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Nutanix: The last chapters of a long running set of transitions
Nutanix (NASDAQ:NASDAQ:NTNX) burst upon the scene as a disruptor in what is known as the hyper-converges infrastructure space about a dozen years ago. Indeed, it might be said that Nutanix was one of first companies to offer HCI technology. The company initially offered both hardware and software but began a transition to an all software model a few years ago. While that transition was still underway, the company further transitioned its business model from one that was based on a term based license model, to that of subscriptions and of SaaS. The net impact of these transitions, as well as other factors, slowed the company’s reported revenue growth dramatically and led, as well, to sales force execution issues, and left the company reporting sizeable losses and a large cash burn.
All the while, the company’s co-founder, and co-CEO, Dheeraj Pandy, persisted in a strategy of introducing more, and more additional pieces of the infrastructure software stack. While these pieces were part of a comprehensive infrastructure solution in their totality, they became quite unwieldy to understand and somewhat difficult to sell. In the wake of continuing losses and cash burn, in the summer of 2020 the company negotiated a transaction with Bain Capital which bought a substantial amount of convertible debt. The capital infusion from Bain Capital was in the form of convertible debt in the amount of $750 million, with a conversion price of $27.75 and a coupon rate of 2.5%, with interest paid through the issuance of additional convertible debt.
Shortly after Bain made the capital commitment, Mr. Pandey decided to step down as the company’s CEO and was replaced by Rajiv Ramaswami. Mr. Ramaswami had been the COO of Products and Cloud Services at VMware (VMW), the principal competitor of Nutanix in the HCI space. Since becoming CEO of Nutanix, Mr. Ramaswami has made a number of strategic pivots that have enabled the company to start to achieve financial results commensurate with the opportunities inherent with its technology and rich product portfolio. And, to an extent, the passage of time, as well as some missteps by its principal competitor, has allowed Nutanix to make up some lost ground.
Along the way, came the pandemic, although it turned out that some of Nutanix’s desktop services could be used to facilitate the work from home paradigm. But regardless, the economic impact of the pandemic eventually led to curtailed revenue growth, which also was hindered by changes in the company’s sales leadership. The road to sustained growth and profitability has been long, torturous and difficult for investors, and that includes this writer. I acknowledge being stubborn in my thesis, simply because the opportunity of being the leader in the hyper-converged space is so substantial and still, I believe, underappreciated.
Nutanix reported its results for the quarter ended 7/31 at the end of August. The results were significantly stronger than expectations or the company’s prior projections, and unlike most other enterprise software companies, the projection for the current fiscal year was also above the forecast of the current consensus. I will review the details of the earnings release and the company’s forecast later in this article. But of significant note, I thought were comments by the CEO regarding demand resiliency and comments by the CFO regarding the record backlog the company has created. Much of the expected growth the company is expecting is a function of a rising volume of renewals; that is probably a much lower risk part of a forecast than trying to close new business logos in these uncertain times.
While the shares responded significantly in the wake of the earnings release, and wound up gaining 20% last week, the valuation of the company is still at exceptionally modest levels. The shares are still down by 29% since the start of the year, and down by 50% since the high they made at the end of August 2021. Needless to say, the combination of progress in terms of operational performance coupled with the share price implosion has brought the valuation to levels not seen heretofore.
I last wrote about Nutanix shares and the company for SA more than 2 years ago. The shares have fallen by a bit more than 1.5% since the time of my last article, while the IGV software ETF is essentially unchanged over the same span, and the WCLD ETF has actually fallen about 18% over that period. If one thing is clear over the last several years of tracking tech stocks, it is that it is very difficult for valuations to escape their environment. It has been almost impossible since the decline in tech shares started last November for any tech shares to substantially outperform the ETFs in the space for any extended period, almost regardless of their operational performance. Investors haven’t been choosing to invest in individual names so much as in groups that they consider more or less risky.
Nutanix is one of the two leading competitors in the hyperconverged infrastructure space-the other being VMWare (VMW). Whether or not Nutanix has a “better” HCI stack compared to VMW is not something I am going to try to answer in this article. Its hypervisor, AHV has long been thought to be the leading competitor in this category but again, I am not about to try to maintain that one particular product is “better” than another.
The company’s founder had a vision of making Nutanix the leading infrastructure software vendor, with offerings far beyond core HCI. While the cadence of additional product announcements and deliveries, and their rather unstructured go-to-market strategy might be reasonably questioned/deprecated, positioning a company as a one stop shop for infrastructure software is a vision that apparently resonates strongly with users.
As a stock, Nutanix has so many false starts and disappointments that it might be said to be star crossed. That said, the opportunities of Nutanix to grow share in a hot space are so considerable that I thought it time to write an article about their positioning and their prospects. I want to make clear, as I have in prior articles, that until the sentiment changes with regards to risk and how IT companies perform during a recession, it would be difficult to postulate that Nutanix shares are going to sustain strong performance in the short term beyond the appreciation they have experienced in the wake of the latest earnings release absent a generalized pivot of investors to a more risk-on investment stance. The call I am making is to buy the shares, carefully, with at least a one year time horizon.
What does Nutanix sell and why is that sustaining strong demand despite cyclical headwinds?
One of the principal reasons to buy Nutanix shares is that it is the leader the HCI space. That is the foundation of its offering, and is likely to remain so for the foreseeable future. A few years ago, the HCI space was considered by investors as one of the hot growth areas. Somehow, for a variety of reasons, that perception has waned and this has been one of the reasons why Nutanix shares have performed so poorly…well outside of the disappointing headline numbers.
These days, Nutanix sells only software; its software runs on a variety of commodity hardware platforms sold by many other vendors including IBM (IBM), HPE (HPE), Lenovo, Dell (DELL) and Fujitsu. Hyperconverged Infrastructure, to give the space its formal name, converges an entire datacenter stack in an appliance that includes compute, storage, networking and virtualization. It is typical for users to build their infrastructure with a cluster of nodes to appropriately size the infrastructure in terms of performance and to provide for resilience.
HCI is steadily replacing converged infrastructure, which had been standard for many years before the emergence of this technology. Overall, HCI is achieving elevated growth because it is significantly cheaper on a total cost of ownership basis that the converged infrastructure it is replacing. When users have a requirement to replace their converged infrastructure for reasons of capacity, performance, security or performance there is a massive propensity to upgrade to HCI. Factors animating this TCO advantage include to reducing the size and the complexity of a data center, as well as providing for the needs for enhanced data protection and disaster recovery. HCI is most often seen by CIOs as a productivity tool reducing the need for multiple data center administrators.
Some commentators see hyperconverged infrastructure as a competitor of the public cloud. Basically, Nutanix and its competition in the HCI space really offer a hybrid cloud infrastructure with a smaller data center footprint, with lower costs, improved performance, and a far more efficient management capability. One of the issues that has probably capped the valuation of Nutanix is the perception that with the use of a public cloud for many workloads, the need for HCI is more limited. At some level, that is likely to be true, on the other hand HCI offers enormous benefits and a very elevated ROI and has a very large TAM. As this linked article suggests, users often work with HCI and hyperscaler cloud vendors such as Amazon (AMZN) in a multi-cloud hybrid environment. The latest market research, linked here, indicates that the TAM of the space will reach nearly $40 billion by 2027, with a CAGR between now and the end point of 27.5%. The TAM suggests that Nutanix has an exceptional opportunity and a very long growth runway.
Unlike most other software segments, the HCI market has only two major competitors, VMware and Nutanix. The pending acquisition of VMW by Broadcom (AVGO) has apparently been a factor in changing the competitive dynamics of the market. According to the CEO of Nutanix, VMW customers are much more open to discussions with Nutanix because of concerns about what might potentially happen when the merger is consummated. I do anticipate that the merger will be consummated on schedule sometime in Broadcom’s FY ’23, and I anticipate that the disruptions and cost remediation necessary to justify the merger will indeed induce some VMW customers to be amenable to working with Nutanix. That, however, is not really quantifiable, and will happen over the course of 12-18 months, with no immediate impact on revenues.
My guess is that the current demand resiliency that Nutanix cited on its most recent conference call is a function of the cost savings elements inherent in HCI investment. While almost all software has some element of cost justification, the justification for HCI is probably more easily quantified. Replacing legacy infrastructure with HCI has positive implications for real estate requirements, and it drives productivity of data center administrators. It comes with some additional benefits such as performance, resiliency and data protection which make it a fairly easy investment to justify.
Nutanix has an extensive solutions portfolio beyond HCI. Over the years, the Nutanix solution portfolio, which was built at break-neck speed had grown unwieldy and has been a factor weighing on sales productivity. A few months ago the company revamped the packaging and bundling of its existing offerings. This has been one of the major factors, I believe, in the company’s over-attainment. It is simpler for customers to understand and for the sales organization to sell. The new offerings, beyond the HCI foundation, include a cloud manager, a unified storage manager, a database service manager and some end-user computing solutions for the desktop.
The company’s hypervisor, AHV, has long been a mainstay of the company’s growth. Without discussing the concept in detail, a hypervisor is the software that is needed to enable server virtualization. It is a software process that creates and runs virtual machines. Basically, physical machines can only run one operating system at a time which leads to wasted resource. A hypervisor enables the optimization of physical resources. Nutanix has been gaining share in the AHV space for years, and this will continue to be a factor in the company’s ability to grow at above market rates. Nutanix has a tool it calls “Move” which is designed to help migrate customers from legacy hypervisors to its technology.
While I won’t try to review each of these offerings in detail I think it is fair to say that all of the additional offerings are designed to reduce operating costs in a data center. I think the vision of being a comprehensive provider of infrastructure software for a hybrid cloud environment is a concept that resonates with many users. And at this point, with the potential turmoil, and different direction being taken by VMW, the opportunities Nutanix enjoys to sell more of a full stack solution have improved.
One of the stronger elements of the quarter that management called out were expansion deals. These deals most often are based on users buying more of the total Nutanix solution to go with the core of HCI. Given the breadth of the offering, there are no TAM statistics that encompass the size of the opportunity Nutanix has beyond the HCI foundation. At the least, it is probably equal in size, and growing faster than the HCI market itself.
The Nutanix business model transition-Is it finished and how will growth relate
Nutanix shares have underperformed for years now, essentially since the company started its multiple transitions. The shares actually reached their high point in the summer of 2018. The transition to a software company is essentially complete and has been complete for a few quarters. The company no longer reports hardware sales, and its product gross margin, i.e. the margin on software sales is now 94%, non-GAAP. The company still has a significant installed base and receives revenue for support and entitlements, and will do so for years, but that percentage is steadily declining. Support revenues were 48% of the total, last quarter, compared to 56% of the total in the year earlier period. As software continues to rise as a percentage of the total, the company’s gross margins will also continue to rise.
At this point, ARR has reached $1.2 billion. That was 37% growth year on year, despite the supply chain headwinds experienced in this latest quarter. Eventually, ARR and reported revenue will converge; when they do, reported revenue growth will accelerate. The company reports metrics for Annual Contract Value of billings. This metric grew by 27% year over year, but only 10% in Q4. This is one metric, that while greater than prior guidance, shows the impact of the supply chain constraints on the business.
The company doesn’t provide ARR guidance, although for a subscription company, the growth in ARR should be the most important metric to review. The company is forecasting that its ACV billings will rise by 19% for the full year, despite some anticipated macro headwinds. It is expecting some, but not total remediation of its supply chain constraints later in the fiscal year. That kind of billings growth should bring ARR growth to around 25%. With churn at 2% or less, most of the ACV growth becomes ARR. The company’s revenue growth forecast for FY 2023, at 12% is constrained because of the supply chain issues that will prevent the company from delivering ordered software.
Nutanix does not have pricing based on consumption. While over time, I think consumption based pricing models will prove to be more profitable for vendors, infrastructure software does not lend itself well to that kind of pricing model, although the company does have very nascent relationships with managed service providers. Over the next 12 months, I expect that the last impacts of the company’s migration to a subscription based model will dissolve, and the correlation between growth in bookings and revenue will tighten substantially.
Nutanix Competitors
I have mentioned that VMware has long been regarded as the principle rival to Nutanix in the HCI space. Because of the way statistics are compiled, it is difficult to determine who really has the largest market shares; the IDC statistics, which are based simply on reported revenues show VMW with a share of 43% while Nutanix has a share of 27%. But that data is not an apples to apples comparison, as VMW reported HCI sales include hardware and Nutanix does not. There are a variety of other competitors, of different sizes and different capabilities. A few years ago HPE bought a struggling HCI vendor called Simplivity; Simplivity seems to be an also-ran in the space without any signs of growth acceleration. Cisco also entered the space through acquisitions of both Springpath and Skyport. That said, Cisco is one of the hardware vendors on which Nutanix software runs-and most of the Cisco hyperconverged installations consist of that company’s UCS product and Nutanix software. Many systems integrators recommend this deployment as a preferred solution to their clients. Huawei is listed by IDC as a competitor in the space. The reality is that Huawei is one of the many hardware platforms that supports Nutanix. The IBM hyperconverged offering is actually a preconfigured offering that includes IBM hardware and Nutanix software. Lenovo is probably the largest hardware partner of Nutanix at this time.
Overall, on an apples to apples basis, I believe that Nutanix is most likely to be the current market leader, and it is almost certainly gaining market share, probably at an accelerated cadence. I have linked here to an analysis from a publication called CRN, that basically has taken data from integration partners, such as CDI in evaluating the two offerings.
Not terribly surprisingly, according to the integrator, the major issue is one of flexibility coupled with ease of implementation. For anyone doing due diligence in terms of evaluating the business opportunity for Nutanix, the article should be quite enlightening.
As mentioned, the pending acquisition of VMW by Broadcom is almost certainly an additional factor that will enable Nutanix to continue its share gains. Thus far, apparently, Broadcom’s efforts to build a stable of software companies, while of indeterminate value financially, have been received less than enthusiastically by some users. In order to justify the price being paid for the VMW acquisition, some steep cuts in expenses are almost inevitable which will wind up creating issues with some customers.
Nutanix has built its business on rapid innovation and user satisfaction. It would be quite difficult for any prospective entrant in this space to be able to replicate the capabilities and the level of user satisfaction that Nutanix has been able to achieve. The company now has to be able to convert its market share position, and its very large base of users into a model that is consistently profitable and generates free cash flow.
The road to consistent profitability and free cashflow generation
A few years ago, Nutanix, at a now notorious analyst day, set some ambitious financial goals for its fiscal 2023. Needless to say it is not going to come close to achieving the kind of performance that was forecast. It has recently set some expectations for FY’25 that are still somewhat ambitious but which I think are reasonable. Specifically, the company is forecasting that its free cashflow margin for that year would be at least $300 million, which would be 10%-15% of revenues. In making estimates to calculate DPV, I have used a 3 year revenue CAGR of 23% which would take revenues to $2.75 billion at that time, with an implied free cash flow margin of at least 11%.
In August, the company announced a modest layoff, expected to bring annualized opex cost savings of about $55-$60 million, or about 4% of current expense run rate. The company’s projection for non-GAAP expenses calls for flat op-ex spending at current levels for the balance of the year. It has been typical for the company to manage opex somewhat better than it has projected and I think the current opex projection is more of a ceiling forecast.
While there is some significant lifting involved in achieving the results Nutanix forecast at the analyst day, it seems reasonable based on the company’s current priorities and the cadence of sequential cost trends. In the latest reported quarter, non-GAAP sales and marketing expenses were 59% of reported revenue compared to 62% in the prior year. Obviously for the company to reach sustainable profitability that ratio has to be a significant area of focus. Year on year, non-GAAP sales and marketing expense fell by 2%, and they were up by 9% sequentially, which was a fiscal Q4 and thus a quarter in which commission accelerators factor into sales and marketing expense.
Non-GAAP Research and Development expenses, which were 28% of revenues, were up 6% year on year, and were up 3% sequentially. General and administrative expense was 9.5% of revenue and was up 7% year on year, and 7% sequentially. Overall, operating expense was 93% of revenue compared to 93% of revenue the prior year. Sequential opex was up 8%.
The company generated a free cash flow margin last year of 4% compared to a cash burn in the prior fiscal year. Free cash flow for the quarter was $23 million; the company had projected a significant cash burn. Stock based comp. fell to 22% of revenue compared to 26% of revenue in the prior year. Overall, the free cash flow generated in the quarter was a function both of a reduced level of non-GAAP losses compared to projections and a much smaller growth in receivables than the company had previously projected. While there were supply chain headwinds last quarter, they were less than the company had expected and so a higher proportion of orders could actually be delivered to a hardware platform and thus generate revenue. The company is expecting to deliver a free cash flow margin of about 5.5% this year driven by a combination of restraining cost growth near the flat line, while growing reported revenues by about 12%.
Because of the rapid growth in projected free cash flow margins, and decent revenue growth as well, even using a 12% weighted average cost of capital which is the mid-point of the Finbox calculation yields a share value almost 2X the current price quote.
Wrapping Up-The recommendation to buy the shares
I can’t say I have been much of a prophet with regards to Nutanix shares. The shares are down by a couple of percent since I last published an article on SA after some years of volatility. I have been a shareholder all that time-not the most pleasant of experiences. My thesis has been that Nutanix is a leader in a hot space, and its competitive position was continuing to improve. I thought so back in 2020, and that still appears to be the case.
There were several elements that probably have constrained the performance of the shares and the company. Obviously, while the transition to a SaaS model was underway in 2020, the evaluation of that transition by investors was more negative has lasted longer than I had hoped. In addition, Nutanix is not what is considered a cloud company and this has been a very significant factor in the evaluation of the shares. The vision of the company’s founder, while a valid strategy, was executed in a fashion that lead to sales force execution issues, turnover, and an inability to create a company with consistent profitability and free cash flow.
The founder has been gone almost 2 years now, and the new CEO, Rajiv Ramaswami, and a new CFO Rukmini Sivaraman have tweaked priorities with an increased focus on profitability and free cash flow generation. There is not much that the company can do with regards to the fact that its solutions are built for the hybrid cloud. It is one factor in constraining the growth rate of the company to the mid-20% range and not something significantly greater. That said, the hyper-converged space has enjoyed rapid growth, and is still projected to achieve a 27% CAGR for several years to come. And Nutanix is still gaining share and Broadcom’s pending acquisition of VMWare is likely to present even more share gain opportunities.
These days, Nutanix has a much more comprehensible set of offerings that are easier for users and its own salesforce to understand and to buy. And the ROI of replacing prior generations of datacenter architecture with HCI is stunning, and perhaps more so now given the improvements that are possible in terms of form factor, power consumption, redundancy and raw performance. It is probably the very discrete savings that are available to users from deploying Nutanix that has sustained its demand despite macro headwinds and this should be the case in spite of continued turbulence in the economic outlook.
The company’s multiple transitions are in their last innings and this is starting to show in reported financials. The company is still projecting constrained growth this year because of supply chain issues, particularly in the first half of the period. But demand for the software that Nutanix sells continues unabated, and as supply chain constraints diminish, revenue growth is most likely to readily surpass 20% again, and could possibly ascend further than that. The company is no longer burning cash, although it has a long way to go before it achieves respectable free cash flow margins. It will need to constrain opex growth for several years, and that will, in turn require significant improvements in salesforce productivity.
Nutanix shares, despite their recent upside, are still painfully cheap. Analyst opinion is still relatively mixed with one sell and 4 hold recommendations out of the 19 analysts reporting their data to 1st call. The EV/S ratio is still just around 3X, and my DPV shows a valuation almost 2X the current share price. About the only metric that I don’t like is the minimal short interest which was just greater than 3% as of the mid-August reporting date.
The company’s guidance implies a significant ramp in terms of sales growth, starting at just 8% in Q1 and Q2, before rising to over 20% by the end of the year. The potential for either increased investment by activist investors or an outright sale of the company to a strategic partner can’t be disregarded. There have been recent rumors of activist interest in the shares, and of course Bain remains a significant stakeholder. I think Nutanix shares have the potential for significant positive alpha over the coming year.
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