Is Nutanix Fixing The Problem Too Late?

About: Nutanix, Inc. (NTNX)
by: Joe Albano

Nutanix dove 33% on a 15% downside guide for Q3.

Management indicates lead generation spend is the cause and it's working to focus capital toward it again like it did in 2016-2017.

The question is: will this execution error be too deep a hole to dig out of or does the company's reputation afford it the ability to mimic earlier results?

Two weeks ago, Nutanix (NTNX) dove on weak guidance. What specifically drove the poor guidance is the focus. Instead of the expected sales of $347.5M, according to analysts' consensus, the company issued a $295M number - a downside guide of 15%.

And this was enough to create a 33% drop in the stock.

This seemed a bit excessive, but to understand the drop, we must understand the reasoning behind the revenue guide. There will still be year-over-year growth with the current guide, but the sudden deceleration is a hefty cause for concern.

The Problem And Solution

Let's start with the easy info: an explanation from management on why guidance was so far under expectations. This is from CFO Duston Williams on the recent earnings call: fiscal 2017 we had increased lead generation spend by 75% over the prior year. This increase drove strong pipeline generation of fiscal 2017 and fiscal 2018, as well as improved efficiencies within the lead generation spend during fiscal 2018. Encouraged by our overall company performance, in fiscal 2018, we reallocated some of our lead generation spending to other priorities.

In Q2, we noticed a pattern that some of our lead generation efficiencies that we had planned for were not being realized. We began taking actions to reallocate capital back to lead generation spending, while at the same time, dialing back on non-sales hiring. We have continued these actions into Q3.

The basis, it appears, was a misallocation of capital spending away from lead generation and, indirectly, sales.

I think ultimately, Rod, we squeeze[d] too hard on lead generation spend and we shouldn't have done that, and we've corrected that.

- Williams Q2 Earnings Call Q&A

Looking at Q2 2019 and comparing it to Q2 2018, we can try to understand just how much of a problem this was and help us determine whether this is the major reason for the guide. Since lead generation is not its own line item, I'll be using the Sales and Marketing line.

Quarter % Of Revenue
Q2 2018 52.7%
Q2 2019 63.7%

(Source: Nutanix's 2019 Q2 Earnings Report)

We can take the above table one of two ways:

  1. It has already begun to implement this spending shift in Q2
  2. Spending is already high and this is not the problem

So, to determine this, let's examine all the quarters in 2018 and 2019 and see if there's a trend downward and/or a resurgence of spending heading into this quarter.

Quarter % Of Revenue Spend Increase Y/Y
Q1 2018 52.7% 13.4%
Q2 2018 52.7% 35.7%
Q3 2018 58.6% 34.0%
Q4 2018 60.3% 36.4%
Q1 2019 62.7% 35.1%
Q2 2019 63.7% 41.3%

(Source: Nutanix's Quarterly Earnings Reports)

After entering fiscal 2018 (post Q1), spending in S&M didn't accelerate until Q2 of 2019 - the just reported quarter. It appears, though, it has now turned up the heat, and if fiscal 2017's 75% increase in S&M is any indicator, then the company should be able to produce significant revenue growth results (as revenue growth from 2016 to 2018 was 115%).

(Source: Nutanix's 2018 10-K)

This result from 2016-2017's S&M spending should allow investors to be more comfortable with the analysis from management for its lack of spending in the same area it drove revenue from last time. In other words, the company has seen results from driving lead generation in the past and it knows it shifted capital away recently, causing revenue growth to slow. This is a pretty direct correlation and shifting capital toward this again should regain lost growth.

What gives me confidence, this isn't a larger, competitive issue for Nutanix, is the continued add-on deals and upselling it has accomplished with its current customers. However, it won't be enough to drive revenue growth back to the level the market was pricing into its stock anytime soon. As I pointed out above, the increase in S&M spending took several quarters across two fiscal years to show results. This thought process is in line with the color the CFO had to add on the call:

Although we started making this adjustment in Q2, we expect it to take a couple of quarters to show meaningful results. In the meantime, we will double down on driving further business from within our large existing enterprise customer base, while the augmented lead generation spending works its way into the pipeline.

Risks Moving Forward

While I draw some similarities between CyberArk (CYBR) and Nutanix as they both grow and operate with subscription software, the difference for Nutanix is the problem isn't a quick one-quarter fix, like when CyberArk was able to pull in the missed business into the following quarter. The kind of spend Nutanix is facing precedes revenue growth and will take significant time. This was a deep execution error on the part of management compounded by not being able to see this coming until the deceleration of growth came to light. Knowing the lack of spend in this area was going to hurt future growth and fixing it before it became apparent in growth is one thing but shifting the spend and not realizing what's happening underneath is another thing and questions the ability of management.

The stock price will depend upon how much further the company can upsell its current customers while it waits for lead generation to kick in as it once did. Most of its revenue growth in the next few quarters will need to come from this, as the new sales leads take time to form, negotiate, and sign. The company has gone from 3,770 customers at the end of 2016 to 10,610 at the end of 2018 - all while increasing S&M by 75% from 2016 to 2017. If the company can produce similar results again, then the stock will find itself ahead in the next 12 months.

The risk is the size of the hole the company has put itself in, especially in the competitive hyper-converged infrastructure ('HCI') sector. This is my main concern - can the company produce these type of results again now two years later? In the technology industry, this is a lifetime. Perhaps the leadership position of Nutanix will allow its reputation to proceed it and gain on the foundation it built.

Right now, the stock looks a bit like a trap, but I still see opportunity down the line. Dipping your toe in here to start a position could be the first step for your investment or perhaps letting the price action play out a little longer and looking for a bottom to form would be the less risky approach. Overall, the company likely will recover from this execution mistake but it won't be for several quarters as this kind of correction requires upfront investment in order to see results.

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.