Summary
- I think the financial results here are somewhat encouraging in light of the fact that the company held the line on operating expenses in spite of a boost to revenue.
- There are some ongoing issues, though, not least the strong disconnect between revenue and net income, and dilution. Additionally, the shares are not cheap in my view.
- Thankfully, the options market provides investors with a way to capture much of the upside we might see here, while deploying a fraction of the risk.
It's been just over four months since I suggested that investors would be wise to avoid Nutanix, Inc. ( NTNX ), and consider call options if they insist on staying long here. In that time, the shares have returned about 9.8% against a gain of about 7% for the S&P 500. The company's about to report earnings, so I thought I'd review the name to see if it makes sense to buy or not. I'll make that determination by looking at the most recent financial results, and by looking at the valuation. Additionally, I can't wait to write about call options on this name, because the calls I recommended previously did much better than the stock, at a fraction of the risk.
I am absolutely obsessed with trying to make your reading lives as enjoyable as possible. If I could mix you all a nice cup of warm cocoa before you sat down to my stuff, I would. Sadly, that's not possible, but I can try to save you time by providing a "thesis statement" paragraph near the beginning of each of my articles. In the thesis statement, you learn the highlights of my thinking about a given stock so you can then decide to continue reading for more detail, or flee before you get hit by too much "Doyle mojo." You're welcome. I'm going to continue to avoid these shares, and I recommend other investors do the same. I think the most recent quarter was actually a good one, in that the company managed to hold the line on expenses in spite of a large boost in revenue. That's saying something for a company that has such a strong negative relationship between revenue and earnings. The problem is that, while it's still quite strong, the capital structure has deteriorated. Additionally, dilution remains a significant problem for me. Finally, there's nothing that's happened recently that has changed my view that this is a perpetual loss machine. I've compiled financial records that go back to 2013, and since then, the company has lost approximately $4.464 billion. There's also the fact of the strong negative relationship between revenue and net income. In my view, those facts will, sooner or later, become important. That written, I understand why some investors want to remain long here. Some people like trading on rumours, for instance. I think the idea of buying a stock based on a buyout rumour can be risky , as we've seen in this case. But the market is an unpredictable place, and what the market "taketh awayeth", the market can also "giveth." Thus, it's possible that the market will drive this stock higher in spite of my problems with the ongoing losses, for instance. If you're someone who disagrees with me and wants to remain long here, I recommend that you act on that bullish perspective by buying call options. These give you most of the upside you'd get from the stock if it rises in price, at a fraction of the risk. This strategy worked out well for those who bought the January calls I recommended earlier, and I think it can work out well again. That does it for the "thesis statement." If you read on from here, that's on you. I don't want to read any complaints in the comments section about the fact that I moan too much about earnings, or that I spell words like "rumour" correctly.
Financial Snapshot
The financial results are in many ways rather good in my view. Specifically, revenue is up by about $55 million, or 14.6% when compared to the same time last year, and the net loss has shrunk by an eye-watering 76%, from $416 million to $99 million. Before we all get too excited about this improvement, though, I have to point out that operating expenses barely budged from last year to this, down to $431 million for the quarter from $434 million last year. So the $57 million improvement in operating results came primarily from revenue growth. The massive improvement in net income (loss, in this case) resulted from the fact that last year "other expense" was $415.8 million, and this year that mysterious expense was "only" $93.67 million.
Though the capital structure is no longer as strong as it was previously, it remains quite robust in my view. Specifically, cash and short-term investments represent about 102% of the convertible notes and about 42% of total liabilities. Never mind that two years ago, cash represented about 198% of the value of convertible notes. The capital structure remains strong, and so there's little risk here on that score, though I hope the recent trend reverses itself.
Finally, I feel an obligation to repeat an observation I've made about this company repeatedly, and that is that there seems to be a very strong negative relationship between revenue and net income. This is troublesome in my view, because investors are rewarded with profits, not revenue. If a company can't turn a profit after a decade of massive revenue increases, that's troublesome in my view. It prompts the question: if growing sales won't lead to profits, what will? For those of you who are interested in statistics, I've taken the liberty of running a correlation between revenue and net income here for your enjoyment and edification. It turns out that over the past decade, there's a very strong (r=-0.89) negative correlation between revenue and net income here. Generally speaking, the more Nutanix sells, the greater are its losses.
In spite of that, I think we live in a world where the crowd doesn't care about something, until it very quickly changes its tune and cares very deeply about that thing. For the moment, revenue seems to be more important which is why this stock has picked up a nice bid over the years. Additionally, given the continued strength of the capital structure, and the fact that the company held the line on expenses in spite of a rather large bump in revenue, I'd be open to nibbling on these shares ahead of next week's earnings announcement at the right price. I'm disturbed by the dilution we've seen here, but the market seems to ignore that, too.
Nutanix Financials (Nutanix investor relations)
The Stock
My regulars know that I've talked myself out of some profitable trades with the words "at the right price." So, if you're heading to the comments section to write about how my fastidiousness in this regard is self-harming, save yourself the effort because I'm way ahead of you. In response to this criticism, I'd point out that I'm of the view that it's better to miss out on some gains than lose capital. My regulars also know that I consider the "business" and the "stock" to be quite different things. Every business buys a number of inputs and turns them into a final product or service. For instance, the company may offer an infrastructure-software stack that is not only "converged" but "hyperconverged." The stock, on the other hand, is one of an increasingly diluted basket of shares that represent an ownership stake in the business, and these get traded around in a market that aggregates the crowd's rapidly changing views about the future health of the business, future demand for cloud services, future margins, and the like. The stock also obviously gets bid up and down based on buyout rumours, and the collapse of the same. The stock also moves around because it gets taken along for the ride when the crowd changes its views about "the market" in general. A reasonable sounding, if counterfactual, argument can be made to suggest that shares of Nutanix have done well since I last wrote about the firm because the market has happened to do well over that timeframe. It's impossible to prove this point definitively, but it's worth considering. In any case, the stock is affected by a host of variables that may be only peripherally related to the health of the business, and that can be frustrating.
This stock price volatility driven by all these factors is troublesome, but it's a potential source of profit because these price movements have the potential to create a disconnect between market expectations and subsequent reality. In my experience, this is the only way to generate profits trading stocks: by determining the crowd's expectations about a given company's performance, spotting discrepancies between those assumptions and stock price, and placing a trade accordingly. I've also found it's the case that investors do better/less badly when they buy shares that are relatively cheap, because cheap shares correlate with low expectations. Cheap shares are insulated from the buffeting that more expensive shares are hit by.
As my regulars know, I measure the relative cheapness of a stock in a few ways, ranging from the simple to the more complex. For example, I like to look at the ratio of price to some measure of economic value, like sales, free cash, and the like. I like to see a company trading at a discount to both the overall market, and to its own history. Now in the case of Nutanix, it's obviously not possible to compare price to earnings, because, at least as far back at 2013, the company has never earned money. In fact, since 2013, it's lost $4.464 billion. It does generate sales, though, so we can review how much the market is willing to pay for $1 of revenue, and compare it to the stock's past. When I last reviewed this stock, the market was paying about $3.64 for $1 of sales. Fast forward to the present, and the shares aren't the most expensive they've ever been, but they're ticking higher. Specifically, the market is paying about 7% more for $1 of sales per the following:
As my regulars also know, in order to validate (or refute) the idea that the shares aren't objectively cheap, I want to try to understand what the crowd is currently "assuming" about the future of a given company. If the crowd is assuming great things from the company, that's a sign that the shares are generally expensive. If you read my articles regularly, you know that I rely on the work of Professor Stephen Penman and his book "Accounting for Value" for this. In this book, Penman walks investors through how they can apply some pretty basic high-school math to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit hard to access, you might want to check out "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and then infer what the market is currently "expecting" about the future.
Anyway, applying this approach to Nutanix stock at the moment suggests the market is assuming that this company will now grow profits at a rate of about 7.5% from here. Given that the company seems to be a perennial loss machine, I think this forecast is massively optimistic. Given the above, I'm inclined to continue to avoid the shares.
Options As An Alternative
In my previous articles on this name, I admitted that some people have a different perspective to mine. It took me a few hours to get over writing that sentence, but when I came back to my machine after much reflection, I accepted that different people get to have different views from my own. I'm maturing. Anyway, I suggested that just because I don't like the stock at its current price doesn't mean that it won't rise dramatically in price. For example, I don't like it now, and I didn't like it in August of last year, for example. That didn't stop the market from bidding the shares from $18 to $28 over the following months. So, just because I'm avoiding the name doesn't mean that the bulls won't make money here.
The question I would ask the bulls is: "how do you manifest the bullish call that you insist on making against my better judgment?" In my view, capital preservation is of critical importance to all investors, even those who buy companies that, shall we say are "earnings light" like this one. For that reason, I would recommend manifesting your bullish call with as little capital as possible. Call options obviously fit this bill. Calls generally give buyers most of any upside the investor gets when the stock rises in price. At the same time, though, because they represent a much lower investment of capital, the call buyer can suffer less than the stock buyer on a dollar-for-dollar basis when merger talks fall apart, for instance.
In my previous missive on this name, for example, I recommended bulls buy the January 2023 calls with a strike of $17.50 for $3.50. These calls finished their lives worth about $10, so that trade would have worked out well. The call buyer earned about $6.50, while the stock buyer earned about $2.50. Additionally, the call buyer earned this superior return with lower capital at risk. Thus, less risk, higher returns.
So, for those of you who insist on staying long here, I would recommend calls in lieu of shares. Specifically, I would recommend manifesting a bullish position here via the April calls with a strike of $30. These are currently priced at $1.75-$1.90. So, if the investor simply buys at market, they are employing about 6.7% of the capital that the shareholder ties up, and I expect that they will capture any upside in the stock that's generated from next week's earnings announcement. If the market finally decides that earnings matter, and the stock is punished after the upcoming earnings announcement, the call buyer will do badly, but will obviously do less badly than the stockholder might, at least on a dollar-for-dollar basis.
For further details see:
Nutanix: Bulls Should Buy Calls