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Morningstar | Splunk’s Results and Business Model Looking Increasingly Moaty; Raising FVE

Splunk delivered a stellar fiscal 2019 third quarter, with the top line coming in above market expectations and our above-consensus estimates. Management also raised revenue guidance for the 2020 fiscal year, roughly in line with our existing expectations but appreciably above consensus. We are raising our fair value estimate to $112 from $103. The increase stems primarily from a decrease in our estimated cost of capital, as the firm was able to increase its financial flexibility through a favorably-priced convertible debt offering during the quarter. We will maintain our no-moat rating for Splunk, as the gamut of conceivable outcomes remains too broad and implies a nontrivial 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.

Revenue of $481 million represented a 40% year-over-year increase, driven by a strong uptick in software revenue to $325 million, a 49% increase. The transition to a revenue stream predicated on renewable contracts is starting to mature, with the mix between perpetual and term/cloud agreements relatively stable since last quarter. The margin story was a humdrum one: gross margins were essentially flat at 84.5%, and operating margins compressed 190 basis points to 13.6%. From our vantage point, the business mix beginning to stabilize bodes well for margins going forward. The confluence of recurring revenue and lower customer acquisition costs due to greater mind share and embeddedness within large enterprises should lead to material operating leverage as usage increases.

From an operational perspective, we were pleased with where sales and marketing spending came in this quarter. The line represented approximately 55% of total revenue, the lowest percentage since 2012. We expect continued volatility from this line quarter to quarter, contingent on the timing of field deployments and contractual agreements with channel partners. Moreover, the firm has been transparent about the fact that sales and marketing spending will remain elevated for the foreseeable future as it continuously evolves the sales apparatus to more fully penetrate the opportunity within specific verticals and use cases. Still, the ultimate rationalization of this spending is a major crux of our long term thesis for Splunk, and management’s ability to ensure that top-line growth supersedes their investments in the salesforce underpins our forecast of eventual sustained GAAP profitability. The firm did a good job in that respect this quarter, and we expect further declines in sales and marketing spend as a proportion of revenue.

Our calculated average annual contract value increased by 23%, quantitatively supporting the qualitative evidence of the firm deepening relationships with existing customers and partners. For example, companies such as Sendgrid began the process of standardizing log analytics and insight across their organization, deploying the core Splunk platform in addition to their SIEM (security information and event management) and IT predictive maintenance solutions. Management alluded to the fact that many of their customers will utilize open-source competitors, such as Elastic, for smaller use-cases, but switch to Splunk as that use case begins to scale and demand greater capacity, flexibility and indexing sources. We think this dynamic lends credence to our view that switching costs are increasing for the disruptive software player. The more complicated the use case, the more customization is typically required to optimize the deployment, and the more aversion there is on the part of the customer to risk downtime within a mission-critical environment.