Splunk (SPLK -0.03%) has dropped like a rock since the end of 2021. Unfortunately for its investors, the stock sold off due to the uncertainty unleashed after former CEO Doug Merritt announced he was stepping down on November 15, 2021. However, the company still has favorable business trends, and now might be the time for astute growth investors to take a look at this company.
Here are three reasons why you should consider buying Splunk today.
1. Splunk is growing faster than its addressable market
Companies use Splunk's platform to monitor, search, analyze, and visualize big data -- a capability that has three broad use cases: information technology (IT) operations, security, and observability. In 2020, these three uses added up to an $81 billion total addressable market (TAM), of which Splunk's annual recurring revenue (ARR), the value of predictable subscription revenue earned from customers in a single calendar year, made up around 2% of the TAM.
In 2022, the same three uses add up to an estimated $100 billion TAM for Splunk. And the company forecasts its ARR to make up approximately 3.5% of its TAM by the end of the year. So, if Splunk's ARR estimates and TAM are correct, Splunk is growing faster than its TAM, grabbing market share, and still has plenty of room to grow.
Additionally, Gartner ranked Splunk as a 2021 market leader in IT Operations for Health and Performance Analysis (observability), with a market share of 8.19%. And it is also a market leader in Security Information and Event Management (security), with a dominant 30.25% market share.
The best growth companies to invest in are market leaders able to grow fast in large expanding markets yet still have significant room to grow, and Splunk checks all of those boxes.
2. Consistently high renewal and expansion rate
Research company MarketsAndMarkets forecasts the global cloud computing market to grow from $445.3 billion in 2021 to $947.3 billion by 2026, a compound annual growth rate of 16.3%. Therefore, to capture that cloud growth, Splunk management decided in 2017 to transition into a Software-as-a-Service (SaaS) cloud platform by incentivizing its salespeople to sell subscriptions rather than perpetual licenses. Another reason for switching to a SaaS business model is that subscription businesses generate predictable revenue, and investors often reward such companies with a higher valuation.
One of the markets' most critical measures to judge a SaaS business is the dollar-based net retention rate (DBNRR). This metric measures whether a company can gain more revenue through sales to existing customers than it loses from customers that cancel their subscriptions. A score above 100% indicates that growth from the existing customer base exceeds any losses from that customer base.
The market likes SaaS companies that score above 110% and salivate over a subscription business scoring above 120% in a bull market.
As you can see in the above chart, Splunk's DBNRR is elite by consistently scoring around 130% for three years. Under better market conditions, investors would likely highly reward the stock of a subscription business racking up such numbers.
3. Growing profitability
While changing to a subscription business model can provide excellent profitability and returns in the long term, cloud infrastructure and other costs often lower margins and free cash flow (FCF) in the short term. As a result, investors usually initially hate businesses transitioning to a subscription model.
For example, in fiscal 2020 (the calendar year 2019), Splunk accelerated the push to a subscription business by canceling perpetual licenses for new products. As a result, FCF dropped to negative $391, a considerable drop from the previous year's positive FCF of $273. And across 2021, investors began fleeing negative FCF companies like Splunk as inflation fears rose.
However, you can see on the chart below that FCF has already rebounded. And the company projects a positive FCF above $400 for fiscal 2023.
In addition, the company is back on the path to achieving the rule of 40. Proponents of the rule of 40 believe that SaaS companies with a combined growth rate and FCF margin exceeding 40% generate cash flows sustainably. Conversely, companies below 40% may eventually have problems raising cash if they need it. The above chart shows Splunk's projections for the rule of 40 for the fiscal year 2023 are approximately 38% -- headed in the right direction.
The stock price should eventually rebound if the company continues improving profitability metrics like FCF.
Good value for a company poised for success
Splunk sells for a price-to-sales (PS) ratio of 3.81, close to its historic low of 3.79 and below the cloud services industry's PS ratio of 4.08 -- signaling an undervalued company.
If you are looking for a company most likely to bounce higher once the economy improves, there are few better places than Splunk.