Splunk Inc (SPLK) 2017 Q3 法說會逐字稿

Good day ladies and gentlemen, and welcome to the Splunk, Inc. third-quarter 2017 financial results conference call.

(Operator Instructions)

As a reminder, today's program is being recorded. I would now like to introduce for today's program, Ken Tinsley, Splunk's Corporate Treasurer, Vice President of Investor Relations. Please go ahead, sir.

Great. Thank you Jonathan, and good afternoon everyone. With me today on the call are Splunk's CEO, Doug Merritt; and CFO, Dave Conte. Our press release was issued after close of market today and is posted on our website.

This conference call is broadcast live via webcast and following the call an audio replay will be available on our website.

On today's call we will be making forward-looking statements including financial guidance and expectations for fourth quarter and FY17, market opportunity, competitive position and momentum, our business including cloud offering, product and services mix, expected growth in our international business, and planned investments and expectations. These statements reflect our best judgment based on factors currently known to us and actual events or results may differ materially.

Please refer to documents we file with the SEC including the Form 8-K filed with today's press release. Those documents contain risks and uncertainties that -- and other factors that may cause our actual results to differ from those contained in our forward-looking statements.

These forward-looking statements are being made today as of today. And we disclaim any obligation to update or revise these statements. If this call is reviewed after today, the information presented may not contain current or accurate information.

We will also discuss non-GAAP financial measures which are not prepared in accordance with generally accepted accounting principles. A reconciliation of GAAP and non-GAAP results is provided in the press release and our website. With that, let me turn it over to Doug.

Thank you, Ken. Greetings everyone, and welcome to the call. I am pleased to report a solid Q3. I want to first thank our employees and partners for their many contributions.

Of course at Splunk it's all about our customers, and the best part of the call for me is having the opportunity to share a small sampling of their successes. This is reflected in our total Q3 revenues of $245 million, up 40% over the same quarter last year. Our growth continues to come from a combination of new customers, our existing customers expending their deployments, and increased adoption in the cloud where we, again, exceeded our internal plan.

Q3 also allows me acknowledge everyone who joined us at dot com, our seventh annual user conference. We had more than 4,500 attendees and the richest set of use cases ever presented.

Two of my favorites were Cox Automotive who uses advanced analytics and machine learning with Splunk and IT Service Intelligence, or ITSI, to ensure their revenue is flowing by keeping their auto options up and running. And Dunkin Donuts, who had a line out the door for their session, and it wasn't just for the free donuts. They use Splunk Enterprise to analyze the preferences of their 5 million loyalty program members and gain real-time insights into the effectiveness of their marketing campaigns. Splunk helps Dunkin Donuts increase revenue and customer loyalty.

Dot com was also a unique opportunity to share the keynote stage with our partners from AWS, Accenture, and Insight Engines. Together with these important partners and hundreds more, we are driving to become the ubiquitous machine data fabric for our customers.

I'd like to call out a few specifics. Let me start by thanking Mike Clayville, Head of Global Commercial Sales for Amazon Web Services, who joined me onstage to speak about the power of Splunk plus AWS to drive innovation and help customers move to the cloud with confidence. Customers across virtually every industry and geography are benefiting from the agility of AWS and Splunk together to get the most from their cloud deployments. Thanks again to AWS for being a lead sponsor of dot com. And we are announcing at Reinvent our 5.0 version of the Splunk app for AWS, a free app that leverages machine learning and delivers a prebuilt set of dashboards and reports containing key operational, security, and billing insights.

Our strategic relationship with Accenture continues to strengthen. We work together closely at a number of our largest clients, and also enable Accenture's intelligent application management and security solutions. As global leaders in our respective fields, the Accenture and Splunk relationship brings unique value to our clients.

It was also a pleasure hosting Grant Wernick, CEO of Insight Engines, onstage during my keynote. Grant demonstrate the power of using natural language built on top of Splunk technology, which greatly expands the number of users who can harness the power of the platform without being SPL experts. Insight Engines acts as a search assistant that empowers users to quickly interact with data using common English phrases. I encourage you to watch the video of my keynote and see Grant's demo.

While not onstage for the keynote, we had another strong quarter of momentum with Cisco which named Splunk it's global ISV Partner Of The Year for a second year in a row. Splunk was also recognized by Cisco as the US West Outstanding Solutions Partner and the US Public Sector ISV and Consultant Partner of the Year.

I was also very proud to unveil the Splunk Pledge, our new philanthropic program through Splunk For Good, targeting nonprofit organizations and educational institutions. The Pledge commits us to donate a minimum of $100 million in software licenses, training, support, education and volunteerism over a 10-year period.

At dot com we showcased our latest product releases, including new versions of Splunk Cloud and Slunk Enterprise 6.5. These releases deliver powerful advances in machine learning, simplification in data analysis, and further reductions in TCO.

Another big change in 6.5 is the removal of metered enforcement, or allowing customers to exceed their license amount on a temporary basis. Our customers increasingly rely upon Splunk in mission-critical situations, and we're ensuring that the power of Splunk is available when they need it most.

This customer-focused change fits into our growing customer success initiatives, including our enterprise adoption programs. We want to make it easier for our customers to index larger volumes and varieties of data, which is key to enabling them to realize greater insights and value from Splunk's solutions. Our goal is to become the standard for machine data in every account.

We also introduced the newest versions of our premium solutions, Splunk IT Service Intelligence, Enterprise Security, and User Behavior Analytics. It was the best conference to date, and really demonstrated the passion customers have for the Splunk family of products.

More broadly, we continue to believe that we have a tremendous market opportunity. Digital transformation is disrupting business models, technology stacks and how organizations operate. Machine data is the lifeblood of this secular change, and Splunk is the leading technology that enables customers to realize value from this data.

With the move to digital, e-commerce, mobile, and social, organizations are now increasingly using machine data to provide critical context to the transactional data stored at ERP and CRM systems and relationship databases and data warehouses. They're doing this so they can make data driven decisions in real time.

Splunk continues to be a leader in operational intelligence with our customers indexing, searching and analyzing orders of magnitude more data daily than ever before. Splunk's platform provides the best solution to enable customers to easily and cost effectively collect, analyze, and get maximum value from this largely unstructured and voluminous data.

Our customers and prospects have diverse and demanding technological needs. And the landscape remains highly heterogeneous, as it has been for decades. Recognizing this, Splunk is designed as an open platform that increasingly works with and leverages third-party and open-source technologies like HCFS, Kafka, Elastic, Plume, and Spark to enable our customers' success.

Increasingly Splunk is evolving towards becoming our customers' ubiquitous machine data fabric, solving their big data and analytics challenges in IT operations, application delivery, security compliance and fraud, business analytics, and the Internet of Things. We are focused on these use cases and markets because each is going through a shift to an analytics-based approach where Splunk continues to deliver for our customers.

Moving onto execution in Q3. We continue to see strong traction in our core use cases of IT operations and security. A great example of that is the velocity we are seeing in our premium solutions, ES and ITSI which serve these core use cases. ES is now well established and we have been recognized as a leader in Gartner's Magic Quadrant for SIM for four straight years.

And while this is our first full year in the market with ITSI, the product is showing the same upside potential as ES. In fact IDC has declared that Splunk is the global market share leader for the emerging segment of IT operations analytics. Q3 notable wins included Rackspace, who extended its use of Splunk Enterprise and ES, and now uses Splunk as its core decision analytics engine across operations, security, compliance, app development and business analytics. Thanks to our partners at Kinney Group for their work on this opportunity.

A large healthcare company purchased Splunk Enterprise and ITSI to increase visibility into its claims process which was lacking. With ITSI the Company will be able to quickly track SLAs around claims processing, troubleshoot any ongoing issues, and help its claims teams process faster and smarter.

Zendesk also expanded this quarter. And in addition to using Splunk Enterprise as their platform for IT ops, they added ES for compliance and to replace a legacy SIM.

A large global financial institution sent an EAA for Splunk Enterprise, which they use for a wide range of use cases including protection against insider and external security threats, fraud detection, ensuring regulatory compliance, and improving customer experience across all of their channels. Other notable wins in the quarter include Emirates Airlines, University of Illinois, XO Star, the US Department of State and BMW.

Our cloud business continues to grow, tripling versus the year ago continuing the momentum we experienced in the second quarter. Consistent with our on-prem business, our cloud customers typically start with a single use case in IT operations or security and then expand across multiple data sources and use cases with Splunk technology delivered as a service.

A sampling of our cloud wins include Dow Jones, a Splunk customer for seven years, who chose Splunk Cloud and ES to replace its legacy SIM to gain a 360-degree view into their machine data to speed up security investigations and to reduce their costs. Educational Testing Services, or ETS, is the world's largest nonprofit testing company. And it expanded its use for Splunk Cloud for application monitoring across the lifecycle of the testing process. Other cloud wins include the University of Miami and Georgia State University.

On the people front, I am very pleased that we have recently strengthened our executive team, welcoming Susan St. Ledger as our Chief Revenue Officer, Richard Campione as our new Chief Product Officer, and Brian Goldfarb as our new CMO. Susan has been on board six months now, while Richard and Brian just recently joined. I look forward to their great contributions to Splunk.

Lots of good progress in Q3. That said, there are a few areas I'd should talk about. As we discussed on last quarter's call, our cloud momentum is strengthening. As we've discussed in the past, for any given use case a customer will typically make an either/or decision on cloud versus on-prem. I think it's obvious to reiterate, the absolute size of cloud orders are generally smaller compared to on-prem professional license sales.

One other area worth highlighting is large orders. While we saw healthy growth in large transactions, on a year-over-year basis we grew six-figure transactions by 30% and drove an almost 40% increase in the number of seven-figure transactions, the average order size for a seven-figure transaction was lower than last year's Q3, which was a particularly difficult compare, specifically because of big deal over performance in last year's quarter.

In summary it was a good quarter with some variability in bookings composition. Most companies would call 40% revenue growth, 34% license growth, and three times cloud growth a runaway success, but we set the bar high for ourselves.

Our business is scaling fast. And we recognize that we are in a classic tornado market. By the nature of the term, tornado markets have tremendous opportunity, but also test the companies going through them. Splunk is no different, and this is part of the fun of the fast-moving world that is Splunk.

We have a once in a generation opportunity that's immediately in front of us. Splunk is uniquely positioned to capitalize on this opportunity, and we are pursuing it aggressively. We are early in our journey and we are investing for scale and growth.

We are delivering high value to our customers who are expanding their adoption of Splunk as their platform for machine data analytics, both on-prem and in the cloud. We look forward to an in-depth discussion about our plans for next year at our upcoming Analyst Day. This is a good place as any to hit the pause button and turn it over to Dave for a deeper dive on the numbers.

All right. Thanks, Doug. Good afternoon, everyone. Thanks joining the call. Our Q3 performance was solid against a very strong comp.

Third-quarter revenues were $244.8 million, a 40% increase over Q3 of last year. License revenues grew 34% year over year, totaling $139.7 million. And we recorded 483 orders greater than $100,000 in the quarter, up 30% year over year.

As Doug described, we had another good quarter with our cloud business which tripled over the prior year and once again exceeded our plan. We achieved these results despite having fewer of our large orders come from cloud transactions in the quarter.

In Q2 we achieved for the first time an annual billings run rate greater than $100 million. We also detailed the overall impact of cloud over performance on license revenues as well as billing growth, given the dollar weighted average duration of cloud orders. Q3 weighted duration was consistent with Q2 at about two and a quarter years.

Similar to our on-prem business, the number of large cloud orders we close in any quarter will continue to impact the variability in our cloud results. At the high end of all of our large orders, those worth over $1 million for either on-prem or in the cloud, we saw average order size lower by approximately $500,000 on a year-over-year basis.

Factoring this change over the total number of seven-figure orders in the quarter represented approximately $20 million in total potential billings. The size and timing of large orders remains highly variable, and we expect that variability to continue. For instance, remember that at the end of the last year I reported a sizable spike in ASPs due to the impact from our largest orders.

Even considering the variable average order size, overall ASPs for the license orders was consistent year over year at about $70,000. This large order size fluctuation quarter to quarter is especially impactful in the back half of the year where we book the majority of our largest transactions.

We're excited about customer adoption and eager for more customers to take advantage of our EAA programs, something Doug highlighted at users conf. With that, we've modeled our fourth quarter considering our actual ASPs levels year to date and reflected that in our guidance.

Now, additional details for the quarter. International revenues were approximately 22% of the total, in line with previous levels and comparable on a year-over-year basis. In the near term we expect overall international revenue as a percentage of the total to continue to be in the 20% to 25% range, increasing and eventually contributing 30% to 35% in the next few years.

Our education and professional services represented 9% of revenues in the quarter. Including our cloud transactions, the ratable mix for all Q3 software bookings was 41%, similar to last year.

Now turning to margins and other metrics, which are all non-GAAP. Q3 overall gross margin was 84%, consistent with the first half of the year and reflecting the expansion of our cloud business as well as services around our core market solutions. For context, we modeled that our cloud offering will reduce total gross margin by 4% to 6% this year and next as we reach higher levels of scale coupled with continued adoption of Splunk Cloud.

Despite all the complexity of our transaction composition between cloud, perpetual, large orders, et cetera, we outperformed on the top line for Q3, which translated to better than expected bottom-line performance as well. Operating income was $16.7 million, representing an operating margin of 6.8%. Q3 net income of $16.3 million and EPS was $0.12 per share based on a fully diluted share count of 138.4 million shares. Cash flow from operations was $45 million, while free cash flow was $32 million. And we ended the quarter with just over $1 billion in cash and investments.

Now looking forward to the remainder of FY17. We expect Q4 total revenues of between $286 million and $288 million, with an 8% to 9% positive non-GAAP operating margin. This translates to full-year revenues of between $930 million and $932 million, up from our prior guidance of $910 million to $914 million.

When combining these top-line expectations with our continued investment in market groups, product teams, the field, and Splunk Cloud, we now expect that non-GAAP operating margin will be between 5% and 6% for the full year, up slightly from our prior expectation of 5% flat. Since we expect to be profitable on a non-GAAP basis for Q4 and for the full year, for your EPS calculations you should use a fully diluted share count of approximately 140 million shares for Q4 and 137 million shares for the full year.

Considering our Q3 actual results around large order composition, including the $20 million impact from seven-figure order sizes and our updated Q4 outlook, I am now expecting our cash flow from operations to be closer to 21% of total revenues for FY17. Regarding CapEx, I'm pleased to report that we are in the final stage of our South Bay campus build-out and we expect to move in next month. I know that's great news for all the employees listening.

The new facility will complement our San Francisco HQ building and provide a unique Bay Area prominence and workplace experience that will attract and retain top talent in the region. The completion of the South Bay project will drive the bulk of our estimated $25 million of CapEx in Q4, yielding full-year CapEx of about $53 million, which is on the low end of the $50 million to $60 million we previously expected.

We look forward to making it easier for our partners to sell and our customers to consume our offering as we shift towards our next stage of growth. We will be taking a deeper dive on our short-term and long-term plans at our analyst meeting, including how we expect our model will translate to revenue, [ceilings] and cash flows. And we plan to provide our initial views for next year's revenue outlook at that time.

We'll also cover Susan's plans for the field organization and how we will continue our market group focus. The new rev rec standard is coming fast, so we'll also spend some important time discussing that interesting topic.

In closing, Q3 reflects continued momentum around customer adoption, cloud consumption, and margin improvements. And I'm enthusiastic about our outlook for the fourth quarter, as well as our prospects going forward. We're all looking forward to spending time with you at our upcoming Analyst Day. So with that, we appreciate your time and interest, and we'll open it up for questions.

Jonathan, we are ready for Q&A, please. Jonathan, are you ready for Q&A, please?

Can you hear me now?

Yes.

Raimo Lenschow, Barclays.

I am calling from the AWS conference here. So maybe let's start with a cloud question. Doug, if you talk to customers at the moment, can you talk a little about how you see that on-prem versus cloud momentum moving?

And also maybe comment on the $20 million billing opportunity that you got from the [ESP] chains on the seven-figure deals? And I have a quick follow-up for Dave?

Thanks, Raimo. I hope you're having a great time down there. I got some reports about the security jam that we are running with 200 participants, and it sounds like it was a smash hit down there at the conference. Really, really excited about it.

So cloud momentum. As we've talked about a number of times, workloads are continuing to play both on-prem and in the cloud. We know the rates of transition to the cloud. [Dino]'s offered the hybrid solution in an arena where you want your product close to data origination, source is key.

I think that's why we keep getting such wonderful (inaudible) of yes. They've got a lot of customers that are performing hybrid approach. And we're thrilled with way the partnership is continuing to progress.

And this cloud growth is so important to our long-term strategy so we can serve our customers the way that we need to. Again we're expecting, as Dave was signaling in his remarks, continued expansion of that cloud growth and opportunity set.

On the large order variability piece, the key element for us was just a tough comp versus Q3 of last year. If we look at the core orders that came through, that $0.5 million delta in average order size was really attributed to a handful of big orders that were a wonderful surprise in Q3. And we've been talking about large order variability for a while. And we just saw a different variable rate this quarter.

Hey, Raimo. It is Dave. In particular those large -- that category of order actually grew 40% year over year, which was pretty good. But again, those very large handful of transactions last year made for an interesting comp. So there was potential billings that changed based on that average order size.

Okay. And then that may even lead into my follow-on question. The one question I got from investors was around short-term deferred. And was that impacted due to that mix affect as well, or what drove that number?

Yes. So as you know, we really focus on total deferred in terms of geography between income statement and balance sheet. When you look at large order contribution and you say, there was a different order size and it was $20 million. Clearly a component of that would've landed in short term versus long.

But as we continue to do adoption transactions and cloud transactions, we see continued contribution on the long-term front. But I do think there's a correlation between those two topics.

Perfect. Okay, make sense. Thank you.

Thanks, Raimo.

(Operator Instructions)

Walter Prichard, Citi.

Thanks. Must be sitting right next to Raimo here. Just on the ratable, Dave. The 41% I think is flat year over year, and you talked about strong cloud adoption which would suggest the cloud was up pretty -- as you said, tripling year over year. What do we read into what happened with the other ratable streams, the EAA and the term licenses, and what's driving what looks like a potentially reduction in that, or a flatness in that (technical difficulty)?

Yes. I think it goes back to the same thing, Walter, which is a pretty interesting comp last year. We had a couple, a handful of extremely large seven-figure orders, greater than seven-figure orders in Q3 of last year which contributed to the ratable percentage at that time.

If I look at the body of the transactions this quarter in terms of the mix of cloud and EAAs, we measure the percentage in terms of percentage of the software bookings. So when you have the change in the comparable of the seven-figure order you get a different numerator and denominator. So I don't think there is an indication of slowdown in terms of adoption, rather we just didn't have a couple of giant transactions in Q3 of this year.

Okay. And then just to follow up on something that Doug said around the Analyst Day, discussing the go-to-market plans. You have a new Chief Revenue Officer, and I'm wondering as you look into next year, how substantial are the changes you expect in the field organization, given it's a new fiscal year, customary to make changes, and then you have a new person in charge there?

Walter, I think it will be a continued evolution that Susan is going to be driving. As we've covered over and over, they've got this massive market that we're trying to go after. The heartache that Dave and I feel on all these calls and in between, the days between us, how do we get enough coverage out there to be effective in prosecuting all the opportunities.

Ad it's that's constant balance of putting enough reps into the existing accounts, so that cohort that we've been talking about actually comes into play and we see the continued adoption, both in the volumes and in overall revenue contribution from the existing accounts. Also carving off enough reps to focus on only net new.

And we just find over and over that's hard to balance those two. So she's -- she'll be making adjustments, keeping in mind not making too many shifts on account relationships and rep relationships and all the usual crossing your T's and dotting your I's as far as minimizing field disruption as much as possible yet doing what's right for the business so we can increase coverage. And there'll be a lot more detail when we go through it in January.

Great. Thank you.

Thanks, Walter.

Brent Thill, UBS.

Doug, just as it relates to the cloud. When you mentioned some of the lower initial deal sizes, when you look at multiple quarters of data and how those customers come back, are you starting to see a trend on the cloud and what you're seeing multiple quarters in, quarters after the subsequent purchase even though they may come in initially smaller, the repeat cadence seems to pick up? Can you just give us a sense of what is happening there?

Great question, Brent. Probably still a little bit early on cloud by itself to have enough data points to be firm on the answer. But what we're seeing in early cloud customers, they look a lot like our on-prem customers. And actually a big chunk of our cloud customers are hybrid customers that are on-prem as well.

We just updated the cohort analysis. We do it on a consistent basis. The numbers are consistent with what we've seen in past cohort analyses that we've driven out, which is the repeat purchasing behavior of customers is very strong which is why we consistently see 70% of revenue coming from existing customers.

And our job is to make sure that we are getting more and more data sources in from each of those customers, going horizontally across those customers, doing whatever we need to, lunch and learns, many Splunk Lives at customer events to help them see the additional use cases so that they can understand the power of harnessing big data when there's multiple conflicting sources that are hard to structure. And that's why I think we see that growth within existing accounts. And for those cloud customers that have been on for a while, we're seeing that same type of characteristic but a lot better information as more quarters go by.

Okay. And quickly for Dave, some questions around the government and some large deals this quarter. Can you just recap there.

And also just maybe clarify, international decelerated again. It looked like it was a tough comp. Any color there other than the comp on international growth?

Yes. If you look at the composition of those large transactions, again up 40% year over year. As you would expect, and again it ties right into the cohort and how we see the buying behavior of customers, our more mature customers who are on that journey to enterprise-wide adoption are the longer tenured ones.

Many of those longer tenured customers, of course, are dispersed geographically, but internationally the UK would be where we've got our longest tenured customers. So when you look at the overall dollars contributed from large orders, it's reflected in our international results and public sector as well.

Now, I know that there is some commentary or some channel information about some eight-figure transaction in public sector. And we had some really nice transactions in the public sector, but we are not reporting any eight-figure transactions that are in our financial statements in the quarter.

Thank you.

Thanks, Brent.

Michael Turits, Raymond James.

Hey, guys. Michael -- question for Dave and for Doug, I guess. I want to come back to Walter's question on the ratable (inaudible). I understand it was a tough comp year over year, but it was also down from last quarter.

So same question, what brought it down sequentially? And just to parse it, wouldn't that have had a positive impact on billings since that seems to have had ratable (technical difficulties) actually hurt billings in the past?

Hey, it's Dave. You've got to look at the ratable percentage in terms of absolute dollars. If we go back to Q1 where our ratable rate was actually over 50%, that looked eye-popping but on a relatively small, much smaller absolute size of the business at that time.

So the early quarters are certainly more impacted by the variability of large orders that happen to be ratable. Q2 specifically, we had 4 of our 10 largest orders were cloud. So that drove a big component of ratability in Q2.

And in Q3 we didn't have four of our largest orders, we had two. So when you look at order composition in the big orders, it really flows through in terms of the ratable rate.

Okay. And just an old question that gets asked. But I wanted to check in on it.

How was pricing and discounting in the quarter? Anything unusual?

There is no significant trend that we saw in discounting this quarter, Michael. I go back to the comp -- if I look at those 40% of orders that are seven-figure orders, that comp was a tough comp. In that band we had that $500,000 drop on average across those deals. But when you look at the body of total transactions, it was very similar as far as ASPs and overall discounting as we've seen in the past quarters as well.

Okay. Thanks, Dave. Thanks, Doug.

Thanks, Michael.

Melissa Gorham, Morgan Stanley.

Great. Thanks for taking my question. Dave, you talked about the cloud being better than expected and then the difficult comparables in large deals. But license revenue did, I think, come ahead of what most of us were expecting and it did accelerate in the quarter. Can you maybe help us reconcile that strength along with the headwinds that you mentioned?

Hey, Melissa. It is a -- I think I had one comment in my prepared remarks that was intended to be sympathetic for everyone building a model out there with the challenges we have building our model in here, which is variability in large orders, cloud mix, adoption transactions, makes it obviously challenging to forecast individual line items in the financial statements.

In terms of the uptick in license, again in Q2 we had 4 of our 10 largest orders be cloud. In Q3 we had 2 of our 10 largest orders be cloud. So even though we had overperformance of our plan in Q3, we still didn't have the large orders that affect more the geography on the income statement than anything else.

Okay, that's helpful. And then just listening to the gross margin impact from Splunk Cloud, you noted it as maybe a headwind to gross margin. I know it's included in maintenance and services so that we don't have that individual line item. Can you maybe just help us understand how much it drags on overall gross margins, and then how it scales over time, particularly as it's built on AWS?

Sure. What I quantified is, it's a 4% to 6% drag on gross margins, the cloud business in terms of overall gross margins. So again, overall gross margins were just over 84% this quarter. If you look at the trend line on gross margin over, say, the last 4 to 8 quarters you can see what is effectively the impact of cloud specifically.

So gross margins went from call it 90% overall down to just over 84% this quarter. And we got a 4% to 6% drag from cloud. What's interesting about that is, again I said in the prepared remarks, we expect a similar drag next year.

So you'd say, aren't you getting greater scale and you're building out on AWS, so wouldn't you have improving margins? And the answer is, absolutely we are. But as cloud -- as we look at cloud as a greater percentage of overall revenue next year, then its margin characteristics will have a greater impact. So the actual drag on margins look to be about the same year over year.

But we've got a lot of really great work going on in the product organization and with our dev op scene around scalability of cloud, efficiency of cloud. I think overall the biggest thing is just absolute critical mass of cloud customers.

And then to Brent's question. As we get to renewing, recurring, expanding deployments of cloud customers that are similar to our historic on-prem trends we'll see better economies of scale in terms of margin characteristics.

Okay, that's helpful. Thank you.

Thanks, Melissa.

Thanks, Melissa.

Brian White, Drexel.

I'm wondering if you'd talk a little bit about how you've been able to execute in this cloud transition? There's a lot of companies that are going through a cloud transition now.

What it means is they are coming up short on revenue or not beating as much on revenue. Their license revenues are sloppy. So maybe talk about what you are doing, because I think tonight's numbers were pretty amazing.

And also touch on the security front, maybe just an update on what percentage of business this is. And some of the trends you've seen, especially after what we saw during the election? Thanks.

Thanks, Brian. I will start with security first. It was the same composition. We've seen security and IT ops both be roughly 40% and other -- of use cases sold in any given quarter. The other 20% being some combination of IoT and business analytics, and it's right in that same range again.

We are seeing more and more traction within our accounts being turned to as a true SIM provider. But as we've in past calls, there's as much incident of us inter-operating with and supporting an existing SIM as there is of customers looking at Splunk to be there primary SIM. So that openness and integration is important. And where that really comes into play is security analytics capability to support a security incident event management SoC type framework. And Dave, I will let you -- .

Hey, Brian. If you think about our transition and the introduction of cloud and how does that feather into our financial results, one journey that we have been on with you guys for a long time is the ratable mix. It's grown from what was four years ago in the 10% to 20% range. It's now consistently between the 40% and 50% range on a quarterly basis. And that's both the combination of adoption transactions and cloud transactions.

Now, what we know is this is a very large market. Doug talked about it. Customers absolutely are thrilled with our solutions. And we've been focused for a long time around adoption. So our objective is to make sure Splunk is where your data is and where your workloads are.

One thing that's hard for us to quantify, but I'll tell you from a qualifying perspective, customers continue to expand their deployments. Many of them are now moving to cloud, which what might have been previously on-prem.

So that's where, and Melissa asked this question earlier about the geography of license revenue versus non-license revenue. Actually I think that's been the more challenging piece for us, just in terms of our own forecastability, is where will the revenue land versus how much is going to be ratable or not ratable?

We've given guidance on the ratable mix. I think I've missed it is many times as I've made it because it is so variable based on large transactions. But that, is a customer going to put their next workload in the cloud or are they going to put it behind a firewall? That one is a bit more challenging for us, but I think overall revenue results, we contemplate the introduction of cloud in our models and we have that going forward.

And Dave we should stick to this 40%, 45% ratable mix for the foreseeable future?

Yes. We are going to give you guys greater insight at Analyst Day in terms of how we are thinking about transaction composition, what does that mean for billings, what does it mean for cash flow and all the important metrics that you guys see in the financial statements. And I can tell you we are working on what do we -- I think we've had the right metrics to help you guys measure us and have inputs to your model.

We're now looking at should we be enhancing those, retiring some, adding some new ones that give you greater insight. Of course when you've got this hybrid model, ultimately the way you cut through all revenue geographies with billing. So we're looking forward to talking you guys at Analyst Day and try to give you better, or I'd say, next gen metrics for how to think about us.

Great. Thank you.

Thank you.

Kash Rangan, Bank of America Merrill Lynch.

Hi. Thank you very much, guys. Dave, just to understand the implications of the cloud impact on margins. If gross margins are going to go down another 300 basis points next year, how should we look at operating margin inflection?

Are we still on track for getting what you had previously implied, call it 200, 300 basis points of margin expansion from this year to next year? Or has that dynamic changed in the short term as you have the preponderance of cloud on your business model? And I have a follow-up question. Thank you.

Hey, Kash. Let me clarify it for everybody. This year we expect and measure the cloud impact on gross margins to be a drag of about 4% to 6%. Next year we think it's also 4% to 6%, not an incremental 4% to 6%. So the drag is going to be consistent year over year.

Next year's gross margins will be roughly similar to this year's gross margins?

That's right.

Okay, got it.

And the impact from cloud is going to be about the same. Cloud's drag (multiple speakers) about 4% to 6%. Yes, yes.

My heart rate went from 120 to 40. I'm sorry, it went from 89 to 84 or something.

There you go, perfect.

The $20 million quantification that you pointed out, it's not a slippage amount, right? It's just that you had a bit of a tougher comp by about $20 million, or were you trying to imply that some of these larger -- or it could have been potential license orders are entering the cloud pipeline? I don't know how to interpret exactly what you said.

I think -- so let's to start with, we're really happy with our large order growth. We did 40% year over year in large order growth. The fact is that the overall average order size was $0.5 million smaller this year than it was last, and that translates to about a $20 million of potential billings.

It's not -- the impact of cloud is a different contributor in terms of geography between license revenue, non-license revenue, and what's in deferred versus what isn't. As Doug mentioned, and you guys know, a typical cloud order will be smaller than a typical perpetual order. So I wouldn't characterize the large order size differential as anything other than it's a tough comp.

Deal slippage, there are always transactions that you have in your pipeline that don't close in the quarter that you forecast them. But the $20 million that we are articulating is not that. It's really a tough comp against a subset of really large orders last year that makes the overall average order size smaller.

No need to apologize, guys. Great results. 40% license growth there is fantastic. Also 37% billings.

Kash, thanks a bunch.

All right. Thanks.

Thanks, Kash.

Jesse Hulsing, Goldman Sachs.

Thank you, guys. A question may be for Doug. I'm curious how the adoption of EAAs are trending versus your expectations, and maybe how they were trending in the first half of the year? And along those lines, are you doing anything to incentivize your customers or your sales reps to sell or adopt EAAs at a faster rate?

Thanks, Jesse. That 40% growth in seven-figure transactions is those scope of deals are generally tightly clustered with adoption oriented transactions. I did make a very explicit statement at dot com to the entire audience, which was 4,500 of some of our best customers, highlighting the unlimited term opportunity for those customers because I was not 100% confident that our average rep was bringing that opportunity to their customers the way that we would like them to.

And it's amazing the correlation. The 30-plus customers that I've gone out and visited since conf, literally every one has asked me questions about how they get some type of an unlimited buying vehicle, how they really go wall to wall with Splunk and not make the data volume initiative that they worry about. So I think rolling that program out was important.

I think making sure that it gets communicated to our accounts is key. I think that 40% increase in seven-figure deals is an indicator that more of it is leaking to accounts, but we have to keep that cadence very, very strong so that pricing and pricing variability, at least on the upper when you're really trying to use Splunk the way it's supposed to be used with tens -- hundreds of data sources and tens of thousands of use cases on top of that single logical index, that we really shine through with that unique, differentiating power there.

Got you. And a quick follow-up for Dave. Last quarter I think you said over $100 million of your billings came from cloud. Did you break out what it was this quarter? I missed that.

Just to clarify. I said last year -- I'm sorry, last quarter we achieved for the first time an annualized billings rate for cloud of over $100 million. So it was an annualized number.

That was a milestone. And it was similar in Q3.

The run rate.

The run rate.

Thanks, guys.

Thanks, Jesse.

Matt Hedberg, RBC Capital Markets.

Thanks. This is actually Matt Swanson on for Matt. Congratulations on the quarter.

You talked a little bit about in the next couple of years being able to scale that international revenue as a percentage of the total up into that 30% to 35% range. Just in the context of what we talked about earlier in the call around the sales force coverage, where does this rank as a priority and how important is it to the long-term growth?

Hey, Matt. It's Doug. How important is sales force coverage to the long-term growth?

And I guess in the international market specifically, how much of a focused investment is that?

Got it, yes. Okay. When I go back to the market opportunity in front of us, the data that we manage is exploding. And the love that the customers that we touch have for our product, and that love is dependent upon them understanding, I've got to put hundreds or thousands of data sources in here so I can drive all these use cases.

That account coverage dilemma comes back to how do you spend enough time with your current accounts and spend enough time on net new non-accounts so that you can cover the market. If I look at the United States, 18 of our 52 states have no rep -- 50 states, sorry, I was counting a few other territories. (Laughter).

My wife is Canadian. There's always that option. (Laughter). 18 of our 50 states don't have reps -- that are covered by reps that don't actually live in those states. So just the density even within the United States is not where I'd like it to be, and the same thing on a country basis.

We've been disciplined at trying to put at critical mass of reps into the countries that we currently have a footprint. So from a criticality to our long-term success, continue to drive coverage, both our own reps, partner resources and online interactions is an absolutely key component to driving that value of Splunk to meet the opportunity.

Hey, Matt. It is Dave. I will just anecdotally tell you that based on a lot of conversations I have with Susan, she would argue our focus isn't high enough on coverage.

She would like more.

She would like more. That is for sure.

Yes. And then building off that same topic, you talked about the strength with Accenture. Wondering if you could just comment on how SIs are driving the growth and how much that can supplement some of the coverage?

I think what we have seen traditionally and here with SIs is that they are really helpful in helping you succeed within accounts where you have rep coverage. They're not as powerful as far as opening doors and helping drive transactions across accounts without rep coverage.

So really, really important partners for us to have, and Accenture in particular, why we keep highlighting them is not only are they building practice around Splunk but they are baking Splunk into a series of their solutions that they roll directly to market. So that is a scenario set where they can help us more specifically with accounts where we may not have reps.

But that's where augmenting the SI strategy and the technology partner strategy with companies like AWS, Cisco, EMC with the classic distributor and VAR architecture is important. Because ultimately what we all would like to see here at Splunk is more partner resources being able to do everything from the initial door knock, chat response, phone call all the way through to implementation, or at least contract delivery.

All right. Thanks for the time, guys.

Thank you, Matt.

Keith Bachman, Bank of Montreal.

Hi. Thank you very much for taking the question. I wanted to ask you about cloud gross margins. And first of all, thanks for clarifying your comments for the impact next year.

If you look at the dollar run rate of billings, it's still a fairly meaningful impact to gross margins this year. And if cloud's growing next year and the impact is the same, then presumably your cloud gross margins are improving next year.

I just like to hear, A, is that the right way to think about it? And B, what's needed to get the cloud margins up? Particularly since you're leveraging the fixed infrastructure of AWS, I would think there'd be a fairly steep ramp. But I wanted to hear your views on what's necessary to improve the cloud gross margins over time?

Hey, Keith. It's Dave. Your interpretation is correct, which is the margin characteristics will be consistent year over year. And that by definition, or mathematically, means that the margins must improve next year on cloud because it's going to be a larger component of the overall business. So that is absolutely accurate.

I think one of the key elements is really just scale and therefore economies of scale. So the way I described our cloud business is it's like creating a Company inside the Company, going from 10 years, almost 10 years as an exclusively on-prem software provider is actually in my view more difficult from an execution perspective and a cost structuring perspective than if we just started from inception as a cloud-only Company.

So as we continue to have great success, we are over-delivering on our own plans in terms of cloud adoption. And it's interesting because a lot of folks inside said, new customers are coming to us via cloud. And the answer is, that is true. But actually half of our cloud business, cloud orders are coming from on-prem customers.

Because guess what? Everyone is moving workloads to the cloud. Our ability to deliver data analytics, regardless of whether your information and your workloads is on-prem or in the cloud, is a huge differentiator for us because we're the only ones out there that can do it.

Just to emphasize that, there's a little bit - both Brian White and Kash's question as well, is data has gravity. There's a whole bunch of physics around it. And it's really risky to move data around if you don't need to, but it's also really expensive.

So any good CIO or technologist wants the data in that thing in storage and retrievable source to be as close as the generation of that data source as possible, which is why we predict that we will always be a hybrid Company. There will always be some percentage on-prem and some percentage on cloud. Who knows if it's 50/50 or 40/60, but I don't see us swinging to 90/10 at any point in time.

The improvements that we are continuing to drive, taking a product and continuing to tune it for an [AWBS], for cloud architecture. AWBS is the pioneer, but other clouds are emulating all the great work that they have done, and some of the on-prem cloud architectures, cloud foundry, et cetera are mimicking that as well.

Tuning the products that actually is able to be more micro-services, containerized and elastic in its approach. So it consumes -- it is less expensive to run. And continuous to run that product with higher and higher degrees of automation so that you don't have to put people in the middle of any process that you're doing with that cloud offering is the core to drive our cloud margins down. But then conversely, in a hybrid world it dramatically helps our on-prem customers because our CIOs there have the exact same problems that any cloud vendor does as well.

Got it, got it. Okay. I was just going to sneak in -- thank you very much for that answer, Dave. Any comments or any parameters you'd like us to think about next year for CapEx as we're looking at our model to tune a bit?

Obviously we expect CapEx to be significantly lower than it has been the last two years.

Yes.

And I've been deliberate on these Bay Area facility build-outs. We are going to give more color at Analyst Day about how to model CapEx for next year.

But again, think about it more from a prior to this fiscal year and the prior fiscal year, we were in the call it mid to upper teens in annual CapEx. And that was all driven by employee headcount. So as employee headcount goes up, of course I think that's going to ratchet up in absolute dollars, but it's going to be notably lower than the last two years.

Okay. Many thanks, guys.

Thank you.

Ed McGuire, CLSA.

Hi, good afternoon. I was wondering if you could comment on the progress in the market groups? And also whether you could provide any color in terms of what you're seeing, whether customers are using Splunk to displace existing applications or what the mix of custom applications is that you are seeing?

I think in one of those earlier questions with Brian, again in the cloud, part of our success comes back to our more solution-centric approach. While ultimately we get this opportunity to be this horizontal data layer for our accounts, that focused approach on going after buying centers, security, IT operations, app dev, et cetera, I think is a huge help for our customers to focus their attention on where they are going to gain value.

And then the development of our premium solutions, enterprise security as a SIM-like product on top of Splunk Enterprise, ITSI as a kind of next-generation analytics driven systems management application on top of Splunk Enterprise, UVA as an insider threat application on top of Splunk Enterprise are really powerful elements as well to help our customers gain value much more quickly. So that solutions orientation I think is key. And when we get to Analyst Day, we will definitely spend some more time walking through with you and the others, or anyone that attends, how we can continue a packaging, pricing and promotions approach to ensure that we are allowing our reps and our partners and the entire community to be able to go after these specific buying centers and use cases on an easy, clean, affordable basis.

And then on ES as a SIM, yes, it's increasingly being viewed that way. And there are more situations we're in where we're going to direct compete against existing SIM vendors. With ITSI there's a lot of communications, there's a lot of back and forth between our SIM customers on what tools can I retire.

The delta between our Splunk solutions and those existing solutions is the flexibility of our platform and the heavy adaptability and analytics orientation of what we do. So it's rarely ever a one-for-one replacement. It is a -- you're going to get a whole different set of value when you use us as a SIM or as a systems management technology, which for most customers means there is a migration over time to be able to retire those other tools. But we do help our customers with tool bake-off just to see if there's a cost savings as they roll in Splunk on a more immediate basis.

Just a quick follow-up on competition, whether you've seen any change at all in the competitive environment or new competition that you're working against?

It remains extremely similar to what we've seen every other quarter.

Right. Okay. Thank you.

Thanks, Ed.

Thanks, Ed.

Alex Zukin, Piper Jaffray.

This is Taylor Reiners on for Alex. I was wondering we've heard anecdotally that you've been a little bit more flexible around both license pricing and data limits. And wondering if you've been seeing customers spend more on layering apps that on top of that with higher data limits?

And then I know last quarter you mentioned that 70% of license revenues came from existing customers. Wondering if you're seeing a similar dynamic this quarter? Thanks.

Thanks, Taylor. This quarter we have consistently seen in all the quarters I've been here this adoption momentum within our current accounts so that 70% or more has been a very consistent factor in, I think, every call that we've had. And it's consistent again this quarter.

One of those announcements that I made at dot com was, which we talked about in the prepared remarks, was the removal of our metered enforcement where we have a license engine that actually looks at data going in. And part of taking out that metered enforcement was to reemphasize to our customers, we know that you want to put more and more data into Splunk. We want you to be able to experiment.

We still want you to comply with the overall license, but we're going to take out any guard rails that will momentarily stop you from putting more data than you want to -- than you had initially licensed into Splunk. And that's part of the steam of that we've seen with every customer that the cohort shows over and over, which is the more data that customers get into Splunk, and the more solutions and use cases that they deploy on top, the more excited they get about the product and the more value they see, and therefore the more data they put in.

When you combine that with all the hyperbole around the exponential growth and machine data and large data volumes, but when you are dealing with a core market that the driver is exploding, then we just want to make it as easy -- we have full confidence in our product's the ability to meet the needs of our customers and serve more use cases. We want to make it as easy as possible for them to keep getting more data in so they get more value out.

Excellent. Thank you.

Thank you.

Steve Ashley, Robert W. Baird.

This is Jason Velkavrh on for Steve. Thanks for taking my questions. Actually I had a question about, Doug, you mentioned in the prepared remarks, Insight Engines natural language processing. I think Tables was also unveiled at conf as another ease-of-use improvement.

I'm just curious, is -- when spreading adoption to business analytics particularly, is ease of use a barrier to adoption there more so than it would be for security or IT ops? And have you seen, I know it's early, any, I guess, reduced hesitance to adopt one for business analytics since these new features have been added?

Thanks, Jason. Yes, both of those were super exciting. I love Grant's demo and the solution he's put in play is phenomenal. And I think the Tables and a bunch of the other data analysis and prep stuff that we are doing is helpful.

It's interesting, since helpful both for our existing use case proponents, they're -- it is hard for any organization to get enough security expertise or IT ops expertise to be actually be effective. The more that we can do to lower the barrier expertise in those quadrants helps even in our natural use cases.

And then for sure as you get beyond our more repetitive use cases, with ES and ITSI there's a single lap that can be deployed thousands of customers. We've been out there working with customers that find that same, what's one out that when you can solve 1,000 instances with.

We're getting better with some ideas around support, help in customer support, help in retail optimization, help in asset management from outside of our traditional markets. We are continuing our experimentation, proof of concept, and build out of different components in that business analytics and IoT arena. But, given that there's a lot more touch of non-technical users with this data as you expand beyond IT, those enhancements and advancements of things like natural language interaction, easier data surfing and traversing, easier data prep and understanding I think become important, just like we've seen in the classic BI category of trying to make those tools more approachable to less technical users.

Great. Thanks, that's helpful. And then just one quick follow-up. Apologies if you've already mentioned this in the call. I think last quarter you said it was roughly half and half for cloud sales to new and existing customers. Is it roughly the same this quarter?

It is, yes. Existing customers represent about half of the cloud transactions, and half of the cloud transactions are new.

Great. Thanks, guys.

Thanks, Jason.

Greg McDowell, JMP Securities.

Thank you very much. Just one quick cash flow from operations question. I know you mentioned that this year you're now expecting 21% of revenue for cash flow from operations. And I was just wondering, after being pretty consistent for the previous four fiscal years at sort of that 23% to 24% range, what exactly has changed on that front? Is it more related to the cloud, or is there something else going on, on the cash flow side? Thanks.

Hey, Greg. It's really -- we're just looking at the linearity of the quarters. And we've talked a lot about the growth in large orders, what we saw year over year from Q3 of last year to Q3 of this year.

And then again, we've got our granular view on the fourth quarter. So when we put all the beans in the gonculator and think about revenue trajectory and how are we delivering on revenue relative to our expectations, and then when do we expect some of these transactions to close, and therefore when do we expect to collect them. Those are the inputs to say, let's give a different view for the balance of the year.

Great. And one quick follow-up. At the Splunk conf, Doug, it sounded like you guys were doing a pretty heavy push on EAAs, not just for your very large customers. I was wondering if you could comment.

Is there sort of a minimum line at which you don't want to do do EAAs, or you are sort of lowering the bar on the size of the customer in which you want to execute these EAAs? If you comment on that, that would be great. Thanks.

That's a good question, Greg. And there is not -- they are not tailored just to large customers. We've got a couple of customers that are sub $1 billion in revenue where we have a term unlimited framework in place for them that is priced differently than for the larger organizations, because when you get that unlimited term structure, it becomes more a factor of total revenue, employee count as well as data volume.

And when I look at how important big data is as a topic and how critical it is to competitive posture and agility of companies going forward, there is the same kind of entry-level need, department-wide need and enterprise-wide need at small, medium and large organizations. And that's going back to focus on net new as well as focus on our existing accounts, and being able to get enough market coverage.

The opportunities at every business ultimately is going to become more software and data driven as a business. Those opportunities all exist for a Company like Splunk, and we've got to be aggressive and pursuing those on a more thorough basis.

Thank you.

Thanks very much.

Karl Keirstead, Deutsche Bank.

Thanks. I will finish up on a positive note, than, So, Doug, on the license performance you guys talked a lot on this call about the ASP decline and tough compare. It almost sounded like you were explaining a miss, but on your license side it easily beat your implied guide.

License growth was -- it accelerated compared to last quarter, despite a tougher comp. Maybe I will finish up by just asking you where you think the 1 or 2 areas of outperformance were on the license side, whether it is by use case, vertical, geo, what surprised you? Thank you.

Thanks, Karl. I'd say by far what we continue to be excited about is that the cloud exceeding our expectations. It's important for our customers, it's important for us, the long-term value with our cloud customers winds up being a benefit to us, as well as the speed of adoption and speed of value that our customers get. So it's really nice to see the continued traction with the cloud, and our need to make continued investments there so that we can meet our customers' expectations.

And then despite the lower average order size, the 40% growth in seven-figure transactions I think was another really nice thing to see. That was a good increase. First of all, we see another quarter, and even though the average order size was lower, mostly because of these mega-deals, I think that's part of that trend that we're looking for of these EAAs and customers using us as this broad-based horizontal platform with lots of data sources and lots of use cases.

And again, when I look at us versus any other technology that is out there, that's where we just continue to shine. If you have a simple use case, a few data sources, they're more structured in nature, you can ask the same question many times, there's lots of technologies you can use. But that's not the nature of big data.

Big data is messy. Some of it's structured, some of it isn't. There is lots and lots of sources that are only growing. And the possible use cases are only limited by your imagination. Whatever we can do to help our customers understand what they can do with big data is really, along with cloud, those are two exciting things for us.

Congrats.

Thanks, Karl.

I want to pile on. There's one thing that I was really excited about in the quarter. You guys have heard us talk about EAAs for a long time. Translation of that familiarity to customers hasn't been nearly as great.

So Doug was very explicit to announce at our conf that we've got this program. And now in the customer visits the awareness that there is a vehicle to get broad adoption, that's really exciting to me. So as we think about number of EAAs, and the number of customers that are going to standardize on Splunk, that's really exciting. I'm really looking forward to it.

Okay, good. Thanks, guys. Congrats.

Thanks, Karl.

Thank you. This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Ken Tinsley for any further remarks.

Great. Thanks, Jonathan. I really appreciate your help today. And thanks everyone for joining. Hope everyone has a wonderful holiday season. We look forward to seeing you at the Analyst Meeting in January. Thanks very much.

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.