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1 Reason to Buy Splunk, but 2 Reasons to Sell After the Q1 Report

By Nicholas Rossolillo - Jun 5, 2021 at 7:30AM

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The company's cloud transformation is continuing at a rapid pace, but overall revenue is still stagnant.

The data analytics and observability industry is growing fast, but data parsing software leader Splunk (SPLK 0.06%) has been a laggard over the last year. Shares are down some 35% over the last 12-month stretch, compared to double-digit percentage gains for smaller peers like Datadog (DDOG -0.32%), Elastic (ESTC -0.13%), and Dynatrace (DT -2.05%)

Part of the reason for the underperformance is that Splunk is undergoing a transition to the cloud, and said transformation is creating some headwinds for the company's overall growth profile. It is still growing, but is valued far cheaper than its peers. On one hand, it might pay off to be patient with Splunk -- but there are also reasons to cut bait and invest elsewhere in the data analytics and observability software space.

Someone in a warehouse holding a tablet.

Image source: Getty Images.

One reason to buy: Splunk is cheap

Splunk's first-quarter 2022 (the three months ended April 30, 2021) revenue increased 16% year over year to $502 million. That's a big improvement after reporting a 5% decline in full-year revenue last year.

Within this headline result, the company actually reported annual recurring revenue (ARR) of $2.47 billion, a 39% year-over-year increase. Why the big discrepancy? ARR accounts for all sales on an annualized basis, including the company's cloud-based products and older legacy software. Put simply, Splunk Cloud is growing at a rapid pace (cloud-only ARR increased 83% year over year in Q1), but its other service revenue is stagnant at best. And since cloud ARR was just over one-third of the total in Q1, overall revenue growth is much slower than the ARR metric would indicate. 

As Cloud slowly overtakes legacy software over time, some of this differential will eventually be fixed. But for the time being, Splunk will continue to report a big disconnect between ARR and actual recognized revenue. The company expects second-quarter revenue to be $550 million to $570 million, implying year-over-year growth of 12% to 16%. Given this expectation, Splunk stock still looks like a value at about 8.5 times trailing 12-month revenue. Its smaller peers trade for 20 times trailing one-year sales or more -- although they are growing at a faster clip. So I'm choosing to be patient with my existing Splunk position for now.

Two reasons to sell: Growth expectations and profits are lagging

Nevertheless, cloud computing has turned the IT world on its head. Organizations' workforces and systems are networked together like never before, and are getting increasingly complex. A new type of cloud-based analytics and observability software is needed.

In fact, Dynatrace was recently named the leader in this space by tech researcher Gartner (IT 0.23%). Splunk stock's underwhelming performance as of late can be partially explained by its lagging software tech. Dynatrace, for example, expects to grow about 30% this year. Put another way, there are other businesses that are cloud native and should expand at a faster pace than Splunk for the foreseeable future. 

Splunk has been making up for its deficiencies by making acquisitions. Most recently, it announced the takeover of security analytics firm TruSTAR for an undisclosed amount. Again, this could eventually pay off, but it will take time. And because of these purchases, paired with effects from revenue recognition delays (because of the aforementioned transition to a cloud-based model), Splunk operated in free-cash-flow-negative territory last year -- negative $289 million to be exact. Free cash flow turned positive again in Q1 at $66.7 million, and the company expects it will stay in positive territory for the balance of this year. But profits are nevertheless slim, and could stay that way for a while longer as Splunk's cloud makeover continues.

Just to reiterate, I'm not parting ways with my Splunk stock. It's been a profitable long-term investment, and I think it could pick up the pace again later this year. Plus, cloud observability is a fast-growing endeavor, and Splunk is forecasting a return to overall growth. But there are better long-term bets to invest in as well, so I'm not buying any more Splunk stock after its Q1 update.

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Stocks Mentioned

Splunk Inc. Stock Quote
Splunk Inc.
SPLK
$94.48 (0.06%) $0.06
Gartner, Inc. Stock Quote
Gartner, Inc.
IT
$241.77 (0.23%) $0.56
Dynatrace, Inc. Stock Quote
Dynatrace, Inc.
DT
$41.16 (-2.05%) $0.86
Datadog, Inc. Stock Quote
Datadog, Inc.
DDOG
$108.03 (-0.32%) $0.35
Elastic N.V. Stock Quote
Elastic N.V.
ESTC
$75.49 (-0.13%) $0.10

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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