Here’s my review of New Relic (NEWR) which Bear brought to the board in June. First, this is what Bear said about it that got me interested, and thanks to Bear for the heads up:
New Relic monitors web and mobile applications in real time, detecting issues before they become problems, and helping companies figure out where the pain points may be before it costs them sales, or even customers. Along with Cisco’s recent acquisition, AppDynamics, and a private company called Dynatrace, New Relic is one of the main leaders in the APM space (Application Performance Monitoring). They recently partnered with Splunk, which I think solidifies their position even more.
I thought it sounded interesting so I looked to see if Bert had ever written it up. Here is my paraphrased, very edited, and much shortened synopsis of Bert’s deep dive in Sept 2016. Note that this was almost a year ago, so some of the specifics may be way out of date.
New Relic is a fast-growing company with a cloud offering in the APM space.
It is still a long way from profitability, but it says it will reach that goal by the end of its fiscal 2018 (Mar 2018).
It has many competitive advantages and it is gaining market share very rapidly.
It has developed a dashboard product to extend its footprint beyond APM, a wise move given the revenue limitations of the space.
Its mobile product, which is a very unique offering, was responsible for a large win last quarter and should provide for further differentiation down the road.
What does it mean to be the top in the Application Performance Monitoring (APM) space? I don’t think that anyone has ever considered that application performance measurement apps are sexy or exciting anymore than a thermometer or a barometer. Screens full of all kinds of numbers and graphs with different colors explaining capacity utilization or latency. Not exciting.
Actually New Relic isn’t quite “the leader” in the APM space, but given its high growth rate, and its status as the only company of some scale to be publicly traded, it has some claim to some kind of market leadership.
The APM category is as old as the software space. The problem with the category is that it has never gotten very large. Gartner’s read on the market is that it is around $3 billion/year in terms of total revenues for APM. Adding Network Performance Monitoring (NPM) software brings the TAM to $8 billion as of 2015. But adding that availability and performance software to the mix decreases the rate of growth as that category is experiencing just 1% expansion. So the largest companies in the space are not all that large. There are signs though that the growth of the APM space as well as the NPM space is accelerating noticeably. In 2015, NPM grew by more than 21% and APM grew by 11%.
Historically, the growth in APM was limited by competition from homegrown systems and because of some ingrained reluctance on the part of larger enterprises to test and monitor the performance of their applications. It has become less feasible to use homegrown technology to monitor web applications, and given the payback from getting performance of web based applications right, the long-term ceiling in this field seems to be lifting.
For many years, it has been typical that many users have contracted for monitoring on a very short-term basis. That has been particularly the case for SMB merchants who are concerned about the Christmas rush or other users who are most concerned about monitoring performance during a seasonally high period for the usage of a particular application. That can lead both to seasonal differences in revenue comparisons and it does lead to difference in average contract terms which impact reported bookings growth.
In the very short term, these kinds of metrics can influence share price performance, so be aware that there will be a quarter that investors dislike because of sub-headline metrics.
Should you buy New Relic? Probably not at this point or with this valuation. There is a mismatch between expected growth, lack of profits and EV/S that needs to be rectified. But this is a company whose prospects are excellent, and it should come to dominate its space and that should lead to sustainable profits and cash flow. The shares are worth putting on a watch list and trying to pick them off. It is how I intend to proceed.
What is happening to wake up the APM space? Basically, as more workloads move to the web, the web is responsible for more commerce. The difference in latency of a few tenths of a second has been found to have a noticeable impact on click-through rates and the amount of commerce transacted on a site and during Christmas holiday season, when sites often bog down, knowing what is happening allows site owners, in some cases, to remediate the problem. But also, as workloads move to third-party infrastructure that has a guaranteed standard of performance, it has become more important to ensure that web service vendors are providing the service they promised.
The largest vendor in the space today is Dynatrace, who became No. 1 in the space by buying its largest competitor. IBM is No. 2 in the space and has lost market share along with the third largest vendor CA whose market share has fallen consistently. The sixth company in market share is a firm called AppDynamics. It has a growth trajectory comparable to that of NEWR and is likely to move up a couple of places in market share this year based on current trends. (Saul – It was acquired by Cisco in Jan 2017 when it was about to go public)
New Relic is in the fourth position overall and has more than doubled its market share in two years. Based on its current performance in terms of revenues and its forecast, the company is likely to be No. 2 in the APM market this year and should outgrow Dynatrace in absolute dollar revenues as well. So while NEWR is relatively small and is estimated to reach only $254 million in total revenues this year, I think it is worthwhile to see if it can translate revenue growth to profitability and sustained positive cash flow. It forecasts that it will reach both sustained positive free cash flow and non-GAAP breakeven by the end of fiscal year 2018 (ends 3/31/18).
The other major question will indeed relate to market share and the company’s growth. Forecasted growth this year is 40%, forecasted growth next year is 27%. From my perspective, I would expect NEWR to outperform its rivals in this space very noticeably and I feel that the reversion to the mean that is forecast is less likely than it might seem. At the moment, and based on a market cap of $1.91 billion and with about $200 million of cash and no debt, the EV/S stands at 6.7X based on the current year forecast of $254 million in revenues and at 5.5X based on revenues forecast in the analyst consensus for 2017. At those levels and lacking either positive cash flow or profitability, there is no significant potential for positive alpha.
A deeper dive into New Relic’s numbers, strategy and outlook - New Relic is a cloud-based company and has always been so. All of the other companies in the space, with the exception of AppDynamics, started with an on-premise model and have migrated. That has given NEWR an advantage in the ease of use of its products. Most companies in this space use a land and expand strategy and NEWR is no exception. It has thousands of small customers who use the tool to monitor the performance of their digital “store-fronts” either at peak retail season or around the year. It also has a growing stable of enterprise customers who are acquiring the software to ensure that they get value from the applications they buy or internally develop. Most investors like to see growth in the enterprise business, which has much longer average contract terms coupled with far larger transaction sizes. Average annualized revenue per customer was only $17,000 a quarter, although that is up 36% year on year and 8% sequentially. Given the new pricing initiatives, the CFO forecast a deceleration in that growth rate.
This past quarter, it said that it had closed a seven-figure plus sale with a brick-and-mortar retailer based to a significant extent on the its abilities to extend its software to the mobile apps space. It also said that New Relic Mobile registered its strongest new business quarter yet and that it was the single greatest contributing factor to the seven figure win in the past quarter.
NEWR evolved a new packaging and pricing offering to enhance its opportunities to capture and land customers. They said their conservative forecast was to an extent based on a strategy that will result in more but smaller customer acquisitions that hopefully will exhibit growth trends equal to or greater than has heretofore been the case. The dollar based net expansion rate in the quarter was 118%, which was actually down as anticipated from the prior quarter. If the new customers who the company plans to capture with the new pricing and packaging follow that pattern, then it will have positive results for the company. It believes that it will see a significant increase in average deal size, and greater seasonality, with typically seeing a very large Q4.
Given the history of the APM space, the company has prudently begun to develop what might be described as a real-time dashboard of surrounding metrics and telemetry to help users have a complete view of their business. This is a very nascent undertaking but it offers the company the ability to escape from the ceilings that have plagued other APM vendors. I think that a key to its retaining its revenue growth at levels well above the consensus forecast is going to be the Insight product that encapsulates this dashboard functionality. Can Insight become a 10% contributor to the company’s revenue? There is not enough evidence yet.
If I were forecasting revenue prospects based on the size of the market, the competition, the company’s current momentum in competitive engagements, and the traction of its new products, I would be inclined to think that it will be able to significantly exceed 26% growth. Its strategy should work, in my view.
How about profitability? It has achieved non-GAAP gross margins of 80% and that is a reasonable goal for that metric in the longer term. There have been some signs that GAAP expense measures are showing lower growth rates with a concomitant improvement in operating margins. R&D was 27% of revenues last quarter and that is up from 23% in the year earlier period. On the other hand, S&M spend was 66% of revenues last quarter, down rather significantly from 75% in the prior year. General and administrative expense was 17% last quarter, significantly down 21% the prior year. Overall, the operating loss ratio was 31% on a GAAP basis, a decent improvement of more than 900 bps from the prior year’s ratio of 39.4%. Stock-based compensation at 12.5% of revenues is less than that of some peers. Stock-based comp was 12.1% of revenues in the same quarter the prior year. The non-GAAP operating loss for the quarter was 17%, which was 14% better than the GAAP operating loss margin. CFFO was marginally profitable this past quarter and has been oscillating between positive and negative. The CFO forecast that it would be negative in the quarter that ends the end of September. The company’s capex at $32-$34 million is expected to be significant this year for a company of this scale as it builds out data center capacity to support its growth. With a current balance of $196 million of cash and equivalents, this company has no liquidity issues.
During the course of the conference call, the CFO said he was proud of 40% growth with a 1,000 bps improvement in profitability. Overall, management forecast is essentially that the GAAP margin for the year will be around a negative 26% for the year. (The company doesn’t forecast GAAP margins, but I have just interpolated from its forecast of non-GAAP using the current levels of stock-based comp.) Since the operating loss margin was 31% this past quarter, the ramp to reach 26% for the full year is pretty steep. That implies quite a bit of cost seasonality as the revenue seasonality required to reach the forecast of $253 million is not all that significant. And it implies very substantial cost discipline of a kind not yet seen at this company to reach its target of non-GAAP breakeven operating income by the end of fiscal year 2018.
On a non-GAAP basis, the operating loss margin was 17% this past quarter and is forecast to be at 13% for the full year. Getting from 17% to the 10%-11% range which is required to average 13% loss for the full year will be no mean feat, I suspect, and yet it has to happen in order to achieve guidance.
While I think the company has an excellent opportunity to grow at significantly above the 26% forecast of the consensus next year, I think getting to non-GAAP breakeven status even by the end of the period is going to be a stretch. While I have no reason to believe that the company will not be able to achieve the cost targets necessary to achieve breakeven by the time period it has forecast, and I am sure that New Relic budgeting apps have conveyed the obvious points to management, the swing from the current non-GAAP operating loss margin of 17% this past quarter to break even seven quarters into the future would be a significant accomplishment.
What’s this worth? I think recommending the shares is a close call. And that is what it is all about. They are simply too expensive for me at current levels absent better visibility with regard to revenue growth significantly above the current forecast. I think investors are going to need to see at least a couple of quarters that show a faster path to profitability or better than forecast revenue growth before there might be the opportunity for the shares to have material positive alpha potential. Investors have many ways of evaluating the timing of their investments. I would certainly be looking to buy these shares if there is a significant market pullback. And I would also look to buy these shares if investors are not pleased with some sub-headline metric as described above. The APM space has been a fraught adventure for investors. I believe that New Relic is likely to be the first opportunity investors will have to make money investing in the space. But not at $37.58/share. I am intrigued, but not quite ready to pull the trigger.
[Saul’s Note: Ten months later the price is $47.50, up 26% - Bert was perhaps over cautious]
Then I found this public July 2017 Seeking Alpha Article by Michael Rogus, which I also paraphrased, edited and shortened.
New Relic - A Relatively Unknown Gem
It’s a relatively small market cap ($2.4B) company in a fast growing segment.
It is on a solid track to profitability by the end of FY18 (non-GAAP).
It is relatively unknown, not a battleground stock, and is worth a speculative buy at current prices.
I don’t normally like to invest in stocks that are not profitable. But in New Relic’s case, I can make the rare exception. Trying to understand exactly what its products actually do, you either get it or you don’t. I didn’t, so I had to find out exactly what they do do. I’ll take a little time and try to explain its business model.
We are defining a new category of enterprise software we call digital intelligence, designed to help companies see their business more clearly. Our cloud-based platform and suite of products, which we call the New Relic Digital Intelligence Platform, enable organizations to collect, store, and analyze massive amounts of data in real time so they can better understand their application and infrastructure performance, improve their digital customer experience, and achieve business success.
Did that clear it up? No? Let’s try this version:
Mostly its software is made for the “backroom” guys who are monitoring and designing a business’s applications. For example, they can show a real-time change in customer retention rates based on a price change. Or, where the mobile app they are designing is requesting too much data from the host. They can show the actual customer experience in real time as the team manages and designs their digital platform and data. They allow you to run custom queries to analyze users by location, device, browser, and other metrics vital to an app’s success. This allows big data that can be seen up the management chain by showing, in a user-friendly format, page views, response times, and sessions of specific users to give support and operations teams insight into the customer experience. Its products aid in benchmarking, test tracking, segmentation, analysis, and refinement of data and apps.
It’s a big data world, and the faster you can maximize your performance metrics, sales programs, and user interaction, well, that’s big money. New Relic helps companies do just that.
New Relic went public in 2014. After some ups and downs, it has now moved to new highs. Here are some key metrics.
It has best-in-class margins.
It reports the number of customers it has with an annual revenue of at least $100,000. This is a nice base of recurring revenue, and it is steadily rising.
It has updated revenue guidance for this year. Sales are now projected to grow from $263 million to $344 million.
It believes it has a multi-billion-dollar market opportunity.
As I mentioned, I don’t like to buy stocks without earnings and almost never stocks with losses into the great unknown. New Relic, however, recently gave guidance that on a non-GAAP basis, it will be profitable by the end of FY 2018. That is impressive for such an early and fast-growing enterprise. This is due to its scalability of growth and its large gross margins. It is also capturing larger customers.
Summary - These types of stocks are always difficult to judge. What appeals to me is their rapid growth rate, the attractive market they are in, and the fact they are relatively unknown. This is not a battleground stock with hundreds of articles reporting on it. It has a lot of time to get more attention and considerably appreciate in price. As a testament to the validity of its model, Cisco purchased one of its competitors, AppDynamics, for $3.7 billion just before it went public in Jan. 2017.
With a relatively low market cap of $2.4 billion, if NEWR can hit or exceed its core estimated numbers, the stock could go much higher. Guidance of turning profitable by the end of FY 2018 gives a clear road map that it is on the right track. Still a risky stock, but a risk that is well worth taking. Disclosure: I may initiate a long position in the next 72 hours.
Then I (Saul) looked at the most recent quarter results and read the conference call transcript.
May 2017 – Mar quarter and Mar fiscal year results
Revenue up 40% to $73.3 million in the quarter, and up 45% on the year.
Dollar-Based Net Expansion Rate of 133%
GAAP operating margin up 16%
Revenue was up 45% on the year!
Digital Intelligence leader New Relic today announced, “We had an incredible finish to our fiscal year, with more than $263 million in revenue and revenue growth of 45%. This growth is driven by our success in the enterprise market, as nearly every forward-thinking company today is making a strategic investment in cloud and digital transformation initiatives. That is why the world’s most innovative enterprises trust us to help them see more clearly into their digital business.”
“We demonstrated significant efficiencies, improving both our GAAP and non-GAAP operating margins by over 13% despite meaningful investments in our enterprise business. We expect these initiatives to drive strong results including positive free cash flow for fiscal 2018 and adjusted operating income breakeven by the end of the fiscal year.”
• Revenue of $73.3 million, up 40%, and up 8% sequentially.
• Adj loss from operations was $5.8 million, down from a loss of $12.0 million.
• Adj net loss per share was 11 cents, down from a loss of 24 cents.
• Cash was $206.4 million up from $195.6 million sequentially
Fiscal Year 2017 Results:
• Revenue of $263.5 million, up 45%.
• Adj loss from operations was $25.4 million down from $41.2 million
• Adj net loss per share was 49 cents, down from with a loss of 85 cents.
Paid Business Accounts of 15,216.
Dollar-Based Net Expansion Rate for the quarter of 133%.
Announced a strategic alliance with Splunk, unifying performance monitoring and machine data that helps enterprises transform customer experiences and drive revenues.
Expanded presence in Europe, announcing strong growth across Dublin, London, Munich and Zurich.
Launched FutureStack Global Tour with events being held in London, Berlin, Sydney, New York and San Francisco.
Next quarter guidance:
Revenue $78 million, representing growth of 33%
Adj net loss per share of 13 cents. This assumes 53.7 million common shares outstanding.
Full Year Fiscal 2018 guidance:
Revenue between $341.5 million and $346.5 million, up 30% tp 32%.
Adj loss from operations of $16 million.
Adj net loss per share of 28 cents.
My take (Saul):, Great results and Bert consistently underestimated what they could do. I decided I really liked the company which is helping to disrupt a previously stagnant field. I took a half position and will probably keep it at that for two reasons: First, the TAM seems somewhat limited, but obviously growing faster than expected, and second, I think that AppDynamics being acquired by Cisco will make it even more of a competitior with Cisco’s clout behind it, and perhaps being integrated by Cisco in some way. I’ll keep a close eye on New Relic’s continued growth for signs of problems with competition.
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