Nutanix, Inc. (NTNX) Earnings Call Transcript & Summary

Okay. Let's go ahead and get started. I'm Katy Huberty, Morgan Stanley's IT hardware analyst, and I'm really pleased to welcome Duston Williams, CFO of Nutanix. Duston has been CFO of public and private companies for...

Forever. Forever.

A very long time. Taken, what 3 companies, public, including Nutanix, in 2016. So we're very happy to have him today.

I have, yes. Yes, thank you.

Thanks for your time. Before we begin, let me just note that important disclosures, including personal holdings disclosures and Morgan Stanley disclosures, appear on the Morgan Stanley public website at morganstanley.com/researchdisclosures or at the registration desk here. So let's jump right into it, and we'll see if we have some time for questions from the audience at the end. Nutanix, as you have seen and worked through very closely, has gone through multiple transformations in a relatively short period as a public company. When you became public, you were embracing the OEM model, shifted from appliance to software only. Currently, moving through a transition from perpetual to term licenses. And then over time, looking to do more SaaS as you move up the stack. So I guess just from a big picture perspective, what lessons have you learned? What have been some of the challenges as you've gone through those transitions?

Yes. So as Katy said, we've been through 2 transitions. And I think if you separate the 2 transitions, I think the first one separating the hardware, although it was unique and really -- for the most part, really never been done, we kind of really nailed that one with a great level of consistency. And we put a plan out there as far as the amount of hardware that would come off over time and the impact to the top line, impact to the gross margins. And a lot of that transition was back office-related, if you will, and we executed, maybe not flawlessly, but pretty flawlessly on the first one. The second one, it was -- which we're going through today, is much more complicated on one hand. But ultimately, the payoff from this transition towards the payoff from the first transition, which I'll get into in a second here, which we're really excited about. But this transition, they're always a bit messy. And again, deep within infrastructure, there's really never been a true subscription model. So we weren't sure how customers would latch on to this. We had a lot of education to do with our sales force. We have a lot of education to do with customers. We had a lot of process changes that we needed to do. There were a lot of -- if you think about lessons learned from that perspective, the education upfront is massively important because think from a rep perspective, a rep was in the field selling an appliance that had some COGS attached to it. And that rep, he or she knew what a, kind of, a good gross margin was, if it was above 60%, it was probably good, if it was below 60%. And then basically, overnight, that rep went to selling 100% margin software. So what's the appropriate discount? What's the appropriate price? So we probably could have been a little bit more prepared from an education perspective on that. We've obviously since done that. But that's clearly a lesson learned there. And just to -- I think a lot of these things have clarity in hindsight, obviously, and all of these transitions have unique characteristics to them, the biggest impact being part of the transition to us now is the top line with the percent of subscription as far as what that percent is going to be. And we have exceeded, quite honestly, our expectations. There's been a lot of focus on this, a lot of hard work. But this quarter, going from 73% to 79% subscription impact to the top line. And -- but it's all goodness as far as going forward. And maybe if we have time or another question, we can touch a little bit on, again, all this messiness, all this hard work, all the impact to the top line will ultimately pay off quite nicely as we move forward to this transition and we get into a little bit of the renewal flow.

So there's clearly financial and valuation benefits to moving to a ratable model. You have more visibility, investors are willing to pay more for that revenue stream. What are some of the other benefits in terms of maybe expanding your TAM or the relationship with the customer?

Yes. Clearly, from a relationship with the customer, there's a lot more, I think, touch points along the way now with the customer. I think we make it easier to consume our software from a customer perspective, but just don't forget, on a life of device transaction, I mean, we were effectively asking customers to chew off 5 years of software value all at once. And there was no option. You had to buy the appliance, you had to buy the associated life of device license, and if you're running that appliance for 5 years, you have to chew off the whole 5 year value. And some customers that works fine, and it's not a big deal, but think about it in the mid-market piece and maybe a customer doesn't want to or maybe a customer doesn't have the budget to chew off 5 years. That customer now has the optionality to do a 1-year deal, or a 3-year deal, or a 4-year deal, or a 2-year -- whatever that customer might want. So clearly, I think that has opened up, clearly, some potential there as we segment and move into the commercial market, which we're doing heavily in the Americas. I think that plays really nicely into expanding things there.

You mentioned before that it took some time to get the pricing right as you move to the subscription model. How do you think about this over the long run? Because one of the reasons investors love these models is that prices could actually go up over time. Do you have any intel yet as to what the pricing might look like on renewal?

Yes, we don't. We have some very primitive looks on the life of the device support renewals, and we've been very successful on those, but that's kind of in a different bucket there. So we'll have to see. I mean, I think when you look at all the new products that we talk about that were 13% of ACV in the last quarter, which we're quite proud of, those products ultimately, in my mind, those products' main mission in life are to add stickiness to the total solution. So that can just help that situation there. What we do know today, just plain subscription versus LOD -- we mentioned this on the call, I think it was your question that I answered, that when you look at the 3-year subscription deal compared to an LOD, life of device deal, and you make them equivalent to 6 years over time, 2-, 3-year subscriptions, one 5-year life of device plus a support renewal, we know we're getting a fair amount of more value upfront on the 3 years. Now 5 years, we learned a lot, which we've talked about, which we're working, and we would expect that to go up. But I think on the renewals, I think as long as we continue to add value to customers with these new products, make their life easier, make the product simpler, I think the opportunity there is huge.

And how are you evolving sales commission structures to drive adoption of of the shift to term from perpetual?

Yes. This is an immense amount of focus. I've taken a heavy interest in this and helping drive a lot of this thinking here because this is the key. And we can't get this wrong. It needs to be well thought out in advance. We're doing it. I've mapped out pretty much a 3-year -- and we do commissions in 6-month increments, I've mapped out a 3-year road map, if you will, for comp structure for the sales group. And we have to get this right, and we have to morph the sales comp, ultimately, for the company to take advantage of a subscription model, just like any other company. So this is -- it's a huge effort. It's going to be a gradual transition, just to -- and we'll talk more at Investor Day about this, but we mentioned last week a couple of things that we're doing, this first go around here, as simple as any rep that wants to do a new life of device deal with a customer, a new customer, that will have a negative multiplier. If we fast forward to the next 6 months, any customer doing life of device, the rep will have a negative multiplier on that deal. So again, driving a higher subscription sooner. I think when you go and look at the next transition, the next big transition will be bringing our -- today, a rep is paid on TCV and not ACV. So that is a massive change, but I don't think it's a -- and we have to do this right, I don't think it's a really high-risk change. Because today, we don't have a lot of -- we have very little renewal flows into the business. So the reps haven't lived off renewal flows. So I think we can do a simple conversion from TCV to ACV quota, we'll get the rate up to kind of keep the initial OTE pretty close to whole, and then once the renewals flow in, we'll treat that just like any other subscription company, right? A rep may get a small piece up the stack of that deal. But effectively, those renewals come in, in a relatively friction-free manner. And that's what we have to do. And that's what's ultimately the payoff here for all the hard work and all the messiness that we've had from this latest transition to subscription. It's when those renewals flow, and don't forget, most every subscription company for the most part started day 0. We started at $1.5 billion, and we started about 1.5 years ago, and the subscription deals are about 3.5 years on average. So we have a ways to go before that renewal flow comes back into the business. But we have to, in the meantime, structure the business, structure the comp, structure processes to make sure that when those renewals flow back in, they come at a very high efficient factor. And if we can do that and get that nailed properly -- and we know we have a 97% retention rate. We know we have a net dollar-based expansion rate into the 130% range. So the business is set up nicely for this. We just have to be a little bit patient. And during Investor Day, the objective here is to kind of show how that works. And we've still had to work through a few things here. But ideally, what I'd like to show is over an extended period of time, and I'm talking maybe a 6- or a 7-year period, how the new business percentage looks over time, how the upsell looks over time and how the life of device refresh looks over time as a percent of the total. And most importantly, how the subscription piece of the business renewals look over time because today, that's tiny. And the only piece of the business today that's really true renewal is the life of device support renewal. And that's 5% or 6% of what it is of the business, very small. But over time, naturally, as these renewals come flowing in with a 97% retention rate, we know that, that becomes a big percentage of the business going forward. And if we can detach a high-efficiency factor, which should be, just like any other subscription company, to those deals, by definition, leverage comes down. And so we'll kind of show that and how we think that plays out. I think it's a massively exciting piece of the business model that's really, really underappreciated because we've seen all the ugliness, we've seen all the hard work, we've taken all the pain and there's really been no gain. And this is what we've set the business up for expanding markets, this, that, make it easier for customers. And I think, ultimately, the business model plays out nicely.

Speaking of the pain, you're ahead on the subscription transition, 79% of billings. But that's putting pressure on revenue. When do we see the transition where that revenue headwind really starts to fade?

Yes, so we would have mentioned that call. If you looked at it now on a total, total revenue perspective, we've now started to see really bottomed out, we believe, had a negative 1% or whatever that was and some re-acceleration when you take out all the noise plus the hardware, the this, that and whatever. So we've seen some of that. We're still -- obviously, the top line is still subject to this percentage remaining of subscription that we've gotten. And think about it again, we've got about 5% of the total revenues that are bookings or professional services. So right now, the max we could go is like 95%. Our goal is to get 100% of nonprofessional services. So we're at 79%, the max we can go is 95%. It's a little tough now to understand exactly that road map to 79% to 95% because we've got legacy customers and how fast can we get those legacy customers over to subscription. Now I always get a little kick out of this because you get the story that, "Oh, Duston, it's impossible. They don't want to do it, they want to do it." But the minute you start tweaking commissions a little bit, then it gets a little easier to do. So ultimately, we'll get to a state here, maybe won't be for another maybe 3 cycles that we probably don't pay anything on or we pay a very small percentage on any life of device deal. So I think we're -- we still have some downward pressure if we accelerate this quicker. I wouldn't -- I'd be surprised. Now we saw a big jump last quarter. I'd be surprised if we saw another big jump. It's a little dependent on big deals and where those big deals flow, life of device or subscription. But again, we've got the term compression when that happens. And we've got still some messiness on the 5-year deals that today, a life of device is getting us a little bit more than a subscription 5-year deal. We've got some compounding things there that go against us. But again, all good for the future.

So over the last year, as you've seen, the near-term revenue headwind from the shift to subscription, you have continued to invest in the sales force, which is the right thing to do. But paying the -- or investing to acquire new customers puts pressure on margins, so you talked a little bit about renewals as driving some operating leverage. What are some other levers that you have to start to drive that operating leverage? And when should investors think about Nutanix starting to balance a little bit more revenue growth and and operating profitability and looking to get to free cash flow neutral?

Yes. I think in the interim here, before we have a big flush of renewals, there's some simple, really, simple things we can do, which we've talked about discounting. And to put some parameters there, but 1% less discounting, there's massive top line leverage and something as simple as that. So that has been a big focus there. I think we've talked a lot about the commercial business and how we're investing quite heavily in segmenting Americas' commercial business. We're now, I think, into roughly the third quarter of that effort. And I'll tell you the first 2 quarters looked pretty good. And we have a ways to go there to really ramp that up. But so far, that has -- I think, to say we have a ways to go. So I don't want to call it done, but it's clearly with the couple of quarters of knowledge, the right thing to do. The deal sizes aren't terrible in that sector. The discounting is actually very good. You'd be surprised of the level of discount. We've got some really good leadership there in the Americas commercial that's helping drive that. So there's lots of -- and then, of course, the big deals. Big deals solve all -- most of all issues. And we've been pretty successful with big deals and continue to be successful. And I guess, I said there was a lot of pain and no gain to subscription. The small piece of gain that we have seen by the conversion of all this subscription is that it has allowed us to have a tool to convert some of these life of device deals over to subscription. And now a customer has all sorts of optionality when we're talking to a customer about converting over because, in some cases, we have a customer coming to us and maybe they want to renew their support on a life of device transaction. We'll go to them and say, "No, let's look at it in its entirety. And maybe you want to do the conversion over now to subscription." We can bulk those deals up significantly. We can co-term a lot of their product and things like that. So we've seen a little bit of that from that perspective. So I mean, those are some of the things in the interim that we're working on that can clearly help that. Now your question on when do we take more of a focus on leverage as opposed to top line growth, and you've seen us, maybe for a little different reason here, but in the next couple of quarters, which we talked about is expensive, and we've taken a somewhat of a pause on some headcount additions. And that's probably a little bit more connected to some uncertainty, what's going on externally with the coronavirus and things like that, some unknowns, but I think we've taken some prudent steps there. And even before that, we've started to look at some things, how we can do things more efficiently. But it's a big market. There's, I think, no doubt, in my mind anyway, and I think I'm right on this, is that our product is clearly a superior product. We fight incumbency every day, but clearly, the product is an elegant solution. We've done quite well. I always focused on big customers and our big customers are giving us the 90 NPS score and they repeat purchasing, and they're buying new products, and they are doing all that. And if that's working, probably the product is working. So we've always been pretty sensitive to back off too much. And even in this latest pause, we continued to add quota-carrying sales reps. We've backed off some of the support infrastructure within sales, but we continue to hire reps pretty much as planned there. Because even in worst case on the rep piece, we've always done these analysis even as a private company for our board of recessions, and we've gone back and looked at history. And most -- and there hasn't been -- thankfully, there hasn't been a ton of evidence lately, but if you go back to the last 2 downturns, which we've studied in the past, and you look at companies and what's the decrease in revenue and how long does it last, it's usually 3 quarters and this and that, whatever, we've done this analysis. And our opinion always has been, you're much better off regardless of the downturn to continue to hire quota-carrying reps because when the upturn comes, if you haven't been hiring the reps, you are 9 months at least behind the curve of the uptick because then you got to hire a rep, you've got to train the reps, you've got to get them up to speed and all that stuff. So we've always taken that approach from that perspective. So we've kept that whole, we backed off some support structure on the sales piece. R&D, we've paused a fair amount there. And then we've always had an emphasis of doing a lot of the R&D in low-cost regions, and we continue to do that. So I mean, it's always in our mind. I think, historically, we've done a really good job of managing growth in cash, '19 and '20, with the subscription, we've had some significant top line impact, which has hampered cash flow a little bit. But I think we've done a reasonable job, not a perfect job of managing that. And with top line, and we're really happy with the product and more so the vision on some of the new things that are coming. And so we'll continue to try to balance that prudently.

Give us some more color on that near-term outlook for fiscal '20. You lowered the billings outlook by 3% to 5% with 2 quarters to go, about half of that is the subscription transition that's happening faster than you expected. The other half is some weakness you're seeing in APJ. I think, particularly, the demand weakness would be interesting to just understand. Is that true demand? Or is that supply chain or a combination of both?

Yes. So great questions. So we did bring the guidance down $50 million to $80 million, I think, low end and top end last week. And roughly, again, $25 million, $30 million was subscription-related. The remainder we kind of tagged on to APJ. And the reason we did that was with the health issues and the coronavirus being kind of a longer trend in APJ. We had a couple of more data points there as far as what was going on in the region based on our roll-ups internally, having some big deals in Japan that became -- I don't think it's a question whether we win them or not, it's just the slowdown impact the timing of those big deals. And I simply looked at it from the perspective of -- some people say, "Well, Duston, what do you worry about China? It's such a small piece of your business, it doesn't matter." And I go, "No, you don't understand." It's that up until last week, and I don't know how things have changed this week, but there was, obviously, no meetings happening in China, there was no meetings happening in Korea, there's no meeting happens in Taiwan -- or in Hong Kong. And there was -- most of the meetings weren't happening in Singapore and Japan was spotty. So you hear that and it can't help. I don't know how much it hurts, but it certainly can't help a business. So we had hired a fair amount of sales reps in APJ over the last several quarters, and this is more coming out of expected growth out of the second half there. Now we'll see how it all plays out. But to your question, whether it's demand or supply, this, in my mind, was -- it wasn't a desire for demand. But it was demand-related because if you don't have meetings -- and don't forget, we don't yet today. We will live much off renewals. And it's not like this is just okay, let's get this renewal, let's get this renewal. And APJ lives off a higher percentage of new business, so there's a lot of upsell. So there's a lot of business that needs to be transacted. So we'll see, hopefully, we took a prudent view on that. And we didn't have the same insight into EMEA. Now Italy is kind of accelerated a little bit there. We'll have to see how that plays out. We didn't put any impact in for EMEA. But the team there was pretty happy with their backlog or -- I'm sorry, their pipeline position going into the second half, they're pretty bullish. And hopefully, this doesn't slow that bullishness down. Now from a supply perspective, we've tried to keep kind of a little bit of the touch points there. I know last week, again, we got a data point of 30%, 40% factories were kind of back capacity. We got another data point late last week that it was 55% to 65%. So it seems like things are kind of going in the right direction there. I think supply would -- I'm told anyway, probably gets a little tight at the end of our Q3. And Q4 is a bit of a question mark as far as how things progress through Q3 here. Now again, we love all of our partners. But ultimately, we don't care what server our software runs on. So that's helpful. It's pretty ambiguous to any server out there running. So we're -- we have no bias there. It's really what the customer wants and what's best for the customer. We did have some interest, [ the data's still ] small, but it's just interesting how these things have different look and feel to them. We've had a couple of deals that folks actually accelerated from Q4, I believe, because they were afraid of service supply. So they wanted to kind of pull things forward.

Get the deals done.

To get the deal done if there was going to be an issue on supply. So there's a couple of small data points, but it was interesting to see there. So -- but that's the -- that's kind of our...

Yes, very dynamic situation.

Yes, it is. And you can -- you'll never get it right. We tried to take an educated guess on the data we have. We didn't have anything for EMEA. And of course, America, we kind of left alone. So now we'll see how it plays out and kind of go from there.

From a product portfolio standpoint, Nutanix, it started out as really an HCI OS and management software company, and you have expanded to providing services for cloud and security and networking and storage, et cetera. What percentage of your sales or what metrics do you look at in terms of your penetration into some of those new software offerings? And where do you think those metrics could go over 3 to 5 years?

Yes. The easiest one to look at, which we've been kind of spottily disclosing is new products as a percent of ACV. Last quarter, that was roughly, I think, 13% and that's in a fairly short period of time. So that's intriguing. And I think we mentioned this on the call, but the even more intriguing thing on that new product percentage is that the Global 2000 is a little higher than that. So people think, "Oh, these are kind of immature products. And this is all kind of smaller customers." That's not the case. And we've had really good traction on some of these deployments, and we continue to enhance the capabilities, much like when we came out with a hypervisor AHV. It's the same thing. At first, it was a little bit limited, and they got better and better and better. And these products would do the exact same thing. And that -- the traction with these products will continue to, I think, accelerate. And as I mentioned earlier, the intriguing thing, again, there is how much stickiness does it add to the total solution because you think base HCI, core HCI, as we define it, just like any large market commoditizes over time. It just is. It will -- it's just any big market commoditizes. And -- but all these new products, obviously, new functionality, new simplicity, up the stack to offer a full solution for customers clearly helps that. So the 13% will continue to accelerate. I think Dheeraj is throwing out a number sometime, at 25% or so. I don't think that is clearly not out of the question at all. As they get bigger function now, we started doing bigger deals with some of these products with big customers. And so I think that it's all very intriguing. With this, Files has done quite well. Era, which is database kind of life cycle management automation. Calm is kind of an interesting one in that, not -- it doesn't drive massive revenues. But it's being used today to get workloads to the public cloud and manage them when they're there. But where Calm will really come into play is with Nutanix Clusters. Now that's our hybrid cloud offering. And ultimately, what you'll be able to do, help like Calm and Beam to some degree, is to take your legacy apps -- and there are legacy apps that, today, aren't conducive to be ported to the public cloud because they weren't written, and they'd have to be redone and all that stuff. To take a lot of your legacy apps using our existing Nutanix operating system with Nutanix Clusters and have kind of some seamless portability of that app and workload to a public cloud, ultimately, to your choice of public cloud in a very elegant, again, seamless way using the same operating system, the same look and feel to be able to move those workloads that you want in the public cloud. And there's workloads that belong in the public cloud, and there's workloads that don't belong in the public cloud. So our view is that's great. We'll take care of the workloads that don't belong in the public cloud in your own private cloud. And we'll help you get the workloads that belong in the public cloud through Clusters in a very seamless, cost-effective way. So we're really excited about that. We believe it's much more elegant than anything else out there. We've been working closely with -- on the Amazon AWS Solution. That, we've said, is kind of the back half of the first part of the year here. And that will, ultimately, utilize bare metal in Amazon. In fact, they run in Amazon. You can use your existing accounts, you can use credits, you can use exist -- all Amazon's AWS' native services, you can use their networking. The difference here is just that it's a Nutanix software that's powering this, and ultimately, having the portability to and from public clouds and all that. So if we get that right or mostly right, very exciting.

Is that -- so that's around the summer time frame? And is that GA? Or is that...

Yes, yes. That would be GA, yes. Yes.

Okay. Interesting.

So AWS is first. We're doing a lot of work from an Azure perspective, so that...

How far behind would Azure be?

A little bit. I don't know if we've said exactly, but it's -- it'd be several months behind. But that's also exciting. We have a few customers, large customers that have some legacy asset they'd like to put there and have a lot of credits to use, and it's too clunky and too tough to do that now. And so this would be a perfect vehicle for them to do that. So it's a complicated product, it's a lot of work. It will, again, like a lot of our products, evolve over time. But this one, if we get it mostly right, will be pretty exciting.

How is the competitive landscape evolving? If you looked at that third-party data between VMware and Nutanix, it's really 70% of the market. So it looks like a 2-horse race, but you do have NetApp and HPE, who have some of their own solutions, and you also have Amazon and Microsoft, who are trying to move into the hybrid world. How is that evolving?

I don't think there's been a really a massive change at all in the competitive landscape. I think if you back up, I think it got a little muddled maybe a year plus ago with some of our thrust into subscription. We had some messiness within sales. We had a bunch of new products all at once. So a lot of that messiness kind of got chalked up to competition. And I was never really bought into all that, but people defaulted, "Oh geez, competition is getting tougher." So okay. But if you fast forward today, I don't think anything has massively changed. I don't like to talk about win rates a lot because you can calculate it in a million different ways. I just rely on our product management folks to do it in a consistent, calculated way. And as long as that happens, I'm happy. And the win rates, historically, over the last several quarters have bounced around a little bit. This quarter, it's a one data point, so it is what it is. But that -- our win rates actually ticked up a bit. So I don't know what to read into that besides it's just factual. So that's encouraging. But yes, from a public cloud perspective, again, we'll go -- I think that's probably more complementary over time to us with how we can help workloads get there because ultimately, that's what they want. They want more workloads running in their location. And I think if we can help our customers do that seamlessly, cost effectively, I think, that's all good there. So I think there hasn't been anything that -- I'm not a great technologist, but I have a close handle on the business. And I don't see anything that's been really different there.

Okay. Let me just stop there and see if there are any questions in the audience. Otherwise, I'll keep going. One back here.

I appreciate that the model that you're going to lay out at the Analyst Day is going to have a 6 to 7, kind of, year time frame in terms of how you guys see the evolution of the business on the subscription side. But just how should we think about some of the more near-term time frames and milestones for you guys? And I guess, as we kind of continue the transition, what's the risk to, sort of, quarterly cadence and kind of hitting numbers, kind of, going forward that may be affected by transitions? Obviously, subscription transitioning faster is a good thing. But in terms of how it affects your, kind of, quarterly financials, it maybe has a bit of a drain. So how should we kind of think about that dynamic between accelerating the ultimate goal versus managing expectations and hitting sort of the more nearer term expectations?

Yes. No, it's a good question. I appreciate it. Some of this, this change from 73% to 79%, if we knew it was going to be 79%, we obviously would have guided with that view of 79% and things like that. But it's not that we're just moving a dial, and it's like, "Duston, what do you want it to be this quarter?" There's, again -- that's somewhat dependent on large deals. If we get a life of device customer that converts over to subscription, that's going to knock the subscription piece up. If we have a life of device customer that wants to do a big deal that's going to stay on life of device for a while, it's going to damper that down a little bit. So I don't think there's ever someone not being conscious about what we put out there for guidance and trying to manage to that guidance number. On the other hand, just getting through subscription is really important for us. And the worst case that we could be is in the middle. And that continual, okay, we've got another percent, we've got another percent here, I'd love to wake up tomorrow and have it done. I don't think that's going to happen, but there's not a perfect answer to your question. But again, I think everybody -- now the good news is we're at 79%, and the most we can get to is 95%, if you take professional services out of the equation, and we still have about 2% hardware [ refits ]. So maybe, say, it's 93%. So there can't be massive volatility here going forward, but we'll continue to take in consideration what we put out there for guidance. And as I say, the level of movement will by definition be smaller and smaller each quarter here.

We've 30 seconds left. Any last questions? Okay, we'll wrap. Great. Duston, thank you so much. Had a blast. Appreciate it.

Okay. Yes, thank you. Okay.