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Splunk's Change of Direction Could Lead to Near-Term Volatility

By Frank DiPietro - Mar 31, 2017 at 4:25PM

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Management has said that this is a transition year for the company. Here's what you need to know.

Investors have had three chances this year to hear Splunk's (SPLK 3.96%) management talk about how the company is doing. I give management a lot of credit for realizing the changes they are making may negatively impact the company's results in the short term and being willing to share that information with investors. Shareholders have been able to tune in to management's words from an analyst day in January, a conference call following the quarterly earnings report in February, and a presentation a few days later at a conference. At all three events, management has talked about the transition underway in the company's sales force and product direction.

Let's dig in to what we've learned.  

Depiction of Splunk being greater than just the cloud.

Image source: Splunk.

What does Splunk do?

Splunk makes software for analyzing machine data. As the company explains: "Machine data is one of the fastest growing and most pervasive segments of 'big data' -- generated by websites, applications, servers, networks, mobile devices and the like ... By monitoring and analyzing everything from customer clickstreams and transactions to network activity and call records -- and more, Splunk turns machine data into valuable insights no matter what business you're in. It's what we call operational intelligence."   

Splunk started fiscal year 2018 on Feb. 1. In the year just ended, the company grew revenue by 42% to $950 million. It guided for 25% growth and $1.185 billion in revenue for the current year and targeted $2 billion in sales by fiscal 2020. 

To achieve the goals, management is taking a step backward to take two steps forward.

What is changing?

There are two fundamental changes that the company is making. One is related to product direction and the other is related to reorganizing the sales team to meet the new product strategy.

Product changes: The company sells both perpetual license agreements and subscriptions for its software products. It wants to transition to selling more subscriptions as this will produce a steadier and more predictable stream of income for the company. The chart below shows the company's subscription bookings as a percentage of total bookings by fiscal year. By fiscal 2020, the goal is to have 75% of bookings from subscriptions, otherwise known as software as a service, or SaaS. 

Bar graph of Splunk subscription revenue by year. It's been growing as a percentage of the total.

Image source: Splunk.

Sales team changes: The Splunk sales force is facing myriad changes this year. Everything from its organizational structure to its account focus and incentive plan are changing. Couple that with having to learn about new products and change sales habits, and you have the underpinnings for a chaotic fiscal 2018.

 Account and organizational changes: Splunk is revamping account coverage to reduce the number of direct accounts it serves down to 25 per salesperson. In comparison, three years ago, each rep had 75 customers to serve. All other accounts will be moved to the third-party distribution channel. The new structure will require a far greater knowledge of strategic selling for all the Splunk account sales personnel. Each salesperson has fewer accounts and will be expected to have the time to fully develop the sales potential of the customer by selling at higher levels of management and across all departments.

Incentive plan changes: Splunk management recognized its sales incentive plan was skewed toward selling perpetual licenses and away from selling software subscriptions, the opposite of management's goal. So the plan has been changed. Changing financial incentives to create a change in behavior can be tricky. Management will have to keep a sharp eye out to see how it effects the first-quarter results and if any further tweaking to the plan is required. 

The company also wants its salespeople to sell more cloud-based subscriptions as opposed to the on-premises product. By selling more cloud-based products, the company can expand its market from just managing data within a customer's firewall. The ideal solution would be to sell a customer a hybrid subscription product that will encompass data both on-site and in the cloud. The chart below shows the company's cloud bookings in relation to overall subscription bookings.

Bar chart of Splunk cloud based bookings as a percentage of subscription bookings by year. They've been growing.

Image source: Splunk.

Moving beyond low-hanging fruit

Splunk needs to expand beyond selling to customers that are familiar with Splunk -- the low-hanging fruit. To do so requires salespeople to break out of their comfort level and develop more departments within current customers as users of the product, create relationships at higher levels within a customer's executive suite, and find altogether new accounts. This takes training, time, effort, and skill.

At the end of January, Splunk management announced it had 13,000 customers. The plan is to grow the customer base to 20,000 accounts by the end of fiscal year 2020. 

Final thoughts on the transition year

There are many companies that have transitioned from $1 billion to $2 billion in revenue size.  As a shareholder, it is important to recognize that this is not easy. It is not a sure thing. If the company hits some speed bumps this year, it may miss quarterly guidance, which could very well result in a hit to the share price. By understanding the complexity of what the company is doing beforehand, you can keep things in perspective and avoid selling shares if the company misses its quarterly guidance. In fact, if you believe in the company's long-term prospects, a shortfall in a given quarter may give you the opportunity to add to your holdings at a discount.

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