Splunk Inc's (SPLK, Financial) transition to a subscription-based cloud data monitoring model has resulted in the company witnessing a string of mediocre results. The Covid-19 pandemic was an important factor driving the company away from its on-premises solutions towards a cloud-based approach, but this effort has been costly.
The most recent earnings result was a relief for Splunk investors, as the company managed to surpass Wall Street's expectations, but the stock price hasn't gained much following the news.
The management announced new enhancements to Splunk Cloud and Splunk Enterprise to strengthen Splunk's Data-to-Everything Platform offering. Also, its new observability platform to help developers measure the performance and health of their systems and applications appears to be a strong offering.
Overall, Splunk appears to be at an interesting juncture today with the transition leading to a relatively low stock price. Could the stock turn out to be a worthwhile investment that's worth the risk?
Recent financial performance
After a series of bad results where the company failed to meet the revenue expectations of Wall Street, Splunk finally managed to produce a decent performance for the fourth quarter of its 2021 fiscal year.
The company reported a top-line of $745.08 million, which was a 5.83% drop compared to the $791.18 million in revenue reported in the corresponding quarter of fiscal 2020. The company cruised past the analyst consensus estimate of $677.54 million.
These revenues translated into a gross margin of 79.85% and an operating margin of -11.11%, which was lower than that in the same quarter of last year.
Splunk reported a net loss of $139.55 million, but its adjusted earnings per share (EPS) came in at 38 cents, which was well above the average analyst expectation of 3 cents.
The company's cash flows continued to be heavily negative during the quarter given its transition phase costs, but I believe that this situation could potentially improve as early as the latter half of the year.
Transition to the SaaS model
Splunk has been undergoing a cloud transition for some time and recently became cloud-first, with over 50% of bookings coming from its cloud product. The company continues to roll out several new offerings and free product trials for customers, including the Remote Work Insights that gathers data and provides dashboards and key metrics for remotely managing IT and cloud infrastructure performance and productivity.
While the transition from an upfront purchase model to a Software-as-a-Service (SaaS) model is a difficult one, if we look at the Annual Recurring Revenue (ARR), the company delivered an impressive performance in its cloud-first initiative. Its ARR delivery of $810 million, a growth of 83% over last year and a relatively higher growth rate as compared to the third quarter.
It is also worth mentioning that economic uncertainty created by the pandemic is leading to shorter-term contracts and reduced visibility for upcoming quarters, thereby highlighting near-term top-line and cash flow pressures. Instead of selling licenses and creating large upfront payments that are immediately recognized as revenue, cloud service subscriptions are recognized over time.
Nevertheless, Splunk is getting paid regularly and it is attempting to gradually increase the duration of the contracts, raise the subscription fees and sell more services. There may be a short-term revenue decline, but I believe Splunk's strategy shift is a smart move that should begin paying off in the years ahead.
New observability cloud
In May, Splunk launched the new Splunk Observability Cloud, a full-stack analytics-powered observability solution for enterprises that enables the technology teams to receive their answers on a unified interface with metrics, traces and logs. The offering is able to collect data in real-time, without any sampling, irrespective of the scale of the enterprise.
Due to the ongoing shift to the cloud, technology teams are dealing with more operational complexity arising from too many existing monitoring tools that have blind spots, siloed data and disjointed workflows. The company's new Observability Cloud addresses this situation, helping them accelerate cloud transformation for their organizations. It has a variety of features including infrastructure monitoring, application performance management, real user monitoring, synthetic monitoring, log investigation and incident response. Splunk should be able to bring a certain level of sophistication and simplicity through this offering. It is an important driver for Splunk's long-term growth.
Final thoughts
Splunk is a rare software company within the cloud space that actually appeas to be undervalued as per the GuruFocus Value chart (shown above).
The recent losses during the course of the transition have been a cause for concern, but I think the valuation of the company should spike once the SaaS transition is successfully completed and it begins earning a profit again.
The company's price-sales ratio of 8.34 is near its historic low and has definite scope for expansion. A positive bottom-line should go a long way in inspiring investor confidence. Overall, I believe that Splunk is a risky yet compelling investment opportunity for growth investors.
Disclosure: No positions.
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