When Splunk (SPLK) reported its fiscal fourth-quarter 2023 earnings on March 1, investors were excited that it beat guidance for the year on total revenue, annual recurring revenue (ARR), cloud ARR, operating margin, and free cash flow, yet simultaneously disappointed at its lower-than-expected revenue forecasts for the first quarter of its fiscal 2024. As a result, the stock price barely budged. Its post-earnings closing price was almost the same as its price before the report was released.
Although the company has high long-term growth potential, the short term holds much uncertainty. On the earnings call, Chief Financial Officer Brian Roberts said Splunk expects poor macro environment conditions to persist throughout its fiscal 2024, resulting in a slowdown in new deals and expansions.
Considering that most economists believe there will be a recession in calendar 2023, and the stock has already appreciated by 45% from the 52-week low it touched in October, should you buy Splunk stock now, even when the potential is high that things could get worse for the company before they get better?
Why are companies gravitating to Splunk?
Splunk is a software platform for ingesting, indexing, searching, analyzing, monitoring, and visualizing machine-generated data gathered from websites, applications, sensors, and the cloud. It provides tools for cybersecurity teams, information technology departments, and developers to keep companies' digital assets up and running.
Image source: Splunk.
Its clients use those capabilities to develop digital resilience -- the ability to keep operating through disruptions and maintain services while minimizing negative impacts on customers.
According to research the company recently published, organizations with advanced digital resilience capabilities save an average of $48 million per year on downtime costs compared to organizations that are just beginning to go down this path. So in this period of corporate cost-cutting, Splunk's tools are valuable.
Many consider Splunk a leader in this market, with over 90% of the Fortune 100 among its clients. The best part is that this business has high switching costs, so its established customers will be reluctant to switch to a competing big data service.
Image source: Splunk.
Despite being a market leader, Splunk has plenty of room to grow. It only has a 3.7% share of a total addressable market of $100 billion.
Why Splunk stock is down
On Nov. 1, 2019, Splunk began shifting its business model from selling perpetual licenses for products or service sales to annually billing customers for term software licenses for on-premises IT infrastructure or using a software-as-a-service model for Splunk Cloud services -- a significant change.
Over the long term, this shift toward a subscription model should prove an excellent strategy. Investors tend to give higher valuations to companies that generate recurring revenue via a subscription model than they do to those that use a perpetual license model. However, in the short term, that transition resulted in decelerating year-over-year revenue growth (and even a period of revenue contraction) and a temporary compression in margins because of the differences in how it now recognizes revenue.
SPLK Revenue (Quarterly YoY Growth) data by YCharts.
In addition to the licensing changes, the company is now dealing with a terrible economic environment and a slowdown in IT spending. As a result, Splunk announced it was laying off approximately 4% of its global workforce in February. It has also made numerous other cost-cutting moves over the last year in its efforts to increase profitability.
Why the stock is an excellent buy
The good news is that the most significant issues that have been holding the company back are substantially behind it.
As shown in the following chart, management has made significant progress on the cost-reduction front -- its operating expense growth has slowed meaningfully.
SPLK Total Operating Expenses (Quarterly YoY Growth) data by YCharts.
Additionally, Chief Executive Officer Gary Steele said during the fiscal fourth-quarter 2023 earnings call that the company's changes from perpetual licensing to annual software licensing are mostly complete. He also said, "[W]e have a strong base of ARR, unlocking opportunities for significant cash flow." Moreover, despite a lackluster economy, Splunk continues to win significant enterprise deals against competitors. For instance, it recently signed one of the largest banks in Norway and one of the largest energy businesses in the Asia-Pacific region to multiyear enterprise security deals.
It ended the fiscal year with 18% ARR growth. And after reporting negative free cash flow (FCF) in its fiscal 2020 and 2021, and modest positive FCF in fiscal 2022, in fiscal 2023, it delivered its highest FCF ever -- an excellent harbinger for the future.
Image source: Splunk.
The market values Splunk at a price-to-sales ratio of 4.4, well below its median ratio of 9.96 over the last 10 years. If the economy rebounds over the next year or two, Splunk's revenue should reaccelerate, and if it maintains firm control of its operating costs, profits should explode higher. So this could be a genuine monster stock coming out of the current downturn.
