Nutanix (NASDAQ:NTNX) stock got a big shot in the arm after its first-quarter results turned out to be much better than Wall Street's expectations. But this wasn't the only reason investors were overjoyed. The hyper-converged cloud infrastructure vendor announced that it is pivoting to a software-only business model, and will gradually eliminate hardware sales.

Analysts have been expecting Nutanix to make the business model switch, and the confirmation arrived with the latest quarterly report. The company plans to reduce hardware-related sales to just 8%-9% of the total by the fourth quarter of the fiscal year, down from its 25% at present.

Now, this move might cause some short-term discomfort, but investors don't seem to be worried given the potential for long-term gains. Let's take a look at how this pivot should boost Nutanix's performance.

Artist's rendering of computers connected to a cloud.

Image Source: Getty Images.

Accelerating its move toward profitability

A move to a software-centric business model will accelerate Nutanix's push toward profitability. The company is already making good progress in this area. It reduced its net loss to $61.5 million last quarter from $140.3 million in the year-ago period.

This massive drop in net loss was driven by a 46% year-over-year jump in revenue, as well as a 3% drop in operating expenses. The only sore point was that Nutanix's gross margin dropped from 65.4% last year to 61.9% during the latest quarter. The company's gross margin would have been even lower had it not eliminated 9% of hardware-related revenue, indicating that Nutanix is doing the right thing by pivoting toward software.

In fact, Nutanix claims that the gross margin of its software business exceeds 80%, significantly higher than the margin it generated in the recently reported quarter. To provide some perspective, had Nutanix management decided to exclude hardware-related sales from the balance sheet in the previous fiscal year, it would have recorded $800 million in billings at an 80%-plus gross margin.

By comparison, the company's billings in the previous fiscal year, which ended in July, stood at $990 million. Billings represent the binding purchase orders received by a company, and a higher billings figure usually indicates stronger revenue growth in the long run. So, Nutanix's bottom-line performance could have been much better this year but at the expense of top-line growth.

The software pivot would have hurt billings, pushing the metric closer to the revenue of almost $767 million generated by Nutanix last year, though this was at a far lower gross margin level of just under 60%. Therefore, Nutanix is doing the right thing by making an aggressive push toward being profitable, as the commoditized nature of the hardware business could have taken a bigger toll on its margin profile in the long run.

Higher DRAM pricing would have hurt margins

Nutanix's gross margin has been under pressure because of the spike in DRAM (dynamic random access memory) prices. In fiscal 2017, the company saw a gross profit margin erosion of 600 basis points thanks to higher DRAM pricing. This is because Nutanix provides various storage configurations in its hardware appliances, ranging from as low as 64 gigabytes to 1 terabyte.

Now, the DRAM industry has seen a terrific rise in pricing for over a year now thanks to oversupply. IC Insights estimates that DRAM pricing could rise another 40% this year, and not much respite can be expected going forward as demand growth could continue outpacing supply due to the absence of capacity additions.

Not surprisingly, Nutanix investors aren't concerned about the lost hardware sales as they would have had a negative impact on its margin profile. The company is now on track to eliminate the one headwind that would have affected growth, making it a good bet to take advantage of the hyper-converged cloud infrastructure market that could hit $8.5 billion revenue by 2020.


Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.