Splunk (SPLK +0.00%) has been a severe underperformer in the last year. As of this writing, shares are down nearly 30% over the last 12-month stretch compared to a 36% run for the S&P 500. The data log management and monitoring software leader has also trailed behind its smaller higher-growth and cloud-native peers as it adapts its business to more modern customer needs.
I think Splunk could be cheap right now after its underwhelming performance in the last year, though, and private equity firm Silver Lake seems to think so too. The Silicon Valley-based tech investor recently plopped $1 billion down on Splunk, a significant cash infusion given Splunk's current enterprise value sits at $23 billion. Is this the software value stock for you too?
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What's to be done with $1 billion?
Splunk's $1 billion cash windfall gets it access to some cheap capital -- at least cheap in the short-term. Silver Lake's investment is via convertible notes, debt that can be turned into new stock later on. The notes have an annual interest rate of just 0.75% per year payable to Silver Lake, and they mature in July 2026 if they haven't been repurchased or redeemed by then. The initial conversion price is $160 per share. At the time of the announced deal, that was some 30% above where Splunk stock was trading, although shares jumped nearly 10% higher on the news. As a reminder, debt converted into new stock dilutes ownership for existing shareholders.
Silver Lake obviously sees upside for Splunk stock and will collect a meager amount of interest along the way for its convertible debt stake in the company. Splunk, for its part, plans to use the cash to continue to transform its business for the cloud era. Concurrent with Silver Lake's investment, Splunk said it will also begin executing a new $1 billion share repurchase plan (which should help offset any future conversion of the debt into new stock). Silver Lake Chairman and Managing Partner Kenneth Hao will also join Splunk's board of directors to help guide the company's journey.
Managing its own migration to the cloud
Splunk's software collects data logs and can give an enterprise added insight into operations, security, and application performance. But the advent of the cloud has shifted these needs away from legacy IT systems, and Splunk wasn't exactly ready for the change. It's had to adapt its suite of services and the way it bills customers for this new cloud era. Cloud annual recurring revenue (ARR) has been off to the races and was up 83% year over year in Q1 fiscal 2022 to $833 million, but these changes have throttled overall revenue expansion. Total revenue in Q1 2022 was up just 16% from a year ago to $502 million, a decent rally after overall revenue fell 5% last year.
This cloud transformation also caused Splunk to dip into negative free cash flow territory, and it only just returned to positive free cash flow in Q1 2022 (to $66.7 million). Management expects to be in the black for the balance of the year ahead, so that's good news. But there's still lots of work to be done on the cloud business. Cloud ARR was only just over one-third of total ARR in the last quarter, so there will likely be more variability in overall growth and profitability in the next couple of years as more customers make the switch.
Then there's also the balance sheet. At the end of April, the company had $1.88 billion in cash, equivalents, and investments, offset by convertible notes of $2.33 billion. Silver Lake thus isn't the only investor in line to convert debt into new stock, and this isn't the cleanest balance sheet in the software industry at the moment. However, cash on hand and positive free cash flow will fund that new $1 billion share repurchase program, which should help boost earnings per share over time.
It appears Splunk is back in growth mode, and recent acquisitions and the launch of its new Observability Suite and Security Cloud offerings could help sustain this return to growth. At just under 10 times trailing-12-month sales, this cloud stock trades for a discount to its higher growth peers like Dynatrace and Datadog. Though it's been beat down in the last year, Splunk operates as the leader in a growing industry and could be a real long-term value for those who can patiently wait out the inevitable bumps in the road.
