Solid Start for Splunk

 Splunk’s (SPLK) first-quarter results were modestly ahead of our expectations, as the firm continues to see strong growth in cloud-based sales. The company is making progress on improving its operating leverage via sales and marketing, though the firm still has material ground to cover to reach our long-term margin targets. We continue to think Splunk’s versatile analytics platform will drive outsize growth, but we still see challenges in the business model that prevent us from awarding the firm an economic moat. We are maintaining our $67 fair value estimate, and shares remain near our fair value despite a 5% sell-off on the heels of these results.

First-quarter sales rose 30% versus the prior-year period to $242 million, ahead of our forecast. Maintenance and services revenue (which include cloud contracts) were the primary growth driver, rising 48% year over year to $125 million, eclipsing the revenue contribution from licenses. We generally think Splunk has handled this transition well, and the company is tracking toward 75% of its revenue mix coming from subscriptions by 2020. Still, Splunk’s operating margin profile has likely suffered to a greater degree because of this transition, a trend realized in continued elevated sales and marketing spending. These expenses totaled nearly 72% of sales on a GAAP basis in the quarter. While this was down from 78% of sales in the prior-year period, we would generally expect a company of Splunk’s revenue scale to be generating significantly greater operating leverage via this expense line. Between the revenue mix transition and what we believe is a more onerous customer education process, we forecast Splunk’s long-term GAAP operating margin topping out in the mid- to high-20s as opposed to the 30% or more for many subscription-based companies in our coverage.

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