U.S. Markets closed

This Momentum Play is Getting Too Big to Not Fail

David Sterman

Momentum investing can be a double-edged sword. If you buy a stock with great technical trends such as rising relative strength (RS), then you can ride the wave to rapid gains. But once momentum investors embark on a fierce buying frenzy, share prices can become disconnected from the fundamentals. Further gains can be had as momentum extends, but once the tide turns and momentum investors exit a stock, the downside can be swift.

The key for such stocks: Identify the event that may trigger a turning point. And that is the basis for today's trade.

Indeed, the froth is reaching dangerous levels for high-flying software provider Splunk (SPLK), and an upcoming quarterly-earnings release (scheduled for Aug. 26) could lead to a serious bout of profit-taking.

Splunk's ongoing surge throughout 2013 is explained away by one simple fact: The company is growing by leaps and bounds. Splunk provides software that helps analyze and optimize the performance of large data sets, especially those found in today's cloud computing. Huge reams of data can be sorted through in a matter of seconds, allowing IT managers to make important network management decisions quickly. Data analyzers in retail, health care and other fields can now react much faster to key changes in trends.

Splunk's founders not only created an advanced software platform, but also implemented a novel pricing approach. Clients don't just pay a fixed price for a software license and maintenance contract, they pay according to the volume of data they analyze. So the bigger the project (and the larger the customer), the higher the billings.

A fast-growing customer list, coupled with higher usage levels from each customer, has led to explosive revenue growth.

In the current quarter, sales are still expected to grow a hefty 40% from a year ago (to around $60 million-$65 million), and a year-over-year quarterly sales growth rate in the 30% to 40% range looks quite feasible for the rest of fiscal 2014. Note, however, that a clear trend has set in. Five straight years of 80%-plus growth was replaced by 64% growth in 2013, and that figure is decelerating.

In recent quarters, other large software firms such as Oracle (ORCL), Hewlett-Packard (HPQ) and TIBCO Software (TIBX) have noted the appeal of the rapidly growing niche for "Big Data" analytics and are rolling out their own software extensions to capture a slice of the market. Smaller, privately held firms such as Sumo Logic, Netwrix and XpoLog are all making headway as well.

For investors who have bid this stock up sharply in the past few quarters, competitive concerns may prove to be an issue that's been overlooked. The coming weeks will produce quarterly results from a series of rivals, all of which will be talking about their own efforts to take market share from Splunk.

The Rival to Watch

While Splunk is set to deliver results in late August, rival Tableau Software (DATA) is scheduled to report quarterly results more than two weeks earlier, on Aug. 8. Those results could show early warnings signs for Splunk in one of two ways.

If Tableau talks about an increasingly intense competitive sales environment, then investors must assume Splunk is seeing similar pressures. But if Tableau talks about gaining market share, investors may wonder if that share is coming from Splunk. Both of these firms have annual revenue bases just above $250 million, though Splunk's market value is 60% larger.

The trouble with any such noise is that shares of Splunk appear overvalued and can't afford even the slightest misstep. Forget the next two fiscal years; to get a sense of this stock's value, investors need to look out to fiscal 2015 and fiscal 2016.

One clear item stands out as you look into the future. Despite its solid sales growth, Splunk isn't on track to generate the kind of EBITDA that a $5.2 billion company would seem to anticipate.

Analysts at UBS noted this disconnect in reviewing the most recent quarterly results, adding a further note of concern about the quarter ended April 30: "Digging deeper, deals were slightly harder to get done in this environment." Will a similar concern be expressed about the current quarter?

Still, since that concern was raised in late May, shares have continued to rally. Considering that this stock is valued at roughly 15 times projected fiscal 2015 revenue, and considering that Splunk's projected revenue base won't be especially profitable, the rubber band is stretched so wide that a slip of the fingers could prove to be very painful for shareholders.

To be sure, a solid quarterly report and outlook can keep shares trading in the $50 range, though further upside appears hard to accomplish in light of the eye-popping price-to-sales ratio. Yet the risk, as outlined above, is considerable. This stock could easily plunge below $40 if investors start to see the end of this company's meteoric growth phase is in sight.

Recommended Trade Setup:

-- Short SPLK at prices down to $50
-- Set stop-loss at $56
-- Set initial price target at $40 for a potential 20% gain in eight weeks

Related Articles

Chip Stock Poised for a Double-Digit Drop in 3-6 Weeks

Play Apple's Recovery at a Huge Discount for the Chance at 70% Profits

Market Outlook: S&P 500 2,000 May be Closer Than You Think