There has been a lot of good discussion on PVTL. Overall the reaction has been mostly negative with some positive perspective thrown in. I tend to agree that the earnings release was more negative than expected and certainly worse in comparison with Q1 earnings. In this post, I’ll take a deeper dive. First let’s focus on the most important aspect, which is revenue and revenue growth. This will be a longer section, as we will dive into the wonderful world of deferred revenue and RPO. I’m posting the updated table again that I borrowed from Saul and updated for Q2:
Total Revenue (in millions of dollars) Apr Jul Oct Jan Total 2017: 88 105 110 113 416 2018: 121 126 129 133 509 2019: 156 164 650 guidance Subscription Revenue (in millions of dollars) Apr Jul Oct Jan Total 2017: 29 36 38 47 150 2018: 53 65 66 75 259 2019: 90 98 388 guidance Service Revenue (in millions of dollars) Apr Jul Oct Jan Total 2017: 59 70 72 65 266 2018: 68 61 63 58 250 2019: 66 67 262 guidance Percent Increase in Subscription Revenue Apr Jul Oct Jan Total 2018: 83 82 74 58 73% 2019: 69 51
Total revenue came in at $164.4 million, up 30% yoy. This compares to their guidance of $157 to $159 million and the analyst estimate of $158.2 million. Subscription revenue was $97.5 million, an increase of 51% yoy. This compares to guidance of $92 to $93 million. Great to see them beat revenue guidance, but for me the big disappointment is that subscription revenue decelerated from 69% growth in Q1 to only 51% growth. If you look at the trend in subscription growth above, the Q1 69% growth seems to be an outlier in the overall pattern. One reason I was so bullish on the company after Q1 is that it looked like subscription growth was starting to accelerate. Unfortunately, we are back to decelerating subscription growth. Overall revenue did accelerate from Q1 growth of 28% to Q2 growth of 30%. The reason that overall revenue growth is increasing is due to the subscription revenue being a higher % of total revenue at 59% (compared to 58% at Q1 and 51% last year). I think overall revenue growth will continue to increase as subscription revenue continues to grow as a total percentage of revenue.
Now let’s look at deferred revenue to get a better sense of how much of the Q2 revenue was made up of previous deferred revenue being recognized vs new revenue that was never deferred. From the 10Q:
During the three months ended August 3, 2018 and August 4, 2017 we recognized revenue of $104.8 million and $62.9 million, respectively, and during the six months ended August 3, 2018 and August 4, 2017 we recognized revenue of $176.5 million and $122.3 million, respectively, which was included in the corresponding deferred revenue balance at the beginning of the reporting periods presented.
So out of the Q2 revenue of $164.4M, $104.8M was previously billed and $59.6M (made up of both subscription and service revenue) was new. For the Q1 revenue of $155.7M, $71.7M was previously billed and $84.0M was new. This is concerning, but only gives us partial view of new revenue as other new revenue (not previously deferred) is deferred and will be recognized in future quarters.
Now let’s look at the deferred revenue on the balance sheet. The current deferred revenue is $244.7M and noncurrent (to be recognized in more than 12 months) is $61.8M. This compares to $260.3M current and $57.1M noncurrent in the prior year. Looking at Q1, current deferred revenue was$260.1M and $77.0M noncurrent deferred revenue. The expectations for deferred revenue for Q3 was actually addressed on the call. This is from the CFO:
In Q1, start dates and prepayments worked in our favor, while in Q2, we did not experience the same level of favorability. Looking ahead to Q3, we expect short term and total deferred revenue to be flat to slightly down compared to Q2, in line with historical seasonality.
Now let’s look at the dreaded RPO. This was discussed quite a bit on the call, but it’s important to understand what it is. Here’s the CFO describing what is it from the call:
Now turning to RPO or Remaining Performance Obligations - an indicator of our future revenue streams. RPO provides a comprehensive view and visibility, as it represents the estimated value of our billed and unbilled subscriptions and services, on and off the balance sheet. We finished the quarter with $790 million of RPO and we expect approximately 50% of these obligations to be realized in the next twelve months.
Now let’s look at the 10Q cover the RPO:
The typical contract term for subscription contracts is one to three years, while the contract term for professional services is generally less than twelve months. Our contracts are non-cancelable over the contractual term. As of August 3, 2018, the aggregate amount of the transaction price allocated to billed and unbilled remaining performance obligations for subscriptions and services for which revenue has not yet been recognized was approximately $790 million. We expect to recognize approximately 50% of the transaction price as subscription or services revenue over the next 12 months and the remainder thereafter. As of February 2, 2018, the aggregate amount of the transaction price allocated to billed and unbilled remaining performance obligations for subscriptions and services for which revenue had not yet been recognized was approximately $820 million.
Here’s more on contract billings:
We receive payments from customers based upon contractual billing schedules; accounts receivable are recorded when the right to consideration becomes unconditional. We generally bill our customers annually in advance, although for our multi-year contracts, some customers prefer to pay the full multi-year contract amount in advance.
RPO represents contracted future revenue that has not yet been recognized. This is mostly made up of longer-term contracts, which can be up to 3 years. The RPO that has been billed would equal the deferred revenue on the balance sheet and the amounts unbilled is the remaining part. Since the contracts are typically billed a year in advance, a large chunk shows up in current liabilities ($244.7M). Also knowing that subscriptions contracts are 1-3 years while service contracts are generally less than 12 months, it tells you that the majority of the RPO is related to subscription revenue (probably almost all of the 50% or $395M, which they will not recognize over the next 12 months. Based on the call it sounds like RPO peaks in Q4. See quote here:
we expect our RPO will be variable quarter-to-quarter and it will peak in Q4 just given the dynamic and the seasonality around Q4 and then the relative – relative to subsequent quarters Q1 to Q3 of the following year we would expect RPO to be slightly up to slightly down and so when you look at Q2 it performed in line with this
One explanation for this seasonality would be if they do most of the annual billing in Q4, and the revenue then gets recognized over the following quarters. It’s difficult to know since management won’t disclose what the RPO was last year. Although there is confusion about RPO and it may not be a good indicator, it is certainly a negative that it has been decreasing from $820M at Q4 to $800M to Q1 and now $790M at Q2. We may not be able to gather much information from the RPO, but the current deferred revenue being lower than both prior quarter and prior year cannot be explained away by timing and is certainly a negative.
The expansion rate is also slowing down from 156% at Q1 to 150% at Q2. They define it as follows:
Pivotal’s dollar-based net expansion rate compares its subscription revenue from a common group of customers across comparable periods. Pivotal calculates its dollar-based net expansion rate for all periods on a trailing four-quarter basis.
Since this is a 12 month calculation, Q2 must have been pretty bad to take it down from 156 to 150 as the quarter only had 25% impact on the calculation. It means that the comparison in Q2 last year to Q2 this year, this year was much lower to bring the annual rate down that much. For Q4 the rate was 158 going down slightly to 156 at Q1, but now the drop is accelerating with it now at 150.
As Ford and GE have investments in PVTL, it shows their spend on PVTL software/services in the 10Q as follows:
Revenue recognized from sales of subscriptions and services to General Electric Company was $2.9 million and $2.6 million for the three months ended August 3, 2018 and August 4, 2017, respectively, and was $5.9 million and $5.6 million for the six months ended August 3, 2018 and August 4, 2017, respectively.
Revenue recognized from sales of subscriptions and services to Ford Motor Company was $3.3 million and $12.2 million for the three months ended August 3, 2018 and August 4, 2017, respectively, and was $6.9 million and $23.0 million for the six months ended August 3, 2018 and August 4, 2017, respectively.
Ford and GE are both more mature customers, so it is interesting to note that GE related revenue increased only 11.5% and Ford related revenue declined 73%. Together their revenue represents 3.7% of total revenue and may not be representative of typical customers especially as both Ford and GE have been struggling.
Now, it’s certainly not all negative. Customers do seem to love the product. Here’s Rob Mee during the call:
We’ve done a deep dive with a cohort of our largest customers, and, on average, they release new software over 60% faster, are able to spend 35% more time writing code, and spend 90% less time provisioning new environments.
Time spent on common operational tasks, like operating system patching, is also reduced by over 90%. And, by reducing the OS patching burden, we found that these clients are much more likely to quickly apply security remediations.
During Q2, we added 15 new customers, including PepsiCo and Autozone, among others in the federal, supply chain management, medical equipment, office supply, and telecom sectors. We continue to have a leading customer net expansion rate of 150% as existing customers grow their usage of PCF, including companies such as Vanguard and TD Ameritrade.
That is a total of 35 customer additions, which is a nice increase from 44 during all of last year. Although it would have been nice to see them better their Q1 additions of 20. Also, adding 19% customers is not overly impressive for a high growth software company. They will need to add customers more quickly as their retention rate continues to slow.
Here’s more discussion on the customer additions:
So I think we are seeing traction, as we talked about on the Q1 call, last year was an expansion year. We wanted to make sure that our strategic customers in their kind of first or second big expansion were successful on the platform and expanded their footprint. We have the right sales structure in place and incentive structure for the field to start the flywheel or keep the flywheel going on new logos. You have to remember though on the customer count we use a very conservative definition, its revenue in quarter, and so it’s not a bookings or booking type of metric, it’s revenue metric. And so, we’re feeling very good about the number of new customers and new logos.
Also, here’s Rob talking about sales on the call:
On the sales and marketing front, we are investing to address strong and growing customer demand. We continue to expand our direct sales capacity and are focusing on field enablement and enhancing our technical sales talent.
Furthermore, our strategic partnerships with Dell Technologies and VMware complement our direct sales force. We work with both companies to market and sell our products and services through their direct and channel sales organizations. We are encouraged by the early traction we are seeing with PKS in our customer pipeline.
Dell, through vxRail, offers Pivotal Ready Architecture, a hyper-converged system built ready for PCF, which is attracting significant interest from customers building new private clouds.
Global systems integrator, HCL extended its partnership with Pivotal to build a global network of ‘Cloud Native Labs’ where enterprises will be able to build new applications as well as modernize existing applications for deployment to PCF. HCL lab advocates will be trained by Pivotal across these products and methodologies.
Here’s more about how they can continue to grow:
We are definitely seeing a lot of uptake in our pipeline for PKS and a lot of our existing customers jumping on the PKS quite quickly and in fact now getting into production which and its first year of delivery we’ve seen some pretty fast uptake. And as we continue to expand the abstractions that we support on the platform not just containers but soon to come function with PFS, we see that we’re going to attract not just additional workloads from existing customers, but new customers coming on who are attracted by those particular abstractions. We’re starting to see a lot of customers coming in wanting to buy PKS, wanting an enterprise Kubernetes solution and we’re seeing some momentum now coming from the VMware partnership and the pipeline there as well. So I think in term of new logos we’re going to see continued improvement.
I will say that definitely in term of the potential to expand the ecosystem because the Kubernetes ecosystem and the third-party services, data services, for example, are growing very rapidly. PKS expands our ecosystem quite a bit, but I think that’s going to be very helpful going forward.
I do like that PVTL is now very much cash flow positive and has improving margins. Operating cash flow was positive $18.4M compared to negative $56.5M last year and positive $4.5M last quarter. Here’s more on the margins from the call:
Our subscription gross margin was 93%. We expect subscription gross margin to remain in the low 90% range.
Services gross margin was 27%. We expect continued quarterly variability in services gross margin due to the timing of engagements and project seasonality.
Total gross margin improved 8 points year over year to 66% in Q2, primarily driven by the strong subscription revenue growth and the continuing shift of our revenue mix towards subscription.
Now let’s look at other costs. Sales and marketing expenses were $64 million or 39% of total revenue. This was a decrease from Q1 of $64.6 million. R&D expense was $41.6 million, or 25% of total revenue. This is exactly flat from Q1. G&A was $17.3 million, or 11% of total revenue. This is up from $14.2M in Q1. Keeping the expense growth minimal is great given the 30% increase in total revenue.
Let’s look again at valuation. At the current price of 20.21, the market cap is 5.22B minus 672M in cash gets you EV of $4.5B and with forecasted sales of $650M, you have an EV/sales of 6.86. This is certainly much cheaper than many of the software names we discuss with several over 20. Now if we ignore the service revenue and just use the forecasted subscription revenue of $390M, you now have an EV/sales of 11.7. That is not a bad valuation for subscription business growing at 51%. The question is, will they be able to maintain this growth. At 69% growth, this was a no brainer, but now with such deceleration, I am not so sure.
My thesis for investing in PVTL was that their subscription business is growing very quickly at very high margins. As this continues to grow quickly, overall revenue growth and margins improve. This was definitely the case after Q1 with subscription revenue growing at 69% with 92% margins and a 156 expansion rate. This did play out in Q2 with both total revenue growth accelerating from 28% in Q1 to 30% in Q2 and big improvement in margins. However, given the much lower valuation and the very high margin of the software revenue while keeping other expenses in check, this may be a good value if subscription revenue growth can be maintained at around 50%. I did sell some of my stake but am keeping the remainder as the current price of around 20 is just too cheap.