Nutanix: The (Not So) Hidden Reasons To Buy

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About: Nutanix (NTNX)
by: Roman Luzgin
Summary

Nutanix reported positive results in its latest quarter, beating on EPS and on revenue.

The shift toward software-centric business model is bearing fruit. The company is on the right track to becoming profitable in the near future.

Revenue growth slowdown is only a temporary event and stems from the diminishing hardware sales, which is a part of the management's strategy.

While certain risks, such as increased competition, still exist, Nutanix remains the leader in the HCI segment.

Therefore, the latest correction provides a solid entry point with low risk and high upside potential.

Over the last year, Nutanix (NTNX) stock has entered and exited my portfolio due to rapid changes in the market conditions, mixed quarterly results, and significant price movements. In more detail, I opened a long position in NTNX at the beginning of February 2018 at $32 and sold my shares 4 months later, in June, for $55 as the stock had rallied 70% by that time. The primary reason for selling the shares was the not so impressive performance that the company demonstrated in Q3. To remind, the company missed on EPS and showed signs of revenue growth slowdown.

Chart NTNX data by YCharts

Since that time, the stock has dropped to the levels of January 2018 but has still been watched by me. However, the current pullback may finally present another attractive opportunity to buy NTNX, especially with positive Q1 results being demonstrated by the corporation. Although certain challenges exist, the bullish thesis is based on the company's fast financial improvements that are likely to lead to Nutanix becoming a profitable company in the nearest future. Let us review this thesis in more detail.

Nutanix demonstrated better than expected Q1 results. The shift toward software-centric business brings dividends

Nutanix reported its quarterly results on November 27, beating on EPS by $0.14 (-$0.13 vs. -$0.27) and on revenue by $8 million. Notably, the main growth driver in the quarter was the company's transition toward the software-focused business model, which we will discuss later in more detail.

The pace of financial improvements is one of the major points that make Nutanix attractive for investment at the moment. The company is actively pursuing the aim of becoming a profitable corporation, which seems to be coming to fruition sooner than expected, evident by the huge degree of EPS surprise in the recent quarter: the net loss turned out to be more than 50% smaller than expected by analysts.

The major highlights in the quarter were all related to software revenue growth: software and support billings increased by 50% year-on-year to $351 million, revenue grew by 44% to $281 million. Even more impressive are the numbers for subscription revenue, as this soared a hefty 104% year-over-year. With around 4 years of average subscription contract length and 90% retention rate, Nutanix is building a solid basis of recurring cash streams through subscription-based sales.

Software and support revenue continues to grow

(Source: Q1 earnings slides)

The success of the software division signifies management's solid execution on the plan to shift the company's business model toward the one concentrated on software and support rather than on hardware sales. This will likely bring Nutanix several benefits, including higher margins and more stable earnings. Hence, non-GAAP gross margin went up by solid 17 percentage points, reaching 79% in the latest quarter. It can be predicted that with the continuing increase in the portion of subscription-based revenue, Nunanix will expand its margins even further in the near future. This will contribute positively to the corporation achieving profitability in the coming years.

Higher mix of subscription revenue will be beneficial for NTNX (Source: Q1 earnings slides)

The crucial point that should be made regarding the software business is the one that can make Nutanix a surprisingly favorable investment: the general slowdown in the corporation's total revenue is only a temporary situation which roots in the same shift toward a software-centric business model.

The picture below explains the situation in a clear way: in Q1 2019, Nutanix reduced its hardware sales from $81 million to just $32 million, which was the part of the management's plan. If the hardware revenue remained on the same level year-over-year, the company's total revenue growth would amount to more than 30%. It is seen that the portion of hardware sales has become almost insignificant over the last year.

Nutanix

(Source: Q1 earnings slides)

As a result, the continuing improvement in the other revenue streams will become significantly more evident next year, which means revenue growth will start to accelerate again. Therefore, Nutanix will likely bring a positive surprise to most investors in FY 2020.

The trend toward profitability is positive

As I mentioned at the beginning of the article, one of the main reasons to be bullish on Nutanix is the company's fast transition toward being a financially viable company. In other words, the corporation's pace of moving the business to profitability is encouraging, which shows the management's vision works more than well at the moment.

Hence, net loss per share has continued to shrink from the moment the company became public in 2016. For instance, in Q1 FY 2017, Nutanix demonstrated net loss of $0.37 per share. In Q1 FY 2018, the number went down to negative $0.16, and the loss of $0.13 achieved in the recent quarter is yet another improvement. While the degree of change seems to be slowing at the moment, this can all be attributed to the diminishing hardware sales, which, again, is just a part of the company's strategy. Moreover, the general trend remains to be exceptionally positive.

Nutanix (Source: the author's calculations based on quarterly reports)

If the trend continues over the next 1-2 years, Nutanix will be on the right track to demonstrating positive EPS already in FY 2021. However, I would expect acceleration in EPS growth over the period, due to the aforementioned transition toward the software-centric business model. It is clear that the hardware sales, which still account for a significant portion of revenue for Nutanix, are associated with the much lower return on sales, compared to software-related sales.

Moreover, maintaining hardware business is likely to require a significant amount of fixed costs which could be eliminated in the near future. This would have a relatively high positive influence on the company's EPS. From here, a significant upward potential arises for the stock price.

The stock performed significantly better compared to the broader market during the selloff

Additional focus should be made on the stock's performance during the recent selloff in the market. While many tech shares experienced major declines due to relative overvaluation and lack of investor confidence, NTNX performed not as negatively as many other securities.

Hence, since October 2018, the level of return has basically fluctuated near the level of 0%, which is not so bad compared to the returns of S&P 500 (SPY) and other indices. This could mean that, in general, institutional investors were not willing to abandon their positions in Nutanix even in the times of low confidence, which shows that NTNX could soar significantly on any positive news. This is something that has been seen over the past days - NTNX surged about 10% on a slight hint of the market's rebound. Therefore, while the situation in the broader market could still remain uncertain in the nearest future, an investment in Nutanix could be a position with a relatively low downward potential.

Chart NTNX data by YCharts

While the competition may intensify in the future, the current stock price provides a solid risk-reward opportunity

The hyperconverged infrastructure segment, where Nutanix operates, is a promising area of technology which grows rapidly due to the significant number of benefits that it can bring to the companies implementing HCI. These include such perks as flexibility for the data centers, scalability, and lower operational costs due to higher efficiency.

Cost benefits will become more apparent as the market matures, but the principle of hyperconvergence means that because there is less equipment needed, it is cheaper to support and maintain hyperconverged infrastructure. Because it is software-based, as new features are added they can simply be pushed out in releases without the need to replace components.

It is in the best interest of businesses to support IT in the modernization of their environments to become more cloudlike, and hyperconverged is a relatively easy step in that direction.

With the demand for HCI increasing over time, more companies can be expected to try to enter the market. For instance, NetApp (NTAP), HPE (HPE), Cisco (CSCO), and VMware (VMW) already offer comprehensive HCI solutions which bring economic benefits to suppliers and clients. Therefore, the risk of competition can become more evident in the future in case the trend in the overall segment remains positive.

However, Nutanix has positioned itself as one of the leaders in the HCI from the early years of the technology's existence, which means the company has an early-mover advantage. For instance, the recent Gartner Magic Quadrant for HCI named Nutanix as a genuine leader in the field, which shows the corporation continues to be ahead of its rivals in most aspects. This should ensure that more potential clients will choose Nutanix's solutions over other offerings, and as a result, the corporation will continue growing its subscription-based cash flows, helping the stock deliver solid results in the coming years.

Gartner puts Nutanix as a leader in the HCI market (Source: Nutanix website)

Regarding actual stock price targets, it is almost impossible to set an exact number at the moment, as the company is still in its early stages of development. However, my estimate is that by 2020, when the company is expected to achieve at least a break-even point in terms of profitability, the stock can easily return to the highs of 2018; namely, the level of $60-65, which defines a solid upside potential of up to 50%.

Disclosure: I am/we are long NTAP. 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.