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Morningstar | Splunk’s Focus on Execution and Disruption Drives Massive Fourth-Quarter Beat; Raising FVE

Splunk ended its fiscal 2019 on a tremendous note, crushing consensus estimates as well as our expectations on both the top and bottom lines. We are raising our fair value estimate to $126 from $112, primarily due to the time value of money and healthier top-line assumptions, partially offset by an appreciably higher diluted share count. 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. We acknowledge, however, that the firm’s path to a narrow moat is becoming increasingly clear. The firm showed evidence yet again that it is seeing tremendous success in fostering continued usage of its platform and solutions across multiple touchpoints within the enterprise, particularly for the most mission-critical use cases. This evidence implies that switching costs are strengthening for the company, thus our positive moat trend rating remains intact.

Total revenue of $622 million and $1.8 billion for the fourth quarter and full-year represented year-over-year increases of 35% and 38%, respectively. Software revenue, which encompasses both license and cloud sales, increased 42% to $464 million in the quarter. Management raised revenue guidance for fiscal 2020 to $2.2 billion, but our expectations remain above the increased estimate as we anticipate the beat-and-raise cadence will continue for Splunk. The firm delivered mixed full-year performance on the margin front, with adjusted gross margins expanding 30 basis points to 84.2% but adjusted operating margins compressing 150 basis points to 12.7%. Management reiterated that it is focused on reinvesting in the business, particularly field sales and marketing, in order to fully penetrate the enterprise opportunity before it. As the ambit of security information and event management (SIEM) continues to expand, the firm’s TAM is becoming increasingly attractive.

Despite the lackluster operating margin performance, we were pleased with the company’s sales and marketing spend. As a percentage of revenue, this line came in at 57% for the year, down from 59.4% in fiscal 2018. Management remains transparent that it will have to continue to invest heavily in both field sales as well as channel partners, perhaps even restructuring the sales apparatus to be more vertically focused as it strives to foster increased usage among the customer base. Still, the ultimate rationalization of this line is a major crux of our long-term thesis for Splunk, and we believe the firm’s ability to sustain profitability and excess returns will hinge on the payoffs of these investments.

Both the quantitative and qualitative evidence from the quarter suggested that the firm continues to extract incremental value from both new and existing customers. Our calculated average annual contract value continued its steady trend upward, and the firm closed 24 eight-figure deals for the year, up from just 10 last year. Management indicated that these deals are driven by customers deploying Splunk as their all-encompassing data platform, standardizing predictive analytics and monitoring across their entire organizations. Moreover, the firm iterated that large deals are not always synonymous with enterprise adoption agreements (EAAs) in the company’s nomenclature. EAAs are a very small part of the company’s installed base, according to management. From our vantage point, this speaks to the mission-critical nature of the use-cases being leveraged, and the extent to which a broad swath of customers who are not on EAAs still see scalable applications across their organizations for the platform.