Splunk (SPLK 2.21%) had a great fiscal 2020 (12 months ended Jan. 31, 2020). Riding the wave of interest in data analytics as organizations around the globe update their operations for the 21st century, the company added hundreds of new customers and made a big $1.05 billion acquisition in cloud computing monitoring outfit SignalFX last August. As a result, sales for the year once again grew north of 30% -- total revenue was up 31% to $2.36 billion, and adjusted earnings per share increased 41% to $1.88.
Perhaps it comes as a surprise, then, that the stock has retreated some 17% since the company released this latest report card. No, coronavirus can't be the sole scapegoat here. As good as the top-line momentum was, it seems that Splunk's own transition to cloud computing-based services is going to cause a hiccup in growth during the first quarter -- to the tune of 6% growth year over year. You read that right, just a single-digit percentage increase. Add in an expected adjusted operating profit margin of negative 25% on revenue of $450 million, and growth seemingly falling off a cliff looks like reason to panic.
But before I convince you to go and sell all of your Splunk stock, let me point out that this situation is likely to be a temporary one. If you originally purchased -- or plan on purchasing -- this stock for the long haul, there's little reason to worry.
New business, new accounting standards
In a move to update its business model to meet current trends, Splunk started transitioning to term and cloud contracts for its customers -- which offer greater flexibility in software use and cost rather than the perpetual licensing it was previously using. In fact, demand for term and cloud was so strong that Splunk eliminated perpetual software licenses altogether and reported that 99% of its revenue bookings were under one of these renewable contracts. With the stated goal of moving away from perpetual complete, the case is closed on this success story, right?
Not so fast. While new licensing standards are a good thing for customers, they cause headaches for Splunk shareholders. That's because there's a difference between how term contract and cloud contract revenues are recognized. As CFO Jason Child explained on the latest earnings conference call:
The bookings mix between term and cloud becomes an important balance to understand, so it too can have a meaningful impact to the financial statements. Going into [fiscal year] 20, the year we just closed, we expected cloud would contribute about 25% of software bookings. Turns out that cloud demand was significantly higher, and ultimately 35% of total software [total contract value] was from cloud, most of which came in the second half of the year. And because revenue recognized from a cloud contract is fully ratable, even a large cloud contract on a [total contract value] basis will yield significantly less revenue than a comparably-sized term contract.
In layperson's terms, when a term contract is signed, most of the revenue is recognized immediately. For a cloud contract, revenue is recognized over time. Splunk is continuing to emphasize cloud contracts and is targeting 60% of revenue to be cloud-based by fiscal year 2023 (up from 35% in fiscal 2020). Put simply, the fast cloud migration will look like slower revenue growth (up 6% in the first quarter and an expected 10% increase for full-year 2021) than what is actually occurring.
To compensate for the transitioning revenue recognition, Splunk management is telling investors to focus on annual recurring revenue (ARR), which counts the growth in cloud subscription and term sales and offers a better view of the services Splunk is actually delivering to customers. Splunk's fiscal 2020 ended with ARR of $1.68 billion, up 54% year-over-year -- made up of $442 million of cloud licenses and $1.24 billion from term licenses. And even though recognized revenue for the year ahead looks dismal, management said it expects ARR to increase in the mid-40% range and then grow at about 40% each in fiscal 2022 and 2023. If successful, that would equate to $4.6 billion in ARR by fiscal 2023 compared with the $1.68 billion just delivered.
Still on pace to reach profitability
Those are some incredible growth rates Splunk's cloud transition is expected to yield, but what about the bottom line?
Just as revenue growth will likely trough this year as the company continuously favors cloud, so too will adjusted operating losses. Though a negative 25% operating margin looks dismal for the first quarter, management forecasts break-even for the full-year period. And by fiscal 2023, the long-term outlook for at least $1 billion in operating cash flow (a roughly 20% margin) was also reiterated.
Not being able to recognize revenue upfront is thus going to wreak havoc on Splunk's cash flow for the short term, but the proof better times are ahead can be seen from the recent past. Before going all-in on cloud transformation, Splunk's free cash flow was positive and rising as the software analytics firm grew and got more efficient. Once weaned off term contracts, the free cash flow situation is likely to recover with a vengeance.
In a nutshell, Splunk's outlook was far better than it looked. While there is sure to be some disruption in the stock as investors try to digest what is actually going on, I'm still a buyer of the big data analytics firm.