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Morningstar | Splunk Continues to Impress Behind Accelerated Renewable Mix Shift; Raising FVE. See Updated Analyst Note from 23 Aug 2018

No-moat Splunk posted a stellar fiscal second quarter, outperforming guidance as well as our expectations on the top and bottom lines. Management raised full-year guidance, and shares traded as much as 10% higher during after-hours. Splunk offered evidence supporting its ability to deepen relationships with existing, as well as new, customers, which in turn has spurred increased usage. We see this theme as the highlight of the quarter. The firm's myriad touchpoints within enterprises corroborate our thesis that Splunk's switching costs are increasing, reinforcing our positive moat trend rating. We were pleased to see continued execution of the transition to a business predicated on renewable contracts, and management indicated that the subscription mix of revenue is progressing much faster than anticipated. While this is certainly constructive long term, we believe profitability will be hampered in the near to medium term. This fact, in conjunction with a very high uncertainty rating, implies a nontrivial possibility of value destruction. As such, we maintain our no-moat rating for this name. After incorporating management's updated guidance, we are raising our fair value estimate to $103 from $100, but also note that shares continue to look fairly valued.

The firm posted revenue of $388 million representing a 39% increase year over year. Software revenue rose by 43% to $240 million, driven in part by a 90% spike in cloud revenue to $39 million. Going into this fiscal year, management had expected a renewable software revenue mix of 65%, ramping up to 75% in fiscal 2020. Throughout the first half of the year, the mix has been 72%, and they now expect to achieve a 75% mix by the end of this fiscal year, a year earlier than initially anticipated. While this will be dilutive to margins initially, as the mix stabilizes, we expect operating leverage to ramp up, leading to significant cash flow generation and GAAP profitability over the longer term.

New and existing customers continued to expand their applications of Splunk's use case-agnostic technology, particularly for security instances. Splunk Enterprise Security, the firm's premium product with a broad range of SIEM use cases, was adopted by existing customers such as WorldPay and new customers such as Grab (a ride-sharing company based in Singapore). More poignantly, management indicated that longtime customer and partner Amazon has entered into an Enterprise Adoption Agreement, or EAA, with the company. These are essentially flexible licensing arrangements that encourage large customers to expand core and premium Splunk technology across all departments in the enterprise, by allowing an exceedance of daily indexing capacity data limits. Given the competency and stature of Amazon's engineering core, the firm tends to build rather than buy in most instances. The fact that it is deepening its relationship with Splunk through this EAA means the firm sees value in the technology and the platform, which we view as a note-worthy achievement for this growing company.

In addition to the positive qualitative management commentary, we continued to see positive trends in our calculated customer ACVs. This lends credence to our thesis that expanding use-cases are allowing Splunk to extract more value from their customer base. We view this as indicative of increasing customer switching costs, forming the basis of a possible narrow moat for this disruptive software name.