Source: Electra Networks

Transforming SDN/NFV: Why Nutanix is Set Post-IPO

Nutanix is an enterprise infrastructure platform that provides hyperconverged solutions for virtualization of storage. They filed a S-1 in December, 2015 but have delayed plans to go public presumably due to frosty tech markets. However, I predict that management will begin their roadshow this month and IPO by the end of 2016 due to thawing in the public tech market this summer. I believe that Nutanix will have a strong public debut and tremendous long-term success based on key financial indicators and its potential to capitalize on the software-defined networking market.

Financial Reasons Why Nutanix Looks Hot

In terms of predicting short-term IPO success, Twilio stands out as the best comparable in this quarter. Twilio priced the IPO at $15/share (above its initial $12-$14 range), jumped 92% in its trading debut, and now trades (as of 9/1/16) about 362% above the IPO price. Other recent tech IPOs include the Line and Acacia Communications — both soared 27% and 35% respectively at the end of their first trading days. While historical, comparable data is not causation for success, it is a good indicator that the public markets are warming up to technology once again.

More importantly, looking at financials, the company shows signs of a maturing technology company that is taking the right steps to transition into profitability. It has averaged 23% in customer growth rate over the past six quarters. Its total customer base is more than 2,638 and includes 250 of the Global 2000 firms. The company’s revenues grew from $30.5MM in 2013 to $241.4MM in 2015. Its revenues increased 364% from 2012–2013, 316% in 2014, and 90% in 2015. This plateauing of revenue growth is common with enterprise software companies hitting critical marketshare and maturing past the early growth phase. Looking at cost of goods sold, the company reported COGS of $26.6MM in 2013, $60.9MM in 2014, and $101.0MM in 2015, representing a COGS increase of 129% in 2014 on a 316% increase in revenue, and just 66% in 2015 on a 90% increase in revenue. In addition, COGS made up 87% of revenue in 2013, 48% in 2014, and 42% in 2015, indicating that the company has been successful in improving gross margins.

Source: Nutanix S-1

Even though total operating expense has widened from $48.5MM in 2013 to $259.2MM in 2015, it is important to note that operating expense increased 198% in 2014 but only 79% in 2015. So while operating cost is still increasing, it is decelerating at a rapid rate and remains below the growth rate for revenue. Breaking down operating expenses, typically sales & marketing is naturally the largest cost item for an enterprise software company. In 2015, sales & marketing alone made up of 62.4% of total operating expense. While we see decelerating sales & marketing costs year-on-year, a more important metric is sales efficiency, which measures how many dollars are generated for each new sales & marketing dollar spent. Sales efficiency was 112% in 2013, 147% in 2014, and 166% in 2015. Nutanix is becoming more and more efficient at generating revenue with its new sales hires; this can be attributed to stronger sales training, shorter employee onboarding time, and/or better business relationships among other causes.

Finally, even though Nutanix still remains unprofitable (no surprise here), net income losses are decelerating, growing at 50% in 2015 compared to 88% in 2014. While you shouldn’t expect Nutanix to become profitable in the near future, there are clear signs that it is on the right track to maximize shareholder returns. Although looking at a snapshot of the company’s historical financials produces a few insights, its long-term success will be largely dependent on high demand for its technological capabilities and dominant position in a rapidly growing market. Nutanix is an incredible innovator in the virtualization vertical which positions it well in the software-defined networking/network function virtualization space for telecommunications.

What is SDN/NFV?

Software-defined networking (SDN) and network function virtualization (NFV) are two complementary technologies that often exist together. NFV technologies virtualize network services that are typically being supported by proprietary, closed hardware. SDN is an approach of using protocols to access and control network switches/routers that typically would be managed by closed firmware. Without going too much into the difference between them, both focus on the decoupling of network functions from dedicated hardware devices (i.e. physical routers) and hosting these network services via virtual machines. Most SDN/NFV tech typically affect Layer 2 to Layer 4 of the OSI model and reduce the need for dedicated hardware devices to build a service chain. To explain in more detail, a typical network’s speed is dependent on its overall architecture, which translates to minimizing the number of switches across a traffic path. In addition, increasing the number of paths to critical network elements also increases routing efficiencies. Typically, a network carrier that detects an increase in bandwidth demand within a region must ping physical switches and routers to redirect traffic; each of these physical switches have their own control functions. SDN/NFV eliminates the number of physical hardware required to support these functions, centralizes the control in cloud (rather than have a control plane for each switch), and creates a more efficient architecture (more redundant/multiple paths). The centralized controller can now have a “hawkeye” view of the entire network and install forwarding decisions to each virtual switch instantly based on the desired end-to-end path of data flow. To simplify it: SDN/NFV technologies allow a carrier to better manage its network by eliminating the need for clunky, inefficient hardware (as well as personnel required to manage each hardware cluster) by utilizing efficient algorithms/protocols to run the system in a centralized form.

What is Nutanix’s Angle?

Nutanix plays a role in this industry by providing software-defined storage (SDS) capabilities. SDS technologies implement storage virtualization by using software to manage data independent of the underlying hardware; this is based on concepts of SDN/NFV. While the two are not exactly the same, Nutanix’s offerings have tremendous synergy with clients that are already NFV-enabled (i.e. telco companies) which means it is a strong complement to traditional SDN/NFV tech. Its proprietary technology can also be a huge target for licensing/partnership deals with pure SDN/NFV startups and even other SDS services; this is evidenced by VMware’s large partnership with Nutanix. Finally, virtualization companies similar to Nutanix have recognized the large potential of telco SDN/NFV market and are likely to break out cash to move directly into it. A good example of this is VMware’s $1.3Bn acquisition of Nicira (SDN company focusing on virtual switches) in 2012.

Why is SDN/NFV Going to be Huge in Telecommunications?

While SDN/NFV technologies are relatively new, the market is projected to grow rapidly. SDX Central (widely regarded as the best platform for SDN/NFV content) predicts that SDN revenues will grow from $15.0Bn in 2015 to $105.0Bn by 2020, representing a 47.8% CAGR. SDN/NFV is going to be huge for telco companies because eliminating the need for hardware significantly reduces CAPEX and OPEX costs. Replacing manual operations with automated scripts and procedures saves these large carriers hundreds of millions and significantly boosts margins. Krish Prabu, CTO of AT&T at the time, has stated that SDN will reduce AT&T’s OPEX costs up to 40% by 2020.

Another important point is that in an increasingly digitalized world, with greater global mobile/web penetration, the amount of data traffic is expected to grow significantly (magnitude of 10 times according to AT&T). This means that carriers have to continue investing in its network to keep up with growing demand — virtualization makes networks more scalable at a better cost structure. This is evidenced by many Tier 1/Tier 2 carriers such as Verizon and AT&T launching their own SDN/NFV initiatives.

The increasing interest in this space can be supported by a jump in SDN/NFV acquisitions in the past five years. Several notable acquisitions include Alcatel-Lucent to Nokia for $16.6Bn, Nicira to VMware for $1.2Bn, Tellabs to Marlin Equity Partners for $891MM, Virtela Technology Services to NTT Communications for $525M, and Cyan to Ciena for $400MM. Even a simple GoogleTrends analysis indicates that the search term “software defined networking” has yielded an increase in only the last five years.

Source: GoogleTrends

It is apparent that the importance of SDN/NFV is beginning to be recognized and companies are scrambling to enter while the market is still fresh. Nutanix is poised perfectly to dominate this sector with its expertise on virtualization software and wealth of big-name telco clients. When its clients AT&T, SK Telecom, Telstra, and NTT Communications virtualize the majority of their network by decade’s end, Nutanix will be there to grow with them. The company should expect larger contracts and its revenues to increase significantly in this scenario. Most importantly, it can be a dominant market player in this telco infrastructure revolution if it can position itself strategically with its marquee clients.

Current State of Telco in U.S.

While Nutanix provides virtualization capabilities across a variety of sectors, the SDN/NFV vertical will be the fat profit-maker here. Telco companies have the big money to spend and virtualizing networks as large as theirs is a tremendous undertaking (translation: big contracts). However, one problem is that the United States telco industry is heavily regulated. Part of the reason why telco carriers still rely on decades-old networking infrastructure is because SDN/NFV legality remains a grey area. Currently, the largest suppliers of telco equipment for U.S. carriers are Cisco, Huawei, and Ericsson; these three suppliers have a stranglehold over the U.S. market. Expect their revenues to be heavily slashed if SDN/NFV becomes prevalent and reliance on hardware decreases. While all three have launched SDN/NFV solutions, if regulation allows change, they will eventually have to compete with virtualization software companies instead of operating in an oligopoly. Nutanix should also focus its efforts on telco companies that operate infrastructure in emerging/recently emerged markets. These markets have large populations and are drastically less regulated. Good targets are Brazil and India, where there have been significant developments in telco infrastructure (heavier infrastructure creates an ideal environment for SDN/NFV). In any case, Nutanix is poised to enter one of the fastest growing technology trends early and has a clear path to return big for its (soon to be public) shareholders.