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New Relic: A pioneer in observability getting back some momentum
This is an article recommending the purchase of shares of software as a service (“SaaS”) company New Relic, Inc. (NYSE:NEWR). I believe, as will be detailed below, that New Relic’s turnaround has enough visibility so that it is reasonable to believe that the company will be able to achieve a CAGR of 20% or greater for the next several years. And New Relic shares, at least to my mind, are reasonably valued.
The company announced on October 11 that it had exceeded the high end of its forecast in terms of both revenues and non-GAAP profitability. The high end of its forecast had implied revenue growth of 14%; sequential revenue growth of 4%. The company had forecast a non-GAAP net loss for the quarter of $.04 for the quarter. Exceeding the high end of that range may hardly seem like much of an accomplishment. On the other hand, the year-earlier quarter marked the start of the company’s transition to its New Relic One consumption model, which makes this comparison significantly more difficult than would otherwise be the case.
The formal earnings release is scheduled for November 8th after the close of the market. The shares have gained all of 10% since that announcement, while the WCLD ETF has appreciated by 6% and the IGC software ETF has gained 6%. In other words, investors basically haven’t cared enough about a company in the midst of a turnaround announcing an upside to bid the shares higher on a relative basis. And it certainly wasn’t prior performance holding the shares in check; the shares are down by 46% thus far this year and are just modestly above their twin lows set in May and June of this year. (All percentage calculations based on closing prices as of Friday, Oct. 28, 2022.)
This will be the initial quarter in which New Relic’s newly appointed CFO will be providing guidance. And the macro environment is certainly challenging and will be a headwind for most IT companies. In the wake of earnings releases from both Microsoft’s (MSFT) and Amazon (AMZN), it will be a very rare IT company that tries to provide any kind of aggressively positive forecast. This company has been transitioning to a consumption-based model which some investors believe to be sensitive to macro trends. So, I wouldn’t count on the company increasing its guidance by any great amount, although I doubt that there is much expectation of that happening in any event.
One reason to recommend the shares is that the company has a leading position in the observability space. I have recommended and owned many of the most prominent names in the observability space, as it is called, for some time now. These include Datadog (DDOG) , Dynatrace (DT) and Elastic (ESTC). Other major companies in the space include Splunk (SPLK) and AppDynamics, a subsidiary of Cisco (CSCO). My belief is that the observability market will show reasonable performance even in the emerging recession – not, perhaps to the level of cybersecurity, but better than other segments such as ERP or some specific apps. But Dynatrace has indeed forecast slower growth, suggesting a worsening environment. Growth will surely slow; but it won’t slow as much in the observability space as in other areas of the IT stack. Companies that can gain share or penetrate what can be described as adjacencies will continue to show positive growth trends, which will be a contrast to some other IT companies.
Observability is a cornerstone of digital transformation, and despite the macro headwinds, digital transformations are still happening…basically because at this point, not having a digital transformation strategy is competitively unacceptable for just about all enterprises. Customers, their employees, and their suppliers all expect to be dealing with digital interfaces, and observability is the way that those interfaces can be monitored, managed, and remediated.
Based on the announcement of above expectations performance for both revenues and non-GAAP operating income, I am expecting revenues for the next 12 months to reach around $985 million and for free cash flow margins to reach 7%. While I have no expectation that New Relic will be able to grow at the rates some of the other companies in its space can achieve, I think it can achieve a 3 year CAGR of 20% or more. If it does better, that will be lagniappe to my own expectations. Given that its EV/S is just around 3.8X, and that it will now be generating positive free cash flow, I think the shares make sense. Not every company has to be able to grow at the rates of Datadog to be a successful investment.
Investors have different priorities in what they are looking for in what has been a hostile investment environment for IT shares. New Relic’s focus on improving profitability and free cash flow generation should, actually resonate with what investors mainly say they want just now. And a substantial component of the company’s growth projection is expected to be a product of renewing existing users with a higher level of product consumption on the company’s New Relic 1 platform. The company has made early renewal a priority with some preliminary indications of success in improving MRR from newly renewed customers. This is a far less risky strategy than other growth strategies in this environment-although of course, eventually, the company is going to need to enhance its ability to sell new name customers.
One of the problems with recommending stocks-more or less any kind of equity investment these days – is that nothing will work until the environment turns. Even recommendations that work out on a fundamental basis, are unlikely to see strong price performance over any extended time span. I have seen that with more than a few of recent recommendations, dragged down by both the market or by analogs with poorly performing companies in the space. That said, there is still room for alpha in this market, and recent recommendations such as that of Arista (ANET) and Adobe (ADBE) have been able to bounce. But the reality is that the problems of Microsoft, Amazon, Meta Platforms (META), and Google (GOOG, GOOGL) are resonating throughout the tech world as valuations compress, once again. And investors are hyper-sensitive to any suggestion of slowing growth. I obviously can’t assure readers that there won’t be cyclical headwinds that impact New Relic – I think there will be. But the relative positioning of the company is improving, and that is how positive alpha is often generated.
As has been pointed out in a recent study, the level of stock price convergence has continued to increase in this bear market, so even the best positive investment thesis can be vitiated in the wake of a market selloff brought on by concerns about macro trends and rising interest rates, coupled with how tech companies will fare in the stormy macro climate. Whether or not stocks are at or near a bottom is probably unknowable – at least by this writer. I hope the recent market action represents a bottom, but I would be the first to acknowledge the many cross currents and risks that concern investors. Presumably a bottom will form when investors are convinced that peak inflation has passed and that global central banks in turn, decide to pivot from further tightening. And the risk-off bias is palpable, and hasn’t seemingly waned, or not to any significant extent. Investors seem more concerned about slowing growth in a recession, than about rates-kind of a perfect storm for IT equities. Even on days with some interest rate relief, high-growth IT shares are often laggards. The valuation compression becomes greater and greater.
I am not going to attempt to pontificate about interest rates, Fed pivots, and so forth. I think, looking at New Relic’s strategy, its competitive position, its new team, and its valuation provide validation for a positive investment thesis, although no matter how the company performs as a business, its share price performance will be heavily influenced by the trend of IT valuations.
New Relic at this point, doesn’t fit into any neat bucket within the IT space in terms of investment characteristics. The EV/S ratio has compressed, and the company is reporting a modest level of non-GAAP profitability and free cash flow. But that hasn’t enabled the shares to escape down drafts during risk-off periods. But for the most part, in the balance of this article, I am going to eschew any additional comments with regards to the market environment. It is what it is until at one point it changes. I am never going to be the commentator that calls that pivot in advance, regardless of my own thoughts on the subject.
Finally, I need to mention that NEWR does use stock-based compensation (“SBC”). SBC expense was 16% of revenues last quarter, down from 23% of revenues in the year-earlier period. SBC expenses will probably continue to decline as a percent of revenues, and perhaps absolutely as well; the company is managing expenses tightly, that means less hiring, and in general, less hiring, coupled with less competition for professional employees from start-ups and V/C funded businesses, should enable SBC levels to decrease.
These are average/below average levels of SBC in the IT space. But for readers who wish to analyze companies on a GAAP basis, these shares will be less attractive. I make no attempt to persuade those who wish to analyze based on SBC levels as opposed to dilution. Over the last year, dilution has been at about 4.5% and I have projected that level into the future to arrive at valuation calculations.
New Relic: Recounting the transition story
New Relic is a mid-sized enterprise software company. Its founder, Lou Cirne, was one of the pioneers in the creation of modern observability solutions, and for a time this company was in hyper-growth mode. Mr. Cirne, as has been well documented, had a fairly unorthodox management style that was responsible, at least in part, for noticeably impacting the growth and profitability of the company. He also has a reputation as an industry thought leader, but he was far less effective in translating that skill into the management of a substantial organization. I gave up on the shares as long ago as the middle of 2019; there were much better alternatives in the observability space, particularly Datadog and Dynatrace, as well as Elastic.
Most observability solutions these days are priced based on consumption, or data ingestion. Of course, that can create vulnerabilities in the revenue model if users run into macro troubles and stop running scans and traces, but that obviously hasn’t been a factor in the market, at least to this point.
New Relic initially offered a seat based model, typical of SaaS software at that time. In the summer of 2020, the company announced a relaunch of New Relic One (The initial incarnation did not resonate with users and had to be redone.) It really was a substantial replatform of what the company had offered before, and in particular it changed the consumption model substantially so that it is usage based and comparable to the pricing models of the major competitors in the space. The transition from seat based to a consumption model had a meaningful and highly visible impact on the company’s revenues, and in terms of operating income which declined sharply in the company’s FY’s 2021 year and has not yet recovered to peak levels.
In May of 2021, the company founder Lew Cirne stepped down, and the company appointed Bill Staples to the CEO position. Previously, Staples had been the company’s CTO, and before that he had been the head of Adobe’s (ADBE) VP of Experience Cloud. He had been the leader of Microsoft’s Azure application platform unit for a number of years. Recently, the company brought on a new CEO, Dave Barter, who had been at Ce.ai (AI). Most recently, the company has appointed a new Chief Revenue Officer, Mark Dodd, who comes to the company from AWS (AMZN).
While new users are essentially all buying the company’s New Relic One platform, the company has a ways to go before all of its installed base renews and moves to the new offering. Recently, the company embarked on a sales program to renew its customers from its legacy platform to New Relic One prior to expiration of their current term. As mentioned, some of these early renewals have come with significantly improved levels of MRR. Churn has declined, and the company has seen its monthly consumption run rate growth accelerate.
One of the keys to New Relic’s future success is going to be to drive the adoption of what it calls “capabilities,” or what most other companies refer to as modules. Last quarter, the company was able to increase the number of customers using its top 4 capabilities which are APM, infrastructure, logs and browser from 26% to 31%. That is still less than the capabilities/modules used by a typical Datadog user these days – last quarter 37% of DDOG’s users were using 4 or more of its modules.
A second requirement to restart growth will be for New Relic to accelerate the acquisition of new customers. Last quarter, New Relic increased its customer count by a net 300, just slightly above earlier levels. Datadog, by comparison, acquired 1700 net new customers. I don’t imagine that this gap is going to be closed entirely – Datadog has too much mind share-but it can be reduced, I believe, with New Relic ultimately adding more new customers.
Some highlights of the observability space as it has evolved
To reiterate, Observability software is one of the cornerstones of any digital transformation strategy. It also has become one of the more crowded spaces in enterprise software. One of the concepts of digital transformation is that users, be they consumers, employees, or suppliers/colleagues need access to applications that perform at high levels. There are significant, and highly visible, consequences when Web applications/infrastructure suffer performance degradation. Almost inevitably, performance degradation leads to lost sales, lost customers, employee frustrations and higher costs.
Observability is also one strategy being deployed by users to enhance their security posture. When anomalies are observed, finding their source, and generating remediation solutions can halt breaches before they damage the integrity of a network, and can prevent application performance from deteriorating unacceptably.
While the concept of observability, and observability software can sound pretty simple, its evolution has made it quite complex, with concepts including synthetic monitoring, open instrumentation, metrics, logs, and distributed traces. It really isn’t necessary to be an expert on all or even any of these components in evaluating the different companies in the space, but the fact is that the concepts of observability are much more involved than might be thought of. The 3 pillars of observability have long been considered to be logs, metrics and traces. While I don’t purport to be an expert on the subject, I think the level of differentiation that can be created with regards to those 3 pillars is no longer substantial.
These days, almost all of the leading vendors in the space are trying to persuade their users to buy multiple modules. I think the best and most visible example of how that works can be seen in the results that Datadog has achieved. But every vendor has to evolve from core application performance measurement to providing users with solutions in adjacencies such as telemetry, full stack observability, applied intelligence, contextual analysis, and to an analysis of the correlations between performance and business impact. This is part of the challenge that faces New Relic, as it tries to resume a rapid growth trajectory.
I have linked here to a 3rd party study published in September by an organization called Enterprise Technology Research. One key conclusion relates to how important C-Suite executives believe observability to be. Another issue is that of pricing. Most users are sold on consumption pricing. In general, users were willing to commit about 10% of their budget to observability. Fact is, very few users are anywhere close to that level of budget in their commitments to vendors in the space.
Full stack observability is said to be a priority of most users, while mean time to detection and mean time to resolution are the metrics that concern most users. Despite macro headwinds, this survey indicates that observability budgets will grow noticeably next year. Usually these surveys underestimate the growth of spend, but in this environment that might not actually be the case.
Very often reports circulate that use very loose definitions as to what constitutes observability and what is APM. The only reason to care about that is to try to figure out the size of the market. Both concepts are designed to figure out the health of a network and to ensure a good user experience. Often users use both approaches for different applications and sometimes they use both tools for the same application.
The most recent market research survey shows the APM market to be worth $8 billion this year, with a CAGR of 11.4% over the next 4 years. The overall observability market, which includes what is called AIops, according to the survey linked here is worth $17 billion. Another study linked here has the TAM at $35 billion, with a double digit CAGR.
There are a number of “cool” private companies in the space; Cribi is an add-on tool that is meant to allow organizations to efficiently manage the large datasets generated by observability systems, Kmodor (nothing to do with the dragon of a similar name) offers correlations in the Kubernetes space, Observe is a company that looks at SIEM data in a unique way and Rookout is a competitor of the main observability vendors. Cribi is probably furthest along of these companies; it trebled its ARR to apparently $65 million last year. The other companies in the “cool” category are quite a bit smaller. Despite some malaise in the VC space these days, they have all been able to raise adequate capital, but that said, they are surely not going to be in a position to launch an IPO in the foreseeable future. Given the difficult environment for start-ups and compressed valuations from VC’s, I would not be surprised to see any or several of these companies become acquisition targets in the next several quarters.
Since the start of earnings season, several mega cap names including Google, Meta, Microsoft and Amazon have announced disappointing quarterly results, and their guidance was found wanting by some as well. That said, the results reported by ServiceNow (NOW), SAP (SAP) and by Teladoc (TDOC) have been apparently received with some favor. But while some companies are still doing well in the IT space, there has been a noticeable slowdown, and it will almost certainly get worse before it gets better.
I mention these somewhat unrelated earnings reports, because one question is just how the Observability space is going to fare through a recession. The fact is that no one really knows, and that remains the case even after the guide down at Dynatrace. Observability in its current form really wasn’t around during the great financial crisis. Splunk, the closest thing there was to modern observability more than a decade past, didn’t actually go public until 2012. New Relic was founded in 2008 while Dynatrace started life in a far different form in Linz, Austria in 2005.
Whatever else is true, neither New Relic, nor its competitors, are anything like a digital advertising platform. It would be difficult, in the extreme, to analogize observability to digital advertising. Observability, as described further on in this article, is a critical piece of digital transformations. And digital transformation is not optional, although perhaps it can be deferred or downsized in the event of a recession, to some degree or the other.
Observability these days is priced on data ingestion, and based on comments from Amazon and from Microsoft, there is some thought that the volumes of data being observed might grow more slowly in a recession than has heretofore been the case. And Microsoft management spoke as well to a somewhat slower movement of workloads to the cloud, and this, too, might be thought to suggest some macro headwinds to the growth of observability. But the key is to look at actual numbers and context. Observability growth will probably slow down by somewhat compared to what might have been the case in a less baleful environment. But that is hardly news, and would seem to be already incorporated in estimates and valuations.
Observability is not completely recession-resistant to the extent that cyber-security probably is. There is probably some cyclicality driving demand both up and down. But it is probably far less cyclical than the demand for digital advertising. If valuations hadn’t already been shredded, perhaps it would make sense to explore this topic in more depth but my belief is that investors have already priced in a fair degree of risk and uncertainty with regards to observability growth. It is clearly one of the segments of the IT firmament that will rapidly recover, once macro headwinds subside.
New Relic’s competitive position: Is it strong enough to deliver reasonable growth?
Evaluating competition in observability can be a fraught undertaking. In one sense, there is Datadog, and then there is everyone else. Last quarter, DDOG grew its revenues by 74%. It also increased its backlog (RPO balance) by 51% which is probably a better metric to consider in evaluating the company’s growth trajectory.
Since competition with Datadog would seem to be crucial in the market place, I have linked here to a 3rd party research analysis comparing Datadog and New Relic. Of course, competitors evolve their offerings at a rapid clip, and so there are some likely changes in the environment, compared to February. 2022 when this analysis was prepared. Datadog started its life as a solution to analyze the performance and visibility of applications running in multiple clouds, and that is one reason why its growth has been at such elevated levels.
Overall, this analysis suggests that differences between the solution offered by Datadog and New Relic are quite small these days. Datadog does better monitoring infrastructure, and New Relic does better monitoring apps, and it monitors apps in real time, a function not currently available from DDOG. New Relic, according to the survey author, is still in the process of simplifying its pricing options, and it suggests that DDOG, at least on a list price basis, can be cheaper in many use cases. I think that since the analysis was prepared earlier this year, the New Relic pricing model has continued to become more competitive. New Relic seems to be in the lead with regards to implementing security features. At least until recently, Datadog has offered more integration options while New Relic supports more devices.
New Relic also seems to be more attractive to users than Splunk’s monitoring tool, at least according to the survey linked here. It also is highly rated vis-à-vis Dynatrace as the linked study here suggests. In no way do I want to suggest that New Relic is the “best” or the most functional, of the observability solutions on the market. But I think it is fair to conclude from these 3rd party analysis, that New Relic has a very competitive offering that stacks up well in comparisons against the leading vendors in the space. It would be hard to make the case at this point that New Relic’s technology is deficient or a hindrance to its success in the market.
So why hasn’t the company been able to grow at rates equivalent to its competitors. While on Wall St. trends are measured in terms of days and hours, in the real world turning an enterprise requires time. And the turnaround is taking place in a backdrop of macro headwinds. The company has shown some progress, and apparently results in Q3 will show more progress, but restoring New Relic to strong growth is taking some time, and will continue to do so.
I also think that it takes time to restart a sales engine and to develop sales momentum in a market. New Relic seems to have been really disadvantaged in that regard by its previous CEO. For example, it took until last quarter until the company announced its commercial partnership with Microsoft Azure which added New Relic to the Azure marketplace. The current CEO, with an explicit background in product management, seems to have a grip on what is needed in the market in order to ensure that New Relic is successful. And of course, the company now has a new sales leader whose background has seen a record of success in achieving strong sales performance for the companies with whom he has worked.
From the perspective of technology, I think it is reasonable to conclude that New Relic is fully competitive, and should be able to achieve consistent growth in line with the overall market space. It isn’t going to fail based on product, or packaging or consumption options. On the other hand, Datadog, in particular, obviously enjoys huge mindshare and substantial market momentum, and it would be, I think, naïve to base an investment thesis on expecting New Relic to upend Datadog’s highly successful go to market motion as well as that company’s rapid pace of new product introductions. But it isn’t necessary for New Relic to achieve some extraordinary win rate against Datadog to believe that it can return to consistent growth at greater than market rates.
New Relic’s Business Model: A path to sustained non-GAAP profitability and free cash flow generation
New Relic has been making progress in developing a reasonable business model, although it is still very much a work in progress. The company had been on a track in which opex, and particularly, research and development spending was increasing substantially. It has moderated the pace of its hiring and recently announced a small layoff to better achieve its financial objectives. It is likely that much of the impact of the layoffs will impact Q3-Q4 opex more than Q2, but it is one factor that should allow the company to reach non-GAAP profitability in the current fiscal year despite macro headwinds which can constrain revenue growth.
In the latest reported quarter, the company’s non-GAAP gross margin rose 400 bps year on year to 73%. Gross margins rose 200 bps sequentially. There is certainly room for improvement. Some of that improvement is likely to come as the company renews its customers on contracts based on its consumption based revenue model. The company instituted a price increase in June; the price increase only takes effect upon renewal so it will be some quarters before its impact is fully seen in terms of gross margin improvement.
The company’s research and development expense ratio was 24% last quarter compared to 21% in the year earlier quarter and to 22% in the prior sequential quarter. Overall, non-GAAP research and development expenses rose by an extraordinary 38% year on year and rose by 13% sequentially. As an analyst, there is a limit to what I can know about what caused this sizable jump in that expense ratio, and what the company was able to accomplish with that level of investment. Most IT companies of this size have far lower research and development expense ratios, and this company has sufficient scale such that its need to increase additional research and development spend could moderate. But I doubt that the research and development expense ratio is where much improvement will be seen.
Part of the issue is that the 600 lb. gorilla in the space, Datadog, has chosen a business model strategy which has been successful that elevates development spend and allow product innovation to essentially carry some of the load of sales and marketing. This past October, at Datadog’s Dash event, the company announced several pieces of technology in adjacencies. One of those was end to end testing. Another is cloud cost management, which sounds to be something that can resonate in the current macro environment. The net of the aggressive product introduction strategy of Datadog is to make it somewhat more difficult for New Relic to achieve substantial cost leverage on the R&D line.
Last quarter, non-GAAP sales and marketing expense at New Relic was 43.5% compared to 43.9% in the year earlier quarter. The growth in sales and marketing expenses was 6% last quarter, a sign, perhaps, of some significant improvement in that cost ratio going forward. I imagine that this cost ratio is going to see the most leverage going forward. Just as a point of comparison, Datadog’s non-GAAP cost of sales and marketing is 24%, so it has made a huge trade off in terms of elevating its development expense ratio, while constraining sales and marketing costs. Over time, I imagine, New Relic will optimize its expense ratios, and enhance its sales and marketing productivity with a trend to a business model looking something more like DDOG, but these kinds of transitions do take time, and longer, perhaps, during an environment of macro headwinds that require sales and marketing expense to overcome objections and budget constraints.
Last quarter, general and administrative cost was 13% of revenue compared to a comparable expense ratio the prior year. Companies of the scale of New Relic can achieve significant G&A leverage and I have every reason to believe that this will be the case over time for this company.
Last quarter the company had a free cash flow margin of about 19%. Much of the cash generation was a function of a reduction in receivable balances. It is very unlikely, I believe, that New Relic will be able to reach double digit free cash flow margins this year-as mentioned, I have projected 7%-but I do expect that the company will consistently grow its margins because of cost containment and rising revenues.
Wrapping up: The case to buy New Relic shares
Like almost all enterprise IT vendors, New Relic has seen its valuation eviscerated this year. I personally don’t believe at this point that it is possible for any positive investment thesis to work on a consistent basis until investors are willing to pay for growth and become less risk sensitive than is currently the case. I hope that some kind of a pivot in that regard is underway, but I am certainly not able to forecast Fed statements with the level of conviction of some commentators.
I do think that New Relic has gotten its product house in order-the surveys all point to an environment in which the company has a fully competitive product. And some of that seems to be confirmed by the company’s latest quarterly earnings reports. But while this has restored some growth to the company, not all of its sales metrics have improved to a sufficient extent to label this turnaround as complete. The company has announced a new, high profile sales leader, and there is probably some time before all of the necessary tweaks are made and bear fruit.
I expect that the observability market space will show signs of a cyclically induced slowdown. And that is going to impact all of the companies in the space, not just New Relic. I certainly don’t expect terribly optimistic guidance when New Relic provides its forecast next week. But given just how far New Relic shares have fallen, and a valuation that is at a discount to other companies in the 20% revenue growth cohort, I think there is some downside support to the shares compared to the more highly valued competitors in the space. I also believe that New Relic’s relative growth compared to competitors will continue to show improvement. That is, I expect that there will be some convergence between New Relic’s revenue growth when compared to that of its competitors.
The company has already taken steps to enhance operating margins including a small layoff, and other cost remediation measures. That said, there is still a long way to go before the company’s non-GAAP operating margins and its free cash flow margins reach levels that investors will find satisfactory.
While always difficult for an outsider to judge, I believe that the company’s newly assembled management team has much to commend it, and will ensure that New Relic, at the least, maintains its competitive position in what should be an attractive space. To me, all of this adds up to a company whose shares are positioned to produce positive alpha over the coming year.
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