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Splunk's Cloud Transition Is Starting to Bear Fruit

The headline numbers didn't appear to be that great, but Splunk's (NASDAQ: SPLK) shareholders have a lot to be happy about after the start to 2020. Revenue in the first quarter increased a meager 2% from a year ago to $434 million, but that obscures massive growth in its cloud-based data analytics business as the company transitions to new accounting standards more suitable for a modern-day software outfit.

The coronavirus lockdown is, of course, clouding the outlook for the rest of the year, but digital transformation is accelerating as organizations look to quickly update operations to avoid any future disruption. For Splunk, which recently surpassed IBM (NYSE: IBM) as the market share leader in IT performance analysis, work-from-home and shelter-in-place mean more fuel just got added to its growth engine.

Image source: Getty Images.

The performance metric driving results

Splunk's Q1 results came in as expected, with its cloud transition taking basic revenue growth down to a meager low single-digit rate. However, as I discussed a few months ago, the company's migration to a cloud-centric software model is hiding the massive growth actually taking place under the surface. Splunk said its customers' demand for cloud products was once again much greater than anticipated, and it reported an 81% year-over-year surge in that department (with cloud representing 44% of software bookings in the quarter, up from 35% just three months ago). Annual recurring revenue (ARR), which combines renewable cloud contracts and term sales and which now makes up nearly all of the revenue mix, was up 52% to $1.78 billion.

That's impressive because management had said to expect a mid-40% increase in ARR this year. But the massive global transformation to digital-first that has been boosting Splunk's business the last few years is stronger than ever with the pandemic on everyone's mind. The acquisition of cloud monitoring outfit SignalFX last year also helps, as will a new strategic partnership with Alphabet's (NASDAQ: GOOGL)(NASDAQ: GOOG) Google Cloud.

The company did withdraw its specific guidance for the current full-year period, but it also provided a little visibility into the second quarter. Revenue is expected to be $520 million -- roughly flat with the year-ago period. However, as the company still laps its old way of billing customers, ARR is still expected to be up in the mid-40% range this year and up by a similar rate in the next two years following.

Back to profitability

The fast move to the cloud is creating some near-term hiccups, the biggest glare coming off the negative operating profit margin. The adjusted operating margin was negative 25.6% in Q1 and expected to be negative 10% to 15% in Q2. Ouch.

However, stopping short at operating margin doesn't tell the whole story. Free cash flow -- revenue less cash operating and capital expenses and excluding non-cash expenses -- remains in positive territory and was $31.3 million in Q1. That's a 56% year-over-year increase and good for a free cash flow profit margin of 7%. As its new cloud and term software license agreements start to kick in, that margin should only increase. The balance sheet is also in good shape, with cash and equivalents of $1.76 billion and debt (which can be converted into stock) of $1.74 billion at the end of April 2020.

In the meantime, there is plenty to like about Splunk. New customers like Zoom Video Communications (NASDAQ: ZM), which is using Splunk to help with its security, and an expanded data monitoring relationship with e-commerce giant Shopify (NYSE: SHOP) help reinforce the long-term tailwind propelling this data analytics firm higher. Splunk remains a staple of my portfolio.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Nicholas Rossolillo and his clients own shares of Alphabet (C shares), Shopify, and Splunk. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Shopify, Splunk, and Zoom Video Communications and recommends the following options: short August 2020 $130 calls on Zoom Video Communications. The Motley Fool has a disclosure policy.


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