New Relic: Strong Q3 Reinforces Long-Term Thesis

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About: New Relic, Inc. (NEWR)
by: Individual Investing Ideas
Summary

New Relic reported another beat and raise quarter, with revenue, billings, and EPS all coming in above consensus estimates.

Management raised FY19 revenue guidance higher than the Q3 revenue beat, implying continued momentum and confidence in the underlying business.

Although valuation remains at a premium level compared to peers, New Relic is one of the few names posting 35%+ revenue growth, 85%+ margins, and expanding FCF margins.

New Relic (NYSE:NEWR) remains one of the leaders in the APM (application performance management) industry, essentially developing tools that measure an application or software. Their software functions are in back-end processes, and the technicals are a bit challenging to understand. But, for most investors, NEWR is a name not well-known. Larger institutional funds have been able to capture significant gains by holding this name over the past few years.

Q3 results were another strong quarter for the company, with revenue, billings, and EPS all beating consensus expectations. Revenue and billings both grew 35% during the quarter, and management once again raised their FY19 outlook. However, the stock traded down ~5% after earnings and has been range-bound ever since. I believe investors' expectations for the company remain high, and as valuation has recovered over the past few months, it has become challenging to build a position and develop a very bullish case.

Chart Data by YCharts

After reporting very strong Q1 results in early August, the stock was largely muted. Then came the late 2018 market correction in which NEWR saw their stock decline by ~30%. However, the company continues to remain in favor of investors, as noted by their strong 2019 performance so far, with the stock up over 30%.

Q3 Earnings and Guidance

NEWR has done a great job over the years at managing expectations, that is they have consistently beat and raised, quarter after quarter. Though NEWR has seen revenues decelerate somewhat meaningfully over the past few quarters, this should come as no surprise, given how fast revenues were growing (previously 50%+ for many quarters). Naturally, revenue growth would decelerate over time, and though it was 35% this past quarter, I would not be shocked to see revenue continue to decelerate into the low-20s over the course of the next year or so.

Source: Company Presentation

The 35% revenue growth this past quarter is impressive and remains comparable to other high-growth software names. In addition to the 35% revenue growth in Q3, NEWR saw another impressive 85% gross margins and is starting to turn bigger profits, with operating margin reaching 6% and FCF margin now at 9% (on an LTM basis).

Source: Company Presentation

Dollar-based net expansion rate of 122% remains very healthy, although was the lowest for Q3 in the past few years. Despite the slight downtick in dollar-based net expansion rate, I believe the 122% is strong and is likely to continue for quite some time.

NEWR also posted 56% of recurring revenue now comes from enterprise accounts, which was flat compared to the prior quarter. Investors have been so used to this figure expanding each quarter that the flat percentage seemed to be somewhat of a disappointment. However, with revenue growth of 35%, this could imply that certain areas of commercial clients are still showing signs of strong demand.

Also, during the quarter, billings grew 35% to $140 million, which came in above consensus estimates of ~$130 million. With the company continuing to report strong gross margins of 85%+, they have been able to post stronger operating margins. For the quarter, NEWR reported operating margins of 6%, which was better than consensus expectations for 4%. The better-than-expected operating margins led to EPS of $0.19, which beat consensus estimate for $0.12.

Source: Company Presentation

Management also provided guidance for Q4 and raised expectations for the full year. For Q4, management expects revenue of $126.5-128.5 million with non-GAAP operating income of $0.5-1.5 million, which represents ~0.5% operating margin at the midpoint. This ultimately leads to EPS of $0.04-0.06, which I believe there is upside to as a result of either better-than-expected revenue or higher margins.

Despite the ~$4 million revenue beat in Q3, management raised full-year revenue guidance by ~$7 million to $473.6-475.6 million. The full-year guidance now also expects EPS of $0.58-0.60, up from their previous $0.42-0.48 expectation.

Source: Company Presentation

Over the long term, NEWR continues to expect gross margins in the low-80s along with expanding operating margins. As NEWR grows and scales, they will be able to spend less on S&M which will ultimately drive higher cash flow margins. For now, cash flow is very lumpy, and management is looking to smooth out their cash flows and earnings over the next few years, which will drive increased value to the company. However, there is a clear upward trend in margins over the past few years as the company remains on the right path towards positive FCF.

Valuation

NEWR has looked very interesting for long-term investors, especially during the late 2018 correction when we saw the multiple contract by 3-4 turns. Coming off another strong quarterly report, the stock's multiple appears to have fully priced in the high expectations for the remained of the fiscal year and heading into FY20. As the company continues to penetrate the enterprise market and revenue growth remains 30%+, we should start to see increased profitability and FCF.

Chart Data by YCharts

The above chart shows a variety of leading software players and their relative forward revenue valuation. As you can tell, valuations had contracted 2-3 turns for a majority of the names. However, over the past few months, valuations have started to expand and approach pre-correction highs. NEWR is no different here, currently trading at 12x forward revenue.

One of the great things about NEWR is their long-term cash flow generating potential. As NEWR scales and continues to grow revenues over 30% and likely above 20% for the next few years, they will be able to deliver greater cash flow potential, which appeals to investors. A lot of the other software names are still focusing on ramping revenue growth through increased internal investments in R&D and S&M. NEWR's leading 85% gross margins and potential for sustainable cash flows put them in a great opportunity to remain at a leading valuation premium for the next few years.

Valuation does remain elevated compared to the overall market and their peer group; however, there are not too many companies out there which continually post 35% revenue growth, 85% gross margins, and expanding free cash flow margins. Over the long term, NEWR will naturally decelerate to a more normalized 20-25% revenue growth, 80-84% gross margins, and sustainable cash flows.

I believe NEWR deserves to be trading at a premium revenue multiple for the next few years, and investors should look to buy on any weakness. A risk to the name is increased competition, such as Cisco's (CSCO) AppDynamics, or other competitors in the market. If NEWR saw their revenue decelerate rapidly or see margins compress, this would also put the stock under pressure.

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.