What does it mean to be the top in the Application Performance Monitoring Space?
I suppose the lead-in might be conceived of as "click-bait." Although writing anything at all about APM that might be considered click-bait would be a real challenge far beyond the abilities of my keyboard. I do not 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 (NYSE:NEWR) doesn't seem to be 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, if the market is defined properly. So, it is certainly possible that investors will get a kick out of investing in the shares as the title of the article suggests. The title for the article - well, it comes from the Cole Porter song "I Get My Kick Out of You". It was part of a very well known Porter show of 1934 called "Anything Goes" that has loads of show stoppers.
Why the name New Relic? I have no idea. Try as I could to see the connection, one is not immediately apparent. A relic is usually considered to be the physical remains of a saint or the personal effects of a saint or other venerated leaders. At least that is what I remember.
There is software that might be considered as a relic of an earlier era that could be identified by New Relic. But that is a stretch. Perhaps the thought is that NEWR software will prevent users from running their apps on relics that have down market performance. Or maybe it is just to get users to wonder amongst themselves and become interested in this company's set of solutions.
The APM category is as old as the software space. If Neanderthals had computers, they would have had APM. (Of course, one of the distinguishing characteristics between ourselves and Neanderthals was that they lacked imagination or the ability to process symbolic information and hence spent their time on this planet without the benefits of IT. How terribly sad.)
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 software that looks at availability and network performance brings the TAM to $8 billion as of 2015.
But adding availability and performance software to the mix decreases the CAGR 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 CAGR of the APM space itself as well as the CAGR of the Network Performance Monitoring 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 both 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 deploy homegrown technology in monitoring web applications, and given the payback there is in 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 vendors 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. That wasn't the case this past quarter. The shares appreciated about 5% in the wake of the earnings report despite significant conference call questions regarding the length of contract terms and deferred revenue. But investors should be aware that there will be a quarter that investors dislike because of sub-headline metrics.
Should investors buy the shares of 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 as I will go on to explain, this is a company whose prospects are excellent and 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 equally, as workloads move to third-party infrastructure which has guaranteed standards of performance and availability, it has become more important to ensure that web service vendors are providing the service for which a user has contracted.
The largest vendor in the space today is a company called Dynatrace. Dynatrace belonged to Compuware for a number of years during which its performance was typical of that for most Compuware assets - and for those readers unfamiliar with that, it means politely put that it was disappointing, although some of us who had the misfortune to cover the name might use a word starting with "s" or two different words starting with "s" to describe the performance of that company's set of solutions. Dynatrace became No. 1 in the space by following the typical software industry playbook - it bought its largest competitor Keynote in 2014 and moved to the top of the heap. Keynote itself had been one of the more frustrating of names to follow. It may have earned the distinction of having the lowest valuation of any company that averaged 20% growth because it could never string two successful quarters together. IBM (NYSE:IBM) is No. 2 in the space and has lost market share along with the third largest vendor CA (NASDAQ:CA) whose market share has fallen consistently and who suffered through a miserable 2015 in the space. The sixth company in market share is a firm called AppDynamics which was founded a few years ago. 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.
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 terms of 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 considering the name and determining if it can translate revenue growth to profitability and significant sustained positive cash flow. Don't worry readers, you haven't missed that part of the story. The company has forecast 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%. 27% is still a decent level but it changes the valuation calculus materially. From my perspective and remembering the antecedents of the market leaders none too fondly, I would put my money on 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 otherwise 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. Indeed, while the shares are near an all-time high at this writing, they are up just 3% YTD. So the question in the eyes of this writer is whether or not those are the correct numbers to use.
A deeper dive into New Relic's numbers, strategy and outlook
New Relic is of course 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 and that has given NEWR an advantage in GUI and the ease of use of its products when compared to competitors. It has been typical of most companies in this space to 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 their companies get value from the applications they buy or internally develop. To the extent that investors drill down significantly, most of them 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, company CEO Lew Cirne announced that the company had closed a seven-figure plus transaction with a brick-and-mortar retailer based to a significant extent on the company's abilities to extend its software to the mobile apps space. President Hilarie Koplow-McAdams said on the call 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.
The company has evolved a new packaging and pricing offering to enhance its opportunities to capture land customers. CFO Mark Sachleben said the company's conservative forecast for the current quarter 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.
The company believes, overall, that it will see a significant increase in average deal size and that in turn will lead to greater seasonality with the typical software phenomena of seeing a very large Q4. Guidance for this year doesn't seem to be tracking that way to any significant extent.
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 the ability of this company to retain its revenue growth at levels well above the consensus forecast is going to be the Insight product that encapsulates the dashboard functionality. Can Insight become a 10% contributor to the company's revenue? There is not enough evidence and the company hasn't provided enough in the way of signposts to develop a real trend analysis for the product.
There are many metrics that some observers look at in trying to analyze the performance of a company with thousands of users, most of whom spend very little. Many of the statistics at this point are noise in that there is is simply not enough history with which to develop a statistically significant trend. But for whatever reason the commentary on this call was very focused on second and third level statistics which do not have much to do with forecasting the trend of revenues for this business.
If I were forecasting the company's revenue prospects based on the size of the market, based on the competition and 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.
Yeah, how about profitability? The company has achieved non-GAAP gross margins of 80% and that is about what a reasonable goal is going to be 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. Research and development was 27% of revenues last quarter and that is up from 23% in the year earlier period. On the other hand, sales and marketing spend was almost 66% of revenues last quarter, down rather significantly from a 75% ratio 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 margin for the quarter was 17%, or 1,400 bps 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 composing a recommendation on the shares of this company is a close call. And that is what it is all about. The shares are simply too expensive for me to recommend at current levels absent better visibility than I have 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.
To put it mildly, the APM space has been a fraught adventure for investors. I believe that New Relic strange name and all 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.
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.