When Splunk (SPLK 0.44%) released fiscal second-quarter 2020 results last week, it was surprising at first to see shares of the operational-intelligence platform leader plunge in response. After all, Splunk's revenue soared 33%, to $516.6 million -- far above its own guidance for $485 million -- which translated into adjusted net income of $0.30 per share, trouncing estimates for $0.12 per share.
But Splunk also reduced its full-year cash flow guidance for the second time in as many reports -- this time telling investors to expect negative operating cash flow of $300 million in fiscal 2020, marking a massive reduction from its old target for positive $250 million. With echoes of its previous quarterly update in late May, management blamed the negative impact on cash collections of Splunk's faster-than-expected acceleration away from perpetual licenses and toward a cloud-based renewable model.
Now that the dust has settled, let's dig deeper in an effort to better understand what's driving Splunk today. To that end, here are five key points management discussed during this quarter's conference call.
1. Splunk is "firing on all cylinders"
I want to be emphatically clear, our business is firing on all cylinders and executing at highest levels. For a little data driven context, only a handful of enterprise software companies in history have had $2 billion in revenue while attaining greater than 25% revenue growth -- the likes of Microsoft, Oracle, Salesforce, ServiceNow, VMware and Workday. Splunk is on track to join this short list by the end of this fiscal year. Not only is Splunk on the cusp of joining these elite companies, we've done it concurrently while making massive investments in new cloud technology and executing on a full business model change. -- Splunk CEO Doug Merritt
Merritt led with this statement to dispel any notion that Splunk's cash flow headwinds might be related to the underlying weakness of its business or waning demand for its products. To the contrary, and in a way few tech leaders have done before it, Spunk is taking market share and sustaining its incredible top-line growth -- both key priorities in these early stages of its long-term story -- despite the inevitable challenge associated with building on an increasingly massive base.
2. The benefits of renewable licenses, pricing changes
Our renewable business model makes it easier to do business with [Splunk]. And in fact customers have adopted term [licensing] in Cloud faster than expected, increasing our mix from renewable by more than 10 percentage points in just one quarter to a stunning 95%. We've also evolved our pricing approach to make it easier for customers of Splunk much more of their data. Our contracting and pricing changes are making a big difference for enterprise customers. And our new pricing meaningfully expands the opportunity for Splunkable data worldwide. -- Doug Merritt
Later in the call, Splunk CFO Jason Child elaborated that renewable license sales are expected to accelerate to 99% of Splunk's total by the fourth quarter, with perpetual licenses comprising the remaining 1%. For perspective, this marks a drastic contrast from Splunk's previous target model, which called for perpetual licenses to represent a full 15% of its total at the end of this fiscal year.
3. On Splunk's enviable long-term margin profile
In Q2 we recorded 93 orders greater than $1 million and added 500 new customers. On margins, which are non-GAAP, Q2, overall gross margin was 84%, up two points on a year-over-year basis. With such rapid growth in the cloud, we are realizing anticipated efficiencies and scale in that business. In Q2 cloud delivered over 50% gross margin, which is an important milestone on the way to our long-term target as 70% or more. Q2 operating margin was 9%, notably better than our plan, driven by our solid top-line performance and some investment optimizations. -- Splunk CFO Jason Child
Make no mistake: While Splunk has purposefully incurred hundreds of millions in GAAP losses over the course of its life as a public company, it has also done so with a longer-term eye on building its customer base, growing its enterprise value, and fostering an attractive margin profile that should pay off when it eventually, consciously takes a turn toward sustained profitability. The cloud business, in particular, is only just coming into its own to that end as it begins to scale in earnest.
4. SignalFx isn't a desperate acquisition
As you know, there are two kinds of M&A [mergers and acquisitions] transactions, consolidation deals in troubled market categories and acceleration deals in growth categories. Make no mistake, we are proactively positioning Splunk for growth and long-term value creation. Splunk is on a mission to become nothing short of the strategic technology partner to the world's most data savvy enterprises. -- Doug Merritt
Even given its cash flow challenges, Splunk isn't shy about continuing to expand its reach through strategic acquisitions -- in this case, with its $1.05 billion cash-and-stock purchase of cloud-monitoring company SignalFX.
Here again, Merritt is taking a proactive approach to reassure investors that Splunk isn't acquiring SignalFX in a desperate attempt to prop up growth in a troubled niche. Rather, Merritt says integrating SignalFX into Splunk's existing core business will position it "as a leader in monitoring and observability at massive scale," which in turn should only improve its value proposition and the stickiness of its offerings with its growing enterprise client base.
5. On revenue, (adjusted) margin guidance
[W]e expect our high growth trajectory to continue. Q3 revenue should reach approximately $600 million with a non-GAAP operating margin of 16%. For the full year, we are now expecting total revenues of $2.3 billion, up from $2.25 billion [before], and we maintain our non-GAAP operating margin target of 14% -- which to confirm will include the acquired operating expense run rate of SignalFx.
For perspective, not only did Splunk provide Q3 revenue guidance that was well above analysts' estimates, but it also unsurprisingly raised its full-year revenue outlook while reiterating its adjusted margin guidance in the process. In short, it seems the only pain point the market had with Splunk's latest quarter was its reported and future cash flow expectations. Both are directly related to the incredible momentum of its transition to renewable licenses, which should leave the company better positioned to continue growing for the foreseeable future.