Stay on the Sidelines With Splunk

If you are interested in Splunk  (SPLK)  I'd advise you to stay on the sidelines. Why? Let's start with for the year to date, shares, at around $53, are flat. The company reports its third quarter on Tuesday. 

Shares of the machine intelligence firm reported a slowdown in license growth and a weak gross margin. Back in August, Splunk reported second-quarter earnings of 5 cents per share, 2 cents better than the consensus estimate. Revenue rose 43.5% to $212.8 million versus the $200.5 million estimate.

Second-quarter license revenue grew 32%, but that was down from 41% in the first quarter. Likewise, billings grew 40% in the second quarter, but that was down from the 48% growth posted in the first quarter.

If that wasn't disappointing enough, the company reported a gross margin of 83.8% below the analyst estimate of 85%.

Management sees third-quarter revenue of $228 million to $230 million versus the $228 million estimate. Operating margin is expected to between 5% and 6%.

For the year, the company is forecasting revenue of $910 million to $914 million versus the $897 million consensus. The company didn't boost guidance and investors found that disappointing as well.

After the second-quarter report, analysts were quick to defend the company. First, analysts said the third-quarter guidance was in line with the consensus estimate -- but the company typically beats the estimate so it is not a big deal the company didn't increase guidance.

Second, the company's cloud computing business is on track to deliver $100 million in revenue and the transition to the cloud is suppressing the company's billings growth. The 40% growth in billings would have been better if customers were buying software licenses instead of the company's cloud offering.

Finally, gross margin was suppressed for exactly the same reason. Licensed software carries a higher margin than the cloud offering, so margins were lower than expected.

Defenders say these are temporary growing pains and the company should be able to shake off these issues.

Two weeks ago, Splunk announced it had appointed Brian Goldfarb as chief marketing officer. Goldfarb will oversee global marketing strategy and drive revenue growth. Goldfarb comes to Splunk from Salesforce.com. He will be tasked with growing the company's cloud computing effort.

However, Splunk has only a 5% operating margin and is spending heavily on marketing. I'm not convinced the company can grow the top line fast enough to reduce its marketing spending anytime soon. The company spends over 50% of revenue on marketing.

In other words, Splunk's software doesn't sell itself. And that has me concerned.

I would wait to see if the company can grow its top line with less marketing spending. Spunk has no earnings leverage with single digit operating margins. That's why I would stay on the sidelines for now. 

No positions in any stocks mentioned.

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