The past couple of months have not been kind to the software-as-a-service sector, as inflation and interest rate fears have caused a quick and violent sell-off in these exciting yet highly priced stocks.
Yet could the sell-off have opened up bargain opportunities? The acceleration of digital transformation amid COVID-19 is still in full swing. Rosenblatt analyst Blair Abernathy recently wrote that digital transformation stocks should continue to see strong growth for at least the next few years, in a recent bullish note.
That’s why my favorite SaaS stock for 2022 is a key player in enabling and protecting those large-scale cloud transformations for big companies. Yet because of some misperceptions around the stock, it trades at a bargain-basement valuation when compared with the rest of its pricey peers.
Splunk got dunked in 2021
Splunk (NASDAQ: SPLK) is a competitively advantaged sticky software suite that collects data from IT infrastructure and software applications, allowing enterprises to operationalize, search, and analyze data produced by any digital device or system. Splunk divides its offerings into three general categories: Splunk Cybersecurity, Slunk IT Systems, and Splunk Observability cloud.
Despite category leadership, the company currently trades at a massive discount to the sector, because of uncertainty around not one but several transitions the company is making simultaneously.
A busy two years
The most important transition is the company’s move from an on-premise software company to a cloud-first-company. However, there are actually several changes going on under the hood in addition to the cloud transition, including:
Perpetual licenses to subscriptions, which affects revenue in the near term as up-front payments are replaced by monthly or annual subscriptions.
Complete term billing to annual invoicing, which affects not only revenue but also cash collection and operating cash flow.
On-prem to cloud, including the development of its observability suite with the help of several tuck-in acquisitions.
Fixed subscription to workload-based pricing.
A recent CEO resignation (announced Nov. 15), with no successor yet selected.
The transition from perpetual licenses to subscriptions has caused a pause in Splunk’s revenue growth trajectory, which actually went negative in fiscal 2021 (Splunk’s fiscal year ends in January). However, revenue has begun returning to growth this year. Operating cash flow also went negative, but it bottomed out around the middle of last year and is steadily recovering:
SPLK Revenue (TTM) data by YCharts
Even though financial results have turned a corner and heading toward a normalization, Splunk’s trailing revenue of $2.51 billion is still tracking below its annualized recurring revenue (ARR) of $2.83 billion, which is really how investors should think about the company’s top-line trajectory until the transition is complete.
Trading at a massive discount
Splunk trades at a massive discount to its peers and is nearly 50% off its all-time highs from mid-2020, when revenue growth went negative and management pulled guidance amid uncertainties. Here’s how Splunk stacks up against its closer peers, based on revenue growth and EV-to-sales ratios:
SPLK Revenue (Quarterly YoY Growth) data by YCharts
Cheap as it is, the above numbers even overrate Splunk’s valuation based on ARR (it currently trades at an EV-to-ARR of around 7 even, vs. 7.9 times revenue), while they underrate ARR growth (37% versus 19% revenue growth in the most recent quarter).
These competitors are not, of course, perfect comps, as they have slightly different though overlapping product portfolios and customer bases; however, since they are further along in their cloud transition, or are cloud-native, each has revenue and ARR that are more or less in-line with each other. EV-to-sales ratios seems to correlate with revenue growth.
Very crudely, if Splunk were to be valued in the same ballpark as Dynatrance (NYSE: DT) or Elastic (NYSE: ESTC) — whose revenue growth most closely resembles Splunk’s 37% ARR growth, its EV-to-revenue should also be in the same ballpark of 15-22. That would mean a two- to threefold increase in the stock price.
Amid confusing financials, Splunk may be suffering from a perception that cloud-native competitors are eating into its market share. The recent resignation of CEO Doug Merritt after six years on the job has also added uncertainty around the company’s leadership.
Rebuttals to these concerns
Still, there is little evidence to suggest that Splunk is losing market share to competitors. Yes, Datadog (NASDAQ: DDOG) is growing much faster and is a “cloud-first” competitor. However, Datadog, for all its success, is mostly geared toward small and medium-sized businesses, whereas Splunk is really geared for large enterprises. Splunk has claimed over 90 of the Fortune 100 companies and that has not changed, even during the bumpy transition.
Moreover, Splunk has continued to post dollar-based net retention (DBNRR) metrics on its cloud subscriptions of 130%, and this number has been quite consistent over the past two years. That means, on average, existing Splunk cloud customers are spending 30% more this year than they did last year. In the third quarter of fiscal 2020, DBNRR was 133%; two years later, in 3Q FY 2022, that figure stood at 130%, only a slight deceleration from two years ago off a much bigger base, and actually an acceleration from 129% in the prior quarter. That appears to indicate Splunk’s customers continue to purchase more services and aren’t flocking to competitors.
It’s also likely large enterprises will be reluctant to switch away from Splunk, because most large enterprises will always retain some on-premises IT infrastructure and will require Splunk’s hybrid offerings. Management has said its business will eventually top out at 80%-90% cloud, with the rest being deployed on-prem.
Finally, the mission-critical nature of Splunk’s software, deployed at scale in large enterprises with diverse data sources and infrastructure, stands to make it a very “sticky” product.
Recent financial metrics seem to back this up
Last quarter, cloud ARR growth accelerated to a 75% rate to just over $1.1 billion, making up 39% of total ARR. Cloud should soon overtake non-cloud ARR in a matter of quarters. Cloud bookings already exceeded 50% of total bookings in the year-ago Q4 for the first time, and jumped strongly from 54% to 68% in a single quarter in Q3.
The faster-than-expected cloud growth has likely been helped along by two key new cloud hires from Amazon (NASDAQ: AMZN) earlier this year. In April, Splunk hired Amazon Web Services (AWS) veteran Teresa Carlson as chief growth officer. In June, Splunk hired Shawn Bice, also from AWS, as president of products and technology. The two hires show Splunk has the ability to attract top senior talent away from a place like AWS — not exactly the struggles of a legacy company losing out to quicker, more agile competitors.
Shortly after these hires, Splunk attracted a $1 billion investment from Silver Lake Partners, in the form of 0.75% convertible notes that are convertible at $160 per share, up from today’s price around $116. At the recent December UBS conference, CFO Jason Child elaborated on the Silver Lake investment.
[W]e first had the discussion with them I think in late June. They got involved on a, I don’t know, Saturday or Sunday; did five days of diligence and then you know basically wired money a week later or something like that, but it was really a very, very accelerated process. And you know the reason it was accelerated is I think they went under NDA and they went deep on all the numbers. They looked at all the customer cohorts, the churn, the LTV [lifetime value], the CAC [customer acquisition cost], the mix adjusted revenue, billings, margins and all that and basically said you know, wow! This is like – while there’s a lot of scary narratives on whatever may be going around with Splunk, the numbers are very, very strong, and so you know that’s why they were willing to invest so quickly.
Some may attribute the recent resignation of CEO Doug Merritt to Silver Lake’s influence, but that’s not necessarily the case. The reason given by management was that Doug had been CEO for six years, has more of an entrepreneurial bent, and there was some question as to how long he wanted to be CEO. After Merritt oversaw has this massive transition, Splunk now has a $3 billion ARR cloud-centered company — much different from the $300 million or so run-rate on-premise company he inherited when he took the job.
In light of the company achieving breakaway momentum on its cloud transition, the board thought that it was time for a CEO with experience running cloud software businesses at large scale. Chairman Graham Smith, the former CFO of Salesforce (NYSE: CRM), the first cloud-centric SaaS company, has stepped in as interim CEO and is likely a candidate for the job, And certainly, the two new AWS hires may also be internal candidates in addition to external ones.
Upcoming Catalysts for 2022
With this many open questions between a business model change, billing process change, and management change, the resolution of these issues could be catalysts for 2022. Since we are past the halfway point of the transition and revenue is growing again, revenue should begin to track closer to ARR overtime.
Given that cloud ARR growth is much faster and is now making up a larger percentage of ARR, ARR and revenue should maintain its current trajectory or perhaps even accelerate as cloud overtakes non-cloud as a percentage of the business.
It’s also possible the new workload-based pricing model implemented over the past year will lead to greater use of data and Splunk. Investors have seen high growth rates posted by data warehouse company Snowflake (NYSE: SNOW), which has been wildly successful with that workload-based billing model. At the same UBS conference, CFO Jason Child noted that when clients move to workload-based pricing, data volume in the cloud goes up between 1.5 and 2 times, as customers aren’t worried about overprovisioning.
Given the “perfect storm” over the past year and even the past two months, a very pessimistic scenario is being priced into Splunk that has derisked the stock in an otherwise highly priced sector. At the same time, the growth of data and the digitization of the enterprise gives Splunk very favorable long-term growth prospects. While there is a void at the CEO level, the company has made several impressive hires in important roles, which should impart some confidence in Splunk’s ability to execute.
I don’t see any reason the company can’t return to its all-time highs of $225 per share, last reached in mid-2020. That would be a terrific feat in an otherwise fully priced market.