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Nutanix Stock: What Investors Need to Know

In this episode of Industry Focus: Tech, Motley Fool analyst Dylan Lewis and contributor Evan Niu talk about recently public Nutanix (NASDAQ: NTNX) and explain exactly what the self-described "hyperconvergence" company does, why it has investors so excited, and how its books look so far. Also, the two talk about some of the biggest risks that potential investors should be aware of before diving in, from intense and potentially crippling competition to an incredibly technical market.

A full transcript follows the video.

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This podcast was recorded on Oct. 7, 2016.

Dylan Lewis: This episode of Industry Focus is brought to you by Rocket Mortgage by Quicken Loans. Rocket Mortgage brings the mortgage process into the 21st century with a fast, easy, and completely online process. Check out Rocket Mortgage today at QuickenLoans.com/fool.

Welcome to Industry Focus, the podcast the dives into a different sector of the stock market every day. It's Friday, Oct. 7th, and we're talking about another hot tech IPO. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com senior technology specialist, Evan Niu. Evan, how's it going?

Evan Niu: Pretty good, happy Friday.

Lewis: Happy Friday. Things are looking pretty rosy over at Nutanix, huh?

Niu: Yeah, today has been a week.

Lewis: Last week, I talked to David Kretzmann about recently public Twilio. Today's show, Evan and I are going to break down another tech company that recently went public, Nutanix -- give you guys a little rundown on what they do, how their books look, a couple things to keep in mind with their business. How's that sound, Evan?

Niu: Sounds good.

Lewis: Shares originally priced at $16. They are currently trading in the mid-30s. So, the stock is up over 100% since they hit the markets. I think the biggest thing most people are wondering is, what the heck does Nutanix do?

Niu: Yeah, no one has heard of this company before. They're like $38 now, so they're up. It's been a pretty wild week, they've been up and down quite a bit each day, because IPOs are always volatile. 

Nutanix takes servers and storage and virtualization and integrates these all into one platform. It's basically and IT infrastructure play. These things are normally separate, so companies usually have to get this stuff from different companies that all use different operating systems, it's inefficient, it's more expensive. So their whole thing is basically to integrate all these things into one platform.

Lewis: And you'll often hear them described as a "hyperconvergence" company. That term, hyperconvergence, gets at that. You're taking all of these disparate things that are delivered and managed separately in the past and bringing them together in a more efficient way.

Niu: Right, exactly. It helps to really improve data center performance. They've been one of the pioneers in this hyperconverged data center area. People are excited about that.

Lewis: Their current customer list ranges the whole spectrum. We have NintendoNordstrom, I think the Department of Defense is also a customer.

Niu: Total, Toyota, Activision, Best Buy. They have about 3,000 customers. About two years ago they only had about 700 or 800 customers. So just the number of customers they have has definitely grown a lot.

Lewis: I think you see that reflected in what's going on with the top line. Looking at growth over the past few years, it's been fairly impressive. Sales have jumped 90% from 2014 to 2015, and now 85% from 2015 to 2016. Their 2016 fiscal year ended in July, so we're looking at a full year there. That puts them at $445 million in revenue for 2016. Not bad.

Niu: Yeah. It's really hard to argue with those growth figures. They're putting up the numbers, especially up top.

Lewis: One of the things that you want to keep in mind, you see a couple different numbers cited with them. They had a non-GAAP number called "billings." We talk about their top line of their revenue. Revenue is what they're able to recognize as sales. Billings is money they've collected. Some of that will be recognized as revenue, some of that is going to be categorized as deferred revenue. That is something that will eventually be recognized later on.

Niu: Right. Most of these subscription software service companies, and a lot of companies in general, use billings which is basically revenue plus or minus the change in deferred revenue. In this case, Nutanix, their revenue is broken down into products and service and support. The product is the physical boxes they sell that have the hardware plus the software. Alternatively, they also sell just the software, if the customer already has a qualified server and already has a hardware so they can just buy the software. So, product revenue is basically just those products, which is the two product families, Acropolis and Prism. The service revenue is, after purchase support, that's where the majority of their deferred revenue is coming from. I should not have characterized it as software as a service. The majority of their revenue is not subscription-type stuff. But, they have about $300 million of deferred revenue on the balance sheet right now, which is a pretty healthy backlog. That will get recognized over time. And most of that is related to service and support.

Lewis: You talk about the two different types of revenue they have. It makes sense that a support and maintenance type revenue stream is going to be the thing that would be recognized over a period of time, rather than up front all at once, because typically those are contracts that are ranging from one to five years for their business. To give you an idea of the mix there, it used to be about a 90-10 split with the product and support, and other services revenue. Now, it's a little closer to 80-20. So, you are seeing that rise over time. I think you'll probably see the gap between billings and revenue continue to spread out a little bit as that becomes a larger part of their business.

Niu: Yeah. I think it makes sense, too. As the customer base grows, those customers, there's a large number of people that need support. That service segment is probably going to be growing as a percentage of sales going forward, I would expect.

Lewis: One of the things that really popped out to me, looking at their numbers, is that profit margins climbed pretty steadily over the last three years. We've seen 52% in 2014, now they're up to 61.6%. That's pretty impressive.

Niu: I think what we're seeing is just operating leverage. I don't think this is a company that has a lot of high capital costs. If you don't have a lot of fixed costs, then operating leverage really kicks in as your revenue base grows larger. You have to spread out those costs over larger base, and then you see margin expansion. So, yeah, I think that's what we're seeing there, which explains why their margins just keep expanding as they grow.

Lewis: Yeah. The year-over-year gains might not be as dramatic as we get into 2017 and 2018. But there might be some upside there.

Niu: Yeah. I definitely think if they keep growing their top line, the margins will keep expanding. At least the growth margin front. I mean, obviously, they operate on a loss because they're investing so heavily in the business. But as far as the gross margin goes, I would definitely expect that to keep going up, if they can keep ramping the top line.

Lewis: Yeah, looking at their bottom line right now, they registered a net loss of $166 million this most recently closed fiscal year. A big reason for that is, the company's sales and marketing costs were up 79% year over year, hitting $288 million. That item single-handedly erased the company's gross profit. That's pretty incredible, not terribly surprising, because that's kind of how it works in the tech space.

Niu: Yeah, that's par for course with any of these high-growth small tech companies in Silicon Valley. (laughs) All that stock-based comp.

Lewis: Yeah, that plays in there too. We're going to take a little bit of a look at some of the competitors in the space, and some other things to keep in mind with Nutanix, but before we do, this episode of Industry Focus is brought to you by Rocket Mortgage by Quicken Loans. If you've ever bought a home, you know how frustrating and time-consuming getting a mortgage can be. Rocket Mortgage brings the mortgage approval process into the 21st century by taking all the complicated, time-consuming parts of applying for a mortgage out of the equation. With Rocket Mortgage you can easily share your bank statements and pay stubs at the touch of a button, helping you get approved in minutes for a custom mortgage solution that's been tailored to your unique financial situation. Even better, with Rocket Mortgage you can do it all online with your phone or tablet. If you're looking to refinance your mortgage or buy a home, check out Rocket Mortgage today at quickenloans.com/fool, Equal Housing lender licensed in all 50 states, NMLS, consumeraccess.org number 3030.

Evan, to help contextualize this business a little bit, it might make sense to look at some of the other players in the space and how they stack up.

Niu: And the risks.

Lewis: And some of the risks, yeah. Looking through their prospectus, they break out their competitors in three different categories. You have your software providers, people like VMware and Red Hat. Those are people that are typically offering a range of things in the virtualization, infrastructure and management product space. That's looking at enterprise cloud-type work. Then you have traditional IT vendors. Hewlett-Packard, Cisco, IBM. That's more in the integrated systems. You're looking at bundles of servers, storage, network solutions, that type of stuff. Then, the traditional storage array vendors like Dell, Hitachi, they name a couple others. They're typically selling centralized storage products. Then they also have people that work in hyperconverged infrastructure, which is a more nascent field. There are a lot of different people trying to grab a share of this market, it sounds like.

Niu: Yeah, that's probably the biggest risk here. There's so much competition. They have pioneered this idea, but at the same time, the IT infrastructure market is huge. As you mentioned, some of these companies that we're talking about are gigantic. Going up against these really large and established companies that have a ton of money, that can really out-spend you in every way, in terms of R&D, marketing, they have existing customers, etc. It's tough. That's an uphill battle. They've done pretty well, you can't argue with the growth they're putting up. But that's just a couple of years. Once these big companies get their act together coming in on this space, they could really take a bite out of Nutanix. Just because Nutanix helped carve out this hyperconverged niche of the data center market, doesn't mean they can keep it all. It's very possible these larger companies will want to replicate what they're doing, particularly since some of their rivals are also their partners.

Lewis: Yeah, that's kind of an interesting dynamic. Do you want to explain that a little bit?

Niu: They sell their products through resellers, distributors, and OEMs.

Lewis: Can you define OEM for our listeners?

Niu: Original equipment manufacturer. So, people who make things and sell them to their own customers. Dell and Lenovo are two of their biggest OEM partners, and they're also two of their biggest competitors. This isn't new for this kind of space, there's lots of times you see this kind of thing. There's all these other companies in the past that had this same kind of competitive dynamic, where they were competing with the people that are their partners. That's pretty normal, it's coopetition, whatever you want to call it. But it's a big risk. If one of those people decide to really come in and replicate it, and can get it out pretty easily ... So, it's a tough space. Generally speaking, I think at the Fool, we're fans of the idea that you should have a good understanding of the business you're investing in. Nutanix is an extremely technical company to understand. I'd even consider that a risk for individual investors.

Lewis: Just because you won't be able to see some of the signals that things are going very well or very poorly.

Niu: Exactly. You need to really understand the company or business, what they do, and also the market dynamics. The IT infrastructure market changes so quickly, and you need to be able to keep up. If you can't keep up with what's happening on a technical side, it's hard to invest in something. I've made IT infrastructure plays that didn't work out before because these companies are hard to follow, and things change so fast. You can get caught off guard really quickly if you're not paying a lot of attention.

Lewis: Yeah. We both cover the tech space pretty regularly, and I think it took us both a decent amount of homework to really get down to the nuts and bolts of this company. It took some time and some serious reading. For the average investor, that might not be something they're interested in doing. Any other risks you notice, besides things in the competitive space?

Niu: There's another one that's not uncommon, but it's an insider control piece. They're another one of these companies in Silicon Valley that's doing this dual-class thing. Class A shares, which people and the public can buy, get one vote. Class B shares, which are only held by insiders, get 10 votes per share. So, they have a supervoting class. Class B shares control 99% of the voting power. Insiders keep all control to themselves. The economic rights are the same. But, public investors should have no illusions of being able to influence the company in any way. Again, this isn't uncommon. Tons of companies do this, Google [Alphabet] is the big example. Pretty much every new tech company does this, which is really annoying.

Lewis: Also Facebook. Facebook went to a stock split in order to enable this to continue to happen. This is industry standard in tech. I will say, to play devil's advocate, that can be seen as a positive thing, as long as you like the management team that's in place, and you think they have the right vision for the company. Because then, they are basically given full control and the clout to make the decisions, maybe a little bit more long-term oriented, and taking some short-term hits to position the company for success.

Niu: Yeah. You have to have faith in leadership and management. It's frustrating because, I don't like how it's become such an accepted thing that everyone does. On principle, that just bothers me, in terms of corporate governance. It's fine in a lot of cases, because you do believe in the company's leadership. But on principle, it bothers me, it's like, come on, guys ... it's a really shareholder unfriendly thing to do, and everyone does it.

Lewis: Yeah. But, it's become commonplace.

Niu: Yeah, because they can get away with it.

Lewis: So, right now, with a market cap of roughly $5.3 billion -- I checked before we started recording -- the company is currently trading at about 12 times fiscal 2016 sales. Not cheap by any means. It seems like, in a lot of ways, this is the kind of company where, if you aren't really gung-ho on it and you don't understand the space very well, you're probably better served sitting on the sidelines.

Niu: Yeah. It's that whole technical thing. It's so hard, because you should be digging in and really understanding the inner workings of how the products work. If you can't do that, it's hard to want to invest, or at least feel responsible about buying. I wouldn't buy a company that I didn't understand.

Lewis: Yeah, and you're doing it at a very expensive valuation. You subject yourself to a lot of swings.

Niu: Yeah, they're super expensive. And, again, the first six months of any IPO is basically the Wild West. I basically never buy any IPO in the first six months, because things are so volatile. Up and down. Think about all the recent tech IPOs, they're wild. That's why IPOs are technically classified as speculative investments. If you've ever tried to buy an IPO from your broker, you have to fill out a survey. That survey has the expected questions, like, "What's your investment objective?" and those kind of standard questions. If you do not click "speculative" as one of your goals, they won't invest it. And this applies to all IPOs. 

The strong performance so far is definitely good news for the broader tech IPO market.

Lewis: That was one thing I wanted to touch on before we wrap up. You look at the successful IPOs of Twilio and Nutanix over the past few months, I think it might be interesting to see if some of the unicorns sitting on the sidelines right now might decide to test the waters.

Niu: Line, too.

Lewis: Right, that's another one. I just saw in the news yesterday that Snapchat is reportedly interested in a filing. Given that there's a solid track record of tech IPOs in 2016, you might start to see some of these other unicorns come out of the woodwork.

Niu: If you remember, last year, it was just not a good environment. Last year, there were several big tech IPOs that just sputtered off, and it scared everyone off. I think one of the big ones was Square. Square came out last November, I think. They priced below the expected range, at $9. And the shares did jump on the first day, 45%. But the IPO pricing didn't inspire a lot of confidence in the stock, even now it hasn't really done much. It's basically just traded flat within a certain range in the past year. Fitbit also fizzled down in their first few months, same thing, it had a decent showing initially but now is trading below the IPO price of $20. 

Lewis: To your point about wanting to stay on the sidelines for the first six months or so, right. Get a better sense of the business, see a couple quarters worth of reports.

Niu: Yeah. And let's not even talk about GoPro, I mean, God, GoPro is ... (laughs) I was never a fan of GoPro. Anyway, in contrast, Nutanix increased their price range, then they priced above that range, then they jumped 130% on the first day. So, I think it really shows that the market is warming up to these new issues in tech. Even Nutanix was a victim of this staying away, because they initially filed their S-1 registration statement with the SEC back in December. 

Lewis: They basically waited 10 months, right?

Niu: Yeah. In the meantime, they took out a loan just to wait longer. They took out a $75 million loan just so they could wait longer. They took it out from Goldman Sachs, who was an underwriter for the IPO. Then, through the IPO, they raised up $220 million. But, the point is, they wanted to wait so bad -- of course, they still need cash, which is the whole point of the IPO. But, they took out some money just to not go public, because the market was so bad. Now it seems like that patience has paid off, because the stock has done very well, and they raised a ton of money because the price of the IPO came back higher than expected, because, presumably, there was strong institutional demand. But yeah, I think it's definitely warming up. You mentioned Snapchat, I think Dropbox has also been looking to go public for several years. Maybe even Uber, God forbid.

Lewis: That would be a show, for sure. Maybe four.

Niu: You have all these VCs that are anxious to get paid. They want these companies to go public, because they want to cash out, too. I think there's a pipeline of people that are sitting and waiting. I think this IPO shows that maybe the water is warm, maybe they can jump in.

Lewis: Yeah. We will happily cover them as they do. These are always fun shows to do. Anything else before I let you go, Evan?

Niu: No, I think we hit all the big pieces.

Lewis: Awesome. Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say, "Hey," you can shoot us an email at industryfocus@fool.com. You can always tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of Alphabet (A shares). Evan Niu, CFA owns shares of Facebook. The Motley Fool owns shares of and recommends Activision Blizzard, Alphabet (A and C shares), Facebook, Fitbit, and GoPro. The Motley Fool recommends Cisco Systems, Nordstrom, Total, and VMware. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.