Splunk Inc’s (NASDAQ: SPLK) shares are currently trading at $118.46 which represents flat gains over the past 12-months basis compared to the broader market returning flat gains over the same time frame. Second-quarter earnings were reported on Wednesday and the question of weakening cash flow is taking center stage.

Splunk Overview

Splunk is a hybrid cloud computing company that harnesses the power of artificial intelligence to offer data analytics solutions to a variety of organizations. The company is one of the leaders in the big data analysis and security space, which according to Statista is expected to grow from roughly $42 billion in 2018 to $103 billion by 2027 representing a CAGR of 9.4 percent.

The company derives the majority of its revenue from licensing its platform which gives users the ability to investigate, monitor, analyze and act on machine data regardless of format or source. “Machine data is produced by nearly every software application and electronic device across an organization and contains a real-time record of various activities, such as transactions, customer and user behavior, and security threats,” Splunk notes in its annual report.

Splunk offers customers two options; either Splunk Enterprise whose license fee is based on the estimated daily data indexing capacity required and Splunk Cloud which offers the core capabilities of Splunk Enterprise as a scalable cloud service.

Splunk’s Q2 Highlights

Ultimately, the most important aspect that potential shareholders were looking for was whether Splunk would be able to improve its cash flow going forward. Back in May when the company released its first-quarter earnings report, the share price tumbled by at least 17 percent driven by concerns about the company’s weakening cash flow.

History seemed to repeat itself again on Wednesday when shares fell over 10 percent after it reported earnings. Apparently, the market chose to ignore the fact that Splunk had another one of its best quarters in recent years and that it had made significant progress towards shifting its business model from perpetual software licenses to recurrent cloud-based revenue.

As a matter of fact, Splunk reported better than expected numbers in the quarter, and also reaffirmed guidance for the rest of the year. According to the earnings release, the new business model is already paying off with revenue for the second quarter posting a 33 percent increase to $517 million compared to the year ago quarter. Software revenues, which combines licensing and cloud, were up $350 million or 46 percent year-over-year.

Moreover, the company added more than 500 new Enterprise customers including Verizon Media Group and ABB Group, in addition to recording 93 orders greater than $1 million. In spite of this, the company still posted an operating loss of $100.9 million, though adjusted earnings came in at $0.30 per share which beat Wall Street’s expectations of $0.12 on revenue of $488.4 million.

Overall, gross margin for the quarter was 84 percent up 2 points on a year-over-year basis with cloud delivering over 50 percent gross margin.

In Q2, 95 percent of software revenue was either term or cloud and management expects the elimination of perpetual license sales will accelerate the renewable mix to 99 percent in Q4 and high 90s for the full year.

As previously highlighted in Q1, the accelerated shift to renewable has a timing impact on cash collections. In other words, Splunk’s transition from perpetual licenses to more predictable, cloud-based subscription model is happening much faster than the company initially anticipated and this has caused the timing of Splunk’s cash flow to take a hit over the short term.

Newly appointed CFO Jason Child had this to say about the cash flow situation:

“As expected, Q2 operating cash flow was negative, given the more rapid growth of multi-year term and cloud contracts. This translates to a greater cash flow drag this year, as more of our contracts are paid ratably. We are now expecting negative operating cash flow for the balance of the current year and expect fiscal 2020 with $300 million net negative operating cash flow.”

This is in stark contrast to the Q1 cash flow guidance of positive $250 million which understandably spooked investors triggering a mild sell off.

According to Child, there were two new drivers behind this expected reduction. First, the renewable transformation is already essentially complete with the mix at 95 percent in Q2 and expected to go to 99 percent by Q4. Second, the company is significantly reducing its upfront cash invoicing for term and cloud deals from 58 percent paid upfront in the first half of FY 2020 to an estimated 33 percent paid upfront in the second half of FY 2020.

William Blair analyst David Griffin further explains that “because the entire value of perpetual contracts is invoiced and collected in cash up front, the lower contribution creates a significant headwind to cash flow.” The company is also billing customers for fewer months in advance, which again reduces cash received up front.

Apart from transitioning away from perpetual licenses, Splunk has made some strategic purchases in the recent past to boost its artificial intelligence position, including SignalSense in 2017 and VictorOps last year. On the call, Splunk revealed that it would be making another acquisition – cloud-monitoring service SignalFX for $1.05 billion in a cash-and-stock deal which is expected to strengthen the company’s application monitoring service.

The combination of Splunk and SignalFx will give application developers and IT departments a unified data platform that allows them to monitor and absorb data in real-time, no matter the infrastructure or scale, in order to cut costs, boost revenue and improve the customer experience. “I am excited by our strong quarter, tremendous cloud growth and our agreement to acquire SignalFx,” Splunk CEO Doug Merritt said during the earnings call. “I am particularly pleased with how quickly we are accelerating our business transformation to cloud, and the impact cloud is having on our customers.”

Splunk’s Valuation

A quick look at Splunk’s revenue multiples shows that it is trading well below its three-year historical price to sales ratio. Furthermore, on a relative valuation basis, Splunk doesn’t appear to be as expensive as other companies in a similar space. The chart below shows the price to sales ratios for Splunk versus Adobe (NASDAQ: ADBE), Talend (NASDAQ: TLND), Salesforce (NASDAQ: CRM), Workday (NASDAQ: WDAY).

(Source: YCharts)

With the company expecting total revenues of approximately $2.25 billion in 2020, this would imply a forward price to sales of roughly 7x which would make it a bargain compared to other companies in the same sector.

Conclusion

Splunk has delivered revenue figures above analysts’ forecasts in the past 12 consecutive quarters. The main takeaway is that the transition of the business model is just about completed and any near-term weakness should be watched closely for a potential buying opportunity. Acquisitions, like Salesforce and Tableau, and Google and Looker, are shaking up the space and this may have also affected buying pressure.

Disclosure:  Subscribers to my premium service may have positions in the securities mentioned in this article or may take positions at any time. Splunk is not currently on my list of top tech stocks although this may change in the future.