Monitoring and analytics company Splunk (SPLK 3.62%) posted fiscal third-quarter earnings that exceeded expectations. Furthermore, management forecast operating cash flow would reach $1 billion by fiscal 2023 -- ending in January 2023 -- which would be a huge improvement compared to the currently negative cash flow. Given the company's solid results, this goal seems realistic, but it doesn't take into account some significant costs that moderate this apparently massive profitability.
Solid third-quarter earnings
During the third quarter, revenue increased to $626 million, up 30% year over year. And remaining performance obligation (RPO), a leading indicator of revenue, jumped to $1.45 billion, up 52% year over year.
Compared to competitors such as New Relic and Datadog -- which grew their quarterly revenue by 27% and 88%, respectively -- Splunk's growth wasn't that impressive. But if you take into account Splunk's larger scale by a factor of more than four based on revenue, its high-double-digit growth shows the strength of its business.
Besides the rising demand for Splunk's products, which is related to the ever-increasing amount of data its customers must deal with, the company's better-than-expected performance this quarter was due to its strength in its public sector business. And since Splunk Cloud -- cloud-based analytics and monitoring solutions -- received a FedRAMP certification one month ago, the company should keep on expanding its footprint in the U.S. public sector.
From negative operating cash flow to $1 billion
Despite these solid top-line results, management expects negative operating cash flow of about $300 million this fiscal year. In contrast, the company had posted positive operating cash flow over the last several years.
This operating cash flow deterioration isn't worrying, though. Splunk has shifted from a perpetual license model, which consists of receiving immediate up-front cash, to a ratable model where the company gets annual smaller payments. And since its average contract lasts about three years , this transition will have a negative impact on the company's operating cash flow during that time frame. But management expects operating cash flow to grow to $1 billion by fiscal 2023, when the billing situation normalizes.
It's not only about cash
There's another aspect you should consider, though. As is the case with many tech stocks, the company's share-based compensation (SBC) represents a significant cost to shareholders. But since SBC isn't a cash expense, it's excluded from operating cash flow.
SBC decreased as a percentage of revenue from 40% in fiscal 2017 to 24.5% in fiscal 2019. However, given the company's strong revenue growth, SBC actually increased from $378.0 million in fiscal 2017 to $441.9 million during fiscal 2019.
The contrast between Splunk's profits under generally accepted accounting principles (GAAP) and its non-GAAP results illustrates the impact of SBC. Since the beginning of the year, the company posted non-GAAP earnings of $140.0 million. But GAAP net income was negative $313.9 million, mostly because of $378.9 million in SBC.
The market currently values Splunk at 21.7 times its forecast fiscal 2023 operating cash flow of $1 billion, which seems reasonable when you take into account the company's strong revenue and RPO growth.
Yet since SBC will still represent a significant part of the company's expenses over the next several years, you should keep in mind Splunk will continue to post GAAP profits well below its operating cash flow. For instance, extrapolating $500 million of SBC deducted from the expected $1 billion of operating cash flow, profits would reach $500 million in fiscal 2023. With its current market capitalization of $21.68 billion, the valuation of 43.3 times those estimated profits becomes much less attractive.
Thus, prudent investors should ignore management's symbolic goal of $1 billion of operating cash flow by fiscal 2023 and focus instead on revenue growth and GAAP profits.