Partners, in the form of a 0.75% convertible bond at $160 per share, up from today’s price of about $116. At a recent UBS conference in December, CFO Jason Child spoke about the Silver Lake investment.
[W]Had a discussion with them for the first time I think in late June. They got involved on a Saturday or Sunday. I put in five days of diligence and then basically you know the money transferred after a week or something, but it was really a very quick process. And you know the reason to speed it up is because I think they went through a non-disclosure agreement and dug into all the numbers. They looked at all the customer groups, butter, LTV [lifetime value], CAC [customer acquisition cost], adjusted the mix for revenue, billing, margins and all of that and basically he said you know, great! It’s like – while there are a lot of scary stories about everything that might happen with Splunk, the numbers are very, very strong, and so you know that’s why they’re willing to invest so quickly.
Some might attribute CEO Doug Merritt’s recent resignation to the Silver Lake effect, but that’s not necessarily the case. The reason given by management was that Doug had been CEO for six years, had more of a penchant for entrepreneurship, and there was some question about how long he wanted to be CEO. After Merritt oversaw that massive turnaround, Splunk now has $3 billion from ARR’s cloud-focused company—much different from the $300 million or so from the local company he inherited when he took over.
With the company achieving separate momentum in its transition to the cloud, the board thought it was time for a CEO with experience running a cloud software business at scale. President Graham Smith, former chief financial officer of sales force (NYSE: CRM), the first cloud-centric SaaS company, has stepped in as an interim CEO and is likely to be a candidate for the job, and sure enough, the two new employees at AWS may also be internal candidates as well as external candidates.
Upcoming Catalysts for 2022
With these many questions open between changing the business model, changing the billing process, and changing management, solving these issues could be catalysts for 2022. As we are past the midway point in the transition and revenue is increasing again, revenue should start tracking closer to the additional ARR. .
Given that cloud ARR growth is much faster and now makes up a larger percentage of ARR, ARR and revenue must maintain its current trajectory or perhaps even accelerate as the cloud overtakes the non-cloud as a percentage of business.
It’s also possible that a new pricing model based on workload implemented over the past year will increase data usage and Splunk. Investors witnessed high growth rates published by the data warehouse company snowflake (NYSE: Snow), which has had great success with the workload-based billing model. At the same UBS conference, CFO Jason Child noted that when customers switch to workload-based pricing, the amount of data in the cloud goes up 1.5 to 2 times, as customers aren’t worried about over-savings.
Given the “perfect storm” over the past year and into the past couple of months, an extremely pessimistic scenario is priced at Splunk which has spilled stocks into a high-priced segment. At the same time, the growth of data and the digitization of the enterprise give Splunk a very favorable long-term growth prospects. While there is a vacuum at the CEO level, the company has hired several great jobs in important roles, which should lend some confidence in Splunk’s ability to execute.
I see no reason why the company couldn’t get back to all-time highs of $225 a share, which was last reached in mid-2020. That would be a pretty impressive feat in a fully priced market.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of the Motley Fool Premium Consulting Service. We are diverse! Asking about an investment thesis — even if it’s our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.