Cloud computing provider Nutanix (NTNX -2.51%) issued a fiscal second-quarter earnings report on Feb. 28 that surprised investors with anemic guidance, causing shares to skid by nearly 33% in the trading session following the earnings release. Below, let's review the quarter's highlights and focus on the third-quarter tea leaves that triggered such an adverse reaction from shareholders. Note that all comparison numbers in this article refer to the prior-year quarter (the second quarter of fiscal 2018).

Nutanix: The raw numbers

Metric Q2 2019 Q2 2018 Year-Over-Year Growth (Decline)
Revenue $335.4 million $286.7 million 17%
Net income (loss) ($122.8 million) ($62.6 million) (96.2%)
Diluted earnings (loss) per share ($0.68) ($0.39) (74.4%)

Data source: Nutanix. 

What happened this quarter?

  • Billings (recorded revenue plus the year-over-year change in deferred revenue) improved 16.2% to $413.4 million. 

  • Nutanix continued its transition to a recurring business model, as subscriptions comprised 57% of billings during the quarter.

  • Software and support billings improved 37% to $375.5 million. 

  • Deferred revenue, which provides insight into the relative health of future revenue, jumped 63% to $779.9 million.

  • The company continued to add customers at a rapid clip: Nutanix signed on 920 new organizations to end the quarter at 12,410 total customers.

  • Nutanix's running total of customers with lifetime spends over $1 million expanded to 779 during the quarter, an increase of 44% over the second quarter of 2018.

  • Gross margin improved by 12.2 percentage points to 74.4%, reflecting the company's shift away from pass-through third-party hardware sales in favor of higher-margin revenue streams.

  • Despite the significantly improved gross margin, Nutanix's loss from operations nearly doubled to $116.2 million, as sales and marketing, research and development, and general and administrative expenses all rose significantly against the prior-year period.

  • After removing the effects of stock-based compensation, the amortization of intangibles, and a few other minor items, Nutanix reported a non-GAAP net loss of $40.4 million and a non-GAAP net loss per diluted share of $0.23.

Check out the latest earnings call transcript for Nutanix.

Chalkboard illustration of cloud networking concept: tangled wires flow into a cloud and emerge sorted on the other side.

Image source: Getty Images.

An unexpectedly tame third-quarter outlook

In its earnings release, Nutanix forecast fiscal third-quarter revenue between $290 million and $300 million. At the low end of this band, Nutanix will book virtually flat revenue against the $289.4 million top line it achieved in the third quarter of fiscal 2018. The range blindsided investors who have become accustomed to much more aggressive growth from the organization.

During Nutanix's earnings conference call, CFO Duston Williams explained to investors that management had recently identified "imbalances" in the company's lead-generation spending that had affected its sales development pipeline. 

Williams stated that Nutanix's spending on new sales leads jumped by 75% in fiscal 2017, resulting in a stronger sales pipeline in fiscal 2017 and 2018. The company also realized efficiencies in its lead-generation spending in fiscal 2018. As management became "encouraged by [our] overall company performance" in fiscal 2018, he said, it began to reallocate some of its lead-generation budget to other priorities.

For four quarters (the fourth quarter of fiscal 2017 through the third quarter of fiscal 2018), spending on new leads remained flat, but Nutanix continued to see growth in its sales pipeline and overall top line. Management assumed this trend would continue into 2019, and reallocated more capital away from nuts and bolts spending on sales prospects.

Over the last two quarters, executives apparently recognized that the company was underspending on lead generation, and started to increase resources allocated to this crucial function. Williams noted that the magnitude of the ongoing spending shift to correct the problem is in the range of "a few tens of millions."

The effect of shackling the front end of Nutanix's sales pipeline was worsened by a shortage of sales reps in the first two quarters of fiscal 2019. Management revealed on the earnings call that it's cut back on non-sales hiring in order to optimize its sales personnel levels. Nonetheless, the company anticipates that sales hiring will proceed at a slower rate than previously expected in the third quarter.

External versus internal factors

During Nutanix's call, executives expressed confidence that neither competition nor changes in market demand played a role in the company's sales pipeline weakness. CEO Dheeraj Pandey reinforced CFO William's assertions that resource allocation is the culprit behind disappointing forward projections:

I just had two simple inputs: It's time and money. And time is what [the] sales force actually puts in, and money is what we give them to go and do all sorts of events and how do you set up meetings. So, we start looking at these different tiers of the funnel, starting from marketing qualified leads, to meeting setup, to opportunities created, to things below that in the funnel itself. And in that sense, I don't think the methodology has changed.

It's just that the input, which is the most basic input, is dollars, and that has a certain formula to that how those dollars convert to leads and to meetings and to opportunity and things of that nature. 

In essence, Nutanix is confident that its projected sales deceleration can be addressed over the next several quarters simply by reprioritizing funds to tactical sales activities, along with the hiring of more salespeople. Management doesn't believe that its top-line issues run any further than a rebalancing of inputs. Shareholders will await third-quarter results for the data to support this thesis.