Summary
- Splunk recently reported Q2 results with revenue and profitability above expectations, though ARR disappointed.
- Management lowered their ARR and cloud ARR guidance for the year as customers delayed some large cloud migrations and became more cautious with budgets.
- Even with the recent pullback in the stock, I remain on the sidelines, with valuation still ~4.8x forward revenue.
Splunk (SPLK) recently reported a pretty good quarter, with revenue and profitability coming in ahead of expectations. However, ARR, and specifically cloud ARR, during the quarter was weaker than expected as customers slowed some large cloud migration and became more cautious with their budgets.
This also led to the company lowering their ARR and cloud ARR guidance for the year, which has pushed the stock 20% lower since earnings.
Not surprisingly, the stock has remained weak in recent weeks as fears have increased around the macro environment. With SPLK's customers pulling back spend and becoming more cautious around their budgets, one fear is that this could impact next year's revenue growth.
On the positive note, the company did raise their guidance for operating margins and FCF, which I believe helped offset any further stock weakness. With management demonstrating some trade-off between the near-term slower revenue growth and increased profitability, I believe this dynamic is something investors should be aware of over the coming quarters.
Nevertheless, I remain on the sidelines until the spending environment among SPLK's customers clears up a little bit. Although the current valuation of ~4.8x forward revenue has pulled back a lot from the more typical 6-10x range, I believe the current environment leads to a more deserving lower multiple.
Financial Review And Guidance
During the quarter, revenue grew 32% yoy to $799 million, which was $50 million above expectations and all things considered, was an impressive beat. What continues to drive the revenue strength is Splunk's cloud revenue, which grew 59% yoy to $346 million and now represents 43% of total revenue.
In addition, cloud dollar-based net retention rate remained very healthy at 129%, clearly demonstrating the company's ability to upsell their services to their existing customer base.
With cloud revenue gross margins remaining around 70%, the company indeed has a long-term margin expansion opportunity, and this is something investors will surely be looking for over the coming quarters.
During Q2, non-GAAP operating margin came in at 3.6% and while SPLK remains early in their profitability trajectory, this was a noticeable improvement from the negative -19.9% margin seen in the year-ago period.
Additionally, FCF loss during the quarter was $25 million, a marked improvement from the FCF loss of $62 million in the year-ago period. On a trailing 12-month basis, FCF was $216 million, which was a 21% improvement relative to last quarter.
In addition to showing some margin improvement, the company's customer growth remains strong, with SPLK having >90 of the Fortune 100 companies deploying SPLK offerings. During Q2, the company saw the number of customers with cloud ARR reach 352, a nice improvement from the 234 seen in the year-ago period.
I believe the ongoing expansion opportunity within cloud remains the company's biggest revenue growth driver over the coming quarters and years. And despite the challenging macro impact, as discussed further below, I do believe there remains a lot to like.
For Q3, the company is expecting total revenue to be $835-855 million, which was slightly better than consensus expectations for $834 million. In addition, non-GAAP operating margin is expected to be 6-8%, again showing nice profitability improvement.
However, the company's full-year revenue guidance of $3.35-3.4 billion, reflecting 25-27% yoy growth, was only slight raised from the prior guidance of $3.3-3.35 billion despite the strong Q2 results.
Additionally, total ARR is now expected to be $3.65 billion, down from their prior guidance of $3.9 billion, largely driven by slower cloud ARR growth. For the full-year, cloud ARR is now expected to be $1.8 billion, down from the prior guidance of $2.0 billion.
Even during Q2, the company started to experience some slowdown with their cloud ARR as customers became more cautious. However, the more cautious approach towards cloud ARR was a little disappointing.
Despite our solid top and bottom line, our cloud ARR and total ARR came in short of our own expectations. This is largely due to the slowing of a number of larger cloud migrations and expansions as customers became more cautious with their Q2 budgets. As many of our customers opted for shorter-term commitments with Splunk beginning in the second half of the quarter, this lower-than-expected cloud adoption resulted in lower Cloud ARR and as a result, total ARR.
Given the post-earnings weakness in the stock, it's no surprise that investors were disappointed with the updated cloud ARR guidance. Fears around customers delaying some larger cloud migrations may weigh on the company's performance near-term. And while some may point towards increased competitive pressures, I believe there continues to remain a long run-way of growth remaining.
Despite the lower ARR guidance, it was positive to see the company raising their profitability metrics. Non-GAAP operating margin is now expected to be ~8%, up from the prior guidance of ~2%. And this improved profitability will flow through to FCF, with operating cash flow guidance raised to $420 million and FCF guidance now standing at least $400 million.
Valuation
Since the company reported earnings on August 24, the stock has been down around 20% given the increased fear around the macro environment impacting SPLK's customers spending.
The challenging macro environment is certainly putting pressure on customers budgets, though this is being seen all throughout the market and is not SPLK specific. However, expectations around SPLK remained high and given the updated cloud ARR guidance, some may fear that growth could decelerate even more next year. While SPLK is not immune from the macro environment, I do believe the long-term growth tailwind from cloud migrations will outweigh the near-term macro headwinds.
Additionally, while revenue growth may be underwhelming during the next few quarters, the company's increased focus on profitability and margin expansion is a positive development that investors should focus on.
Admittedly, it was not a massive surprise to see the stock trade down after earnings, given the updated guidance. With valuation previously around 6x forward revenue, the newly introduced risk of slower revenue growth has set the current multiple of 4.8x forward revenue more in line with expectations.
The big trade-off here is the company's improved margin profile, which could continue to impress investors over the coming quarters. With revenue growth guidance of 25-27% still remaining strong, the bigger fear is the potential that revenue remains pressured and slips below 20% next year. In that scenario, I believe the stock could fall much lower.
As things currently stand, I would be patient around SPLK in the near-term given the current macro headwinds and customers slowing their cloud migrations. Yes, this seems to only be a near-term issues, but until the macro environment starts to paint a cleaner picture, I believe there could be better entry points over the coming months.
For further details see:
Splunk: Cloud ARR Disappoints; Waiting For Macro To Clear