Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: Brandon Leon

By Valuentum Analysts

Dividend Growth Newsletter portfolio holding Cisco (CSCO) is all about growing its recurring revenue base these days, and its announcement that it will buy Splunk (SPLK) on September 21 will not only help in a big way towards that goal, but the deal will also position Cisco for tremendous opportunities in the booming market that has become artificial intelligence [AI]. That said, some investors were not fans of the purchase price – some $28 billion in cash – but we think the price is fair and strategically, there’s nothing wrong with adding to the fold an asset-light, recurring-revenue business that has the foundation to be a key long-term player in AI. We’ll be taking a close look at our valuation model on Cisco as we further digest this proposed transaction, but for now, we’re comfortable with our $53 per-share fair value estimate of the networking giant.

For those unfamiliar with Splunk, the company provides the engine for machine-generated big data. Its software collects and indexes big data coming from websites, servers, networks and mobile devices that power businesses of any size. In particular, the firm's software helps organizations monitor, search, analyze, visualize and act on massive streams of real-time machine data. The firm's software is designed to accelerate adoption and return on investment and does not require customization or extensive professional services. Users can simply download and install the software in a matter of hours. Though we don’t have working knowledge of Splunk’s product suite, the proof is in the numbers, and Splunk has simply been growing like a weed.

By itself, Splunk expects its total addressable market [TAM] to grow to $140+ billion in 2023 from ~$80 billion in 2020, and expansion beyond that will likely accelerate given interest in AI these days. Data production across all media continues to soar, and the number of complex devices connected to IP networks is proliferating. These trends present a substantial opportunity for Splunk's hybrid cloud offerings. By our estimates, the share of its estimated TAM is just a few percentage points, and Cisco’s sprawling, decades-long customer relationships will likely aid in accelerating adoption of Splunk’s product suite. As of its most recently-reported quarter, Splunk had annual recurring revenue [ARR] of $3.858 billion, up 16% on a year-over-year basis, while trailing twelve-month free cash flow for the firm advanced nearly four-fold, to $805 million.

To get more into the details about Cisco’s/Splunk’s long-term opportunities, on a standalone basis, Splunk's TAM breaks down into four key growth areas: 1) observability/DevOps, 2) security, compliance, and fraud, 3) IT operations, and 4) platform/other. As of its most recently-reported quarter, Splunk had ~830 customers that generated annual recurring revenue north of $1 million, a metric that has grown considerably of late, and was up by 111 on a year-over-year basis. By itself, Splunk’s long-range plan is impressive and includes massive gross margin leverage and material double-digit compound growth in annual recurring revenue, goals that appear readily achievable given the benefits behind its tie-up with behemoth Cisco.

Splunk’s shares finished up more than 20% on the day the deal was announced, while Cisco’s shares fell nearly 4% to rest pretty much at our fair value estimate. The market seems to think that Cisco may have overpaid for Splunk, but our January 2022 fair value estimate of Splunk's shares stood at $150 at that time, so Cisco proposing to pay $157 per share in cash for the firm isn’t too far off the mark, at least by our archived estimates. We like the trajectory of Cisco’s business model transformation toward annualized recurring revenue, and Splunk should be a great fit while providing a boost in AI capabilities. The all-cash deal will tip Cisco’s balance sheet into a net debt position once completed, but Cisco's already-strong free cash flow will be augmented by Splunk's, and we see no concern about the long-term health of Cisco’s dividend emanating from the deal. All in, we think we’ll look back and say that Cisco’s purchase of Splunk was one of the best deals of the decade.

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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, RSP, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson's household owns shares in HON, DIS, HAS, NKE, DIA, and RSP. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.  

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