Nutanix Stumbles on Sales Execution and Subscription Model Growing Pains

Slowing growth at cloud infrastructure software innovator Nutanix (NASDAQ: NTNX) was coupled with rising losses in the company's fiscal third quarter of 2019, as shown in the company's May 30 earnings release. Nutanix had disclosed sales execution issues last quarter; nonetheless, investors still seemed surprised by a curbed top line and a tepid outlook for the final quarter of the fiscal year.

Let's review the highlights of the last three months and discuss the factors behind Nutanix's revenue compression. Note that all comparative numbers in the following discussion refer to the prior-year quarter.

Nutanix: The raw numbers

What happened this quarter?

  • Revenue fell below management's previously issued guidance of $290 million-$300 million, a range that already represented meager growth compared with prior periods.
  • Billings -- recorded revenue plus the year-over-year change in deferred revenue -- declined 1.5% to $346 million, also falling below management's guidance of $360 million-$370 million.
  • Software and support billings increased 11% to $324.2 million.
  • Management pointed out that the company continued to make progress in its shift to a subscription-based model, as subscription billings made up 65% of total billings, and subscription revenue of $168.4 million jumped 110% over the third quarter of 2018.
  • Deferred revenue, an important barometer of future revenue recognition, increased 55.3% to $838.3 million.
  • Gross margin jumped nearly 700 basis points to 73.9%, as a continued shift away from pass-through hardware sales reflected improved profitability. Hardware sales reached a historic low of under 8% of total Nutanix revenue during the quarter.
  • Nutanix ended the quarter with 13,190 end customers, a sequential quarterly improvement of 6.2%.
  • The company notched its largest subscription sale with a new client, a $6 million deal with a global Big Four accounting firm.
  • Sales and marketing expenses climbed 44.7% to $245.7 million, while research and development expenses leaped 70% to $138 million. These were the primary drivers behind Nutanix's expansive net loss during the quarter.
  • Growing software companies often incur significant amounts of non-cash stock-based compensation expense in hiring and offering incentives to employees. After removing stock-based compensation, as well as the amortization of intangibles and a few smaller adjusting items, Nutanix's non-GAAP loss landed at $103 million, and it recorded a non-GAAP loss per diluted share of $0.56.

Sales execution and subscription growing pains

As the company explained last quarter, a deficiency in spending on sales lead generation and execution missteps in its sales pipeline is part of the issue Nutanix is experiencing in a faltering top line. The immediate solution is to allocate more dollars to lead generation, while hiring additional sales personnel. This initiative is one of the reasons sales and marketing expense rose so significantly this quarter. During the company's earnings conference call, CEO Dheeraj Pandey updated investors on the condition of its sales pipeline:

Management also discussed another revenue headwind during the call. CFO Duston Williams explained that after reaching scale in its subscription revenue stream, Nutanix is in a better position to analyze differences between the older sales model, in which length of licenses were tied to life-of-device estimates, and the current model, in which subscription lengths are based on cores and flash capacity.

The current model appears to produce shorter license lengths on average, creating an initial negative revenue differential of 5% to 10% against the former model. However, under the subscription model, the company can count on a high probability of license renewal, so over time, the difference will work itself out. Still, the differential is creating near-term revenue compression as the company completes its transition to selling subscription licenses.

Looking forward

For the fourth quarter of fiscal 2019, Nutanix expects revenue of $280 million-$310 million, and billings of $350 million-$380 million. At the midpoint of the expected revenue band, the company's top line will increase by only 2% over the $289 million Nutanix recorded in the fourth quarter of 2018. However, as CEO Pandey hinted at, Nutanix is looking to regain some top-line momentum in the coming fiscal year. The company anticipates that it will generate a non-GAAP net loss per share of $0.65 in the fourth quarter.

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Asit Sharma has no position in any of the stocks mentioned. The Motley Fool recommends Nutanix. The Motley Fool has a disclosure policy.