IT systems management, cybersecurity, and observability company Splunk (SPLK) surged more than 11% late Friday, after The Wall Street Journal reported tech giant Cisco Systems (CSCO -0.14%) had made an offer to buy the company for more than $20 billion.

It's obviously a nice thing when someone is interested in your stock, but as a recent Splunk shareholder, I'm hoping the company doesn't sell, if the offer is in fact close to $20 billion. Splunk finished trading on Friday at roughly an $18 billion market cap, and after the after-hours surge, the market cap rose to $20.2 billion.

At this price, it appears Cisco would be getting a steal, unless the price winds up being a lot higher than the $20 billion reported.

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Image source: Getty Images.

Splunk's advantages

Splunk has positioned itself as the leader in helping large enterprises manage and monitor their IT systems. Founded in 2003, it was an early mover in the data analytics space, even before cloud computing came into being. So Splunk has been able to capture over 90 of the Fortune 100 companies as customers, even in spite of new cloud-based competition. And over the past few years, Splunk has made a number of tuck-in acquisitions to enter into the hot observability space, which allows corporations to monitor the health of software applications, in addition to IT infrastructure.

Deeply embedded in the largest companies and their technology systems, it would be a big undertaking to replace Splunk with a competitor. In fact, many large companies use multiple vendors for internal data analytics. So Splunk appears to have staying power, and is bound to benefit from the growth of the enterprise data analytics industry this decade. IDC forecasts data creation and replication will grow at a 23% annualized growth rate from 2020 to 2025, and that acts as a powerful tailwind for the industry.

Why Splunk is so undervalued

In spite of these strong qualities, Splunk traded at just 7.5 times trailing sales at the end of trading Friday -- a relative bargain in the high-growth software sector. This is because of several transitions the company is undertaking at once.

Several years ago, Splunk began to deploy its offering via the cloud on a subscription basis. That's a change from its traditional business model of selling perpetual software licenses, deployed in customers' data centers. Other tech companies have made that transition in the past, but when they do undertake this transition, they will initially show revenue declines, as larger multi-year deals are replaced by smaller annual but recurring revenue. Additionally, cloud revenue has a lower gross margin than term software licenses, but that's generally made up for in higher growth.

However, as Splunk gets further through the transition, revenue growth will gradually track closer to annualized recurring revenue (ARR), which includes the annualized value of all cloud, on-premise, and maintenance service contracts. You can see Splunk's revenue took a dip in 2020 as it went through the trough of this transition. However, now it's coming through the other end of it:

SPLK Revenue (TTM) Chart

SPLK Revenue (TTM) data by YCharts

Even though Splunk is now past the bottom of the transition, revenue growth according to generally accepted accounting principles (GAAP) is still lagging behind the real recurring top line the company is taking in. In the most recent quarter, revenue growth came in at 19%, but ARR grew 37%. And cloud-based annualized recurring revenue grew 75%, with a cloud-based net retention rate of 130%. That certainly indicates the new cloud offerings are very successful with customers.

So, headline revenue numbers may be misleading, giving the impression Splunk is lagging behind cloud-native upstarts such as Dynatrace and Datadog. But looking under the hood to ARR and the cloud segment shows a much better growth picture.

Adding to the complication is that Doug Merritt, Splunk's CEO over the past six years, resigned back in November, which sent the stock another leg down. However, it appears Splunk has a fairly deep bench, especially with two big new hires from Amazon, so it should be able to find a suitable replacement either internally or externally.

Finally, recent concerns about inflation and higher interest rates have hurt most tech companies, especially those still losing money. Splunk is currently unprofitable, and the stock has been unable to bounce back from last year's challenges with this interest rate cloud hanging over it.

In that light, it's no wonder Cisco may see an opportunity to swoop in at this time of transition and uncertainty to take Splunk for itself. Cisco was built on its leading position in enterprise hardware, but has made a big strategic effort to buy its way into the more stable software space. Splunk would be a perfect target for its ambitions, and would be Cisco's biggest acquisition ever, about triple (or more) the $7 billion acquisition of Scientific Atlanta back in 2005.

Why I don't think a deal will happen -- at least not for $20 billion

While the offer from Cisco is a nice indicator of Splunk's value, as a Splunk shareholder, I really hope management rejects the offer or demands a much higher price.

First of all, Splunk is far off from its all-time highs, down about 48% from its 2020 highs at the end of trading on Friday. Every sell-side analyst on Wall Street has a higher price target than Friday's close, with the lowest at $120 per share, and the highest at $225 per share, with the average at $162. That compares with a $114 share price at the end of trading Friday and $127.45 after hours.

Finally, Splunk attracted tech-focused private equity firm Silver Lake last summer, which invested $1 billion in Splunk in the form of convertible preferred stock in June 2021. The notes only bear an interest rate of 0.75%, but convert to equity at $160 per share. That would equate to a market cap of just over $25 billion.

It's pretty likely Silver Lake didn't invest in Splunk to make 0.75%, but rather to make big money on the conversion. Given that Silver Lake has a seat on the board of directors, it would probably be difficult for it to vote for any acquisition below that $160 price.

In any case, the reporting suggested the offer was more than $20 billion. How far over that figure will determine whether the acquisition goes through or not. As a shareholder, I'm certainly hoping Splunk holds out for a higher price.