Cloud computing is a large, fast-growing industry that's expected to grow at a rate of nearly 18% annually to reach $791 billion by 2028. With such a big market opportunity, there have been lots of players entering the space, and Splunk (SPLK) is one of them.
Shares of the company are trading almost 50% off the all-time highs set in late 2020, which has brought its valuation down to 7.4 times sales -- a valuation that Splunk has reached only a handful of times in its almost 10-year life as a public company. Is now the time to take advantage of this rock-bottom multiple?
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The Data-to-Everything Platform
Splunk deems itself a Data-to-Everything Platform, and that name is well-fitting. The company delivers analysis of data to its customers in an actionable way, specializing in three segments: security, IT, and observability. With companies producing increasing amounts of data from their software every day, analyzing and deriving insights from all of it is becoming increasingly challenging. More importantly, noticing security breaches and application outages can also be difficult with all of this data, and Splunk is trying to make these observations easier.
Splunk's services are quite good at what they do. The company says that its customers have 70% fewer data breaches with Splunk, and with its observability platform, developers can be 90% more effective when developing and monitoring applications. These impressive improvements have attracted 92 of the Fortune 100 companies, and 635 customers find its services so critical that they are willing to spend over $1 million with Splunk.
The real growth story for Splunk is its transition to the cloud. The company was originally an on-premise service provider, but it has since transitioned to a subscription-based cloud model. Splunk now receives 33% of its revenue from cloud services, which improved nicely from 7% in fiscal year 2018. Over the past year, the company has seen impressive growth in its cloud segment. In each quarter of the 2022 fiscal year (the calendar year 2021), Splunk has seen 68% or more year-over-year cloud revenue growth.
The dark side of the moon
This cloud transition looks impressive on the surface, but Splunk has some aspects that certainly make it less appealing. The first is its management shifts. In November, CEO Doug Merritt stepped down effective immediately. He had been at the helm of Splunk for eight years and had driven the company's successful cloud transformation so far. During his years at the company, he helped it grow from $300 million in revenue to nearly $3 billion in annual recurring revenue, so the transition was a massive ding to the company.
Splunk is also experiencing a growth slowdown. Through fiscal years 2018-2020, it was growing its top line consistently in the 30% range, but in FY 2021 and so far in FY 2022, the company's growth has been extremely poor. In FY 2021 (the calendar year 2020), revenue dropped 5% year over year and so far this year revenue is only up 11% compared to the year-ago period. This shows me that while Splunk is successfully moving to the cloud, it's happening at the cost of growth.
Profitability and positive free cash are also seemingly the costs of this attempted cloud transition. So far this year, the company has lost almost $1.2 billion, which represents roughly two-thirds of the company's total revenue. Additionally, its net loss so far in 2022 (the calendar year 2021) grew 56% year over year compared to revenue growth of 20% over the same period. This is in addition to a free cash flow of negative $20 million so far this year.
Is it investable?
The company is seeing a strong cloud transformation, but I don't think continued success is in the cards for Splunk. While its cloud revenue is growing as a percentage of total revenue, Splunk's total revenue is still primarily driven by its old, non-cloud services. These services are doing quite poorly: The segment did not grow at all year over year in its recent quarter.
Splunk's former CEO seemed to lead the transition to the cloud, and he did a good job doing so. However, without him, the company has to find someone new directly in the middle of their cloud transition process, and that is concerning. With competitors like Datadog catching up to Splunk, this transition is simply bad timing.
Splunk could be successful but there are simply too many variables and too much risk right now, which is why I don't think it is currently investable. At a bare minimum, I would wait until the company finds a CEO and turns around its growth before I reconsider. At all-time low valuations, this stock is either a value play or a value trap, and I see it as the latter today.
