Splunk (SPLK) Due Diligence

Price Target: $118 by December 2023

Premium to current price: +34%

TL;DR: Splunk has undergone a significant business-model transformation, and it’s future free cash flow is heavily discounted in its current share price. If FY24 FCF exceeds current estimates, shares could increase materially from today’s levels. I’ve invested 30% of my retirement account on this thesis.

​

Splunk (SPLK) is an enterprise software company that specializes in log management, and has expanded into security, application management, and other IT operations areas.

Historically, Splunk sold its products as perpetual licenses with attached maintenance. The company shifted its business model in 2020 to begin selling cloud services as its main focus. This impacts both revenue and free cash flow significantly:

Under the perpetual-license model:

• License revenue is recognized in the period in which a deal is signed (~60% in year 1), maintenance revenue is recognized ratably across the contract period
• Cash for the entire deal (~3 years) is invoiced up front (100% in year 1)

As a cloud-service model:

• Cloud revenue is recognized ratably each month for the full life of the deal (33% each year for a 3-year deal)
• Cash is billed annually, over the course of the deal (33% each year for a 3-year deal)

How does this impact the financials? Revenue growth slowed dramatically in FY21 and FY22 due to this transition. Similarly, free cash flow cratered as the company shifted to annual invoicing.

We are now on year three of this business model transition (CY20 > CY22, or FY21 > FY23). Revenue growth has rebounded, and cash flow is following:

• Quarterly revenue
• Annual revenue
• Annual free cash flow

FY24 (CY23) is set to be a breakout year as free cash flow normalizes to trends seen before the business-model shift. For reference, FCF was ~17% of revenue on average between FY18-FY19.

In 2021, Splunk’s management team predicted operating cash flow of ~20% of annual recurring revenue (ARR), which equates to ~$920M OCF in FY23.

They retracted this guidance in a very short amount of time, and have clearly missed this target as free cash flow is now expected to land at ~$420M in FY23 (CapEx is much lower than ~$500M).

Since that time, the CEO has stepped down (read: was let go) and the CFO left the company. These are bad signs for any company, let alone one that is going through a major business-model transition. Shares retracted significantly as a result.

Before the transition, Splunk shares were trading around $210 per share. They reached a low of ~$70 per share this fall. They now trade between $80-$90 depending on the week and where interest rates trend.

In April 2022, Splunk hired Gary Steele as CEO, who previously led the software company Proofpoint.

In the latest quarterly earnings call (Q3 FY23), Splunk’s new CEO highlighted cost-reduction efforts that will benefit cash flow moving forward, including:

• Slowing hiring
• Restructuring sales to a single-seller model
• Reducing the company’s real estate footprint
• Reducing the use of contractors
• Limiting travel to only sales engagement efforts

​

During this business model transition, a number of large investors and fellow technology companies have taken notice of Splunk. Silver Lake, Hellman & Friedman, and Starboard have invested significant stakes in the company:

• Silver Lake invests $1B in Splunk through convertible notes
• Hellman & Friedman acquires 7.5% of Splunk
• Starboard Value LP acquires 5% of Splunk

​

During this time, networking giant Cisco also considered purchasing Splunk for ~$20B, but the Board of Directors could not agree on price (read: Splunk’s Board felt this undervalued the company).

Today, shares trade at ~$88, or an Enterprise Value of ~$16.5B. Cisco was willing to pay a ~$20B ten months ago, and the underlying business has only improved since that time.

Here is the results page of my discounted cash flow model, which includes many assumptions: DCF

Here’s a sensitivity analysis for Splunk’s share price based on the two most-impactful variables, WACC and the terminal growth rate.

A few notes about this model:

• WACC is based on current 10-year Treasury prices. I’ve added in a buffer of +100bps over the next two years to account for potential rate rises and higher baseline interest rates.
• FCF margin of 18% in FY24 is a larger driver of near-term value. If this estimate is significantly off from actual performance, share price will be impacted by both fundamentals and investor sentiment.
• Shares outstanding include all issued shares per the latest 10-Q, as well as unvested RSUs/PRSUs and stock options.
• Debt consists of convertible notes. If share price materially increases before the debt is due, then debt holders will convert to equity instead. This will results in a larger cash balance in the future, but future share count will be diluted.

​

Near-term catalysts:

• Announcement of new CFO – actively searching to fill this role.
• Q4 FY23 earnings (Feb 2023) – company may provide FY24 FCF guidance on the next call, but may hold back due to macro-economic uncertainty.
• M&A risk is high given poor share price performance over the past three years (rTSR vs. software peers) and the quantity of high-profile investments from Silver Lake, H&F, and Starboard. These investment companies are looking for a near-term return on investment and will push Splunk’s Board to a sale if the price is adequate.

​

Potential risks to price target:

• Macro environment uncertainty. This is the biggest potential concern, but impacts all software companies and the broader economy as companies tighten their budgets. With that said, this is mission-critical software with a large install base in Fortune 100/500 companies. My believe is that most companies will renew existing agreements, but future expansion is at risk.
• Company specific risks include a slowdown in customers switching to the cloud version of the software, which has a positive risk to license revenue. However, this could benefit near-term revenue and FCF.
• FX, specifically in Q4 (Jan 2024) when most OCF arrives for software companies. If the USD continues to strengthen over the next 12 months, FCF would be negatively impacted.

​

Please let me know your thoughts and criticisms, especially if you’re bearish and can provide specific viewpoints.

I am not a financial advisor and this is not financial advice.