Will Nutanix’s Rule Of 40 Propel Its Stock to $100?
Plenty of tech companies these days are able to go public without being profitable. That’s because investors keep driving up their shares due to their ability to grow faster than expected.
What’s more, CEOs of such companies have introduced a new way to measure their success — which investors seem to be buying.
Needless to say, the strategy of investing in fast-growing, money-losing companies works well until investors are gripped by the fear that such companies will bleed out.
All of which comes to mind in considering San Jose, Calif.-based hyperconverged systems-provider, Nutanix, which went public in 2016 and has since enjoyed a 217% increase in its stock price.
I’ve been writing about the hyperconverged systems industry since September 2012 when I met the founder of SimpliVity — a Westborough, Mass.-based privately held supplier of a device that purported to combine as many as 12 different data storage products into one appliance that operated on low-priced servers.
Hyperconverged systems represent a modest market that’s growing rapidly. According to IDC, such systems grew 64.3% to $3.7 billion in 2017, accounting for 34% of the total converged systems market.
SimpliVity raised about $277 million and in 2015 was valued at more than $1 billion — but it could not go public and was ultimately acquired by HP Enterprise for a mere $650 million in January 2017.
But Nutanix had a happier fate. The companies was founded in 2009 by a talented collection of entrepreneurs — Dheeraj Pandey, who is Nutanix’s CEO, Ajeet Singh (who founded ThoughtSpot and recently hired Nutanix’s president to join as CEO — Pandey congratulated Singh saying he considers him a Nutanix founder), and Mohit Aron (who left to start Cohesity).
Nutanix raised nearly $238 million in private capital before going public on September 30, 2016 at $16 a share — after bumping around a bit, Nutanix has risen 217% to $50.68 on August 3 — yielding a market capitalization of about $8.7 billion.
Nutanix has enjoyed expectations-beating revenue growth but has not managed to make a profit. For its 2018 third quarter ending in April, Nutanix reported a 41% increase in revenues to $289.4 million — nearly $10 million more than analysts expected. And it reported a loss of $85.7 million. Indeed, since May 23, the day before that report came out, its shares have lost about 11% of their value.
The good news is that Nutanix guided investors to expect higher revenues in the quarter that ended July 2018. In May, Nutanix said it expected revenues between $295 million and $300 million – analysts were looking for $289 million. But Nutanix forecast a non-GAAP net loss per share between $0.20 and $0.22 — above the loss of $0.19 that analysts expect.
One source of profit improvement at Nutanix — its most recent gross margin increased from 59.5% to 67% — has been a shift to a software-based business and away from a hybrid of selling hardware and software.
In the third quarter, Nutanix’s product revenue was up 38% to $221.1 million — with software revenue growing 57% to $158.5 million while hardware revenue inched up 5% to $62.6 million. Nutanix’s support revenue increased 50% to $68.3 million.
Nutanix believes that investors need to understand that there is a tradeoff in its business between growth and profitability. And as Pandey explained in an August 2 interview, Nutanix has found the right balance between the two as evidenced by what he calls, “the rule of 40: the revenue growth rate plus free cash flow as a percent of revenue should be at least 40.”
At 49, Nutanix passes this test with flying colors — if you exclude its hardware revenue (which accounted for 22% of its revenue in the most recent quarter). According to Shane Xie, Manager, Investor Relations at Nutanix, “Nutanix looks at software and support (not all revenue) because we are removing hardware from the business as we transition to a software-centric model.”
The 49 comes mostly from revenue growth (47%) and a little bit from free cash flow (2%). As Xie explained, “We used rolling-4-quarter software and support revenue and free cash flow for the calculation. Rolling-4-quarter software and support revenue growth: ($810 million/$550 million) – 1 = 47% from our Q3 18 investor presentation. Rolling-4-quarter free cash flow of $17 million is 2% of software and support revenue.”
He believes that the rule of 40 — which he said was developed to help investors understand software as a service providers like Salesforce — helps Nutanix strike the right balance between the two. “When growth slows down, a company pays out its cash to shareholders. But we are building a business.”
Pandey is quite a prolific management theorist. For example, he believes that it is better to pay attention to what he calls “Main Street” — Nutanix’s customers and employees than to focus exclusively on “Wall Street.”
He also says Nutanix has a strong culture. As Pandey explained, “We have 3,700 or 3,800 employees as of the second quarter. And we operate based on the 4Hs — Hungry, Humble, and Honest, with Heart.”
The culture is important for his relationship with Main Street. As he told Channelnomics Europe, “When you have to stay connected to Main Street, you have to be humble, you have to be hungry and you have to be paranoid, and be very honest about things. Because Main Street doesn’t give a hoot about what your stock price is. It is demanding more authenticity from itself – from CEOs down, we are having to think about the consumer all the time. That is a great development for our industry.”
The role of the CEO at Nutanix has changed over the years. “In year one, I wrote 20,000 lines of code to get the product out the door. In year 2, I was acting as the VP of engineering and writing code, and in year 3, I was acting more like a CEO — as a generalist. Even today part of my role is as a product manager and architect. But I have learned how to speak the language of marketers, sales, and finance. You have to speak their language [to lead them],” Pandey said.
He is acutely conscious of the dangers of complacency that often accompany success. As he said, “Bain & Co. has an 18 minute video on the Founder’s Mentality which is amazingly instructive. When companies start acting like incumbents they stop growing. The paradox of growth is that growth creates complexity which kills growth. We always think of it being Day 1 — we keep our scrappiness. We are in 55 to 60 countries and we have 50 to 100 people in hubs so we can be global and act local.”
Pandey is working to make culture even more pervasive at Nutanix. “We are launching the 12 cultural principles to put the 4Hs into action. We will put them in the hallways and meeting rooms. Even though I cannot physically be in every room, with these principles I will be there mentally. These principles will help us fight cognitive biases, drive decisions, and resolve conflicts,” he said.
Nutanix also tries to balance its “heart” and “brain.” As he said, “Engineering and the product are the heart of the company. All the other functions — such as customer success — are the brain. Our goal is to earn a high net promoter score from our customers [a measure of how eager customers are to recommend the company to others]. We don’t sell and run, we sell and stay.”
Pandey believes a balance must be stuck when innovating. As he said, “People love new things (they’re neophilic) and they don’t love new things (neophobic). For example, Google Glass failed because it was not socially acceptable to record a video of the person you were talking to. To find the right balance, we build products that are Most Advanced Yet Acceptable (MAYA). We also apply this principle to customer experience, organizational design, and business design.”
Nutanix’s organization pushes responsibility for individual services down to general managers. “Our products support 10,000 customers and products get very complicated. So we break the products down into smaller pieces — we call them micro-services. We have general managers who are in charge of service level agreements, product design and go-to-market [functions such as marketing and sales]. Otherwise it becomes a hairball. We believe in scale out — we have these general managers all over — in Bangalore, Durham, and Seattle. Eventually it all comes together again with customer being our true North,” Pandey said.
Nutanix is full of original-sounding management philosophies and if it can use them to keep growing faster than investors expect without burning through too much cash, its stock price could keep moving up.
If you think Nutanix will beat expectations when it reports later this month, this could be a good time to buy.