Shares of Splunk (SPLK -0.04%) were sporting a big double-digit percentage gain through the second half of this year, but took an abrupt 20%-plus plunge after the company reported third-quarter earnings on Dec. 2. The data analytics and digital observation software stock suddenly went from market outperformer to laggard. Some shareholders might be inclined to sell, but I'm leaning towards doing the opposite headed into 2021.
A big revenue and earnings miss, with an equally big footnote
In Splunk's fiscal 2021 Q3 (the three months ended Oct. 31, 2020), revenue fell 11% year-over-year to $559 million, well below the guidance for at least $600 million provided just a few months ago by the company. CEO Doug Merritt said some large customers were "hesitating to commit to long-term contracts" due to ongoing uncertainty in the economy. Merritt said simply that "our third quarter did not meet our expectations."
But I can dig in on reasons why revenue fell short of projections. In keeping with the first two quarters of the year, some of Splunk's recent shortcomings can be attributed to its transition to cloud-based software. Basically, when a term contract (in which all of the revenue was realized up front) got replaced with a cloud contract (in which revenue is realized over time), the result looked like a loss of income. It isn't a loss, however, just an accounting change. In normal circumstances, a company's migration to more modern cloud software business contracts would be a good thing. But Splunk has been managing a rapid migration to the cloud among its customers, and the recent turbulence in business results (and thus stock price) can be chalked up to this.
I'd direct investor attention to Splunk's annual recurring revenue (ARR) figure, which combines all types of revenue (term and cloud) on an annualized basis. And on this front, Splunk continues to execute according to its long-term plan. ARR increased 44% year-over-year and was $2.07 billion in Q3, the first time the metric has exceeded the $2 billion milestone. Cloud ARR was $630 million, up 71% year-over-year and illustrating the accounting issue outlined above.
Why I'm still bullish on Splunk
Splunk management reiterated that it sees ARR staying in the mid-40% growth range, though it expects recent challenges with some of its customer renewals to persist into the fourth quarter. Resulting Q4 ARR is expected to be between $2.3 billion and $2.35 billion. That's an 11% quarterly increase at the low end of guidance, certainly nothing to frown at. As Merritt said it on the earnings call, "Splunk remains one of the fastest-growing enterprise software companies in history. As we outlined at our Investor and Analyst Day, we're early in the penetration of our $81 billion [total addressable market]."
That's why I remain a buyer even after Splunk stock just took a 20%-plus nosedive. This data analytics software company operates in a massive industry, and though it's the largest among its peers (as measured by revenue), there is plenty of sandbox for itself and everyone else. Splunk's recently launched "observability suite" for cloud infrastructure monitoring and management; and acquisitions of small software firms Plumbr, Rigor, and Flowmill in support of its new product; will help it break into a new market. On that front, it will go head to head against cloud observability pioneer Dynatrace -- but again, these are large markets with enough space for everyone.
As a final note, I think Splunk continues to trade for a reasonable valuation at just over 11 times full-year expected ARR of $2.3 billion. Free cash flow remains negative, again due to accounting as its customers migrate en masse to cloud contracts, but 2021 could be a big rebound year on that front. Put simply, this isn't time to panic sell. I still like Splunk's long-term prospects, and I think making a purchase now will pay off down the road.