No. of Recommendations: 55
As I mentioned, this will be broken out into 3 posts: 1) the business, 2) the financials and 3) comparing PVTL against my earlier posted checklist. I will borrow frequently from the 10Q and S1 filings, the Q1 earnings release, presentation and transcript and the investor relations page, which I will highlight in italics. Note that my background is accounting and audit, so I don’t fully appreciate the technology and rely on others like SteppenWulf to help me better appreciate their business.

Part 1 – the business

The rise of cloud software: Cloud-native software is reshaping businesses across all industries, empowering enterprises to innovate at a higher velocity and become more digital, mobile, data-driven and always-connected. Cloud-native software is designed to be highly available, scalable and modular to allow for frequent iteration and feature releases.

The problem: Despite the widespread availability of private and public cloud infrastructure, many organizations are burdened by legacy technologies and software development processes that prevent them from fully realizing the benefits of cloud-native software.

PVTL’s solution: We provide a leading cloud-native platform that makes software development and IT operations a strategic advantage for our customers. Our cloud-native platform, <b<Pivotal Cloud Foundry ("PCF"), accelerates and streamlines software development by reducing the complexity of building, deploying and operating new cloud-native applications and modernizing legacy applications. This enables our customers' development and IT operations teams to spend more time writing code, waste less time on mundane tasks and focus on activities that drive business value – building and deploying great software. PCF customers can accelerate their adoption of a modern software development process and their business success using our platform through our complementary strategic services, Pivotal Labs ("Labs"). Enterprises across industries have adopted our platform to build, deploy and operate software, including enterprises in the automotive and transportation, industrial and business services, financial services, healthcare and insurance, technology and media, consumer and communications and government sectors.

Market Opportunity: Our cloud-native software addresses IT spending across the rapidly growing market for public cloud workloads, sometimes referred to as Platform-as-a-service ("PaaS"), and the market for application infrastructure, middleware and development software. We believe our cloud-native platform opportunity is the aggregate of these two markets, with spending today estimated at over $50 billion. According to Gartner, spending on cloud application infrastructure services (PaaS) is expected to be $16.0 billion in 2018, growing to $29.0 billion by 2021, representing a 22% compound annual growth rate ("CAGR"). According to Gartner, spending on application infrastructure, middleware and development solutions is expected to be $43.2 billion in 2018, growing to $51.4 billion by 2021, representing a 6% CAGR.

PVTL basically has two revenue streams. The fast growing subscription business:

PCF integrates an expansive set of critical, modern software technologies to provide a turnkey cloud-native platform. PCF combines leading open-source software with our robust proprietary software to meet the exacting enterprise-grade requirements of large organizations, including the ability to operate and manage software across private and public cloud environments, such as Amazon Web Services, Microsoft Azure, Google Cloud Platform, VMware vSphere and OpenStack. PCF is sold on a subscription basis.

The second revenue stream is the service business:

Labs software development experts deliver strategic services that transfer the expertise for enterprises to accelerate their cloud-native transformation by implementing modern agile development practices. With Labs, we help customers co-develop new applications and transform existing ones while accelerating software development, streamlining IT operations and ultimately driving self-sustaining business transformation.

The investment thesis is the significant growth of the PCF subscription business. The subscriptions are typically for 1 or 3 year terms and the revenue is recognized over the subscription period. The revenue that cannot be recognized when the subscription is booked is deferred into future quarters. This gives the company very good visibility into future revenue. The Labs service business helps with the implementation of PCF. Specifically the implementation services enable customers to configure, deploy, test, launch and operate PCF. Over time the PCF business will become more and more significant to the overall revenue and growth. As PCF becomes larger than Labs, PVTL will rely on systems integrator partnerships to deliver Labs-like services to customers.

Here is Rob Mee, PVTL CEO, during the earnings call on integrator partnerships:

we think there’s a large and growing opportunity for systems integrators to help enterprises modernize and re-platform their existing application portfolio. So, we’re working with global systems integrators like Accenture and Cognizant, along with other firms like Perficient that I mentioned. They’re building focused practices around Pivotal technology implementation including application migration but also including cloud-native development. So, they’re very much looking to do modern co-developments in an enablement kind of mode just like Pivotal Labs. And from our perspective, we really feel -- along with the mission of transforming how the world builds software, the more people are enabled to build that way and help others build software that way, the better for the world in general.

PVTL’s strategy is to have the Labs business support and grow the subscription business. The Labs business is low margin and so the company is relying on system integrators to help act as the Labs business in continuing to push PCF. As such, the company expects service revenue to grow slowly and PCF to become a much larger part of the overall company revenue. This is ideal given the high margins (92%) of the PCF business.

Don’t expect PVTL to be a cash cow any time soon. Given the high margin, recurring revenue that PCF generates, the focus is on expanding as soon as possible:

To realize this rapid growth, we have made and expect to continue to make substantial investments across our business. Specifically, we have increased our total employee base over time, and we intend to continue to invest in our business to take advantage of our market opportunity and to expand our sales capacity and further improve sales productivity to drive additional revenue and support the growth of our global customer base. Additionally, we continue to invest in the development and expansion of our partner ecosystem to supplement our sales and services resources and increase our reach in our target markets. We also expect to continue to make significant investments in research and development to expand our product and engineering teams to further develop our platform. We expect to incur increased general and administrative expenses to support our growth and operations as a public company.

The company has key performance indicators, which lets us know what they are focusing on. There are two and they both focus on growing revenue:

1. Subscription Customers - We believe that the number of our subscription customers is an important indicator of the growth of our business, our increased customer footprint and the market acceptance of our platform. We define the number of subscription customers as the organizations that have a subscription contract for our software resulting in at least $50,000 of annual revenue in that period. While we may enter into subscription agreements with multiple parties inside a larger organization, we count a customer as an addition to our subscription customers only if it represents a unique global ultimate parent. In the case of the U.S. government, we count U.S. government departments and major agencies as unique subscription customers. We view our total number of subscription customers as reflective of the number of sources of revenue to us and our growth and potential for future growth.

We had 339, 319 and 282 subscription customers as of May 4, 2018, February 2, 2018 and May 5, 2017, respectively. With the launch of PCF v2.0, including the release of PKS, we expect growth in new customers to continue as we increase our focus on adding new customers. Our total number of subscription customers and the net additions in any period may continue to fluctuate as a result of several factors, including the focus of our sales force, customer satisfaction with the functionality, features, performance or pricing of our offering, consolidation of our customer base and other factors, a number of which are beyond our control.

Customer growth has slowed, but may be picking back up. Customers by fiscal year is 2014 – 0, 2015 – 75, 2016 – 180, 2017 – 275, 2018 – 319, Q1 2019 – 339. While customer growth has slowed markedly in 2018 with only 44 customers added all year, the company has invested into growing customer count and added 20 customer in Q1 alone (annualized 80). Here is more on this from the call:

We haven’t had that many net adds since Q4 of fiscal ‘17. So, we were really pleased with the results. And as I mentioned earlier, we did make some pretty significant investments in the back half of last year to really help drive the field on new customer acquisition and making sure that we were both renewing our existing customers and expanding their footprint but also adding new customers. And so, I think what you saw in Q1 is kind of the starting to kind of realize the benefit of some of those earlier investments.


Raimo Lenschow

Thank you. And one quick follow-up for Cynthia. Just we talked a lot about the second half last year investments into increasingly singing more customers. I would assume what we saw this quarter, since they were kind of longer term investments, should be like just the beginning of something, rather than just a one-off quarter thing, correct?

Cynthia Gaylor

Yes. I would say, it’s just the beginning. And I think -- I would say, we don’t forecast guidance on customer account for quarter. So, I would expect different quarters to exhibit different trends there. But, it is a focus area for us. And so, we would expect those investments to pay off over time, but I wouldn’t say we’re forecasting that to be every quarter for the remainder of the year.

Rob Mee mentioned that they are focused on the global 2000, which are the 2,000 largest publicly traded companies in the world and represent $39 trillion is sales. ( Another area of growth is the US government. We have already seen them pick up the Air Force and the IRS as customers. As an approved government vendor, they may be a preferred supplier for other government entities. Here’s more form Rob:

As we look ahead, we are excited about Pivotal’s ability to penetrate the global 2000. We believe we are well-positioned to disrupt some of the largest areas in IT investment as we help enterprises across industries transform.

2. Dollar-Based Net Expansion Rate - We believe that the dollar-based net expansion rate is an important measure of our business because it is an indicator of our subscription customers’ expanded use of and demand for our platform and our ability to grow revenue and profitability. Our dollar-based net expansion rate compares our subscription revenue from a common group of customers across comparable periods. We calculate our dollar-based net expansion rate for all periods on a trailing four-quarter basis. To do so, we calculate our dollar-based net expansion rate as of each quarter end by starting with the subscription revenue from customers as of the prior year’s same quarter (the “Prior Period Subscription Revenue”). We then calculate subscription revenue from these same customers as of the current quarter end (the “Current Period Subscription Revenue”). Finally, to assess net expansion level for common groups of customers over time, we divide the aggregate Current Period Subscription Revenue for the trailing four quarters by the aggregate Prior Period Subscription Revenue for the trailing four quarters resulting in our dollar-based expansion rate.

We expect our dollar-based net expansion rate to remain a significant indicator of our business momentum and results of operations as existing customers realize the benefits of our software and expand their PCF subscriptions. Our dollar-based net expansion rate has fluctuated and we expect it to continue to fluctuate and decline over time as we scale our business and as a result of several factors, including the size of the transactions, the timing and terms of the deals and our customers’ satisfaction with our offering. Our dollar-based net expansion rate was approximately 156% for the three months ended May 4, 2018, 158% for the three months ended February 2, 2018 and 164% for the three months ended May 5, 2017.

In the earnings call, they discussed the expansion rate and how we should expect this to come down over time. However, adding new customers does support a higher expansion rate as they will likely expand as they see the initial benefits. Here is more from the earnings call:

We’re at kind of leading -- industry leading net expansion rate of 156%. Now that we’re at scale, we wouldn’t expect to maintain that rate, so you should expect that rate to come down over time. But we also saw strong demand from new customers in the quarter.

Background and Dell

We were formed in April 2013. DellEMC and VMware transferred teams and contributed assets and technology to Pivotal that have become key elements of our cloud-native platform and strategic services. Following the acquisition of EMC Corporation by Dell Technologies in September 2016, Pivotal's majority stockholder became Dell Technologies. While we initially received certain back office and other administrative services from DellEMC and VMware, over time we have implemented our own systems and processes, reducing our reliance on these partners for most of these services. Today, we jointly market and sell our products and services with DellEMC and VMware and enjoy significant and mutually beneficial commercial and go-to-market relationships with them.

Dell Technologies is our majority stockholder. For more information on our relationship with Dell Technologies, see "Certain Relationships and Related Party Transactions" and "Principal and Selling Stockholders."

Currently, Dell Technologies will own, indirectly through its subsidiaries (including VMware), 175,514,272 shares of our outstanding Class B common stock, which will represent approximately 70.1% of our total outstanding shares of common stock and approximately 95.9% of the combined voting power of both classes of our outstanding common As a result, Dell Technologies will be able to exercise control over all matters requiring approval by our stockholders, including the election of our directors and approval of significant corporate transactions. Dell Technologies' controlling interest may discourage or prevent a change in control of our company that other holders of our common stock may favor.

Competitive Strengths:

• First mover in cloud-native transformations.
• Enterprise-grade software platform integrating open source.
• Blue-chip customer adoption.
• Large and growing PCF ecosystem.
• Leading cloud-native platform with strategic services.
• Viral adoption together with C-level focus.

Growth Strategy

• Extend technology lead of our cloud-native platform.
• Maintain open cloud-native platform advantage.
• Continue to drive new customer adoption.
• Expand adoption within existing customers.
• Continue to capitalize upon our relationships with our strategic partners.
• Further leverage partnerships with public cloud vendors.
• Continue to leverage the combined strengths of PCF and Labs to drive PCF expansion.
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