It’s been just over a year since I wrote my latest bearish piece on Nutanix Inc. (NTNX). Since then, the shares are down about 12.25% against a gain of 13.8% for the S&P 500. This is on top of a loss of 58.5% from the time I wrote my first bearish piece on the name. The fact is, though, that every business has some value embedded in it. I think markets overreact to good news on the upside and to bad news on the downside, and it may be the case that the shares represent excellent value. Also, the company has another year of financial history that’s worthy of commentary. A stock that is trading at $22.25 has a much different level of risk than one that was trading at $25.35, so should I switch from bearish to bullish on this name?
You may not be a busy crowd, dear readers, but you may be able to think of a few thousand things that are more fun to do than reading my article about a specific company. For that reason, I’ll reiterate the general point made by the title of this article along with the bullet points above. The problems that I referenced in my earlier articles linger. Specifically, it seems that the more this company sells, the more it loses.
In fact there’s a very strong negative correlation (r=-.85) between sales and net income. There’s nothing that I can spot on the horizon that will change this multi-year dynamic. In spite of this, the shares remain quite expensive in my estimation. I think investors would be wise to avoid this name. That said, I think the crowd can drive these shares higher. For people who want to maintain a long position, I think options make the most sense here.
There’s much to like about the financial situation here, obviously. First, over the past eight years, the company has managed to grow revenue at an eye-watering CAGR of 106%. Gross profit growth has also been impressive, having grown at a CAGR of 93% over the same time period. Also, I think the capital structure is in very solid shape, as evidenced by the fact that cash and short-term securities are about twice the value of the convertible notes outstanding. Finally, the per share loss has grown at a CAGR of “only” 3.6%.
Unfortunately, that’s where the relatively good news ends. Investors aren’t compensated with sales; they’re compensated with whatever cash is left over after all of the suppliers, landlords, research scientists, salespeople and every other source of cost is paid. The problem that I’d noted in the past seems to persist here. Specifically, it seems that the more this company sells, the greater are its losses.
So as sales have grown at a remarkable pace, so too have losses. Specifically, losses have grown at a CAGR of about 27% over the same time period. I ran a correlation analysis on revenue and net income and found a very strong (r=-.85) correlation between the two. This demonstrates a persistent relationship that is harmful to shareholders: the more this company sells, the greater are its losses over time. It’s easy enough to spot the culprits here.
In support of the growth of the business, sales and marketing expenses, R&D, and general and administrative expenses grew at CAGRs of 49%, 44.5%, and 43.4% respectively. This suggests to me that the company is on the financial equivalent of a hamster wheel. In order to support growing sales, it must spend ever-growing amounts on those things that attract customers. This prompts two questions of the bullish case here:
If the company can’t turn a profit after sales have grown at a CAGR of 106% for the better part of a decade, what will it take for this business to turn a profit?
What future process or event will cause cost growth to slow, which will then enable the company to turn a profit?
These two questions are fundamental in my opinion. As far as I can tell, no one has answered these, and I eagerly await any feedback from bulls in the comment section.
Finally, the reason that EPS losses have grown at a rate of only 3.6% is because of the massive dilution that investors have been exposed to over the years. Since 2013, the number of shares outstanding has grown at a CAGR of about 22%. Dilution is troublesome, too.
Source: Company filings
Just because I think there’s little reason to hope that this company will turn profitable anytime soon doesn’t mean there’s no value here. As I’ve written repeatedly (and no doubt tiresomely), a great business can be a terrible investment at the wrong price, and a mediocre business can be a great investment at the right price. In my view, the price paid for a given investment is the single biggest variable in determining investment returns, and for that reason I need to write about the stock as a thing distinct from the business.
Because there’s an inverse relationship between the price paid for a stream of future cash flows and the returns on those cash flows, I want to try to determine whether the shares are expensive or cheap. Cheap is better. I measure whether a stock is cheap in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value, like earnings, free cash flow, and the like. There are obviously no earnings to speak of in this case, so I’ll look at the ratio of price to cash from operations. There is one advantage of this ratio and a few disadvantages. The advantage is the fact both numbers are positive at the moment.
The downside is that CFO obviously adds back some significant charges, and includes figures that may give an excessively rosy assessment of the firm’s financial health, per the following from the latest 10-K.
For more, feel free to check out page 86 of the latest 10-K, as it’s a real page-turner.
In my view, cash from operations is a much more “generous” measure of a company’s earnings generating capacity because it adds back things like depreciation, in spite of the fact that depreciation and amortization represent real economic costs, especially for a company like this one. Stock- based compensation is obviously an expense that impacts shareholders, though it’s obviously “added back” to earnings to come up with cash from operations. Perhaps most strange is the fact that $262 million in deferred revenue is added to cash from operations. Remember that deferred revenue involves the company receiving cash today for services that it’ll have to deliver in the future. Where I come from that’s called an “obligation,” but it’s added back to cash from operations.
So, because of these three items, cash from operations is ~$505 million higher than it would otherwise be. I consider this somewhat ridiculous, but as I wrote above, at least it allows for a positive figure to compare price to.
As we can see from the chart below, at this time last year this ratio of price to cash from operations was about 126 times.
At the moment, the ratio of price ($22.25) to CFO/share ($.50) is just under 45 times. I consider this to be very expensive, but I will admit that 45 times this inflated number is much better than 126 times this inflated number. It seems the shares are much cheaper than they were this time last year, which is slightly positive in my estimation.
In addition to working out the simple ratio of price to some measure of economic value, I like to try to understand what the market is assuming about a given company’s future. In order to do that, I turn to the work of Professor Stephen Penman and his book “Accounting for Value.” In this book, Penman walks investors through how they might isolate the “g” (growth) variable in a standard finance formula to work out what the market must be assuming about a given company. According to this approach, it seems that the market assumes this company will grow at a perpetual rate of about 15%. I would consider this an optimistic forecast if this company was massively profitable. In the case of this company, though, this forecast seems downright insane in my view.
Options As Alternative
I can understand the challenge faced by someone who remains bullish in the teeth of the continued losses. Such people understand that investors buy the future, and that some of the greatest companies in history incurred losses for years before turning a profit. They may also take some consolation in the fact that losses are less egregious now, and that the stock is relatively less expensive now. Finally, stock prices are more often than not driven by crowd sentiments and there’s no evidence that the crowd has become any more sane recently.
While I haven’t been wrong in my assessment of Nutanix yet, I may be underestimating something. To be absolutely clear, I recommend avoiding these shares. For people who wish to remain long here, though, I recommend a solution involving the options market. This solution involves far less risk.
Instead of remaining long the shares at current levels, I think the options market is offering generous premia on put options. I think a short put option represents a win-win trade at the moment. If the shares remain above the strike price, the investor simply pockets the (generous) premia. If the shares continue to languish, the investor is obliged to buy, but must do so at a price that’s a significant discount to the current market price. Thus, selling puts represents the opportunity to generate a decent return at a much-reduced level of risk.
Specifically, I think people who want to maintain some exposure to Nutanix would be wise to sell any shares they own and also sell the April Nutanix puts with a strike of $17.50. These are currently bid-asked at $3.05-$3.15. If the investor simply takes the bid on these, and the shares remain above $17.50, they’ll enjoy a very nice return over the next 6 ½ months. If the shares languish, as I suspect they will actually, the investor will be obliged to buy, but will do so at a net price ~35% below the current market price.
Now that you’re hopefully intrigued by the “win-win” character of short puts, dear reader, it’s time for me to revert to type and disappoint you by writing about risk. The nature of the world is such that we must choose between a host of imperfect trade-offs, as there’s no “risk-free” option. Short puts are no different in this regard. We do our best to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. The risks of share ownership should be obvious to readers on this forum.
I think the risks of put options are very similar to those associated with a long stock position, actually. If the shares drop in price, the stockholder loses money, and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.
Puts are distinct from stocks in that some put writers don’t want to actually buy the stock – they simply want to collect premia. Such investors care more about maximizing their income and will, therefore, be less discriminating about which stock they sell puts on. These people don’t want to own the underlying security. I like my sleep far too much to play short puts in this way. I’m only willing to sell puts on companies I’m willing to buy at prices I’m willing to pay. For that reason, being exercised isn’t the hardship for me that it might be for many other put writers.
My advice is that if you are considering this strategy yourself, you would be wise to only ever write puts on companies you’d be happy to own. I feel that I need to repeat the point that I made earlier. I don’t recommend owning Nutanix at any price, and so for that reason I will not be selling puts on it. Short put options are only viable in this case as an alternative to actual share ownership.
In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day.
I’ll conclude this rather long discussion of risks by indulging my tendency toward tedious repetition, and I’ll use the trade I’m currently recommending as an example. An investor can choose to buy Nutanix today at a price of ~$22.50. Alternatively, they can generate a credit for their accounts immediately by selling put options that oblige them – under the worst possible circumstance – to buy the shares at a net price about 35% below today’s level. Buying the same asset at a discount is the definition of lower risk.
If you would not be content making “only” $3.05 while tying up $17.50 in capital for six months, and you want to get a bit more sophisticated, you might consider using the put premia you generate to buy call options that give you most of the upside of the stock. For reference, the April Nutanix call with a strike of $22.50 is bid-asked at the moment for $4.20-$5.10. If the investor simply takes the ask on these, they will have access to most of the upside for the shares over the next 6 ½ months. They will also only have ~23% of the capital at risk. I consider having most of the upside while exposing only 23% of the capital to be an ideal situation. To repeat, I don’t recommend any exposure to Nutanix. I recommend selling puts and (perhaps) buying calls on this name the most viable way to gain exposure on the long side.
I’ve been writing about Nutanix for a while, and I’ve never found much to like about the business. Shareholders have been diluted massively over the past several years, and there seems to be nothing on the horizon to suggest that that will stop. It seems the necessary precondition to sales growth has been massive cost growth, and there seems to be nothing on the horizon to suggest that that will stop. In spite of these troubles, the shares remain quite expensive on a cash from operations basis. On the “plus” side, these shares are less expensive than they were last year, but they remain objectively pricey in my estimation. Also, I would note that cash from operations isn’t a good proxy for the cash that’s available to shareholders, as it adds back too many items.
All of that said, I understand that there are certain shareholders who have a greater level of faith than I do. They understand that the crowd can drive shares higher in the short term. For such people, I would recommend selling put options as a great way to maintain some exposure here while generating credits for their accounts. There may be less return with this approach if the crowd suddenly drives these shares higher, but there’s certainly less risk too.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.