Nutanix: Puzzling Price Reaction

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About: Nutanix (NTNX)
by: Bert Hochfeld
Summary

Nutanix reported the results of its fiscal Q4 last Thursday afternoon.

The company reported very strong operational performance with beats in terms of revenues, earnings and cash flow from operations.

The company significantly raised its guidance for revenue growth in this current quarter.

The company had an exceptionally strong bookings quarter, with bookings growing by 24%  sequentially and reaching 1.28X the amount of recorded revenues.

The company enjoyed significant success in strategy of penetrating the Fortune 2000 and saw software revenues grow by 96% year on year and 45% sequentially.

Nutanix - The share price reaction to the quarterly report is surely a puzzlement

Well, yes it was. Nutanix (NTNX) reported the results of its fiscal Q4 on the last day of August. It might possibly have better held the release until April Fool's Day. Just to reprise, the company exceeded almost all operating metrics and raised revenue guidance quite significantly-and even so developed its revenue forecast assuming a government shutdown and less traction from a key partner. Specifically, revenues for the period reached $226 million, with billings of $289 million. The deferred revenue balance has now reached $526 million, up 77% from the year earlier level.

Usually, when a business delivers results that are substantially ahead of its own forecast and prior expectations, analysts try to figure out why. Were the results the product of some special circumstances. Are the results repeatable. Is there a new competitor that is a particular threat to the company's longer-term success? In the balance of this article I will take a crack at answering some of those questions. But sadly for current holders, and an opportunity for those considering the name as an investment, the results of the quarter apparently left negative analysts unpersuaded.

One analyst, for example wrote that "the steady expansion of its software merely adds "credibility to the narrative." The analyst went on to write that "the problem is that Nutanix still suffers from a reputation that it is just a provider of collapsed storage and compute…Moreover, the extent to which the company is able to improve on its image and successfully re-platform its entire enterprise stack and become a defacto enterprise OS play is a tall order and still very much an open question." The analyst said that "there are long-term concerns surrounding Nutanix's growth and margin sustainability offset the otherwise constructive view that the company presented in its earnings report." Basically, without much in the way of credible substantiation, this analyst and other nay-sayers seemingly didn't care about results-and continued to rate the shares based on their own predilections. It would seem, at least from the note from which I quoted, that the actual results, at least to these analysts, are seeming less important than actual results and company guidance.

An analyst on this site suggests that Nutanix shares are capped in terms of their share price because of the lack of a path to profitability. Actually, as I will be at pains to show below, last quarter did see some positive traction with regards to expense management. The company has been rather specific that as long as it is in hyper-growth mode, it is going to be reinvesting gross margin dollars in favor of leveraging its market share and its growth rather than its profits. There are many other companies in the IT space with similar strategies whose shares sell at far higher multiples of EV/S. There is, no doubt, a balance between growth and profitability-and it is a rare company in tech that can do both. Again, as I will write about below, the company is pivoting to selling larger deals to larger users. That is an expensive undertaking-but one that makes sense given the company's success with "land and expand" and with the penetration of large users in the last couple of quarters.

Writing this on Labor Day evening, I think it is worth pointing out that today, Sept. 5th, the company plans to hold a conference call to reset its numbers and guidance to provide for the use of the new 606 accounting standard. While, of course, I do not know the precise nature of the results presented this new way and the new guidance, it is almost certain that the new presentation will show Nutanix to be far more profitable than it has previously reported. In turn that will further reduce guidance and provide a justification for some investors to look more seriously at the shares.

For some years now, both the business and share price performance of almost all companies selling enterprise hardware has been miserable. The server market has shown steady declines and even the market for integrated systems (usually described as converged)has reached an asymptote according to most market research. The space has been troubled because of the cloud, because of commoditization and frankly because of lack of innovation.

Simply put, Nutanix sells something quite different and has done so since it started out 8 years ago. At this point, the level of disruption and innovation that Nutanix has brought to this space is dramatically under-appreciated by many brokerage analysts-and apparently by many investors. And therein lies the opportunity-one of the more significant opportunities in the IT world to come along in quite some while.

Many readers of these blogs are simply looking for buy/hold/sell recommendations. But for those who are not, I strongly commend the interview that CEO Dheeraj Pandey gave to a reporter at Barron's. I think it ought to strike most observers that the CEO believes that he is running a software company and that software will continue to be the growth driver in the future. I simply have no objective evidence to dispute his assertion. The Benzinga analyst who I quoted above, simply doesn't seem to accept any of Mr. Pandy's comments about the direction of the IT hardware space or about the path of the product strategy that Nutanix has been following.

Over the next few weeks, I imagine that others besides this writer will take a more objective look at the results the company posted this quarter-and last quarter as well-and come up with different conclusions than were reflected by the share price action on Friday. The market has disdained hardware companies and storage companies for some years now-and for the most part the disdain has been merited. That disdain, however, is now at sharp variance with the actual performance of companies on the forefront of technology. At some point, one assumes, facts will trump predilections when it comes to analysis and share valuation.

Why were the shares unchanged in Friday's trading? There is a famous song, from a famous show, called the "King and I", by Rogers and Hammerstein titled "It's a Puzzlement." The song was initially performed by one of the more famous actors of the era, Yul Brenner and has been reprised many, many times. The song best reflects my own reaction to Friday's share price reaction. At the end of the day, the company beat numbers, significantly raised guidance and presented an outlook for accelerated growth that relates to its overall disruptive capabilities and product differentiation. The market seemed to ignore the reality in favor of looking at outdated and incorrect perceptions.

Nutanix shares are remarkably cheap, at least for a company growing at 50% and which have been described by Goldman Sachs as a "one-in-a decade" opportunity. The quarter reflected some of the reasons for that enthusiasm. Everything indeed came up roses for this company…except the share price. The shares remain far below where they had traded in the wake of the IPO, or even before the company's quarterly miss back in March. They had hardly spiked going into the numbers. It has been several months since the lock-up concluded. Sometimes markets mis-price securities in illogical ways. About the best I can offer to readers is that the lack of a share price response to the numbers of the quarter and to the company's current valuation is not really capable of being logically explained. It provides investors with an unusual opportunity and one that makes sense to take. I had shares going into the earnings report; I have more shares now.

The anatomy of a quarter-could it have been misunderstood?

I doubt it. Even some analysts who are negative about the shares recognized the results were strong, the guidance was a substantial raise and that the management was presenting a very positive picture. The conference call was certainly spiced with more than a few congratulatory comments, even from one high profile analyst at Morgan, Stanley who does not currently recommend the shares. Price targets from brokerages rose almost universally. And the CEO presented a series of comments that were attempts to dispel some of the myths about HCI (Hyper-Converge Infrastructure) and how the space is developing in favor of the strategies that Nutanix has adopted.

The company handily beat prior expectations in almost all categories related to revenue and costs. Revenues of $226 million beat the company's prior forecast by about 4%. The loss of $.33 non-GAAP was $.05 better than had been projected by the First Call consensus. The company's revenue guidance for Q1 of $240-$250 million is, at the mid-point, about 6% above the prior consensus expectation.

The company generated $6 million of operating cash flow (CFFO) in the quarter, which was about double the CFFO of the prior year. The GAAP loss margin for the period was 39% compared to 35% in the prior year. Gross margins were about 57% on a GAAP basis compared to 61% the prior year. The gross margin decline year on year, was entirely a function of the increase in DRAM prices which cost the company 600 bps of margin last quarter according to the CFO.

There are plenty of other numbers worthy of discussion and I will touch on some of them below-but they were all good. The 24% sequential increase in billings, which were 1.28X the revenues for the period was considerably greater than company targets for that ratio and were a principle factor in the company achieving a modest level of positive CFFO (Billings growth faster than revenue growth drives deferred revenues which drive cash flow.). The company achieved a 45% increase in software revenues sequentially-for the full year software bookings rose by 96%. I think the quarterly acceleration in software bookings was one of the major accomplishments of this past quarter. The company, sells its own hyper-visor, AHV, which provides it with significant differentiation from the other HCI offerings. AHV bookings rose by 214% based on the number of nodes. The company had a net promoter score of 90 last quarter, one of the highest ratings I have seen in terms of IT vendors for that metric. (Net promoter scores relate to user satisfaction-I have linked to an infographic which depicts just how much of an outlier a score of 90 is.)

I quoted above from a note that said that there remains skepticism regarding the company's ability to become more and more of a company that is able to provide software to OEM partners. The facts on the ground are what was reported and not some negative hyperbole conjured by a poorly informed analyst. Software as a percentage of total revenues reached 17% on a rolling four quarter average, an increase of 100 bps sequentially but still far below the company's business model aspiration of 33%. It has been the rapid increase in software sales that has allowed this company to weather the gales of the increase in DRAM costs without a dramatic fall-off in gross margins. Going forward, as software sales continue to rise as a proportion of the total, it is reasonable to anticipate, a healthy increase in gross margins.

Operating expenses for the quarter were $217 million, on a GAAP basis. That was an increase of 63% year on year but flat sequentially, and noticeably below the company's forecast provided during the Q3 earnings release. Research and development costs, on a GAAP basis, almost doubled in the last quarter year on year. On the other hand, research and development costs actually declined modestly sequentially, perhaps a function of the company's inability to find enough research and development professionals. Sales and marketing costs were up marginally in Q4 on a sequential basis, which given the massive sequential quarter increase in bookings, and the fact that the quarter was a Q4, represent some indication of positive operating leverage. Year on year, sales and marketing costs rose by 49%. General and administrative costs were up 7% sequentially, but were 60%+ greater than a year earlier.

Stock based comp expenses fell quite sharply sequentially from $50 million to $37 million. Self-evidently, operating margin performance this past quarter reflected a better quality in terms of reported numbers, and in turn probably related to lower level of hiring compared to prior periods. As the company gains more confidence that the results in Q2 were more of a blip than a trend, hiring is likely to rise and there may be some growth in stock based comp although this wasn't discussed on the call.

The company has provided guidance that calls for a 6.4% sequential quarter increase in revenues at the mid-point. While revenue guidance, as mentioned earlier, represented a noticeable increase from prior expectations, it is quite constrained for a couple of specific factors that are certainly not set in stone.

That forecast is predicated on a significantly lower than normal contribution from the normal seasonality in sales to the Federal government at the end of its fiscal year. The CFO said that the company had baked into its projections some factor that related to the potential for a government shut-down. In addition, sales to Dell were stronger last quarter than the company had anticipated and actually surpassed 10% of total bookings. For those familiar with this company, sales to Dell have been considered a risk factor for several years-but in actuality, sales with Dell have shown very strong trends.

As many observers have pointed out over the past years, Dell-or VMware (VMW) - is and will be this company's most significant competitor for the foreseeable future. So, few observers had thought that Dell would remain a major customer for Nutanix. The fact that it has ought to suggest, at least to some, that this company has a compelling set of solutions that has provided Dell with an opportunity to sell its hardware that would not be available otherwise without partnering with Nutanix.

As mentioned, last quarter Dell contributed a bit more than 10% of bookings, a level above its percentage of bookings in the recent past. The company is not counting on that kind of performance in its quarter ending 10/31. Based on the hints provided by the CFO, these two factors represent perhaps 5%-6% of revenues and potentially set the table for another significant upside.

This company has several other major OEM clients who certainly might be reasonably expected to take up the slack, although forecasting the precise cadence of OEM orders is not completely feasible. Business with Cisco (CSCO), where Nutanix supplies software for that company's UCS offering doubled last quarter. The company ought to see some initial business from its recently announced OEM transaction with IBM as well as continued growth of its business with HP Enterprise (HPE). And Lenovo, which was a strong contributor to Q3 results, is also likely to show continued growth, albeit on a lumpy basis.

The company is forecasting sequentially flat EPS next quarter. It is forecasting that the dollar amount of gross margins will increase by about $10 million related to higher volumes and that it will incur about $10 million of greater opex. That is almost certainly likely to prove to be conservative, although much relates to the software mix. But if software revenues track strongly this quarter because of the numerous OEM deals that are starting to contribute revenue, then it seems likely that gross margins will start to recover because the impact of DRAM price increases is starting to abate. Further, it also seems likely that there will be no government shutdown this quarter-or that is what I have read most recently-post the Harvey catastrophe and the need to fund relief for those victims-and perhaps the victims to come of pending Hurricane Irma. And given the track of GAAP expenses last quarter, which as I have elaborated were essentially flat sequentially, it seems unlikely that non-GAAP opex will rise by $10 million unless stock base comp falls another $10 million sequentially-not terribly likely I imagine.

The concept that the company will be able to ramp expenses rapidly to consume any additional gross margin upside is probably not realistic in a given quarter. Overall, I think the set-up in terms of what to expect, is for an earnings beat-and probably a beat on bookings and reported revenues as well.

Since the company's miss in the February quarter, this company has provided an unusual amount of detail on its larger wins. It is unlikely to continue to provide all of the metrics it has been reporting the last couple of quarters, and indeed, it is not totally necessary to do so. Last quarter the company closed 15 significant transactions of greater than $2 million. These deals aggregated $57 million of bookings, up by $12 million or by 26% sequentially. Obviously, the company focus on larger transactions with Global 2000 customers in the wake of the Q2 miss has borne some fruit.

Nutanix has always offered virtual desktop infrastructure (VDI) that accelerates the performance of both Citrix (CTXS) Xen desktop and VMware Horizon View. Nutanix sales of its VDI solutions shrunk to the lowest percentage of total bookings in the history of Nutanix. This is an important milestone-at least is should be-for most observers as typically VDI is sold in smaller deals to smaller users.

Some thoughts about how to define Nutanix and where the company is going

I have written about this subject in prior articles about this company. Obviously, it remains a controversial topic and negative analysts are seeking to label this company as a hardware vendor and to suggest that the company will not be able to escape the limitations of those kinds of vendors in terms of sustainable growth and valuation. Of course the company sells appliances. That is currently about half of its business according to the study linked here. And it helps users to deploy and support the appliances that they buy. Nutanix calls what they do a hybrid cloud solution. Essentially, the appliances that Nutanix offers bridge the gap between the efficiency and performance of typical public clouds and legacy enterprise data centers. Some people call the solution a "data-center in a box." Nutanix, in addition to selling its appliance also has a software fabric that will unify private and public clouds and delivers lots of simplicity in terms of management. Users can deploy the appliance as a turnkey installation or as software on all leading servers. Nutanix can be used with most relevant hardware, it runs on all virtualization (Acropolis-Hypervisor) platforms and it operates with all of the major public clouds. Because of the architecture of HCI, and Nutanix in particular, users are able to buy and use just the amount of capability they need to have and aren't stuck buying unused capability in advance. Users can deploy Nutanix and then run almost all of the popular software applications currently available. For those interested in the details, I have linked here to the company web site. Nutanix has been selling its own hypervisor called Acropolis for two years now and it is starting to become an increasing component of the company's overall offerings. The company has most recently introduced Calm which is a software offering that can help enterprises manage the applications that run on the Nutanix appliances. It is likely to become a nice add-on in terms of its revenue opportunity.

A few months ago, the company announced a partnership with Google which will offer a public cloud service called Xi. Xi will be a service in which the same OS will be used on both sides of a hybrid cloud installation. In some ways, this will blur the boundaries of between the public cloud and user controlled hardware. It is hard to know just what the market might be for this new service and how long it will take before it contributes meaningfully to Nutanix revenue.

In addition to Xi, the company is working with Google to develop an offering based on the evolving Kubernetes container management system. Nutanix is developing a version of software which will incorporate Kubernetes with its own offering. Kubernetes, and Container technology are often said to be one of the main future directions of computing. For readers wanting a more thorough understanding than I can provide, I have linked to the Kubernetes site which might give a better explanation of how the product functions-certainly better than I might offer.

In terms of its business, as I have written above, the company is going up-market as its most important go to market strategy. Last quarter the company sold a large proportion of its bookings to large users. The company has 7000 customers but 400 of them have bought more than $1 million of product lifetime. The company, last quarter sold its largest deal $11 million) to an unidentified customer who provides business, legal and financial services-perhaps Dun and Bradstreet. The customer already was using Nutanix and this deal was a massive extension of its installation. Despite the well-publicized woes of the retail sector, Nutanix has sold significant deals in that vertical and it is one of the leading verticals using Nutanix infrastructure.

Despite the focus on Global 2000, the company continued to sell new name accounts. Overall, over the course of the prior fiscal year, the company about doubled its customer count to more than 7000, and it closed more than 800 new accounts just in the last quarter.

Valuation

Valuing the shares of this company involves more than a bit of guess-work and assumption at this point. Whenever something is in the process of significantly disrupting a particular segment of the IT space, it is simply difficult to figure out just how far it will go and how large it will get to be. At the start of the decade, no one thought the public cloud would achieve the disruption it has, or grow into the revenue stream that it has for many different companies. Of course the opposite is also true in that disruptive technology has both winners and losers-at the start of the decade, storage vendors certainly got more respect than they do at this point. And it also true, that not all disruptive technologies take place on schedule. RFID is still having a bumpy road to broad scale adoption.

One thing that is worth noting-specifically with regards to valuation. As mentioned, on Tuesday afternoon, the company will be sharing the results of its new reporting methodology. It is early adopting ASC 606 as of the start of the current fiscal year (8/1). I do not know the magnitude of the change that will be seen in the reported numbers but it is likely to be substantial and will bring the company's reported numbers much closer to break-even. In essence, it will be able to report the revenues from multi-year consumption arrangements which had heretofore been recorded as deferred revenue-or in some cases not reported as all. For companies such as this, that are selling multi-year, major implementations to larger users, the impact is going to be not inconsequential. At least from an optical point of view, the company's valuation will come down. Does that mean investors will rethink what they should pay for Nutanix shares in the absence of any other changes? I really do not know although that kind of share price action has been speculated by some analysts.

At the moment, using 152 million shares, as currently forecast by the company. Nutanix has a market capitalization of $3.3 billion. Its current cash balance is about $350 million which yields an enterprise value of just below $3 billion. Current estimates for this fiscal year are about $1.1 billion, or 41% growth. What the number will be given the new 606 rules is not knowable-but it will be significantly higher. Given the major gap between reported bookings and reported revenue which will almost certainly narrow. But currently, the EV/S is just 2.7X. How much should it be? How much of the company's revenue stream will come from recurring sources, i.e. software and services? How long will the company continue to see growth above 50%?

I do not think anyone can really answer all of those questions at this moment absent second-sight, a commodity in short supply and one that I certainly make no claims to have. I will leave this segment, simply by saying, that software companies with this type of growth outlook, or even with noticeably slower growth outlooks, that are equally without profits, are selling for EV/S ratios of 6X-11X.

I have presented some detailed analysis of the quarterly evolution of this company's major expense categories. Obviously a company that has operating expenses of 96% of revenues on a GAAP basis, or even,80.5% of revenues on a non-GAAP basis will not soon reach profitability. Those ratios will change for the better with the adoption of the ASC 606 rule-but by how much, is not quite known at this point. The companies most significant outlier in terms of expenses is sales and marketing which was 53% of revenues on a non-GAAP basis in Q4. Again, the issue with regards to profitability is going to be the future track of software revenues as a percentage of the total and how that will eventually impact gross margins. Spending 53% of revenues on sales and marketing makes total sense given the company's ability to actually land and expand, and given the increased amount of software the company has in its mix.

It is expected that the company will be revising its business model goal in conjunction with the release of its 606 presentation. AT this point, valuing the shares of Nutanix on the basis of earnings is quite premature and doesn't present a valid picture of the company's overall evolution.

The company has been generating a modest amount of cash flow from operations during the past several quarters, and that was the case in Q4. The positive cash flow generation is a function of stock based comp and the rapid increase in deferred revenue balances which are offsetting the company's GAAP losses. As the result of the company's very rapid growth, some balance sheet items that correlate strongly with revenue were also a major use of funds-in particular accounts receivable. That was offset during this last quarter, for the most part, by accrued compensation expense and other accruals.

Cash flow going forward is going to be influenced by changes in the level of reported GAAP loss, offset by stock based comp and the increase in deferred revenues. The new ASC 606 rules will not impact cash flow-although I do expect to see CFFO track higher, over time given the strong trajectory of bookings.

At this point, I do not have enough data or company input to readily forecast CFFO going forward. My best guess is that even without material improvement in GAAP operating earnings, both stock based comp and deferred revenue balances will rise by enough to significantly increase CFFO next year-but by how much is really unknowable at this point.

The company has a modest level of capex-running at about $50 million/year. I think it is possible that free cash flow might approach $100 million in this current fiscal year.

I do not want to minimize the fact that any company in a new space, offering new products and different solutions has some risk. While virtualization is a well-accepted and widespread technology at this point, its use on such a wide scale is perhaps a leap in the dark at some level.

And whatever else is the case, Nutanix does make hardware-and in a general sense, hardware in the IT space is simply not a growth area at this point. The fact is that the hardware business is not an area one might pick for sustained high growth. The fact is that there will always be concerns regarding commoditization or gross margins risks in evaluating companies such as this.

But overall, the preponderance of the evidence suggests that this company and its management have a significant technology advantage over the other competitors offering some flavor of hyper-converged technology. And based on the empirical evidence, it seems that the company is using its technology to forge partnerships with hardware vendors who will wind up buying the company's hypervisor and other bits and pieces of its software. It is potentially a model that will almost certainly lead to lots of revenue growth for the next several years and is likely to see a fair level of growth both in reported earnings and in cash flow as well. The failure of the shares to react to the company's very strong operational performance has afforded users an excellent opportunity-one that does not come along that often. The percentage upside in these shares is as great as anything in my current coverage universe.

Disclosure: I am/we are long NTNX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.