Description

Recommendation: Long NTNX

NTNX is a high-quality infrastructure technology company levered to positive secular trends and led by visionary management currently executing a transformation to a 100% software business model. With its vendor-agnostic, neutral market position and a category killer collection of products (many of which are still in very early stages of ramping), NTNX is in pole position to become the de facto multi-cloud operating system for the enterprise. Given the many moving parts involved in the transition as well as persistent market chatter on competitive threats from deep-pocketed public cloud vendors like Google, there is significant investor debate around the future growth trajectory of the business. However, my work suggests that consensus view underappreciates NTNX’s product differentiation and competitive position, which translates into a fundamental misunderstanding of both long-term growth and FCF generation. Importantly, NTNX has several catalysts over the next 12 months that should help disprove bears’ arguments. Management will report new disclosure starting with fiscal Q1’19 earnings (11/27 AMC), which will shed more light on the moving parts behind the current model transition, and the company will host an Investor Day where more detail will be provided on future billings/revenue contribution from various new products. At current levels, NTNX presents the opportunity to own a differentiated asset at a very reasonable growth-adjusted EV/S (even on Street numbers that are too low), offering compelling risk/reward. Beats to Street numbers should also support multiple expansion as the market increasingly recognizes NTNX as a software company as it moves through its model transition. At $40, long NTNX offers a 2.8x risk/reward in my base case exit based on FY20, with a trading range of $34 by $57. In the upside case with an exit based on FY23, the stock has the potential to return 133%, implying 26% IRR.

Background

NTNX is a hybrid-cloud, multi-cloud operating system (OS) vendor, offering compute, storage, networking, security, and application mobility solutions to enterprise customers. NTNX began as a company selling hyperconverged infrastructure (HCI) solutions while emphasizing its own branded appliance in the sales process to land customers. This fueled the bear case that NTNX was swimming into a bloody ocean of competition, where large server OEMs like VMWare, Cisco, and HP traditionally had a stronghold and the industry profit pool couldn’t support another player, particularly when pricing power was limited due to the commoditization of hardware and basic virtualization. However, NTNX’s goal going forward now is to dominate the ecosystem on the software side, delivering its cloud OS to customers through an internet consumption model just like SaaS vendors. The high-level product focus is to provide customers with high-efficacy, super-low-latency technical results while maintaining consumer-grade design and deemphasizing sales of its own NX hardware, which obviously also has positive impacts on P&L and cash flow.

Management is fixated with the idea that Nutanix is building the enterprise analog to iOS or Android in consumer/mobile, so design elements and value-added software capabilities are key to NTNX’s share gains going forward. At the core of NTNX’s product offering is the Acropolis Hypervisor (AHV), the “data plane” that powers the HCI platform across compute, storage, security, and network. Prism, a one-click infrastructure management solution, and Calm, an IT orchestration/automation tool, collectively form Nutanix’s “control plane”. Every other product offering basically revolves around the ecosystem anchored by these three key components. The next leg of meaningful product growth is set to come from Xi Cloud Services, a collection of tools built both organically and through acquisitions that manage various aspects of hybrid and multi-cloud environments such as security, compliance, and application reliability/availability.

NTNX’s high-level sales pitch today is that customers should have Nutanix as a single point of control to orchestrate their IT infrastructure and application development initiatives across multi-cloud environments. The idea is essentially that a customer gets the intuitive functionality and experience of the public cloud, but with the integrity and security afforded by the private cloud. With the amount of applications/data proliferating across both on-prem and cloud environments (and now increasingly encompassing multi-cloud silos from different vendors), it’s clear that there is real white space for a neutral third-party vendor to provide the infrastructure to stitch together and manage all of these workloads and environments. This is NTNX’s opportunity going forward, and it is one that will be powered through selling software rather than hardware. The goal is to increasingly leverage OEM partnerships to deliver Nutanix branded software solutions over other vendors’ hardware, which allows NTNX to focus on selling differentiated products while being the “Switzerland of clouds”, continue deploying R&D dollars to innovating new value-added services and thereby enable long-term pricing power, and improve underlying unit economics. This also is key to NTNX’s customer-centric go-to-market, as it enables customer choice in the hardware and virtualization technology purchase decisions.

The deemphasis of hardware and migration to a pure software model has now been underway for several quarters and gaining is more traction vs. management’s initial plan, setting up NTNX’s FY19 as a pivotal part of the overall growth story. In FY18, software/support billings were 82% of total billings and hardware accounted for the remaining 18%. Over the next several years, management believes Nutanix branded hardware will trend down to 5% of total billings and around 8-9% of total revenue. By this point, management estimates that software will comprise 60%+ of the total business at ~100% gross margin, support making up 30%+ at mid 50%’s gross margins, and the rest hardware at 0% gross margin (pass-through).

Long-term Model / Growth Algorithm: At its Investor Day on 3/16/18, NTNX provided a framework for its long-term financial model with FY17 as the base period. Most importantly, management outlined a path to achieving $3bn in software/support billings in FY21, with underlying assumptions on customer mix and overall slope of growth. Management believes it can sustain several years of 30%+ revenue growth with gross margins trending above 75% and 400-600bps of non-GAAP operating margin expansion, producing LSD-MSD% FCF margins. On the software/subscription side, increasingly relevant at this juncture, NTNX envisions 80% gross margins with adjusted EBIT margins approaching 25%, which should enable 25%+ FCF margins.

Management: As a quick note, NTNX’s management team is founder-led, evangelical, customer-obsessed, and shareholder-oriented. “Hard tech” companies increasingly require visionaries at the helm, and Dheeraj Pandey is no exception. Laser-focused, honest, humble, Pandey leads NTNX with a keen focus on technical product superiority and rapid market share gains, but tempered with an understanding that investors ultimately want thoughtful, profitable growth. After watching even just a few of Pandey’s interviews and presentations, it’s clear that this is a next-level intelligent operator. His focus along with innovation led by Chief Product & Development Officer Sunil Potti and a coherent go-to-market strategy from Chief Revenue Officer Lou Attanasio provide the leadership foundation for NTNX to continue gaining share over a multi-year period.

Stock Opportunity/Debate

Due to NTNX’s model transformation, the stock is significantly controversial. Compounding the difficulty for many investors in understanding the technology and business model changes, the last two earnings prints haven’t helped the NTNX bull case. On the fiscal Q4’18 print, NTNX saw upside to billings, revenue, and gross margins, all driven by an accelerating mix shift to software (as hardware declines by more than originally anticipated), and notably with higher attach of premium software versions such as Prism Pro. Importantly, the acceleration in software/support billings showcased an increased ability to sell into different IT buyers at large organizations, with emerging use cases being highlighted to a greater degree. However, the flipside is that the last two quarters saw lower customer adds than some bulls expected plus heightened opex, leading bears to believe that any upside from the software mix shift will be reinvested to a greater degree than consensus thinks, aggressive investments are required to keep growth elevated, and the competitive environment may not be as benign as management suggests. Opex-related concerns plus an ongoing debate on competition (latest data point from GCP potentially offering a combined cloud storage/computing offering, which was subsequently dialed back) against a backdrop of volatile trading in tech stocks has resulted in NTNX trading back down to technical levels last seen in March, which now put the stock at <5.0x EV/S on NTM consensus.

The Street’s major model-related concern is that NTNX could find it tough to hit the FY21 software/support billings guide of $3bn given at Investor Day. The argument here is that there is a big ramp implied in this guide, particularly as G2K penetration is anticipated to grow meaningfully from the 30%’s today to 55% by FY21. In addition, billings per new customer will have to maintain strong growth rates while repeat customer billings must also remain stable. Basically, if you’re bearish, you believe that a lot has to go right in order for NTNX to hit the $3bn target, especially while management continues to navigate the software transition and is more reliant on channel partners to cooperate. Structurally, there is still significant debate as to whether NTNX enjoys a real competitive moat that will allow it to scale into a powerhouse vendor against incumbent VMWare while also defending against the likelihood that there may be increasing “co-opetition” from partners like Google as they potentially look to carve out a piece of the hybrid cloud pie. The healthy dose of skepticism among the investment community from these factors plus attractive valuation on numbers I believe are too low produce a favorable setup for long NTNX.

Why Now?: The transition is now fully underway, with the elimination of low-margin hardware revenue happening faster than management initially expected. Starting in Q1’19, additional disclosure will be provided to make transition progress even more transparent and reflect the fact that a higher percentage of offerings going forward will be tied to renewable software (term licenses, SaaS, and renewal software entitlement and support subscriptions). The four new billings/revenue categories will be: pass-through hardware, non-portable software (tied to life of appliance provided either by NTNX or partners), subscription, and professional services. This level of clarity should unpack billings growth easily for investors and drive more confidence in the overall growth algorithm, while also showcasing contributions from more software/services such as Xi. Software/support billings accelerated to the mid 60%’s in H2’18, with management guiding to 50-55% y/y in Q1 and overall billings of $370-390mm (implying 17-24% y/y and sequentially down on a dollar basis). While some of the sequentially down guide reflects greater seasonality with bigger Q2 and Q4 going forward and a significant federal market lap y/y, this expectation still looks extremely conservative. With new product attach rates that should continue picking up sequentially and core software strength accelerating, it’s unlikely that the weaker seasonality management is hinting at starts really showing up in a pronounced way in FY19. NTNX’s Investor Day in 2019 should also provide more detail.

FY21 Software/Support Billings Target of $3bn Is Highly Achievable

Most analysts haven’t bothered to break down NTNX’s billings and revenue into constituent parts between hardware and software/support, leading to estimates being too low and the worry that $3bn in billings by FY21 may be a tough bar to clear. Management outlines the path to thinking about the $3bn as supported by the split between G2K and non-G2K customers. Looking at various analyst models, very few have even spent the time to decompose the growth trajectory into these separate customer bases despite management explicitly providing numbers on how to get there. My model assumes NTNX can add ~30-40+ G2K customers per quarter. While the pace of G2K net adds slowed in FY18 vs. the prior two years, I believe it should reaccelerate starting in FY19 given: 1) hardware partnerships (where partners have started teaming up with NTNX more) enable large customers to have choice in deployment of Nutanix and leverage investments already made; 2) NTNX’s sales force is now more incentivized to sell software (no compensation for selling branded hardware), which should improve productivity especially within G2K as the momentum of the largest enterprises adopting multi-cloud should keep ticking up; and 3) new products such as Calm and Xi don’t contribute meaningful revenue today but this should help with G2K adoption as they highlight NTNX’s clear competitive differentiation. Management states the G2K customer base should reach 1,100 by FY21, implying 55% penetration, but I believe there could be some slight upside to this and am assuming ~60% penetration by this point. On top of this, it’s unlikely that there is a meaningful slowdown in the near term on the non-G2K side as well. Although G2K adoption will help deal sizes grow and stay elevated for a longer period than consensus believes, sales volumes in non-G2K should also be supported by this segment’s increasing need to adopt neutral third-party hybrid cloud infrastructure.

With respect to billings per customer, I break down the opportunity into billings per new customer vs. billings per existing customer and drive overall billings this way. Optically, meaningful declines in hardware billings over the last several quarters has pressured growth rates in billings per customer, and the sheer number of customer adds hasn’t helped as it has inflated the denominator in billings per customer as well. As NTNX makes further progress with the hardware transition, billings per customer growth should stabilize and inflect. This will be supported by initial lands increasing as the attach on new products should improve and drive a lift. These products also should facilitate a smoother expansion motion with many new software products as subscriptions, where NTNX can also upsell easier and potentially raise prices based on product differentiation over time. The real key in believing the billings per customer math is that there should be an overall improvement in lifetime customer values driven by spending multiples, which is understandable if you’re bullish on the opportunity presented by software offerings like Xi, Beam, Flow, Frame, etc. on top of continued core product (Nutanix Files, etc.) strength. Analysts seem to be confused because they are looking at historical spend behavior and are extrapolating based on this, but the reality is that these rates should naturally inflect as NTNX builds out a more robust ecosystem. I believe there should be continued strength in both new customer and repeat customer billings due to higher attach rates and deal sizes, which is all happening now (and therefore not well understood by the investment community).

Putting these assumptions together, I believe the runway implied by management’s $3bn software and support target is attainable. In fact, I believe if new products really catch fire, my estimates (already well above Street) could actually be very conservative.

Long-term Margin Opportunity and FCF Is Significantly Underestimated

The C-suite manages the business to the Rule of 40, which is made possible due to the fact that NTNX already has market-leading unit economics. While the market is myopically focused on near-term opex pressures and worries that the profitability and FCF generation of the business may structurally not be as powerful as management indicates, I believe this is wrong. First of all, the basic math on the hardware transition is pretty well understood and therefore I won’t spend much time talking about consolidated gross margins, which one should easily understand will trend towards 80% over time as the software mix increases. The wall of worry that has caused analysts to not model operating margins appropriately stems from management messaging that FY19 will be an investment year. NTNX is significantly boosting its sales force footprint to support all of its offerings, both organically and through recent acquisitions of Minjar and Frame, but to assume that these investments won’t generate meaningful ROI (which is implied by Street estimates through both lower billings/revenue as well as not showing significant operating leverage) is probably fallacious.

The shift to deemphasizing branded hardware has an embedded positive impact not well captured by sellside numbers, which is that there should be less channel friction going forward, which should boost effective sales productivity. With the move to pure software, the company is basically making the bet that hardware vendors who historically had channel conflict with NTNX will increasingly want to partner, behavior that should increase over the course of FY19. Layer this on top of a compensation model where NTNX salespeople are only paid on software billings, and it should follow that S&M expense will significantly see leverage over the next several years. R&D should also see a slight pick-up as the company continues to throw dollars into innovation, which should again translate into the longer-term software billings opportunity being believable. In fact, my numbers assume management will continue investing in R&D as I see organic product development accelerating from here as NTNX continues to build out its ecosystem and folding in teams from opportunistic M&A potentially increasing from here as well. Given that the Street is too low on billings/revenue and too high on opex (implying no top-line upside from investments made in the near term), estimates imply a deterioration in the Rule of 40. After modeling a wide range of software companies over the years, I find it hard to believe that the interplay between top-line growth and margins as modeled by the Street is realistic; if you believe Street margins and FCF, then it stands to reason that top-line growth should be faster and not slower. My model goes out to FY23 and shows a business that can get to $4bn of revenue by FY23 with adjusted EBIT margins of ~20%, implying FCF margins also near 20%. At this point, revenue is still growing in the mid 20%’s, suggesting the Rule of 40 is still firmly intact and holds around constant in the mid 40%’s in the out-years.

Estimates

Consensus in the table above refers to analyst models from Morgan Stanley and Jefferies. These are the only two analysts that somewhat thoughtfully break down the business and look at software billings/revenue more granularly. I am comfortably ahead of analyst estimates in both the near term and looking out to FY20, beyond which barely any analysts I have access to currently even model the company. The only pushback here is that perhaps software/support revenue doesn’t have as much upside looking at H1’19, but I believe this will meaningfully pick up as the year progresses and into FY20 as compares normalize and more subscription revenue starts flowing through the model. Overall, I’m confident that the company can do numbers that are more in-line with my projections than the Street, which appears too conservative on both top-line and profitability.

Valuation

The primary valuation methodology is EV/S given the lack of meaningful FCF today, but triangulating with EV/FCF in the out years evidences how cheap I think NTNX is today. Given the model transition and top-line growth that will bottom in the 20%’s and inflect to 30%+ through FY21, I am assuming a very moderate 5.0x EV/S (embeds some execution risk and hardware declining meaningfully throughout most of FY19) on my FY20 revenue. This implies a near-term base case stock price of $57, or 36% upside over the next 12 months. Modeling the business out to FY23, I assume some natural multiple compression but think NTNX still deserves to trade at 4.0x EV/S given it will still be growing revenue at that point in the mid 20%’s at a $4bn scale. At this point, there is also ample FCF support with 20% adjusted EBIT and FCF margins, implying that 4.0x EV/S translates into ~20x EV/FCF. This also makes sense as I have NTNX clearly growing FCF very rapidly through the projection period, ending with >$4.00 FCF/share (implies ~10% FCF yield on today’s stock price). On my FY23 revenue estimate, NTNX is worth $93. If I’m wrong, I assume today’s ~5.0x EV/S on NTM consensus compresses to 4.0x on FY19 Street sales for a $34 stock, or 19% downside. While I don’t underwrite a strategic acquisition given it could compromise NTNX’s position of neutrality in the marketplace, it is always possible and likely protects the downside along with an ample net cash position.

Risk/Reward: 2.8x in base case (FY20 sales)

·         Downside: 4.0x consensus FY19 sales of $1.4bn = $34 (-15%)

·         Upside: 5.0x my FY20 sales of $1.9bn = $57 (+43%)

Entry Point: NTNX has traded between 4.0-6.0x EV/S for most of its history, with an all-time low of <3.0x in early 2017. Over the last 12 months, valuation has gone from 4.0x all the way up ~9.0x on the back of strong results earlier in FY18, but I would argue that valuation was overdone at the time. The stock has now settled and has a “coiled spring” setup that could result in material re-rating over the next 12 months with billings/revenue beats. At $40, the technical level and valuation relative to growth (particularly compared to the high-growth software universe) both indicate the stock is cheap.

Risks/Pushbacks

Public cloud vendors may decide to up the ante. The reality is that there is a real value proposition from the Nutanix ecosystem being the “Switzerland” of its space as far as multi-cloud is concerned. However, in the hybrid cloud opportunity, GCP made noise as recently as September before Diane Greene talked down the company’s ambitions. Last week, Diane Greene stepped down and was replaced by Thomas Kurian, who most recently spearheaded Oracle’s cloud efforts, which have been fairly disastrous. Kurian may decide to be more aggressive (as is the mentality of many Oracle executives), which could lead to Google’s position with NTNX as moving from more of a go-to-market partner to an all-out competitor. If AWS and Azure follow at some point, this could potentially pressure NTNX estimates and its multiple. I don’t view this as a legitimate risk in the near term given that its unlikely that the cloud vendors want to throw as many investment dollars into HCI opportunities that may or may not pan out for them due to customer resistance to vendor lock-in, but it is worth monitoring.

VMW may be a tougher competitor than what I give them credit for, and hardware partner allegiances may be split. Probably less of a risk than I should admit given an inferior tech moat, but it’s worth mentioning that VMW may put up a bigger fight in the channel. Dell has traditionally favored EMC/VMW solutions. While NTNX software solutions should far and away become the industry standard in my view, which should compel more OEM partners to join forces with NTNX, there is always the chance that historical relationships may result in some resistance. This could filter down to the customer purchase decision and potentially elongate evaluation periods or sales cycles.

Sales force segmentation work could cause disruptions along the way. NTNX’s go-to-market has been constantly evolving to better segment between large enterprises and smaller customers. Sudheesh Nair left the President post and Lou Attanasio effectively took over the sales effort, and with only a few months of attribution under his belt now, it’s tough to say if there are any further changes being implemented that may cause more lumpiness in billings than I’m modeling. It’s also worth noting that to the extent larger deals become the norm, the lumpiness seen by most enterprise software companies may be seen at NTNX as well. However, I believe management is thoughtful and has been messaging more pronounced seasonality going forward to set investor expectations appropriately.

Transition stories are difficult and hedge funds seem to be piling in now. Though NTNX is idiosyncratically different from other software transition stories (ADBE, ADSK, more recently DATA, etc.), it unfortunately has all of the signs of beckoning hedge funds that don’t always do the most thoughtful work. Hedge fund ownership currently stands at 16% of the float. As tends to be the case, event-oriented generalists who don’t appreciate the technology or longer-term story could be prone to owning the stock, so any squishiness on quarterly prints from the transition could could cause significant selling pressure.

Catalyst

Earnings (improved transition disclosure starting fiscal Q1'19), 2019 Investor Day