Splunk Financials and Underlying Story - Repost from Reddit

I received a request to take a deeper dive into Splunk (SPLK), a rapidly growing company in the IT Operations Management (ITOM) space.

One quick note before I kick off, I might reorganize these posts just to give them a bit more structure, which may evolve as time goes on.

Industry

Splunk fits within an interesting niche of the ITOM space. Their specialization is part of an area focused on machine learning and big data for logging, monitoring, and reporting IT Operations. To quote from Gartner and Forbes, “By 2022, 40% of all large enterprises will combine big data and machine learning functionality to support and partially replace monitoring, service desk and automation processes and tasks.” Given the upside, there are a ton of vendors craming into a very crowded market. In Gartner’s most recent report, the market size is $5.2B and grew at 12% YoY, also here.

Revenue

For Splunk, their (reported) revenue is broken down into 3 main categories: Licensing, Maintenance and Services, and Cloud. The License line is a one-time payment for a perpetual license for on-premise deployment of the Splunk Enterprise suite, while the maintenance and service and cloud license pay an annual subscription fee, which is tiered based on the amount of data ingested. Their revenue is rapidly transitioning from the perpetual license to the their annual subscription as they said in their most recent earnings call “We expect the elimination of perpetual license sales will accelerate renewable mix to 99% in Q4 and high 90s for the full-year.” seen here.

This transition has a bit of uncertainty around it. Exabeam, one of Splunk’s competitors in the SIEM space, recently mentioned that customers are unable to predict their expenditure since Splunk prices based on data ingested, which can be a varying target. Additionally, the cloud transition provides a more sticky cash flow for the company, but will provide short-term pain since the amounts are billed annually vs. entirely upfront. While this might help customers from an initial expenditure outlay (potentially removing one of the roadblocks), it is the reason that Splunk recently revised their cash flow forecast from a positive $250mm inflow to a negative $300mm outflow (despite raising annual guidance from $2.25B to $2.3B).

The critical KPI for the company here is their Remaining Performance Obligations, which is non-cancellable (future) contracted revenue. In 2Q20, the RPO was $1.235B, with 61% of that to be recognized over the next twelve months ($753mm). The average contract duration for the contracts signed have hovered just shy of 3 years (33 months). One concerning metric in their most recent quarter was that the contract bookings slowed dramatically in the most recent quarter, $554mm, which is only a 19% growth rate.

Finally, Splunk just closed on their acquisition of SignalFX on October 1st, so guidance and RPO will likely look dramatically different in Q3 and Q4 as the company represents a combined platform.

Costs

From a cost perspective, the company’s costs have stayed broadly consistent with topline growth. On an LTM basis, the company has ~$1.8B of expenses, excluding stock-based compensation and amortization of acquired intangibles. The number of employees has grown from 2,700, to 3,200, to 4,400, to 4,700 from Jan-2017, Jan-2018, to Jan-2019, and today respectively. Assuming an average total compensation of $261,231, accounts for ~$1.15B of those expenses or ~72% for FY19. This has remained relatively constant for 2015 to current.

As a result, cloud margins are improving, as 2Q20 reached a 50% margin, nearing their 70% gross margin target. Research and Development has remained relatively constant at 15 - 17.5% of sales, sales and marketing at 45% - 50% of sales, and G&A at ~10% of sales. These percentages strip out stock-based compensation, but since there is no breakdown, still include D&A.

Capitalization

Splunk is well funded with 2 convertible senior notes (convertible at $148.30) for a total debt of $2.1B, but has $2.7B in cash and investments. This gives the company a great war-chest to continue to acquire companies in the space. The company has acquired 7 companies in the past 2 years, with the most notable being SignalFX, augmenting their suite of products in the monitoring segment.

Returns

Over the last 4 - 5 quarters, Splunk’s return on capital has settled into the 5 - 10% range. Given their reinvestment rate of ~150% (math from here on p 26), this implies a sustainable EBIT growth rate of 7 - 10%. To me, this passes the smell test since it’s broadly consistent with the industry growth predicted by IDC and Gartner, implying that Splunk’s organic revenue growth will continue and acquisitions should provide further juice to the topline growth rate.

Outlook

Splunk issued guidance of $2.3B for FY2020, with $600mm in Q3 (implying ~$760mm in Q4). Wall street is right in line with guidance for 2020, and showing $2.8B for 2021 (or a 22% growth rate). The challenge for the company will be to weather the transition from the upfront payment to the cloud subscriptions, since that will depress cash flow for the next year or two. The company even noted on their last earnings call that their target cash flow yield won’t be realized until after 2021.

TL;DR Splunk is a rapidly growing player in the IT Operations Management space that is growing dramatically and starting the shift into turning their revenue stream into longer-term contracts. As the company transitions, it will depress cash flow in the near-term, but could accelerate onboarding as it manages the initial expense outlay for customers. Images here.

I opined that wave 4 had completed and in wave 5. So going forward, I don’t expect SPLK to be trade lower than $107.16, if it does, need to go back to drawing board.