Nutanix: Subscription Revenue Indicates More Growth To Come

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About: Nutanix, Inc. (NTNX)
by: Individual Investing Ideas
Summary

Nutanix reported a solid Q4 earnings with revenue coming in over 2% ahead of consensus expectations.

While management’s Q1 guidance still shows revenue declining, subscription billings remains well above expected subscription revenue.

When only looking at subscription revenue, the stock trades at under 3x FY21 subscription revenue, well below comparable SaaS peers.

Since reporting disappointing Q3 earnings in late May, Nutanix (NTNX) saw their shares decline by over 40%. However, Q4 results were a positive surprise and management provided a solid guidance for FY20, giving investors hope the stock can reach their previous 2018 high of over $60 a share.

Since reporting Q4 earnings and providing FY20 guidance, the stock is up just under 20% and I believe there is a lot of upside remaining left in this name. While overall revenue did decline 1% to just under $300 million, this was above consensus expectations for revenue decline of 3% to just over $293 million. What remains an important element for this company is their subscription revenue, which grew nearly 72% to $196 million, representing over 65% of total revenue. While this does just depict the positive aspect of the company’s revenue growth, investors should place a higher emphasis on this figure as this is the direction management is heading towards.

Chart Data by YCharts

NTNX has struggled over the past year for two main reasons. First, management noted they are shifting away from hardware sales and instead will eliminate pass-through hardware revenue. Second, NTNX has pushed customers to purchase subscriptions rather than upfront licenses. Subscription revenue is spread out over a longer period of time compared to the large upfront revenue seen with licenses.

Investors have punished NTNX for seeing their overall revenue growth decelerate quite significantly, though we should start to look at what revenue growth may look like in the next few quarters and years once these revenue headwinds begin to lap.

While there is still a lot of concern over revenue growth and what the appropriate revenue multiple should be for valuation, I believe investors should continue to focus on two things, the company’s rather impressive transition to a software subscription model and the magnitude of billings growth. NTNX remains one of the top competitors, if not the leader, in a competitive hyperconverged infrastructure market. Even after the recent post-earnings pop, I believe NTNX remains a buy at these levels as we could either see the revenue multiple start to expand or the company become a takeout target.

Q4 Earnings And Guidance

During Q4, NTNX saw their software and support revenue grow by 7% to $286.9 million and total revenue decline by 1% to 299.9 million. Hardware revenue continues to be a drag on the company’s revenue growth but now represents less than 5% of total revenue. The other main drag to revenue growth is the company’s transition to a subscription-based model instead of selling licenses. With subscription revenue, the revenue stream is typically highly recurring and visible as the revenue stream is spread out over the contract life. This compares with license revenue which is lumpier as the total contract is typically recorded in a single quarter. As the company moves away from licenses, they have seen revenue growth slowdown, as there is less upfront revenue recognized.

Source: Company Presentation

During the quarter, subscription revenue grew nearly 72% to $195.6 million and represented over 65% of total revenue. This means the remaining revenue groups declined quite significantly. Non-portable software (license) declined by nearly 45% to $82.2 million and now represents only 27% of revenue. Hardware revenue also declined to only $13.0 million for the quarter and represented under 5% of total revenue.

As NTNX continues on their journey of getting rid of hardware revenue, which they are a few quarters away from doing, and eventually lap some of the large license revenue declines, we could start to see revenue growth return to double digit growth.

Billings for the quarter declined 6% to $371.7 million, though subscription based billings actually increased 30% to $263.3 million and represented over 70% of total billings. While the total dollar value of billings continues to decline, this is heavily impacted by both license and hardware billings. License billings declined nearly $68 million and hardware billings another $23 million. While this is definitely not a clear comparison, if we were to eliminate half of the license billings decline and the full hardware billings decline, we could have seen a $57 million benefit to billings, brining overall growth to just under 10%.

Source: Company Presentation

As expected, gross margins continue to improve and reached 80% during Q4. This is very impressive and among the highest gross margins of software companies. While revenue growth remains under pressure, the transition away from hardware revenue has a positive impact to margins.

Source: Company Presentation

NTNX’s customer cohort is also a big driver of their future growth. Traditionally, they have focused on the enterprise market, leaving the middle market companies largely untouched. However, NTNX has placed a lot more emphasis on the middle market and has initiated several internal sales programs over the past few quarters to place more emphasis on this large market opportunity.

At the end of Q4, NTNX had over 14k customers with 810 from the Global 2,000 client list. Their net expansion rate remains very impressive at 137%, meaning customers increase their purchases by 37% the next year after initial purchase. This goes hand in hand with their average lifetime purchase multiple of 11.7x, meaning after a customer’s initial purchase, they go on to spend 11.7x that amount over their lifetime with NTNX. This multiple continues to rise over time as customers continue to go back to NTNX and increase their spend.

Source: Company Presentation

Management provided guidance for Q1 which includes software and support revenue of $290-300 million, implying another quarter of revenue decline (revenue in the year ago period was $313 million). It should be noted that while this revenue does not include hardware revenue, it includes license revenue which continues to decline rapidly.

Software and support billings are expected to remain well above revenue at $360-370 million and are a good indication of future revenue growth. Management also noted hardware should be 3% or less of total billings, which will help gross margins reach ~80%.

Another area of potential growth could come from NTNX’s recent FedRAMP certification update, which could enable to company to receive contracts from the federal government. While this could be a revenue stream more suited for the following year, earning the FedRAMP certification could open the doors to longer-term contracts.

I believe there is a little conservatism baked into management’s Q1 guidance as they do not want to disappoint investors with their lackluster revenue growth. Subscription revenue growth continues to remain healthy and has increased as a percentage of total revenue. This trend will continue for the next several quarters and we could see some upside to guidance.

Valuation

Valuation remains very challenging for this name as some investors see declining revenue growth and question why this name deserves to trade at a revenue multiple above 2x. However, when just looking at the company’s subscription revenue (the recurring, highly visible revenue stream), we can see how undervalued NTNX remains. Over time with the larger subscription revenue base, investors will be able to better assess recurring revenue and visibility, leading to a higher valuation.

While total revenue for FY19 was $1.2 billion, subscription revenue was just under $650 million, representing ~52% of total revenue and grew 96% during the year. While this growth rate is inflated because management is pushing more contracts to be subscription rather than license, it paints a picture of more recurring, faster growth, highly predictable revenue stream. In Q4, subscription revenue grew nearly 72% and represented over 65% of total revenue.

Chart Data by YCharts

Even as the transition to subscription revenue ultimately means overall revenue declining for another quarter or two, we could see meaningful acceleration in revenue growth for the out year. Using the $650 million in subscription revenue for FY19 and assuming a 60% growth for FY20 (remember, Q4 just grew 72%), we could see FY20 subscription revenue of $1.04 billion. Although there will be other forms of revenue (some hardware and license as well as professional services), I will only be focusing on the subscription revenue.

NTNX has a current market cap of $4.3 billion and with ~$935 million of cash/investment and $430 million of debt, the company has a current enterprise value of ~$3.8 billion. Using by FY20 subscription revenue of $1.04 billion, this represents a multiple of ~3.6x. Compared to the above group of leading SaaS players, a multiple under 4x is relatively cheap.

Using my FY20 subscription revenue base of $1.04 billion and growing this a modest 25% in FY21, at which that point subscription revenue would likely represents a vast majority of overall revenue, we could see subscription revenue of $1.3 billion, representing a multiple of just 2.9x.

Though this valuation metric is a bit unique, it only gives credit to the subscription revenue base and not the entire revenue stream. By just valuing the highly recurring and visible revenue stream, the company remains undervalued and underappreciated. At under 3x FY21 subscription revenue, NTNX should be on everybody’s radar as a buying opportunity despite the recent pop in the stock price. Optimistically speaking, we could eventually see the company trade at an overall revenue multiple closer to 4x, which would imply a subscription-only revenue multiple above 5x, closer to some of the other leading SaaS-based companies.

Risks to NTNX include a slower-than-expected transition to software-only sales, though it would have a slight benefit to revenue growth and would negatively impact gross margins. The emergence of more competitors would also impact NTNX’s growth.

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.