Splunk - Impressive Growth And Margins, But What About Those Excessive Shareholder Payouts?

Sep. 1.14 | About: Splunk Inc. (SPLK)

Summary

Splunk reports a blowout quarter as sales unexpectedly breached the $100 million mark.

Growth is impressive, gross margins even more so, as costs are on the increase.

Focus on the GAAP earnings instead of the non-GAAP earnings amidst excessive stock-based compensation.

Investors in Splunk (NASDAQ:SPLK) finally have a reason to celebrate again as the company demonstrated very impressive topline sales growth, in what has been a very difficult year for shareholders so far.

Despite the operational momentum in sales, I am worried about the continued increase in the cost base and the level of sustainable operating margins at a more mature phase in the company's life cycle.

For that reason, I continue to be worried, remaining on the sidelines as a short position remains too risky.

Second Quarter Highlights

Splunk posted second quarter sales of $101.5 million, a nearly 52% improvement compared to last year. Reported revenues came in far above the company's own guidance and analysts consensus at $93.8 million.

Spending has been on the rise as well with operating expenses more than doubling resulting in greater GAAP losses. Reported losses came in at $60.8 million versus a much more modest $13.7 million loss as reported last year. On a per share basis, losses came in at $0.51 per share.

There is quite some discrepancy between GAAP and non-GAAP accounting metrics with the company posting a penny profit on a non-GAAP per share basis versus the loss of a penny last year. Analyst expected the company to report a modest non-GAAP loss of two cents.

Looking Into The Numbers

Reported headline sales growth of over 50% is rather impressive with the nearly 52% reported growth rate actually accelerating on an annual basis compared to the first quarter performance.

Total license revenues rose by 43.8% to $62.1 million as revenues from maintenance and other services rose by 66.7% to $39.5 million.

Overall gross margins came in at 85.2% of sales, which are simply very impressive numbers. Despite the high absolute level, gross margins were down by some 370 basis points compared to last year. This is due to lower than overall revenue growth at the licensing business which carries incredible gross margins of 99.9%.

Yet all of this revenue growth was made undone by operating expenses which rose by 101.8% to $146.8 million. Within the cost segment expenses on R&D, sales and marketing as well as general and administrative expenses all rose sharply. The aggressive cost base expansion explains the steep increase in reported GAAP losses.

Note that the $60.5 million loss was entirely explained by stock-based compensation. On the website Splunk states that it employs over a 1,000 employees. If the company would indeed employ a thousand workers, this compensation would come down to $60k per worker for just a three months period.

The company cited a myriad of operating metrics to show the momentum which in all honesty is quite impressive. During the quarter it signed deals with 500 customers, ending the quarter with some 7,900 corporate clients across the globe. Despite the strong growth in the number of customers, it have actually been the existing customers being responsible for 70% of the license bookings growth through upgrades and expansions.

New customers brought in less revenues as they typically order solutions which bring in lower than average sales. This came after many new customers were attracted to the 33% price cut in Splunk's Cloud offerings as well. Of course the hope is that these new customers will upgrade over time as well, thereby becoming more valuable customers.

Comforting Outlook

For the current third quarter, Splunk sees sales coming in between $105 and $107 million which is actually largely in line with consensus estimates. While this still demonstrates healthy sequential growth, this growth is expected to slow down to roughly 35% on an annual basis. While this would represent quite a slowdown in growth on an annual basis, take into account that the company issued a conservative guidance for the past quarter as well. Again the company aims to squeeze out a tiny non-GAAP operating margin of a percent.

For the entire year sales are seen between $423 and $428 million versus the previous outlook for sales between $402 and $410 million. Analysts anticipated that the company would raise the guidance to a level of around $418 million in sales.

The new guidance implies that fourth quarter sales could come in around $132 million. It should be noted that the last quarter typically is seasonally strong, and that the outlook calls for year-on-year sales growth in the thirty to mid-thirty percentage range.

Valuation

At the end of the quarter, Splunk held roughly $935 million in cash, equivalents and investments while it has no debt outstanding. All of this results in a very comfortable net cash position.

With some 119 million hares outstanding at the end of the quarter equity in the business is valued at $6.2 billion at $52 per share. Excluding the cash holdings of the firm, operating assets are valued at around $5.3 billion.

Based on the revised full year guidance, shares now trade at about 12.5 times sales.

Implications

Back in June after the release of the first quarter results for the fiscal year, I last checked out the prospects for the business. While non-GAAP earnings have improved, the ever increasing shareholder compensation expenses have actually resulted in larger GAAP losses for the quarter.

It must be said however that the company had a very strong quarter with revenues and non-GAAP earnings coming in much stronger than anticipated. As such the company has the capacity to perhaps surprise towards the upside even after already raising the full year guidance.

The very high gross margins make the valuation at 12 times revenues not even that ridiculous, especially given the pace of the current growth. Yet the real worry is the operating expense base, and notably the insane stock-based compensation expenses which are very high. As such I argue that investors should not be fooled to look at non-GAAP accounting metrics as these expenses really do dilute the ownership base in the company.

At the time following the disappointment from the first quarter results shares have been trading in the low forties, while I argued that a short position would be very risky as well despite the problems with the valuation. Sentiment in these kind of companies can shift very quickly, something which has indeed occurred in recent months.

Despite the improved operational momentum, the high margins and forecasted growth I am not a fan of the shares given the operating losses at the moment.

This leaves me wondering what the true sustainable GAAP margin of the business can become at a more mature phase in the company's life cycle. This makes the risk-reward scenario not attractive in my opinion at this point in time.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.