This Just In: Upgrades and Downgrades

When a little-known analyst upgrades one of the hottest names in tech, should you be excited -- or scared?

Rich Smith
Rich Smith
Dec 2, 2015 at 12:04PM
Technology and Telecom

For 12 long months, shares of Splunk (NASDAQ:SPLK) have gone nowhere fast. Actually, it's even worse than that. Over the past 12 months, Splunk shares have actually lost nearly 5% of their value, and in a (mildly) positive stock market. And yet, at long last, there's a bit of good news to report for shareholders of this operational intelligence company.

"Ker-plop!" goes the banker
Bright and early Wednesday morning, a new report on Splunk dropped on the market -- and according to investment banker Drexel Hamilton, the time has come for Splunk to "break out" of its funk.

As related by this morning, Drexel attributes much of the weakness in Splunk shares to the recent announcement of its CEO's departure. And yet, Drexel sees investors' worries as unwarranted. Last month, if you recall, Splunk reported fiscal third-quarter results featuring a 50% increase in revenue, 45% growth in high-margin licensing revenue, and "adjusted earnings" of $0.05 per share.

Although the company's GAAP earnings were somewhat underwhelming (a $0.57 net loss), revenue came in 10% ahead of previous management guidance. And more important than the GAAP loss, or the "pro forma" profit, Splunk reported strong free cash flow of $21.1 million for the quarter.

Best of all, Splunk has upped its guidance for the rest of this year -- and next year as well. Management is looking for fourth-quarter revenue to grow about 15% sequentially, for full-year revenue ($650 million) to come in about 44% ahead of 2014 numbers, and for next year's revenue to grow a further 31%.

In short, Splunk is going boffo -- and Drexel thinks it's a buy (with an $80 price target).

Let's go to the tape
But is Drexel Hamilton right about that? Here at Motley Fool CAPS, we've been tracking this analyst's performance for a few years now, and initial indications are good. From what we've seen so far, Drexel is an above-average analyst, getting more picks right than wrong, and ranking in about the second quintile among the investors we track.

But the sad truth is that unlike most analysts, for which we've got pretty good data on past picks, Drexel is a bit of a "black box" to us. (And not just us. Data from suggests that Drexel only began releasing its recommendations publicly in 2012 -- the same year we began receiving data on its picks).

Be that as it may, while our data on Drexel is not perfect, it is at least positive. Now, let's turn to the stock that Drexel is telling you to buy: Splunk itself.

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Should you plunk down your money on Splunk?
According to Drexel Hamilton, $60 spent on a share of Splunk today should turn into $80 a share over the course of a year -- close to a 33% profit. But how likely is that to happen?

Well, let's take a look at the valuation. Currently, Splunk carries a market capitalization of $7.8 billion. GAAP net income is running negative, but according to data from S&P Capital IQ, Splunk generated nearly $103 million in positive free cash flow ("cash profits") over the past 12 months. That works out to a price-to-free-cash-flow ratio of 76 -- a mite pricey even if Splunk succeeds in hitting Yahoo! Finance projections for 40% annualized profit growth over the next five years.

Last chance ...
But let's give Splunk every possible benefit of the doubt. Mathematically speaking, the P/E on this profitless stock is "infinity." The P/FCF valuation is merely "expensive." So what about EV/FCF?

Credit Splunk for its $949 million in cash, and its total lack of debt, and Splunk's enterprise value drops to just $6.8 billion. Divide $103 million in free cash flow into that number, though, and the EV/FCF ratio still works out to more than 66.

When you get right down to it, even after reading Drexel's report, and even knowing that other Fool services are optimistic about the stock, I -- personally -- just can't get excited about Splunk's potential as an investment. Even taking 40% long-term profit growth as a given (which it isn't), 66 times cash profits is an awful lot to pay for a company like Splunk, situated in the fast-changing tech sector, and at constant risk of disruption by the next new thing. And if the growth should fail to materialize?

Look out below.