Shares of data search, analytics, and cloud monitoring software company Splunk (SPLK) are finally rising again after a beating from investors the last few years. Profitability, at least as measured by free cash flow, is solidly in positive territory, and generally accepted accounting principles (GAAP) net income is nearly break-even. With the economy slowing rapidly in 2023, these are the only real metrics most investors care about right now, and shares have rallied as a result.
However, though Splunk was an early pioneer of searchable unstructured business data, it's fallen behind the curve of many of its peers. A new management team is trying to get up to speed and is making progress on this front too. But is Splunk stock's rally for real?
Splunk's growth is resilient, but how resilient?
Splunk was late to make a full pivot to cloud-based software and modern pricing for its customers. To be fair, Splunk is still growing in spite of this, benefiting from a general migration from legacy IT to massive-yet-efficient cloud-based infrastructure of today. But its transition from legacy customer billing to cloud software billing created an accounting profit headache for investors in the last few years. At least the trough for GAAP net income is far in the rearview mirror at this point.
Data by YCharts.
However, like many of its peers -- including cloud-native ones like Datadog and Dynatrace -- revenue growth has been slowing for Splunk. Total revenue increased 14% in Q2 fiscal 2024 (the three months ended in July 2023), or up 16% from a year ago on an annualized recurring revenue basis (or ARR) to $3.86 billion. Quarterly revenue grew 39% in the final quarter of last year, or 18% ARR growth.
In a sign this slowdown isn't over yet, ARR is expected to close out the current fiscal year at $3.98 billion, just 3% higher than where it was just reported in Q2. Customers are tightening their budgets this year, and it appears Splunk is feeling the pinch, with some of its chief competitors (again, Dynatrace and Datadog) faring a bit better.
Splunk is promising, but there might be better buys
There are two main points to the investment thesis in Splunk at this juncture: improving profit margins, and narrowing its software technology gap with leaders.
Neither of these are super-compelling reasons to buy for me right now, which is why I decided to whittle down my data and cloud observability stock holdings, starting in 2021. That meant parting ways with Splunk stock, and I haven't looked back since.
In fact, with revenue growth showing signs of stalling out, Splunk's ability to more dramatically improve profit margins doesn't look super promising. It's still transitioning many customer contracts to the cloud, which should help. Still, I don't see much reason beyond that for operating margin leverage (the ability to ramp up cash profits as a business gets bigger). For the record, Splunk's cloud revenue grew 29% year over year to $445 million last quarter, which seems to account for the majority of the business' overall expansion.
And as for software technology, customers are looking for holistic solutions (basically, a platform) that can unify various tasks with one software vendor. Increasingly, that means cloud applications and data observability, and Dynatrace was recently named far and away the leader in this department. Datadog has done a bang-up job in this area too, crafting a more tightly integrated platform for businesses of all sizes to get a firmer grasp on complex cloud-based operations versus the hodgepodge of tools Splunk offers. The company continues to try and unify its various offerings, but others have already surpassed what it's capable of today.
The one thing Splunk stock does have going for it is that, even after the most recent rally, shares trade for 25 times trailing-12-month free cash flow. But if Splunk continues to decelerate, it could be cheap for a reason. The market is pleased at the moment, but the recent earnings report didn't provide enough good information to coax me back into buying this software stock. I see better buys out there in the cloud universe.
