Following lower-than-expected fiscal third-quarter results, Splunk (SPLK 0.62%) stock price dropped by approximately 20% during after-hours. Yet the data analytics and monitoring specialist's cloud business kept generating impressive growth, and the company remains exposed to a huge addressable market management estimated at $81 billion. So should investors worry about Splunk's disappointing performance? Or is the stock now a buy?
Disappointing quarterly results
Given the surge in demand for cloud computing and subscription offerings over the last several years, Splunk has been transitioning from its legacy on-premises data analytics and monitoring software business to a subscription-based cloud portfolio.
That shift negatively affects revenue recognition under generally accepted accounting principles (GAAP), though. The company's new subscription business model corresponds to lower revenue recognition because of smaller annual ratable payments compared to previous multi-year term licenses with large upfront payments.
Investors should expect that accounting trick to depress Splunk's top-line performance until that transition to a subscription-based business is over, by 2023. But even with that context, the company's fiscal third-quarter revenue decline of 11% year over year to $558.6 million, way below management's guidance of $600 million to $630 million, remains disappointing.
However, Splunk's cloud-based business delivered solid performance thanks to a strong cloud portfolio boosted by the acquisitions of the cloud outfits SignalFx and Streamlio in 2019. Cloud annual recurring revenue, or cloud ARR (the annualized revenue run-rate of active subscription contracts at the end of the quarter), grew 71% to $630 million. In particular, existing cloud customers contributed to that performance as they spent 31% more than the prior-year period, as evidenced by the cloud dollar-based net retention rate of 131%.
As a result, the company's transition to a subscription-based cloud model is materializing. During the last quarter, cloud revenue represented 26% of total revenue, up from 13% in the prior-year period.
A temporary issue?
So what caused such a disappointing top-line performance?
During the earnings call, CEO Doug Merritt justified the company's weak results with pressure from macro conditions that delayed some large deals, and he highlighted that these deals were not lost to competitors.
You should take these explanations with a grain of salt, though.
Given the underwhelming quarterly results, management withdrew some of the long-term goals it had reiterated during the company's analyst day in October. It had expected ARR to grow at a compound annual rate (CAGR) of 40% by fiscal 2023, ending in January 2023, with operating cash flow exceeding 20% of ARR by that time.
Withdrawing the long-term outlook seems odd, as Merritt referred to temporary challenges to explain the disappointing fiscal third-quarter performance, which should not affect the company's results beyond the next couple of quarters. A potentially prolonged underperformance may actually indicate Splunk may be facing difficulties because of tough competition.
That's another reason to consider management's justifications with prudence. Splunk's competitors Datadog and Elastic haven't reported such challenges during their latest quarterly reports; they even posted better-than-expected results and raised their guidance. That suggests Splunk's competitiveness may be eroding as competitors have been enhancing their offerings. For instance, Datadog has been developing several integrations with Amazon's Amazon Web Services (AWS) over the last several quarters.
Besides, the timing of these difficulties corresponds to the departure of the company's head of sales in September, which creates some extra uncertainty about the outcome of the delayed large deals.
Wait and see
Because of these worrying developments, Splunk's stock plunged during after-hours, but the tech stock is still trading at a high multiple of 12.3 times revenue, based on the midpoint of the full-year guidance range.
Next-quarter results in March will certainly shed some more light on the real nature of the company's challenges as management will update its long-term outlook. Any additional delay in large deals may reveal worrying competitive pressures rather than temporary unfavorable macro conditions.
Thus, Splunk's stock price remains too pricey for me to get involved. I'd rather stay on the sidelines and wait for next-quarter updates to make sure Splunk's competitiveness isn't eroding.