The pains of transitioning from a licensing to a subscription SaaS model

Splunk provides mission-critical data to customers navigating transformations on an epic scale. Yet they missed on both revenue and margin dollars in their Q3 FY2021. Is this a reflection of demand, a misaligned offering, poor execution, new competition, or something less obvious? We think Spunk’s transformation from licensing to the cloud is thrusting them into a revenue “Valley of Despair”.

Splunk reported a revenue increase of only $67M in Q2 to Q3 of 2021 ($492 in Q2 to $559 in Q3), less than forecasted. We believe the revenue miss is less an execution issue and more a revenue composition challenge.

The Valley of Despair

Companies transitioning from licensing to subscription models often find an initial drop in reported quarterly revenues either as they transition from reporting the entire license value to a monthly or quarterly license or as their customers evolve to a larger group of smaller customers attracted to the affordability of monthly subscriptions. There is also a delay in SaaS growth as license customers wait until necessary to move to the cloud. Sales teams trained to sell large enterprise license contracts struggle with negotiating SaaS agreements. A company’s demand engine is not easily adjusted to a different offering or to a new customer base. Most companies find the transition harder culturally and operationally than contractually.

In this illustration, we see the impact of a drop in total revenue until a company changes its cloud-focused sales and marketing model.

Why is Splunk in the Valley of Despair

Splunk’s revenue is suffering because they are not driving a faster transition to the cloud which is driving them into the Valley of Despair where their cloud revenue grows slower than licensing. Their Cloud/SaaS revenue was $145M in Q3 2021, up from $80m in the same period of 2020 but only up $19M Q/Q while their traditional licensing business was up $78m in the same period.

Our View

Cloud models are more appealing to a broader group of customers. Adoption rates are faster, cost of sales lower, LTV/CAC more reliable than a licensing model. Any argument that enterprises prefer licensing models is disputed by how many companies are adopting Office 365, SF.com, or Slack.

There are a few reasons why their cloud/SaaS revenue may be tracking slower than necessary to avoid the valley.

1. Trying to sell their cloud offering to the same customer base. That is a slow transition and does not leverage the cloud economies to a larger customer segment. Splunk needs to reach mid-market and SMB customers with their cloud solution.

2. Only 20% of their Cloud/SaaS revenue is outside the US while 30% of their total revenue is foreign-based. This may be attributed to slower cloud adoption in Europe or Splunk may not have cloud offerings in all foreign markets. This needs to be resolved since the company cannot switch to “cloud” successfully in foreign markets without local domains.

3. Their sales teams may not be better-compensated to transition customers to their cloud offering. Sales teams follow compensation. Sales compensation must be biased to cloud sales even to the extent of denying compensation for any license renewals.

Our Investment Thesis

Cloud/SaaS is a better model for Splunk. GMs for cloud/SaaS grew 6% Y/Y to 62% while licensing margins are down -5.9% Y/Y to 79.9%. It appears most of the revenue from Q3 2021 came from customer engagements of over $1M per year. Cloud is a way to expand their customer base by making their offering affordable for more enterprise and mid-size companies.

Splunk should more aggressively bias their sales compensation model to their cloud offering as other companies who lived through this transition including Adobe and Microsoft.

Splunk has every opportunity to make a successful transition to a cloud model, to expand its customer base, offering, and global footprint. Data companies offering will be in great demand by enterprises, mid-market, and SMBs. The key is to align every resource to make the cloud model a success.

It is time for Splunk to be serious about driving customers to their Cloud offering and rapidly the Valley of Despair.