Go Splunk Somewhere Else

By Jon Quast - August 24, 2012 | Tickers: AMZN, AAPL, GOOG, IBM, SPLK | 0 Comments

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The cloud has become quite a buzzword over the last couple years.  I remember my first exposure to it was from those Windows commercials where they showed happy people saying “it’s the cloud.”  However, I had no idea what this nebulous (…or was it cumulus?) cloud creature was.  I eventually came to the conclusion that it was a place for you to store files that you didn’t want on your computer, or for files that you wanted to recover in case you had a problem with your hard drive.  How wrong I was.

I’m still a little hazy when it comes to the cloud.  I can’t explain all the ins and outs, but I can tell you that it is way more than just storage.  Storage is a part of what “cloud can do for you” but just a part, and a relatively small part at that.  Storage is likely what you or I would use the cloud for.  Apple (NASDAQ: AAPL) has cloud storage for my iPod touch.  I have a 32 GB touch, but I have 5 gigabytes of free cloud storage with the option of buying more if I would like too.  Amazon’s (NASDAQ: AMZN) Kindle Fire is kind of built around the idea that you’ll be using the cloud in conjunction with the device.  It only offers 6 gigabytes of usable memory on the device itself, which isn’t very much if you have a couple of movies or a lot of music.  The idea is that you'll use their cloud service.  They also offer 5 gigabytes of free storage on the cloud, with the chance to upgrade.  But major businesses would use the cloud for different reasons, and that is where the bulk of the revenue in this revolution will come from.

Since “cloud” is a buzzword, as an investor it makes me want to get in on this "next big thing" before I’ve missed my chance.  My personal investing preference is investing in small-caps with plenty of growing room.  So, when I heard about the company Splunk (NASDAQ: SPLK), I wanted to take a closer look to see what they were all about.

Splunk

Splunk was started less than a decade ago in 2003.  It has had a very short career up to this point as a publicly traded company.  The company went public in April this year.  Gross income has been growing at a fantastic rate from $15 million in fiscal 2009, to $109 million in fiscal 2012.  Given the quick jump onto the scene, and the rapid income growth, it earned an even closer look.

 Risky Business

It’s good to assess the risk before you go out investing.  While all companies do face risk, it’s important to size up the challenges that stand in a company’s way that would impede them from reaching their business goals.  As I was reading through Splunk’s most recent (and only) quarterly report, I was shocked with what I found inside.  All quarterly reports contain a “risks” section, and sometimes you can kind of read into those risk statements just how seriously the management actually fears the risks cited.  Sometimes a report will have about 3 risks, one of which says “the Mayans may be right and the world may end in 2012, which would subsequently inhibit us from executing our business plan…” and you kind of get the feeling that they aren’t actually worried.  But this report from Splunk contained the most exhaustive Risk Factors section I have ever seen.  Pages 27-54 were all risk factors Splunk acknowledges as a threat to their business.  Is a cloud business really that risky?

Here are a couple risks that stood out to me:

• Lawsuits

Ok, we live in a lawsuit world.  But Splunk made reference to the fact that people may take them to court over intellectual property, or patent infringement.  Not that there would be necessarily anything true with those claims, but even if someone takes an innocent man to court, the innocent man still has to pay to defend his innocence.  Here’s a key quote “many of these companies have the capability to dedicate substantially greater resources to enforce their intellectual property rights and to defend claims that may be brought against them.”  Basically that says “we are the little guy, and the big guy might have more money to prove his case in court than we would have to defend ourselves.”

Lawsuits in the Risk Factor section is not new, and most reports say something similar.  But, it is very true that they have shallower pockets than some major competitors, which gives more credence to this risk.

• Software as a Service

Without getting technical, let’s just say that there are a couple of different kinds of cloud service models, one of which being "software as a service" (or SaaS).  Splunk does not offer SaaS.  However, in their report they said “In recent years, companies have begun to expect that key software” (in reference to SaaS).  Ok, so if the customers want SaaS, then why not just give them SaaS right?  Not so easy.  “…we would need to direct a significant portion of our capital investments…which would negatively affect our gross margins.” It seems that Splunk doesn’t offer what is becoming industry standard, and it is going to cost a lot of money to be able to offer it.

• The Competition

Splunk is a little guy.  This is an emerging business opportunity.  Do you think that the big guys are going to sit this one out?  No way!  Everyone is trying to take a piece of this pie.  I’ve already mentioned Amazon and Apple offering cloud storage, but Splunk cited many competitors including IBM (NYSE: IBM) and Google (NASDAQ: GOOG) as a risk to their business.  IBM did a study and reports "The number of enterprises turning to cloud computing to revamp existing business models will more than double in the next three years..." If IBM truly believes this, you know that they are also revamping their business model to handle this double.  Google compute engine also got completely off the ground recently.  It remains to be seen how accepted it will be, but hey, it's google right?

Another Factor

With every year that gross income has gone up with Splunk, they haven't turned a net profit.  This past fiscal 2012, net income was down 188.81%.  It appears that the bigger they get, the more money they have had to put out to meet their needs.  Now, to a certain extent you expect this with a young company.  It's not uncommon for a company to go years without turning a profit, because they are spending to grow the business.  While not uncommon, it is something to be taken into consideration.

I always cheer for the underdog, but in this case the challenges may just be too great for Splunk to overcome. If this is something that interests you, do your research.  Cloud is a big animal.  If the industry is growing at the rate that IBM suggests, someone will make some money here.  I'm just not convinced that Splunk is one of them.

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