Splunk: "Big Data", big opportunities

What's “Big Data”? Well, every day we create over 2.5 exabytes of data. What's an exabyte you ask? It's one quintillion bytes (which equals 1,000 petabytes, 1 million terabytes or 1 billion gigabytes!) – in other words “Big”! According to IBM, 90% of today's existing data has been created in the last two years due to the proliferation of social media posts, digital pictures and videos sent online, transaction records of online purchases, cell phone GPS signals and sensors as the “Internet of Things” gains traction. It's unlikely this trend will be reversed anytime soon, and it is a huge challenge for any business to manage it.

Big data is characterised by data sets so large and complex it can't be managed by traditional database software and data processing applications and is currently growing at 45% per annum. Technology companies large and small are clamouring to provide products for their clients to make sense of the data deluge. According to IDC, more than 90% of “machine” generated big data is unstructured and therefore almost impossible, if not prohibitively costly, to use traditional relational databases that historically have been supplied by IBM, Oracle, Microsoft etc. This is where Splunk comes in – a pure-play on the growth in big data and a database “disrupter” par excellence.

Splunk is a US-based company that offers software products for searching, monitoring, and analysing machine generated big data. The rather curious name is derived from “Spelunking”, an obscure sport whereby participants explore caves.

Splunk's value proposition is to make machine data accessible, usable and valuable to everyone in the enterprise. Machine data is one of the fastest growing and most pervasive segments of “big data” – generated by websites, applications, servers, networks, mobile devices and all the sensors and RFID assets that produce data every second of every day. By monitoring and analysing everything from customer clickstreams and transactions to network activity and call records, its software sifts through these largely unstructured digital data sources and provides a management tool to get a sense of transaction activity, system performance, security threats and fraudulent activity.

Traditional databases can't deal with the size or complexity of this data, nor can they provide analysis in real time. One of Splunk's particular strengths is that it monitor every data source in the enterprise – IT systems, sensors, mobile devices, security systems, even air conditioning systems and elevators etc. In other words it provides the infrastructure that allows customers to collect, index, store, analyse and monitor data in real time or perform “operational intelligence” as the company calls it. The key to understanding Splunk is to realise that it is a platform  upon which a number of IT and analytical applications will be built, and not just a single product. A number of early customers are discovering by analysing machine data they are also receiving valuable business intelligence as well as how their systems are performing.

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The addressable market for Splunk is vast and the company's  penetration is still small – hence the opportunity. Any company or organisation, no matter what industry it operates in, has to know what's going on with all the data in the enterprise.  Basically, customers use Splunk to fix problems, troubleshoot, analyse customer behaviour, and mitigate security threats. It is also likely that IT departments will find new ways of using the Splunk engine that haven't even been contemplated before.

Splunk's customers are from a broad selection of industries – online retailers, bricks and mortar retailers, online services, universities, financial services, telecommunications, IT companies, government agencies, business product suppliers, manufacturing, health care, media providers, and medical device companies, to name a few. Some of the company's largest customers include Autodesk, Bank of America, Comcast, Etsy, Harvard University, Viacom and Zynga.

Business Model

Splunk's business model is unique. Most application and infrastructure software companies charge by the person (seat) or per processor. Splunk's pricing is based on the amount of data used, which provides a growth engine for the company going forward and also allows smaller companies to use the service while scaling up. Essentially Splunk sells a perpetual licence and associated maintenance fees (about 20% of the licence fee). These licences will remain the largest source of revenue for the company.

Management

The management team is solid, experienced and comes from some of the best companies in Silicon Valley – Disney, Apple, Hyperion, Oracle, Autodesk, Microsoft and SAP. CEO Godfrey Sullivan has been in charge since 2008 and prior to that was President and CEO of Hyperion Solutions, a leading provider of performance management software (purchased by Oracle in 2007). Both co-founders (Splunk was started in 2003) remain with the companies in senior roles. Eric Swan is the CTO (Chief Technology Officer) and Robin Das is Chief Systems Architect.

Financials

Splunk is scheduled to report its latest quarter on August 28, 2014. In the previous quarter, the company reported revenues that beat expectations and raised guidance for the July quarter and FY15. More importantly, maintenance renewals rates rose to a 92% rate (happy customers!), and the company added more than 350 new enterprise customers. Investors will want to see more of the same this quarter and will probably also want to see some half re-acceleration of total billings year over year. I expect the shares will be volatile going into and after the report, but given the size and dynamics of Splunk's installed base and overall market opportunity I expect “more of the same”.

Splunk is not yet profitable, but that's not unusual in new high-growth companies as they continue to ramp up spending in SG&A as well as R&D in order to grow the business. Since 2008, Splunk's revenues have gone from $US9 million to an estimated $US300 million in 2014.

Going forward, I am estimating total revenues of $US303 million in FY2014, $US420 million for FY2015 and $US535 million in FY2016. That represents a 2013-2016 sales CAGR of 50%.Cash flow from operations is expected to increase over the next three years from $US47 million to $US153 million in 2016 – a 56% CAGR.

Price Action

Splunk debuted as a public company in April 2012. Priced at $US17 the stock closed at $US31.75, up 88% on its first day of trading .The shares traded sideways for most of 2012 in a lacklustre market. I met with the company in March of 2013, was impressed by the story, initiated a fund position in the low 30s and enjoyed a stellar run into the high $US70s. The stock continued to rally into the first quarter of 2014 along with all the other ultra-high growth tech names and peaked at $US92.75. Since then a combination of profit taking and a “risk off” market environment for high-growth names has seen Splunk fall back to Earth in spite of good numbers and positive guidance.

Conclusion and Recommendation

The investment case for Splunk is a combination of what I believe to be an attractive entry point in terms of the stock price in a company that is growing the top line at 50% plus AND an opportunity to participate in the company's growth as it continues to improve and expand its vertical footprint (broadening out in a variety of industries), upsell a growing installed base, and gain a significant share of public sector business. International, currently only 20% of revenues, will also be a growth opportunity. The company is targeting international to be at least 30% of total revenues over the medium term.

Since Splunk is cash flow positive we can value the company on a discounted cash flow (DCF) methodology.*  Assuming a terminal NPV of $US5650 in FCF and 108 million shares outstanding plus 10% of revenues in cash we get a target price of $US55.00.

Splunk is currently trading at $US42 – therefore a buying opportunity for patient investors who can appreciate the big data thesis and can also tolerate a lot of share price volatility

(*DCF assumptions; Risk free rate 3.5%, 1.4 beta, 12.5% cost of equity in Year 1 and a terminal growth rate of 5.0% )

Risks

Large IT vendors such as IBM, Microsoft, Computer Associates, and Oracle have flagged “Big Data” as a growth area. Whether they try and replicate Splunk's functionality in the machine logging space (which is patent protected) or take another approach is open to question.

Splunk's consumption based pricing model could come under pressure as data volumes grow in excess of 40-50% per annum and customers become more price sensitive possibly inviting some competitive threats of discounts.

Splunk's products are based on a single technology which may or may not evolve into multiple platforms.