Splunk's Transition Year: What You Need to Know

At the beginning of this year, Splunk Inc. (NASDAQ: SPLK) management signaled to investors that this would be a time of transition for the company. They were right.

When a baseball club announces it is entering a rebuilding year, fans' expectations are adjusted accordingly. Stock investors appear to have taken the same attitude with Splunk. Its most recent quarter demonstrated a beat-and-raise performance and the stock dropped 7% the next day. Investors, to some extent, may be confused by the changing business model, its impact on year-over-year revenue comparisons, and slow international growth.

Splunk told investors it would be a tough year

Splunk's software products help its customers make sense of unstructured machine data. Management has been quite transparent in letting investors know that the company would change its business model from selling on-premises software licenses with maintenance contracts to a cloud-based subscription product. The end goal is to replicate the software-as-a-service (SaaS) subscription-based business model that has been so successful in transforming companies like Autodesk and Adobe Systems into veritable money-making machines. Let's not forget Splunk is playing in a developing market of unstructured data and machine learning that is considered essential for driving artificial intelligence solutions forward. This is a hot market and Splunk is a pioneer in the space. Migrating to the most lucrative business model is all about building that championship team.

Splunk beats its own guidance

Splunk's numbers for the quarter were better than management's guidance. Revenue was $242.2 million, up 30% from the same quarter last year and well above its guidance range of $231 million to $233 million.

Management also raised revenue guidance for the fiscal year 2018 from $1.185 billion to $1.195 billion.

So why did the stock drop 7% the day after it reported earnings?

Is the growth rate slowing or are the numbers negatively biased due to the change in the business model? It's a bit of both.

The numbers obscure the true story

Splunk's new business model means all subscription-based license revenue will be recognized monthly as the service is delivered to its customers. The old perpetual license model recognized all the software license revenue upfront.

As the company moves forward with its plan to move to SaaS and exchanges upfront revenue recognition for back-end monthly revenue, the year-over-year revenue comparisons will become negatively distorted. As an example, cloud-based revenue more than doubled to $17.7 million in Q1, all of which is recorded monthly.

Here is how the company describes the transition in its annual report: "Transitioning to a cloud-based model also impacts the way we recognize revenues, which may affect our operating results and could have an adverse effect on our business operations and financial results."

The chart below shows the company's past performance and future forecast for its software bookings.

Splunk is not happy with its international sales growth

Splunk's management revealed on its conference call that not all was quite right in Splunk's international business. Sales were not up to par in its European, Middle East, and African (EMEA) geographic region. As a result, a change in management within the sales group will be taking place.

Splunk does not break outs its revenue beyond the United States and international sales. In the fiscal year 2017, 24% of the company's revenue, or $224 million, was international. President and CEO Doug Merritt stated on the earnings call:

Investors need to look ahead to the future

It's easy to get caught up in the drama of the moment. Splunk's international sales management shuffle is a temporary situation. Many companies go through this phase of growth. Looking through to the other side is important as acknowledging that management identified a problem, acted, and hopefully has the ship sailing in the right direction.

As for folks getting caught up in the revenue-growth rate debate. keep in mind the change in the business model is artificially negatively impacting that number for now.

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Frank DiPietro owns shares of Splunk. The Motley Fool owns shares of and recommends Splunk. The Motley Fool recommends Adobe Systems. The Motley Fool has a disclosure policy.