Nutanix ( NTNX -3.55% ) posted worrying fiscal first-quarter results with declining revenue, increasing losses, and negative free cash flow. But the cloud-computing company has initiated a significant transformation that should lead to improving performance. Here's the key metric investors should watch during that transition before considering buying the stock.
Opportunity in the hybrid cloud
Nutanix's fiscal first-quarter year-over-year revenue decline of 0.6%, to $312.8 million, seems weak given the attractive market for the hybrid cloud (any combination of public and private cloud) that the company addresses. The research outfit Mordor Intelligence estimates that the hybrid cloud market will have a compound annual growth rate (CAGR) of 18.7% by 2025.
Nutanix is poised to capture that opportunity. Its hyper-converged infrastructure software simplifies the administration of the server, storage, and networking hardware infrastructures by virtualizing them and making them look like a private cloud. And last quarter, the company expanded its footprint to public clouds thanks to partnerships with Microsoft and Amazon, enabling new features such as seamless application mobility between private and public clouds.
In the medium term, Nutanix's solutions should allow customers to seamlessly run any workload (cloud applications) on any cloud.
Transitioning to a subscription-based business
Despite its attractive offering, Nutanix has had heavy losses over the last several years. During the last quarter, losses increased to $265.0 million, compared to $229.3 million one year ago, because of huge sales and marketing expenses as a percentage of revenue (82.3% during the last quarter).
That poor performance partly explains why management decided to transition its sales strategy from multiyear deals to annual subscriptions in 2018 (the pivot of the tech industry to subscription offerings didn't leave many other options anyway).
In any case, shorter-term contracts command lower discounts compared to large multiyear deals, which will support higher revenue and better gross margins. And renewing short-term contracts involves reduced marketing costs compared to acquiring new customers with multiyear deals, which should contribute to improving operating margins.
However, that transition will blur the company's top line with a negative effect on revenue over the next few years. Indeed, under generally accepted accounting principles (GAAP), ratable subscriptions lead to lower revenue recognition compared to large multiyear deals and up-front payments.
Focus on run-rate ACV
Revenue will remain less relevant in gauging Nutanix's performance during the transition to a subscription-based business. Therefore, management is focusing instead on metrics that depend on annual contract value (ACV), which corresponds to the total annualized value of a contract, excluding amounts related to professional services and hardware. It also aligned its sales force's compensation scheme last quarter with ACV-based metrics.
Usually, I become rather skeptical when executives switch their attention to non-GAAP (adjusted) metrics. But given Nutanix's transition to a subscription-based offering, that decision makes sense. Compared to GAAP revenue, ACV-based metrics better match the ratable nature of subscriptions, which better represents the company's performance as it switches to subscriptions.
So looking at the fiscal first-quarter results, the run-rate ACV (the sum of all ACV contracts at the end of the period) grew 29% year over year to $1.29 billion. And management expects run-rate ACV to increase by 25% during the next quarter. Those results indicate the transition to subscriptions is succeeding, and performance seems better than suggested by the revenue decline during the last quarter.
Nutanix stock is trading at only 4.4 times revenue, which seems cheap compared to many high-growth cloud players. But to justify a higher valuation, the company must provide solid execution on its transition that brings strong revenue growth and improving margins beyond the short term. So before considering this tech stock, investors should watch to see if strong double-digit growth in run-rate ACV is sustained over the next several quarters.