Nutanix (NASDAQ:NTNX) is both a pioneer and a leader in the market for Hyperconverged Infrastructure (HCI) solutions. The company offers an enterprise cloud platform that converges and integrates virtualized servers and storage to reduce both the footprint and cost of enterprise infrastructure. The company was founded in 2009, launched the 1.0 version of its offering in early 2012, and its own virtual machine monitor (also called a hypervisor) in late 2013. To maintain a competitive lead, the company invests heavily in its platform and technology. It released the 5.0 version of its software last year as it prepared for its initial public offering, which occurred on September 30, 2016, at $16 per share.
Since having gone public, Nutanix's shares have been volatile, initially trading up to $47 per share and since round-tripping the band between the low 30s and the low 20s, especially around earnings. The company is growing very fast and dominates a rapidly growing market it defined with its offering. Both the product and the market are complex, however. Hence, there is much to learn if one is to get comfortable enough with the company to purchase its shares. Accordingly, we offer the following analysis in two stages. First, we will take a close look at the company and its products, and review the recent earnings report. Then, we will give an overview of both the technology of HCI and the market that is growing so rapidly around it.
A Look at Nutanix
In its most recent fiscal year (ended July 31st), Nutanix generated revenue of $444.9 million, posting an increase of 84.3% over the prior year. Of this amount, nearly 80% derived from the sale of products and the remainder from support and services. Both businesses have a cost of revenue of just under 40%, yielding a gross margin for the year of 61.6%. We note, though, that it has since trended down a bit in the first and second quarters due to increases in DRAM and Flash memory pricing. The company is investing heavily in its businesses, and operating expense readily exceeds gross profit. Yet, management must invest ahead of revenue, given such strong growth. Based on consensus estimates, it is clear analysts expect this growth to continue, albeit at a declining rate; the consensus revenue estimates for fiscal 2017 and 2018 are $741 million and $1.04 billion, representing respective growth rates of 66.6% and 39.8%.
The company's products comprise Hyperconverged Infrastructure solutions, both as Nutanix-branded systems and through OEM relationships with Dell and Lenovo (OTCPK:LNVGY). In its 10-K, Nutanix lists Partners A through F that assist it in serving end customers. The company uses the distributors Carahsoft Technology and Promark Technology to ship its products to end customers and, in fiscal 2016, the two accounted for 15% and 20% of revenues, respectively. Three other partners (Partners C, E and F) accounted for 14%, 11% and 15%, respectively, of revenues in the year. The concentration is considerable, indeed, as these five partners contribute 75% of revenue. The company also sells software-only solutions for installation on third-party hardware, most notably on the Dell XE series and Lenovo Converged HX series, as well as on the Cisco (NASDAQ:CSCO) UCS rack-mountable server series. By way of reference, software accounts for 15% of bookings and ultimately revenue as well. Two thirds of this amount is generated from software license sales, the remainder from support and services.
The company's core technologies reside in its software, which is designed to run on industry standard servers. It outsources the assembly and test of its own products to Super Micro (NASDAQ:SMCI) and Avnet (NYSE:AVT), which procure the required components, assemble the systems, and install and test the software. Its third-party logistics firms handle shipment while holding no inventory. Product revenues are recognized on shipment and support and other services revenue is recognized ratably over the life of the contract.
Nutanix recently reported its fiscal second-quarter results, its second release since going public (See Table 1 above). It again surpassed expectations. Revenues for the quarter were $182.2 million, up 77% over the prior year level. Billings of $227 million were up 59% year to year and deferred revenue of $420.6 million was up 128% on the same basis. The billings to revenue ratio remains healthy 1.25x, down 23 basis point from the fourth-quarter peak of 1.48x. The company continues to add customers at a rapid clip, with an additional 900 bringing the total to 5,384. This represented year-to-year and quarter-to-quarter increases of 104% and 20.3%, respectively. Indeed, the company could rightfully claim in its recent earnings conference call that "we're extremely proud of our rapidly growing customer roster," which features prominent companies large and small. Cash generation improved as well, as the company generated positive operating cash flow for the fifth quarter in a row. And, for the first time, free cash flow was positive as well. A singular blemish was a slight decrease in profitability (noted above), as the non-GAAP gross margin inched down to 59.8%, due to increases in DRAM and NAND pricing. Still, on balance, the metrics were strong.
The company's performance in the quarter was impressive on qualitative factors as well. Nutanix continues to see strong adoption of its built-in Hypervisor (AHV, described below). On a rolling four-quarter basis, usage in the quarter rose to 21% from 17% in the prior quarter. This product was also certified for use on SAP's (NYSE:SAP) Business Suite, which is integrated within its Netweaver Platform. It can now be integrated with Nutanix's Enterprise Cloud Platform deployments with this widely used software environment. The platform this quarter was also selected by Computer Reseller News as product of the year in the Hyperconverged Infrastructure category, taking first place in both the Product and Customer Demand sub-categories. The award was made in conjunction with its use on Cisco's UCS (Unified Computing Systems) offering (also commonly used and discussed below).
The company's call soured a bit, however, when management gave guidance. For the third quarter, revenues are now expected to be between $180 and $190 million, yielding a midpoint somewhat below the consensus of $188 million. And, with additional memory pricing pressure, the gross margin is to be between 57% and 58%. Accounting for the weaker-than-expected revenue guidance is a transition that is underway in its North American sales force. The company is moving some of its most productive people into sales management roles. As a result, the company booked fewer large deals and came into the third quarter with somewhat less momentum. Still, the miss is a slight one and a reflection of the difficulty of managing such strong revenue growth. But however transient, it produced a 26% drop in the share price, as such events do with rapid growers. The consensus estimates have held steady, however, with revenues for fiscal 2017 and 2018 (as we noted above) growing, 66.6% to $741 million and 39.8% to $1.04 billion, respectively.
Nutanix Product Solution
Nutanix Enterprise Cloud Platform, as stated in the Offering Memorandum, "converges server, storage and virtualization resources into one integrated solution delivered on commodity x86 servers." The company's two products are Prism and Acropolis and can be best understood in the following schema, which we have adapted from the company's graphic.
Acropolis offers the meat of the solution and runs virtually above the hardware layer and its OS. It includes the Distributed Storage Fabric, which provides "high performance storage services for all applications," and the App Mobility Fabric, which allows for "intelligent application placement and migration." Multiple hypervisors are supported, including VMware's (NYSE:VMW) bare-metal ESXi, Microsoft's (NASDAQ:MSFT) Hyper-V and, more recently, its own Acropolis Hypervisor (AHV). Based on the KVM native to Linux, AHV obviates the need and cost of third-party hypervisors. As we will see below, individual hypervisors support so-called containers, comprising an operating system with its required application and workload. Based on research confirmed by IDC, Acropolis allows for a 60% reduction in cost relative to traditional infrastructure and an 80% reduction in virtualization costs. Given the rate of growth displayed by both the market and Nutanix, customers are finding these benefits compelling.
Prism runs above Acropolis as an interface that allows administrators to manage virtualization and infrastructure. It offers administrators "robust operational analytics," as well as search and self-service capabilities. Capacity planning, application provisioning, upgrades and troubleshooting can be managed and even automated through its GUI, often with one click.
HCI: A Look At The Technology
Data center technologies have undergone rapid transformation over the past decade, with the emergence of Big Data and a fundamental shift in focus from Enterprise Computing to the requirements of social media infrastructure and Cloud Computing. Standards and technologies have proliferated with the emergence of both open and proprietary web-scale computing infrastructures (i.e., of Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Microsoft Azure, Amazon (NASDAQ:AMZN) AWS, etc.) and widely embraced open-source computing technologies (Linux, Hadoop, the Open Compute Project, Openstack, etc.). And in utilizing their own on-premise infrastructure and that of cloud service providers, enterprises have significantly increased the complexity and the heterogeneity of their computing environments. This rich situation merits special treatment elsewhere. But it is the launching point for any discussion of Converged and Hyperconverged Infrastructure.
With Converged Infrastructure, vendors have converged formerly discrete compute, storage and even network hardware to ease the implementation of new deployments. And to maximize utilization of this converged hardware, companies have adopted virtualization as a software management layer over the "bare metal" hardware and, most often, its operating system. Hypervisors, or virtual machine monitors, reside above the operating system of the so-called host machine to run multiple virtual machines (also called guest machines), each with its own operating system. Multiple applications can thus be run simultaneously, each within its own so-called container supported by an individual hypervisor and virtualized OS.
Hyperconverged Infrastructure is a natural progression from virtualization intended to further increase computing capacity, manageability and utilization within these complex computing structures. Above the converged hardware, data management and processing occur in virtualized software-defined servers and storage, hence the notion of hyperconvergence. As they arise, workloads can by dynamically provisioned by system administrators across hypervisors and virtual machines from a management console. Processes can be automated as well. Hyperconverged infrastructure allows enterprise systems administrators to optimally leverage the abundant, differentiated and heterogeneous computing resources available to them. And they now can do so within individual Hyperconverged systems and the Private and Public Clouds with which they are networked. Some term this Superconvergence as it involves software-defined networking. A key point to recall is that HCI is a hyper-converged computing system with software-defined servers and storage, integrated into what are termed "nodes." The market appears segmented as, depending on the vendor, these systems can scale to 24, 100 and close to 1,000 nodes. Moreover, the market continues to grow and evolve very rapidly.
HCI: A Look At The Market
As much trade press coverage as there is for the Hyperconverged Infrastructure market, there is not as much analysis of the market as you would think. This is because the market is only now gaining scale and size of note. Moreover, many participants are either captive business units of larger companies or private. IDC includes Hyperconverged Systems within its Converged Systems quarterly tracker, and we have some idea of its size from the most recent published data. Mousing over the graph, we have extrapolated that the trailing 12-month revenues for the third quarter of 2016 totaled $1,774.7 million. We believe this amount to be understated by IDC's rigorous methodology, but it is just as likely that the very rapid growth of the market, and the precise timing of the observations we have considered, are issues as well.
We have other insights to offer. Last May, Gartner forecast that the market for HCI would grow 79% in 2016 to almost $2 billion. And it stated the market could grow to $5 billion in 2019 to encompass 24% of the market. Last August, this researcher posited that 30% of x86 workloads will be in HCI environments in 2019, up from the then present 5% level. And 20% of mission-critical applications will transition to HCI systems by 2020, in its view. So the market will continue to display strong growth. Only Nutanix is public and it is said by Gartner to have 50% share of the market. SimpliVity is positioned second with an additional 20% of the market. The remainder of the market is fragmented. In any event, the market opportunity is considerable. Nutanix's Targeted Available Market (TAM), as it is identified in the offering memorandum, totals $125.6 billion for 2016. Were 20% transition to HCI, the opportunity would amount to $25.1 billion. This surely has the interest of major vendors, as we shall see.
A Forrester Wave report on all 12 participants in the HCI market was published last summer, though it is only available through purchase or intermediaries. It is well summarized in Network World by Brandon Butler. Nutanix, which named the market with its first product release in 2011, is (as is often said) the mind and market share leader. With annualized revenue and deployments at that time, respectively, of $460 million and 3,100, it is the clear market leader. It is also said to have the most robustly featured offering as well. Forrester cited SimpliVity as runner-up, praising its platform while noting it scales only to clusters of 48 nodes (versus the 100 node clusters of Nutanix). The third company in Forrester's leaders category is Pivot3, which introduced its first HCI offering in 2007. It has focused more on data rich surveillance applications than the enterprise, and to that degree is seen as an outlier.
Beyond these three leading participants, there are a handful of small non-public vendors, as well as the major hardware vendors you would expect. And this is notable as it is clear the latter are increasing their focus on the market significantly. HPE (NYSE:HPE) has recently completed the acquisition of SympliVity and plans an integrated offering within 60 days. Combining HPE's "best-in-class infrastructure, automation and cloud management software with SimpliVity's industry-leading software-defined data management platform," the company will offer what it terms the industry's only "built-for-enterprise hyperconverged offering." Cisco has also stepped up with its HyperFlex Systems portfolio, which it has shipped to 1,100 customers in the three quarters since its introduction. It has just released a series of new features for the system, which it sells with its widely used Cisco UCS platform. And it deems its offering to be "purpose-built" with "ground-up innovation for Hyperconverged Infrastructure." Clearly, it is a formidable competitor.
Last but not least, there is the obvious pairing of EMC and VMware, which Forrester treated separately in last year's analysis (See Figure 2 above). Of course, the latter is a subsidiary of the former, albeit one that is publicly-traded. EMC and VMware, together with Cisco's and EMC's pivotal, have offered converged, and more recently hyperconverged, systems through their VCE alliance, which they formed in 2009. (The acronym VCE resolves to Virtualized Computing Environment, though it could as easily stand for VMware, Cisco, and EMC). And with Dell's inclusion of EMC and its Converged Systems business (VCE and by extension VMware), the company's HCI offering operates in manifold ways. Together, this aggregation of Tech leaders has significantly and broadly increased its focus on hyperconverged infrastructure over the past 18 months.
VMware is a software company and deploys its product offering on a range of vendor hardware. Its chief hyperconverged offering is its vSAN. In August 2016, VMware re-architected its software offering, introducing the Cross-Cloud Architecture, which is targeted squarely at what it terms SSDC Clouds (i.e., Software-Defined Data Center Clouds). As such, the release significantly increased its focus on hyper-converged solutions. As stated, the VMware Cloud Foundation "delivers the next-generation hyper-converged infrastructure for building Private Clouds. "
EMC and VMware together offer two Hyperconverged Infrastructure products: the VxRail appliance family, introduced in February 2016, and the VxRack SDDC family, introduced in May 2015 (See Figure 2 above). Both are intended for use in VMware environments, which account for much of the market. While the former is a true appliance comparable to Nutanix, the latter is a more robust hyperconverged rackscale system. So named, it relies on the Intel Rack Scale architecture in which storage is decentralized and distributed across server racks, typically within large system cabinets. With virtualization, the entire system can power computing, and in this sense, it is ripe for hyperconvergence and software-defined computing. The VxRack is a true enterprise product that can scale to far larger clusters of nodes (to nearly 1,000).
With EMC's acquisition by Dell, VCE also offers the Dell EMC CX as a third hyperconverged solution, along with its VxRack and VxRail systems. The Dell product is indeed powered by Nutanix software and its optimized to support heterogeneous environments requiring multiple hypervisors. The VxRail is likewise an appliance suited to the large part of the market using VMware's vSphere and ESXi. That is, the Dell EMC CX can support multiple hypervisors, including Nutanix AVM, VMware's ESXi, and Microsoft's Hyper-V. This clearly differentiates the platform and its Nutanix software from the VxRail and VxRack, which are optimized for VMware-based deployments. Some question the willingness of Dell EMC and VMware to support all three platforms, though the company has stated its commitment to each of them. In a letter from November 2016, VCE President Chad Zakac and Nutanix CEO Dheeraj Pandey strenuously reaffirmed their commitment to the platform and its many joint customers, noting that it had sold 10,000 nodes to 1,000 customers in the preceding 19 months. Clearly, there is strong demand for the product.
Two Key Individual Views of HCI
Much additional insight into Hyperconverged Infrastructure can be gained from two very long and expansive interviews of VCE's Zacak and Nutanix's Pandey in IDG's Network World by its chief of content, John Gallant. The earlier of the two, from last August, was with Zacak, just six months after the February launch of the VCE VxRail appliance. Indeed, the titles of each of the interviews are telling. The former of Zacak reads: "VCE Chief Boasts of Hyperconvergence Superpower." He clearly expects VxRail to become the number one hyperconverged appliance. He also suggests that HCI is only now growing out of its early phase, where it has been served by the dominant incumbents, Nutanix and SimpliVity. He sees these current leaders as wedded to their singular platforms, whereas he believes the market is segmented and requires a range of converged and hyperconverged solutions. This is because, in using software-defined servers and storage, hyperconverged infrastructure is unable to support services required in certain mission critical tasks. He thus sees healthy demand for both VCE's converged offerings (Vblock and VxBlock) and its hyperconverged offerings (VxRack and VxRail), as well. He also notes the very large majority of the market standardized on VMware's vSphere virtualization platform and states the VCE converged and hyperconverged solutions are purpose-built to integrate seamlessly with it.
Indeed, HCI grew initially at the edge of the Enterprise, supporting Virtualized Desktops Infrastructure and VDI still accounts for about 30% of the market served by Nutanix and Simplivity. Mr. Zacak believes these first generation appliances, so well suited to ROBO (Remote Office/Branch Office) applications, will have trouble attaining the scale and reach required to serve what will truly be an Enterprise market. For example, Simplivity installations can scale only to 48 nodes, and Nutanix to 100 nodes. VxRack, in contrast, can scale from four to close to 1,000 nodes. He notes that the market grew from a $1 billion market last year to a $2 billion market this year. As it grows to $10s of billions in "the next few years," participants will need scale to stay in the game, in his view. Either way, VCE is having great success. With just four months at the time from its launch (including what is typically a three-month adoption and deployment period), VxRail had gained 360 customers in 60 countries, selling over 2,000 nodes over an entrenched market leader. As with Cisco's HyperFlex, the market seems very receptive to VxRail and what Zacak calls "its big brother" VxRack. In fact, in VMware's fourth-quarter earnings conference call, the company stated the vSAN and VxRail license bookings were up 150% year to year and that the business is now at a $300 million run rate with more than 7,000 customers across all segments. And the company repeated claims to be the leader in HCI. Including the revenue it generates from the Nutanix-based Dell EMC CX, this may well someday be the case.
The second Network World interview, from late September, was with Nutanix CEO Dheeraj Pandey. Its title, "Nutanix CEO Skewers Box-based Hyperconvergence Rivals," is illuminating as well. The interviewer notes the complexity of the HCI market, ranging from stand-alone providers like Nutanix and SimpliVity to a "semi-bewildering array" of partnerships between these stand-alones and their OEM partners. Asked how this might shake out, Pandey states there are only two operating system players, VMware and Nutanix. SimpliVity, Cisco and HPE all rely on VMware. And Dell relies on Nutanix. And only Nutanix started with an "empty canvas," much like VMware started with vSAN 12 to 15 years ago.
While Pandey has "a lot of respect" for VMware, he seems too dismissive of SimpliVity when he describes it to be "a smoke and mirrors company" set "to crater under their own weight around the false promises" they made. CEOs should never discuss competitors in such a way, even those under duress. Moreover, it is not clear SimpliVity was under duress; its venture investors, in selling out to HPE, alluded to its strong growth and third-party observers have praised its offering. Another unsatisfying feature in his characterization of the market is that he fails to note the dominance of VMware and its virtualization in the marketplace and the fact that it has driven most participants to standardize on it as the operating system because of its ubiquity. Still, he notes the utility of Prism as a management interface and its appeal to administrators of virtualized desktop infrastructure. Finally, he notes the enormity of capital and operational expenditures spent on the hardware, software, and virtualization of infrastructure and believes it will support a multiplicity of players. Indeed, Nutanix retains its market leadership.
In sum, the market for Hyperconverged Infrastructure products is growing and evolving rapidly. Created with the release of Nutanix's first product five years ago, it has been populated up to now by a handful of upstarts and major players with products that could be adapted, to some degree, to the specific needs of the market. The technologies now, however, are highly developed and highly in demand. Major vendors anticipate rapid adoption in the Enterprise and are now aligned to satisfy the resulting demand. VCE and HPE, as well as Cisco, see the great opportunity the market presents and have developed, or are developing, the products it now requires. And they are now generating significant traction in the marketplace. This is what VMware terms next-generation hyperconvergence. We believe competitive pressure in the market is set to increase in very significant ways.
And Regarding Nutanix the Stock?
Nutanix remains the mind and market share leader for Hyperconverged Infrastructure Solutions, as it confronts a rapidly changing market. In a brief 18 months or so, it is doubling from a half-billion-dollar company to a billion-dollar company in a market that, in many ways, it created, gaining a share of roughly 50%. Though profitability is likely still over the horizon, cash flow metrics have turned positive and the company is clearly gaining scale. Moreover, it seems to have the strong support of its customers and its partners, even those with which it competes. This speaks to the compelling nature of its products.
This being readily acknowledged the fact remains the market for HCI solutions is changing as fast as it is growing. It has been a market in which Nutanix and Simplivity could lead with shares of 70% and 20%, respectively. Yet, major vendors with newly charged offerings have come crashing in with momentum of their own. HPE has acquired SimpliVity and hopes to boost the combined market position with its broad customer base and strong balance sheet. Cisco recently cited as a possible third OEM partner for Nutanix, has recharged its HyperFlex offering and, with its popular UCS server platform, has added 1,100 customers in a few quarters. And VCE and VMware, having really just entered the market, have gained considerable traction with their manifold offering, which includes not only VMware, nSAN, VxRack and VxRail, but also the paring of the Dell EMC CX appliance and Nutanix software. Clearly, the rapidly growing market for Hyperconverged Infrastructure is well served with abundant alternatives.
As we noted above, Nutanix's shares rocketed from $16 per share to $47 per share out of its IPO last fall, subsiding as such recently issued stocks do. It now trades at the low end of the $20 per share to $30 per share range and thus would seem to have upside, especially once the lock-up from the IPO expires at the end of March. Nutanix is the leader of very hot market, but one that is now hotly contested. Large, well capitalized Tech leaders are now positioned to compete more forcefully. Yet, the market and technologies are very complex and the use-cases for customers both complex and differentiated. This is clear in the HCI offerings of Dell EMC, which range from VMware's vSAN, through VCE's VxRack and VxRail, and the Dell EMC CX running Nutanix software. Surely the high growth of the market will blunt some volatility for Nutanix shares. That said, we expect some volatility in the stock price as market share shifts become clear with earnings. For investors, we recommend nimble trading as opportunities arise on the up- or down-side in share price movement. And if indeed one captures gains, we will have to advise hyper-vigilance. This is one stock to watch closely as trading opportunities are sure to arise and offer rewards.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.