NTNX: The lead gen snafu

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Snafu:

noun

  1. a confused or chaotic state; a mess.
    adjective
  2. in utter confusion or chaos.
    verb
  3. throw (a situation) into chaos.

“Lead generation issues” really means “We can’t find new large customers!”

For several quarters, Nutanix has been adding almost 1,000 “customers” each quarter. In the last 2 years, customer count has gone from 5,380 to 8,870 to 12,410. That sounds great, right?!?

But what Nutanix is saying now is that their impressive rate of growth in revenues and billings has come not from the new customers, but from upselling their current customers:

From the CFO: Now, looking back at it, we probably over rotated a bit to the existing customer base and large customers there, where those efficiency dollars are easier to get and probably underspent a little bit on new customers, which those efficiencies are little tougher to get on new customers.

Yes, it’s easier to sell to current customers than to find significant new customers. If you didn’t see that you need both, you’re not fit to manage a company. Apparently the only individual within Nutanix that understood this was Chris Kaddaras, who they are now promoting from head of EMEA to head of Americas and EMEA (nearly everything). Unfortunately, it’s easier to grow something off a small base than to work the same magic on a whole $1b+ revenue company. Good luck, Chris.

The opposite of a flywheel

This is almost exactly what happened with Pivotal. Lots of large, fanboy customers. They drink the Kool-aid and spend more and more like crazy until the company (NTNX or PVTL) has a fairly large base of revenue. Then, the company has trouble both:

  1. continuing to upsell to these customers (they can only spend so much!)
  2. finding new customers of the same magnitude

Even as NTNX has gone from 541 $1m+ customers in the Jan 2018 quarter to 779 such customers in the Jan 2019 quarter, the $1m+ deals they closed during each respective quarter have only gone from 57 to 63. In other words, even though they have about 40% more customers, they could only manage about 10% more large deals. Customer spending growth is drying up.

This problem cannot be overstated. Each quarter they spend more and more on sales and marketing, but the incremental growth in billings slows. They were killing it at 60%+ just TWO QUARTERS AGO! Then last quarter software billings grew just 50%. This quarter it grew less than 40%, and next quarter it looks like they’re guiding for less than 20%! That’s a phenomenally rapid slow down, not a little sales strategy oopsie.

It gets worse?

For the last several quarters, I’ve been nervous about the lack of information they were giving on the mix of subscription and non-subscription revenue. Last quarter the subscription revenue grew over 100%, but I sold NTNX because I thought they were just sacrificing non-subscription software sales (robbing their left hand to pay their right hand). Turns out I was at least somewhat right, as this quarter non-sub software revenue decreased QoQ from 147m to 132m. But subscription grew over 100% again, so software revenue ticked up. Here’s the last few quarters:

Apr 18: 227m
Jul 18: 268m
Oct 18: 281m
Jan 19: 297m

(slide 14: https://s21.q4cdn.com/380967694/files/doc_financials/2019/Q1…)

Problem is, they’re guiding for 300m TOTAL revenue next quarter (including probably 40m+ of hardware and prof serv), so the next number in the above series will be something like 260m? Ouch. That means while software and support will probably be up 100%+ again to say, 170m or 180m or 190m, non-sub software’s trend will look like this:

Apr 18: 141m
Jul 18: 147m
Oct 18: 147m
Jan 19: 132m
Apr 19:  90m?   80m?   70m?

I don’t know how they can any more clearly demonstrate that they’re robbing from one hand to pay another.

The glimmer of hope

If there is one thing that could be made more clear, it’s where subscription revenue levels off in a few quarters. Does it stop growing almost altogether when they have no non-sub revenue left to rob? Or do they keep growing it at even 30% for years to come? While 30% might not seem fantastic, Nutanix is currently being priced for almost no growth at all. Honestly, 30% might not happen. I think these things (in this case, HCI demand) grow in fits and starts. Maybe a lot of Global 2000 companies (which account for most of Nutanix’s revenue) are already topping out on the spend they want to devote to HCI. Maybe not…but I don’t think there’s reason to believe it grows in the future like it has thus far. So while there’s a glimmer of hope for Nutanix, it seems to be a long shot.

Note that there are a lot of “ifs” and “coulds” in the hope section. Perhaps Nutanix gets to growing semi-rapidly again, but it’s no certainty, and even if it does, how long does it take?

Margin concerns

Even if sales can somehow, at some point, get back on track, there’s another concern: profitability. The CFO says that they will probably not only miss their revenue goal, but they’re also going to miss on the rule of 40 (profit/growth mix):

We have further analysis to perform. However, based on the plan to increase in lead generation spending, combined with the incremental growth that we expect from license refreshes and new essentials and enterprise products, we remain encouraged by our growth potential into FY 2020 and 2021. And we’ll provide additional detail and thoughts around our $3 billion billings target at our upcoming Investor Day on March 20. And regarding the Rule of 40, we will dip below our target score of 40 over the next couple of quarters with the objective to return to 40, as soon as practical.

Makes sense, because they already said that the reason sales are suffering is because they didn’t spend enough. That’s the opposite of economies of scale. Yikes.

The only logical case for holding

To hold Nutanix you need to believe a lot of things:

  1. They will be able to find new customers that spend as much as current customers
  2. Subscription growth will continue (once all the non-sub revenue is robbed) for years at 30%+
  3. They won’t have to spend so much more on sales and expenses that they fail to profit
  4. HCI won’t be displaced by another technology for years
  5. The market will at some point also believe all this and value Nutanix more highly
    6) There’s a greater likelihood that all this is true than that your money would do better elsewhere

Conclusion

To me, even with today’s discounted price, it’s too murky. Even if you believe 1 through 5 above (obviously I’m skeptical but I respect your decision), please consider #6. I just think other companies have a better chance of growing my money. That’s the bottom line for me.

Bear

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In the meantime as NTNX is down this morning about 2%, all the better places to put your money names are getting absolutely crushed on nothing more then valuation concerns.

One morning does not make a trend, but in a sell off I think that It’s no surprise that many of these names can drop suddenly 10% or more in a flash.

A couple of days of this and you may have a much better opportunity to move out of NTNX and into a TWLO, or an AYX or a ZS.

Chris

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Fantastic write up Bear

The one thought I have that might add to the glimmer of hope, is whether the small new customers are really small customers, or could many of them be large customers taking smaller trial purchases of new products with the potential to increase their spend significantly if they like the initial trial

Two things make me think that might be possible

  1. they are already demonstrating the ability Howell current customers rapidly so maybe the goal of getting a small in with a large company is almost as valuable as getting a large company to make a big commitment up front and

  2. they have spread into so many new products that maybe they almost have to start small in many cases. Maybe they were overly optimistic (definitely) that they could get big commitments up front but maybe this is the way it more realistically should go?

Time will tell

-mekong

Who isn’t thinking to add more NTNX yet but hasn’t sold any yet either tho is tempted to shift a bit more into AYX with today’s drop there

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Snafu

Situation Normal, All F…U.

The Captain

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Great write up, bear!

If I remember correctly they were supposed to turn the corner last summer. There were hints of it, but nothing definitive. Then they were supposed to do that in the next quarter and the next one and the current one.

I’m beginning to think that they did in fact turn the corner in each and every quarter and are running in circles.

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Hey Paul - thanks for looking into this.

Sorry to turn up late to this party, been traveling for work in JP.

If you don’t mind - a question or two about your numbers and in I ask this with the greatest respect for the value you bring to this board…

Even as NTNX has gone from 541 $1m+ customers in the Jan 2018 quarter to 779 such customers in the Jan 2019 quarter, the $1m+ deals they closed during each respective quarter have only gone from 57 to 63. In other words, even though they have about 40% more customers, they could only manage about 10% more large deals. Customer spending growth is drying up.

Q1) Are these like for like $ numbers or are you calculating HW as well as SW/Subs into these numbers?
If you are including HW then the progression is not like for like. A year ago they were including HW/SW into $m deals and $m clients. Now they all but phased out the HW recognition so the number of SW only $1m clients and deals especially will not be a LFL comparison with the $1m clients and deals (especially).

Also as they release add-on solution sets and incentivise the SF to secure early wins on these they are likely to be “expand” not “land” type deals and less likely to be $ deals in nature even if they take clients past the $1m mark as an account overall.

I don’t know how they can any more clearly demonstrate that they’re robbing from one hand to pay another.

Q2) Have you observed or studied numbers for other companies going through this business model transition?

This is the very nature of this transition as far as I am concerned and a natural consequence. You string out revenue recognition from 1 period to a far longer period. Analysts hate it, shareholders hate it, the numbers look awful during the transition. That’s the way it is. Now I would be more worried if the future subscriptions were stealing from in period subscriptions but switching from software to subscriptions is simply the transition that is involved. I’d also be intrigued to know whether there is any seasonality at play in this. I’ve seen other companies in this transition looking at their worst around the Q2 stage.

I haven’t compiled a substantial statistically valid base data set but I looked back at Palo Alto as an example when it was going through it’s transition. There were points in its business model transition where its top line growth rate fell from 40%/50% to 24% at the base of the trough. At that point the product sales went flat and negative at one point (YoY) whilst the recognised subscription revenue growth continued at 100%. At that time billings growth was 12% and deferred revenues growth was down to 50% (from 60% and 70% in the preceding 2 quarters). At that point they missed some numbers and it wasn’t pretty. Within a couple of quarters growth had bounced and were re-accelerating to 27% however interestingly, billings growth stayed in the dumps at 15% and the deferred revenue growth continued to decline to 37% growth and 33% the quarter after that.

How did the story finish? PANW is back to beat and beats, has reached a $2.5bn run rate and sits at an all time high and today top line growth is in the 30%s and deferred revenue growth stabilised in the 30%s with billings growth re-accelerating to 27%. Oh for anyone who likes deferred numbers - Palo Alto sits on $2.5bn of deferred revenues that it is growing at 33% YoY. The ratio of product sales vs subscription sales stabilised 38:62.

My 2 concerns to watch out for are 1) What happens with deferred revs growth in the next few Qs and 2) What happens with margin from here.

As another comment, I find it interesting that for Nutanix we are prepared to throw the book at it based on next quarter’s guidance but for every other company issuing guidance the board has taken the position of ignoring or poo-pooing the very practice of paying attention to it. Just sayin.

Ant

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This is the very nature of this transition as far as I am concerned and a natural consequence. You string out revenue recognition from 1 period to a far longer period. Analysts hate it, shareholders hate it, the numbers look awful during the transition. That’s the way it is. Now I would be more worried if the future subscriptions were stealing from in period subscriptions but switching from software to subscriptions is simply the transition that is involved. I’d also be intrigued to know whether there is any seasonality at play in this. I’ve seen other companies in this transition looking at their worst around the Q2 stage.

I haven’t compiled a substantial statistically valid base data set but I looked back at Palo Alto as an example when it was going through it’s transition. There were points in its business model transition where its top line growth rate fell from 40%/50% to 24% at the base of the trough. At that point the product sales went flat and negative at one point (YoY) whilst the recognised subscription revenue growth continued at 100%. At that time billings growth was 12% and deferred revenues growth was down to 50% (from 60% and 70% in the preceding 2 quarters). At that point they missed some numbers and it wasn’t pretty. Within a couple of quarters growth had bounced and were re-accelerating to 27% however interestingly, billings growth stayed in the dumps at 15% and the deferred revenue growth continued to decline to 37% growth and 33% the quarter after that.

How did the story finish? PANW is back to beat and beats, has reached a $2.5bn run rate and sits at an all time high and today top line growth is in the 30%s and deferred revenue growth stabilised in the 30%s with billings growth re-accelerating to 27%. Oh for anyone who likes deferred numbers - Palo Alto sits on $2.5bn of deferred revenues that it is growing at 33% YoY. The ratio of product sales vs subscription sales stabilised 38:62.

My 2 concerns to watch out for are 1) What happens with deferred revs growth in the next few Qs and 2) What happens with margin from here.

As another comment, I find it interesting that for Nutanix we are prepared to throw the book at it based on next quarter’s guidance but for every other company issuing guidance the board has taken the position of ignoring or poo-pooing the very practice of paying attention to it. Just sayin.

Interesting comparison. It is possible it may come true for Nutanix as well.

However, throwing the book at Nutanix is justified. The other companies are reporting hyper-growth in their guidance, just lower than most believe they will achieve (from experience).

Nutanix is dramatically decreasing their forward guidance in a catastrophic manner. Not as bad as Nvidia mind you, but still enough to cut 30% in one day off its market cap. There is a real and material difference there.

I did sell out Nutanix, but still don’t feel like I had to. I just decided to stick with my rules, rules that have been tremendously successful. And yeah it has paid off. The two rules I broke in the last year were with Nvidia (after I had sold it off months earlier because it was time) and Nutanix (because I thought the market just threw it out because of the business transition). Bam, the only two catastrophes of the past year.

So I would not call it equivalent to the optimism otherwise expressed in some other holdings. But no, I don’t think Nutanix is finished at all. But in that same basis of thought, neither is Pure, but Pure does not meet my rules either. Just like I tell my clients that they can “leave some things unsaid,” when in court, you can leave some investments uninvested.

In the end it is all about risk/reward. You don’t have to hold every successful stock to make great returns, just enough of them. You maximize that ratio by sticking with the rules that appear to have near 100% correlation to success (amazing, yes, anecdotal, yes, but a large set of anecdotal data - I know you’ve seen our discussions on this on New Paradigm).

No, I still have a good feel with Nutanix (unlike Nvidia). I am just forcing myself to follow the rules from here on in and stop adventuring around. They are very similar to what Saul does (at least we almost always seem to reach the same conclusions, but coming from a different perspective) and Nutanix should not have been in my holdings to being with other than a swing trade. I had a nice 50% profit on it…if I had stuck to my rules I would have taken that profit because it could not be a long-term hold within my rules.

Each to their own, but that is my feelings on Nutanix. Yeah, I think it has a good chance of being an excellent return from here, but it is also not an investment I need to make.

Tinker

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As another comment, I find it interesting that for Nutanix we are prepared to throw the book at it based on next quarter’s guidance but for every other company issuing guidance the board has taken the position of ignoring or poo-pooing the very practice of paying attention to it. Just sayin.

In general I agree with the idea that everyone’s playing the beat-and-raise guidance game. The difference for me has become the conference call. Those companies doing this correctly seem to emphasize business as usual on their call while extolling future prospects. When asked about low guidance they all answer with some short and sweet version of “we haven’t changed our guidance methods” which I’ve been translating as wink, wink “don’t worry, we’ll beat again as usual”.

In the case of NTNX and VCEL (which I also owned), their answers to low guidance questions were either verbal gymnastics or identifying legitimate areas where operational improvements were needed. As we’ve passed through this last earnings cycle I’ve personally found myself discounting guidance numbers but paying much closer attention to the guidance words.

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Fair and perceptive points Stock Novice - although the Nutanix CEO has always been humble, self-critical and told it worts and all. I think he has actually been very specific about the operational issue - sales force and sales force leadership with the turnover in their key staff and their challenging incentive mix.

A

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Q1) Are these like for like $ numbers or are you calculating HW as well as SW/Subs into these numbers?
If you are including HW then the progression is not like for like. A year ago they were including HW/SW into $m deals and $m clients. Now they all but phased out the HW recognition so the number of SW only $1m clients and deals especially will not be a LFL comparison with the $1m clients and deals (especially).

These aren’t quarterly spend numbers – these are deals for a lifetime total of $1m or more that were made in the quarter. I’m not calculating; Nutanix gave the numbers.

Q2) Have you observed or studied numbers for other companies going through this business model transition?
I haven’t compiled a substantial statistically valid base data set but I looked back at Palo Alto as an example…

They’re not saying, “we’re going to grow at a slower pace because we’re selling subscriptions instead of licenses.” They’re saying, “We’re selling less because we didn’t staff the sales team properly, and this will carry forward for a few quarters.” Translation: Not even Nutanix is blaming this on the hardware or subscription transitions. They’ve found a new scapegoat: sales lead generation.

Also, not for nothing, but if you bought Palo Alto in 2015 and held til 2017 you were still down.

My 2 concerns to watch out for are 1) What happens with deferred revs growth in the next few Qs and 2) What happens with margin from here.

My biggest concern is that I don’t trust Nutanix. First it was the hardware transition. Then it was the subscription transition. Now it’s lead generation. Maybe the problem is just that growth is slowing and they don’t want to admit it! Or possibly worse, that competition is beating them. Either way, you can’t just keep giving them a pass every time they come up with a new excuse.

the Nutanix CEO has always been humble, self-critical and told it worts and all.

Maybe he’s being transparent, but it’s a little hard to parse what he is actually saying most of the time, because Pandey speaks so often in buzzwords. Here are some hackneyed phrases he used on the CC:

building this business is like building a software
obviously there are things we don’t know that we don’t know
productivity is still a derived variable
Let Chaos Reign and then Rein in the Chaos
Right now, we’re doing first principle thinking, which is input-output
how do we go create new earth is a hard problem

Even if he’s not being intentionally misleading, it’s still true that just because he says something and it sounds good doesn’t mean it is good for the company. I think the numbers tell a scary story, and nothing Pandey can say about reining in the chaos can make the sales tick up or the losses tick down.

Bear

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building this business is like building a software

Building a business is NOT like building a software. And I think this is exactly where we have an issue here - this company is run by a gearhead who sees everything as an engineering problem. For Nutanix to truly turn around, Pandey needs to step aside and become a CTO, CPO or whatever, a technical visionary, and they need to bring in a true business-minded CEO to run the company.

Alex

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Also, not for nothing, but if you bought Palo Alto in 2015 and held til 2017 you were still down.

Actually I’m up exactly 261% in Palo Alto, (but I take your point - there was a period of time when you were below breakeven - or another way to look at it, it is up over 100% since its business model transition/sales force snafu drop happened).

If this board wasn’t completely focused around applying the Saul investing principles to individual stock selection, I would say there has been a strategic error in the complete absence of cyber security from the investments discussed and selected here; other multi baggers I’ve had in the space have been: Checkpoint, CyberArk, Qualys and Fortinet. The sector has produced as high a proportion of multi baggers as any sector I have ever come across and FireEye is the only one I can think of that hasn’t. Others that have also multi-bagged include ProofPoint, Rapid7, Gigamon and a bunch of companies with some getting acquired along the way. This was a star sector hiding in plain site.

Nothing growing 75% top line but with secular tail winds of a 20% growth rate (much like eCommerce) it was very hard to go wrong.

It makes me feel that we should consider the secular growth rates in our selections as they provide a much higher likelihood of strong double digit terminal growth rates as well as strong operating leverage on the profitability front - but that’s another conversation.

A

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I would say there has been a strategic error in the complete absence of cyber security from the investments discussed and selected here;

Ant,

You forget about Zs and Okta. Disruptive cybersecurity companies. Do these not qualify? They are part of Saul’s port.

Tinker

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ZS is part of the cyber security arena yes although one aspect of it, I classify OKTA & SAIL as sign on access and identity management not cyber security.
Ant

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It makes me feel that we should consider the secular growth rates in our selections…

What do you mean by “secular growth rates?” Stock price appreciation? If so, I agree and have been doing it.

Denny Schlesinger

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I was checking the price performance of the cyber security stocks you mentioned. Are you referring to CKPT which is Checkpoint Therapeutics, Inc. ? It is down by 40% in 6 months, 43% in one year and 66% in 3 years. If not, then what is the symbol for this stock?

The other three (CYBR, QLYS and FTNT) have indeed done quite well as you mention, particularly CYBR and over 2 or 3 yr periods, although QLYS has been almost flat during the last 12 months.

alpha

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Are you referring to CKPT which is Checkpoint Therapeutics, Inc. ?

Check Point Software Technologies Ltd. [CHKP]

https://www.checkpoint.com/
https://finance.yahoo.com/quote/CHKP/

I invested in them a long time ago but did not do well, appliances were just not making it.

Denny Schlesinger

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Thanks.
CHKP is not much better - nearly flat over 6 months, 1 and 2 yrs and +43% over 3 yrs.

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