U.S. Markets closed

Is Splunk a Buy?

Nicholas Rossolillo, The Motley Fool

As the world converts to digital, the amount of data being generated by computers, phones, and other systems has exploded. To fully unlock all the benefits of digitization, organizing all of that information into usable form and analyzing it in an efficient manner is a must.

Enter Splunk (NASDAQ: SPLK), a data-parsing software service that delivers usable insights into digital systems -- everything from websites and apps to servers and mobile devices. The company has said that the amount of data production each year will be 44 times greater in 2020 than it was just a decade ago. With the amount of digital information booming, Splunk has been growing by leaps and bounds.

SPLK Chart

Data by YCharts.

Who wants a bleeding stock?

Though Splunk's stock has notched strong returns the last few years, many investors have steered clear because of steep losses. Even as the company has grown -- revenues have doubled several times over the last five years to $1.8 billion last year -- the amount of red at the bottom of the operating statement has also grown. During the recently completed 2019 fiscal year (the 12 months ended Jan. 31, 2019), net losses were $275.6 million, up from $190.2 million the year prior even though sales went up 38% over that same stretch of time.

The reason for those losses, though, is intentionally elevated expenses to foster the most growth possible. Splunk notched big annual increases in spending last year, especially in research on new products and headcount to support sales.

Expenses

Year Ended Jan. 31, 2019

Year Ended Jan. 31, 2018

Increase (YOY)

Research and development

$442.0 million

$301.1 million

47%

Sales and marketing

$1.030 billion

$777.9 million

32%

General and administrative

$237.6 million

$159.1 million

49%

YOY = year over year. Data source: Splunk.

Given the inordinate amount of expense at Splunk, some math can give some perspective. Adjusted profit -- which backs out a massive $441.9 million in stock-based compensation to employees last year and $394.9 million on acquisitions of smaller peers -- changes a steep loss into a profit of $202.1 million. Free cash flow (money left over after basic operations and capital expenditures are paid for, a more accurate portrayal of cash-based profitability) was $273.3 million in the 2019 fiscal year, a 13% increase over last year. As a result, price to free cash flow currently sits at 72.8. Paying nearly three-quarters of a century's worth of profits is ludicrously expensive, right? That's what the stock is trading for nonetheless. Here's why.

An artist's illustration of digital data. Charts and graphs are shown being shared around the world.

Image source: Getty Images.

It's all about the future

Splunk has the accelerator mashed to the floor to the detriment of the bottom line. What's the upshot for shareholders? Gross profit margin on services is enviably high at Splunk -- to the tune of 97.8% on the large licensing revenues segment and 58.3% on maintenance and services.

With those kinds of profit margins and a fast-growing industry around data analytics, it makes sense that the company would try to scoop up all the sales it possibly could. It's all about growing now and worrying about profits later. And there's plenty of growth left in the tank. Splunk's software has a myriad of uses like cybersecurity, website traffic pattern analysis, monitoring of machines and devices connected to networks, and data center management, to name just a few.

Headed into a new fiscal year, management expects total revenues to increase to $2.20 billion, another 22% increase over last year. That's a slowdown from recent rates -- although Splunk has a history of underpromising and overdelivering -- but the company is beginning to ease off the throttle and grow the bottom line. Adjusted operating profit margin should come in at 14%, up from 12.7% last year.

Still, that's just a glimpse of Splunk's potential payoff given how fast the digital world is expanding and all of the new data getting created that businesses need help making sense of. Granted, Splunk stock isn't for everyone. Since it doesn't run an unadjusted profit, variance in its top-line growth trajectory will send share prices on a volatile ride that only the steeliest of investors should think about owning. Owning Splunk is all about the future, though. For those who can stomach it and have a long-term view, this one's worth a look.

More From The Motley Fool

Nicholas Rossolillo and his clients own shares of Splunk. The Motley Fool owns shares of and recommends Splunk. The Motley Fool has a disclosure policy.