Splunk's fiscal second-quarter performance looked ugly. In contrast to competitors that have recently posted strong double-digit revenue growth, the data specialist's top line declined despite sales and marketing expenses reaching almost two-thirds of revenue. However, investors should pay closer attention to the company's performance as its transition to the cloud hides a more attractive long-term story.

Short-term headwinds

Splunk offers solutions to store, monitor, and analyze data from applications and devices. And given the digitization of enterprises, the quantity of data is exploding. Research specialist IDC estimates that the collective sum of the world's data will grow at a compound annual growth rate (CAGR) of 61% through 2025, which bodes well for Splunk.

Yet the company posted underwhelming second-quarter results as revenue declined 5% year over year to $491.7 million. In contrast, some competitors delivered much stronger numbers on the top line.

Company Latest Quarter's Revenue YOY Change
Splunk (NASDAQ:SPLK) $491.7 million (5%)
Datadog $140.0 million 68%
Elastic N.V. $128.9 million 44%

Data source: company press releases. Latest quarter ended June 30, 2020 for Datadog and July 31, 2020 for Splunk and Elastic. YOY = year over year.

Splunk's weak performance was due to its declining legacy license segment, which shrank to $176.8 million, down 37% year over year. By comparison, cloud services increased 79% to $125.9 million. Growing revenue from cloud services could not quite offset the decline of the license segment, as the former corresponds to ratable revenue versus the larger upfront payments for the latter.

For that reason, management expects another quarter of unexciting performance with third-quarter revenue expected to land in the range of $600 million to $630 million, depending on how the cloud segment performs. Splunk reported $626.3 million of revenue in the prior-year quarter.

In addition, that transition to the cloud is pressuring the company's gross margin. Its legacy licensing business involves minimal costs, as it consists of distributing software to its customers' infrastructure. But now, Splunk must provide the computing infrastructure with its cloud-based offerings.

Thus, during the recent quarter, cloud services' relatively low gross margin of 52.5% paled in comparison to the license segment's 96.9%. And non-GAAP (adjusted) total gross margin declined 560 basis points to 78.4%, down from 84.2% one year ago.

Unsurprisingly, diminishing revenue and lower gross margin led to a larger GAAP loss of $261 million, more than doubling the loss posted in the prior-year quarter and reflecting the company's near-term challenges.

Man reading data charts on head up display interface screen

Image source: Getty Images.

Accelerated transition to the cloud

Splunk's transition to the cloud is happening faster than anticipated. As an illustration, cloud-based bookings represented 53% of total software bookings in the fiscal second quarter, up from 36% one year ago. During the earnings call, CEO Doug Merritt anticipated that this forward-looking metric will reach 60% this fiscal year, ending Jan. 31, two years ahead of the initial plan.

That accelerated development led to lower-than-expected fiscal second-quarter revenue. But it remains a positive outcome that shows customers are embracing Splunk's cloud portfolio, which bodes well for its long-term business. In particular, management highlighted the company's observability solutions, an essential element for monitoring and managing cloud infrastructures and applications, as contributing to the strong cloud performance.

During the second quarter, cloud annual recurring revenue (annualized revenue run-rate of active subscription contracts) growth accelerated to 89% year over year, up from 81% in the prior-year period, to $568 million. Trailing 12-month dollar-based net retention rate for cloud reached 132%, which means existing customers spent 32% more than one year ago to use the company's cloud solutions.

In addition, as Splunk is scaling its cloud business, its gross margins should improve. Management forecast cloud non-GAAP (adjusted) gross margins to exceed 70% by next year, which seems reasonable considering the 80% gross margin reported by the cloud-native competitor Datadog last quarter.

Looking forward

As the transition to the cloud is progressing, management expects operating cash flow to become positive in fiscal 2022 and grow to $1 billion the following year.

Splunk's market cap is 35 times that forecasted 2023 operating cash flow, but despite that rich valuation and the short-term headwinds, investors should keep Splunk on their watchlists. The company is poised to profit from the explosive growth of data in the coming years, thanks to its rapid transition to the cloud.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.