Splunk Stock Will Keep Powering Higher Despite Being Overvalued

There's probably a better entry-point for Splunk stock

Shares of big data analytics platform Splunk (NASDAQ:SPLK) have come very far, very fast over the past five years. During that stretch, Splunk stock has essentially tripled, thanks to accelerating enterprise demand for the big data capture, monitoring, and analysis tools that Splunk offers.

The good news? Demand for these tools will continue to accelerate higher. Splunk will sustain strong operational momentum for the next several quarters. And, the long term outlook for Splunk is very positive, with enough promise, visibility, and opportunity to realistically support Splunk stock at much higher prices in the future.

The bad news? Splunk is very richly valued here. Even under aggressive long term growth assumptions, it’s still tough to warrant a bearly $160 price tag. So, fundamentally speaking, Splunk is overvalued at the moment.

Where does Splunk stock go from here?

Probably higher, mostly because valuation friction alone won’t be enough to derail the SPLK rally, especially in a world dominated by low interest rates and momentum investing strategies. In that world, sustained strong operational momentum and an increasingly bullish long term outlook will keep pushing Splunk stock higher.

Splunk Is a Winning Business

In the big picture, Splunk is the right business, at the right time, with a ton of visibility to sustain huge growth over the next five to ten years.

At its core, Splunk is about turning data into action. Through its Data-to-Everything platform, Splunk offers various services and tools which enable enterprises to seamlessly capture, aggregate, monitor, and analyze data from various sources, with an endless number of end-applications, including security, consumer experience, product development, marketing, etc.

Gradually, Splunk’s big data tools are morphing into a “must-have” for enterprises in today’s increasingly data-driven world. Long story short, there’s a ton of data out there and all that data contains a ton of valuable information that can improve processes across every major enterprise vertical.

Extracting all that information from all that data used to be a luxury. Now, it’s a necessity for the enterprise, because if a company doesn’t do it, they will be left behind on every single front.

So, over the next several years, demand for Splunk’s big data services will broaden out to encompass almost every enterprise out there. At the same time, current customers will up their spend on Splunk, because the volume of data these customers are generating is growing exponentially with the rapid proliferation of data-collecting smart devices and apps.

Net net, over the next five to ten years, Splunk will turn into a necessary big data analytics tool for enterprises, on which enterprises will spend a ton of money to extract all the information they can from all the data they have. Ultimately, these secular trends imply that Splunk will stay on a huge growth trajectory for a lot longer.

Splunk Stock is Overvalued

The numbers are pretty easy to follow. Thanks to the aforementioned secular trends, the global big data market is expected to grow at a ~10% compounded annual growth rate over the next decade or so.

According to those numbers, Splunk presently controls about 5% of the global big data market. Their market share has been gradually expanding by roughly 30 to 50 basis points every year.

This expansion is expected to persist. According to consensus Wall Street estimates calling for $2.9 billion and $3.5 billion in revenue in each of the next two years, Splunk’s big data market share should expand by about 40 basis points in each fiscal 2021 and fiscal 2022.

This cadence of annual market share expansion should slow with scale. Consequently, my long term model assumes that the company can expand market share at a cadence of roughly 30 basis points per year into 2030. Assuming so, Splunk projects as 15%-plus revenue grower over the next decade.

Gross margins should continue to improve with scale, improved priced power, and higher platform usage. Operating margins should improve doubly thanks to economies of scale and reduced marketing spend (scale sells itself).

Under all these optimistic assumptions, my modeling pegs Splunk’s 2030 earnings per share potential at about $10. Based on a 35-times forward earnings multiple — which is the medium-term average for application software stocks — that implies a 2029 price target of $350. Discounted back by 10% per year, that equates to 2020 price target of under $150.

Overvaluation Won’t Stop Shares

Although Splunk stock is fundamentally overvalued at current levels, this overvaluation isn’t extreme enough to derail the SPLK rally.

According to my numbers, Splunk stock today is overvalued by just a few percentage points. That’s not much. And, it’s certainly not much when you consider that: 1) Splunk has a ton of operational momentum at present, 2) Splunk’s operational momentum will only increase in 2020 with rebounding enterprise software spending trends, and 3) interest rates across the globe remain at or near record lows, thereby providing support for both extended valuations and growth investment strategies.

In that world, Splunk pushes aside minor valuation risks, and goes higher.

Bottom Line on SPLK Stock

Splunk is a long term winner with some valuation risks at current levels. But, those valuation risks aren’t big enough to derail the rally. That’s especially true considering the world we live in today, with rebounding enterprise software spending trends and record-low interest rates.

All in all, I’m not chasing this rally. I think a better buying opportunity will present itself in the future. But, for the time being, I think shares can and will push higher.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.