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Morningstar | Secular Tailwinds and Execution Continue to Drive Splunk Beat-and-Raise Cadence; Maintain FVE

Splunk reported another excellent quarter, delivering upside to consensus estimates as well as our expectations on both the top and bottom lines, as well as raising its full-year guidance. The confluence of execution and secular tailwinds continues to buoy the firm’s results, as enterprise systems generate more and more raw data, and leveraging this data becomes increasingly important to operational efficiency and competitive differentiation. We will maintain our no-moat rating for Splunk, as the gamut of conceivable outcomes remains too broad and implies a non-trivial probability of material value destruction. Still, there was reams of evidence in the quarter that Splunk is extracting more value from customers and increasing the touchpoints across which its platform is deployed, leaving our positive trend intact. Shares fell modestly after-hours, possibly due to broader de-risking in equity markets, but current levels still do not offer a compelling margin of safety relative to our unchanged $126 fair value estimate.

Total revenue came in at $425 million, a 36% year-over-year increase, driven by a 54% increase in software revenue to $265 million. Cloud sales were particularly impressive during the quarter, up 85% to $62 million, as the firm’s mix continues to shift away from perpetual licenses. The increased scale in cloud drove adjusted gross margins higher by 220 basis points to 81.6%. We expect continued gross margin expansion longer-term, as more cloud deployments should allow Splunk to leverage the infrastructure costs of delivering those solutions.

On the adjusted operating margin front, the firm reported a 1.8% loss, improving 290 basis points over the prior year. This was largely driven by a decrease in sales and marketing spending as a percentage of revenue, which we were pleased to see and expect to persist. The ultimate rationalization of this spending is core to our long-term thesis for Splunk.

The firm also announced its first meaningful move toward reorienting its go-to-market approach. Specifically, management highlighted the formation a vertical-specific sales group, dubbed the vertical solutions build team, that will focus on the financial services, healthcare, telecom and media sectors. These teams will be focused on achieving greater penetration by leveraging the existing platform to promote use-cases across different areas of the enterprise and to engage with non-security and IT personnel. The writing has been on the wall for a while as it relates to this shift in the sales apparatus, and we believe the investments will bear fruit given the gargantuan addressable market opportunity.

Our calculated average revenue per account continued to increase, suggesting that customers are demanding greater indexing capacity, as well as additional modules, to extract value from the cornucopia of data being generated within their organizational ecosystems. Two new modules announced this quarter were Splunk Connected Experiences and Splunk Business Flow. These products essentially expand the scope of visibility from which Splunk users can investigate, monitor, analyze, and act on operational issues across the various functional departments in the enterprise. We view these innovations favorably and are not surprised, as they seem consistent with a quintessential "land-and-expand" strategy. As Splunk customers deploy the firm’s platform in unique and nonconventional areas of the enterprise, the company then takes the insights from these deployments and parlays it into integrated, turnkey solutions that can be more easily adopted by new and existing customers, speeding the ultimate time to value.