Since I wrote my bearish piece on Nutanix (NTNX) a few months ago, the company has posted their latest 10-K and the shares are down about 28%. While that’s somewhat gratifying, I must now look in on the company again to see if it is reasonable to remain pessimistic about the name. After all, this company presents a very different risk-reward profile now that the shares have dropped so much. A terrible investment at $55 may be a great investment at $35, so I must review the name to see if marginal investors would be wise to buy. Also, since my article came out, the company has restated their financial numbers for 2017 and 2016 and I’ll comment on this change also. There’s nothing nefarious in this restatement. The company simply adopted the ASC 606 revenue recognition standard and this needs some comment.
Improved Financial Picture Under ASC 606
On August 1, 2017, the company changed its revenue recognition policies to align with the FASB rule generally referred to as ASC 606. This has resulted in no changes to the cash flow statement, but has caused the company to restate elements of the income statement and balance sheet for 2017 and 2016. Without getting too technical, this standard tries to present a more “principles based” approach, as opposed to the “rules based” approach that has traditionally been a part of GAAP accounting for years. There are several advantages to this approach. For instance, this change should allows for greater comparability between companies that report under GAAP and those that report under IFRS. In addition, a principles based approach is more flexible, allowing companies to account for revenue, assets etc. in a manner that is relevant to their industry. This flexibility is also a drawback, though, in that it allows for greater management discretion. Giving managers greater leeway in deciding what gets reported doesn’t always work in investors' favor.
Relative to the previously stated financial statements, revenue, gross profit, and net loss are all changed significantly from the previously stated figures in 2017 and 2016. For instance, revenue has been restated 10.3% higher, in 2017 and 13.15% higher in 2016. Improvements were also seen in gross profit (up 18% in 2017, and up 21% in 2016) and net loss (reduced 17% in 2017, and 35% in 2016). Whether this change to a principles based approach is “good” or “bad” depends on your particular use of financial statements. I don’t believe the change is, on balance, a positive for small shareholders, but I see the benefits also.
In some sense, though, the change to ASC 606 is irrelevant. In my view, the financial statements still reflect a company that continues to bleed red ink. Over the past six years, revenue has grown at a CAGR of about 83%, while the net loss is up at a CAGR of 37%. In fact, I ran a correlation analysis on revenue and net income over the past six years and found a very strong negative relationship between revenue and net income (r=-.87). This prompts the question “if growing sales at this rate doesn’t lead to profitability (or at least reduced losses), what will?”
At the same time, investors have been massively diluted over the past six years. The share count is up at a CAGR of about 30% over the past six years.
Source: Company filings
As I’ve said many times, a high quality business can be a terrible investment if the investor pays too high a price for it. This gets to the idea that price paid for a stock is one of the, if not the most, important variables in determining the success of the enterprise. With that said, the valuation has improved massively, but it remains quite rich in my view.
As an aside, one of the reasons I like looking at price to free cash flow is that free cash is not affected by accounting changes like ASC 606. At the moment, the best that can be said is that the shares are less expensive on a price to free cash flow basis than they were this time last year. That’s where the good news ends in my view. Investors are still paying more than 200 times free cash flow for their shares. In my view, this is massively expensive and must end in further losses for investors.
Can Calls Rescue The Marginal Investor Again?
In my previous article about the stock, I recommended that investors who insisted on staying long, reduce their risk by switching to calls. I specifically recommended January calls with a strike of $60. At the time, these calls were sporting a bid-ask spread of $4.8-$5.30. At the moment, those calls sport a bid-ask spread of $.55 and $.70, so they have dropped in price by approximately 85%. The investors who purchased one call for every lot of shares have lost about ~$4.70 per call. That’s terrible, but it reminds us of the benefit of calls over stock ownership, since share owners have lost about 3.5 times as much. I’ve said it before and I’ll say it again. Call ownership can be a far less risky way to “play” certain companies at certain prices.
I’ve looked at a strategy of using calls as a means to gain access to any share bounce from here and unfortunately I haven’t found any. The problem is that as the shares drop in price, calls remain relatively expensive on a percentage of price basis. In other words, the most reasonable calls are priced at about 20% of the price of the shares themselves. In my view, that is too high a premium, and thus it makes little sense to use calls as a proxy for share ownership at these levels.
The shares have dropped just under 30% in just under 3 months and that dramatic price move put the company back on my radar. A company priced at $39 is definitionally less risky than one that was priced at $55 when I first wrote about the business. While $39 is a less bad price, and the people who buy at $39 will suffer less than the people who bought at $55, the shares are still currently overpriced. Even with the change in accounting rules, revenue growth and net income have been strongly negatively correlated for years. This prompts the obvious question about what will happen to turn this relationship around. Additionally, the market remains very optimistic about these shares, bidding them at over 200 times free cash flow. For all of these reasons, I must recommend that investors continue to avoid this name.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.