Splunk Q4 Earnings Preview

Summary

• Splunk is in the midst of a business model transition, from upfront licenses to subscription, from on-premises to cloud. It reports earnings after the close today.
• Achieving this move is exceptionally difficult as a public company, since it requires recognized revenue and earnings to slow or go backwards, whilst building up deferred revenue and cash flow.
• The market tends to react more keenly to recognized revenue and earnings measures - accounting measures - than it does hard-to-discern improvements in cash flow and balance sheet strength.
• This makes Splunk a challenging stock to own whilst it attempts the transition. We're at Neutral as a result, but we are watching the fundamentals closely indeed.
• Looking for more investing ideas like this one? Get them exclusively at The Fundamentals. Get started today »

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At A Critical Juncture

Since around the late 1990s, when subscription software began to come back into fashion (the original version being mainframe timeshare!), a rising number of companies born with a perpetual license model have seen that the certainty from subscription revenue in the end provides for a more relaxing relationship with Wall Street. In the last five years or so this has reached tipping point. Salesforce (CRM), the first at-scale cloud IPO, was an oddity when it first came to market. Investors and sell-side analysts alike were puzzled by the accounting and struggled to value the company as a result. The method is simple once you understand it, and has now become orthodox, but it wasn't obvious to everyone at the time.

This is the background to why Splunk (NASDAQ:SPLK) stock has underperformed the Nasdaq so woefully this past year, and understanding it is key to working out when might be a good time to commit to a long position in SPLK.

First, let's look at how the stock has performed vs. the technology cohort.

Source: YCharts.com

Very badly, is the answer in the last twelve months. The Covid-accelerated digital shift has lifted many boats in the tech sector, but SPLK has not been one of them.

The reason for this, insofar as there is ever any reason for a stock's movement, is the relative performance in revenue and earnings growth at SPLK vs. other software vendors. Here's SPLK vs. Microsoft (MSFT) vs. CRM in the last three years - the chart shows quarter-vs-prior-year-quarter growth over the period. Now, both CRM and MSFT are mature companies, not a young hotshot IPO stock, but in this digital shift environment even these relative old lags are regularly delivering growth in the 15-30% range. SPLK though has seen its revenue growth turn negative as it committed to the subscription transition.

The problem gets worse when you look at earnings.

Guess which one of those the market doesn't want to own? Exactly.

Now, all is not lost. This is potentially a temporary phenomenon and if you can call the turnaround in SPLK earnings trajectory, you might have a hot stock on your hands. To work out when this might happen, let's spend a moment in Accountsville, USA - population, us.

Here's how GAAP works for software companies. It's not complicated, though everyone will try to tell you it is. Ignore them. It's easy.

• Revenue and earnings are recognized at the rate at which the customer consumes the product or service. If you sell a subscription service, your revenue and earnings drip in every month over the life of the subscription contract. If you used to sell a one-time product, like a perpetual software license, you used to be able to recognize that all in one big hit upfront. So if you suddenly switch from upfront to drip-drip-drip, as Splunk and others are doing right now, then your growth rate is going to slow dramatically, as Splunk's has done.
• Cash is recognized when it arrives in the bank. If you sell a subscription service - but you charge say a year or more upfront - then you get a year's worth of cash on day one, before you have delivered any service. So you have a strange situation where you have a lump of money in the bank but you can't recognize any revenue associated with that money, because you have yet to deliver the service. So you have a stranded asset on your balance sheet.
• Balance sheets have to balance. The clue being in the name. So you need a matching liability somewhere, and that liability is deferred revenue. It sounds like it should be an asset, but it isn't. It's a liability because it is what you owe the customer - they have paid you (cash up) and now you owe them the delivery of the service (deferred revenue liability up).
• As you deliver the service each quarter, you recognize a quarter's worth of revenue. Revenue up, earnings up, deferred revenue down, cash down (because you will have spent some of it).
• As your upfront commitments rise, your earnings growth will lag. But if you can understand the basics of financial statements, you could potentially spot when the wall of upfront commitments is likely to turn into accelerating revenue and earnings growth. And, on fundamentals at least, that would be the moment to buy.

So if you want to find evidence of a turnup in SPLK's fortunes, do cast a brief glance at revenue and earnings. But spend a lot of time on the balance sheet and the SEC filings. Allow us to explain.

We don't think now is the moment to commit to SPLK. Anything can happen come earnings of course - up, down, sideways - but if you want to know the moment when the transition in business model is starting to work in favor of SPLK revenue and earnings vs. the market, not against, we don't think that's quite yet. Here's why.

To the end of Q3 (31 October 2020), revenue growth was still negative and getting more negative, not less negative. So as of last quarter the business model change had yet to start working for the stock.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

And the same was true at the earnings and cash flow level. Still getting worse, not yet flattening out or getting better.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

Looking at the balance sheet, deferred revenue growth was also falling, or negative, and the company was moving into a net debt position, rather than its previously cash-rich status.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

Now, this might all be OK if the company is selling a lot of multi-year contracts where they don't get paid the full amount upfront. They don't appear anywhere in the GAAP financial statements, unhelpfully. But if you know where to look, you can find a little window into the future - look at the 10-Q or 10-K for the relevant period, search for the phrase 'remaining performance obligation' and hey presto - a time machine, of sorts. Not very accurate, prone to land in 2024 when you meant to land in 2023 - but a time machine nonetheless. Remaining performance obligation is a non-GAAP quantity that you won't see reported in most any company's earnings press release. Sometimes it is mentioned on an earnings call - Zscaler (ZS) did so in their earnings call this quarter for instance - but rarely if ever in a press release. It's worth doing the work on this measure, not least because few people do. RPO is the total book of contracted business including prepaid and yet-to-be-paid. It is usually a larger number than deferred revenue, because deferred revenue is a subset of RPO. And the direction of travel of RPO gives you just a little insight into the likely direction of travel of recognized revenue growth.

Here's the situation with RPO at SPLK.

Source: Company SEC filings, Cestrian Analysis

It's not getting any better. It was looking good in late 2019/early 2020 as you can see, but RPO growth is listless right now. And that means no clarity on where recognized revenue growth is going. Also, that RPO is only 75% of TTM recognized revenue tells you there really isn't that big of a book of business at work here. Best in class software companies have RPO > 100% of TTM recognized revenue. (If you want to see what good looks like, do take a look at ZS - our most recent note on that name is here - or CrowdStrike (CRWD) - our most recent note on that one is here).

So for us, SPLK remains a Neutral on fundamentals. We make no particular call on the near term stock movement - anything can happen. We would like to jump into this name because we think the above method can give you confidence before others develop it - just a tiny edge on folks who don't read SEC filings or listen to earnings calls. But the moment for that is yet to come. Perhaps this earnings release will be the moment. We'll be reading it avidly.

Cestrian Capital Research, Inc - 3 March 2021.

Analyst’s Disclosure: I am/we are long MSFT, CRM, ZS, CRWD.

Business relationship disclosure: See disclaimer text at the top of this article.

Cestrian Capital Research, Inc staff personal account(s) hold long position(s) in CRM, CRWD, MSFT, and CRM.

Comments

[Cestrian Capital Research]

Our latest on transitioning to the cloud: seekingalpha.com/...

[dgiinvestor]

Good call being conservative with this name. Down 18.4% since you published this article vs. 9% increase in S&P.

Still, wonder if this is a good entry down here...

[Cestrian Capital Research]

@dgiinvestor generally speaking we file "cloud transition" stocks under "too hard and too many things that can go wrong" given how many other places there are to put our hard earned. SPLK is down a lot and when we get time we'll take another look. But it's hard to get motivated to do so, to be honest. Growth names are just easier. (Especially when everyone has decided that Growth Is Just So Over Right Now).

[GiGaInvestor]

I like your lucid articulation!
It would perhaps be useful to touch on the ARR metric in your otherwise detailed analysis.
The summary, as you aptly pointed, is that the stock is currently listless. Good for only short term, swing trading.

[nitalsando077]

Any comments now after the Splunk earnings?

[SAGAR76]

Splunk story is buried under the Selling General & Admin Expenses. Something is seriously wrong with the above expense. Last 5 years above expense is more than 65% of revenue. Even in 2020 the expense has increased when travel expenses should be low considering all COVID related restrictions. This suggests that deep down some expenses are directly linked to the sales and unless those expenses are reduced the company can never return to profit.
With revenue above $2 Billion the company should better manage expenses and return to profit.

[HumphreyAppleby]

I read through the comments by the SA Editors, but thought I would post my concerns about the quarter here.
People seem to be looking at the ARR number and concluding that the problems are over.

Does anyone know what ARR means?

In other words, Splunk reported Cloud ARR growth of 83% YOY, but the reported financials show Cloud revenues grew 72% YOY, and that was down from 80% in the previous sequential quarter. In fact, Cloud Revenue YOY growth YOY over the last 4 quarters was 81% (Q1), 79% (Q2), 80% (Q3), and 72% (Q4). As is put in context, that 72% growth hardly looks like a "pop."
Moreover, cloud operations margins dropped from 56.2% to 55.8%.

Did anyone bother to look at Maintenance revenues? YOY was -39%. Enterprise software revenues were -3% YOY and Total Revenues YOY were -6%.

Just to save you a trip to Wikipedia, ARR growth simply means that Splunk was able to sign customers to contracts longer than one year. If all the signings were just one year, the ARR growth would have been 72%, or equal to the reported numbers. SaaS vendors typically sign customers to one-year deals, but those customers pay month to month. Splunk has always been focused on signing Enterprise customers to 3-year term deals, and that is what they are doing as they move to cloud. You should note that signing a 3-year deal means that the customer gets an additional discount for that longer-term deal signing. Does anyone have any idea of ASP, per volume grouping, in year 1 vs. year 2 and year 3?, or was that discount taken upfront, and recognized ratably over the term of the contract? Neither do I, but the working assumption is that the discount was more than zero.

Therefore, Splunk only recognizes the revenue from the first year of the deal and defers the remainder of the contracted revenues (depending on how the contract is written) to the Balance sheet. Deferred Revenues were up $267M in Q4 vs, Q3, but the NET increase vs. 2020 was $201M, so $66M of the previous Q3 balance was recognized as revenue in Q4. Therefore, the Net New increase in total revenue was $679M, not $745M – which means that YOY revenues would have decreased by 14%. It's sure nice to have that bank of deferred revenues, which is why they focus on signing customers to longer-term deals.

Summary. The quarter wasn't nearly as good as the analysts think.

[Cestrian Capital Research]

@SirHumphreyAppleby Absolutely correct, Sir.

[Crowded Place]

@HumphreyAppleby do you know Cloud ARR is the leading indicator of Cloud Revenue?

[HumphreyAppleby]

@Crowded Place What a charming insight. Unfortunately, the numbers don't support your assertion. Per financial statements, Cloud ARR, Q1F21 = 81%, Q2 = 89% (nice one, Splunk gets "hall pass"), Q3 = 71% (oops), Q4 = 83%.
Cloud GAAP Rev: Q1 = 81%, Q2 = 79%, Q3 = 80%, Q4 = 72%.
How many quarters would you like to lag to prevent rejection of H0?

[knoxmarlow]

Great article

[Cestrian Capital Research]

@knoxmarlow Thanks!

[Robin12]

Thank you very much for your analysis. I don't know very much about the company, but your writing Style is brilliant - the best I've read so far on SA.

Just wanted to say thank you. It is always a pleasure reading your articles!

[Ted Stamas]

This is not an apples to apples comparison, but Nuance Communications $NUAN went through a similar transition about five years ago. The stock treaded water for a few years, then tripled once the transition was completed.

[Cestrian Capital Research]

@Ted Stamas Great point, Autodesk (ADSK), Cadence (CDNS) and others have succeeded too. It is absolutely do-able and SPLK could well succeed. We just want to see a little evidence of success before going long the name.