- The net expansion rate is depressed for the third quarter in a row after the introduction of New Relic One.
- The introduction of a new president/COO and new Chief Product Officer suggests that there may be ongoing problems.
- New Relic has ramped sales rep hiring in an attempt to increase revenue growth in a competitive environment.
- New Relic now has a platform of 3 apps that is expected to boost revenue. The jury is out.
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Back in July, I made one of my worst calls in recent memory by giving New Relic, Inc. (NYSE:NEWR) a bullish rating. 8 months later, this company is trading 40% lower than when the article was published.
Admitting when one is wrong, and learning from one's mistakes are important attributes for making it in the world of finance. I admit that I was wrong but it remains to be seen if I have learned anything. Today I am taking another look at New Relic and updating my rating.
Net Expansion Rate
One striking observation that I have made is the clear drop in the dollar-based net expansion rate for the last three quarters. Coincidentally, this lines up with the introduction of New Relic One which gives the product a new front and paves the way for addition of new apps. This is the company's attempt at converting to a Platform-as-a-Service offering.
(Source: New Relic)
Rewinding the clock back to earlier in the year, management indicated that:
changes within their sales organizational structure and moving to a new user interface platform hurt billings, though suggested these were only short-term issues and should be resolved in the coming quarter.
It is safe to say that the issues have not yet been rectified and in a broken record kind of way, management is still calling for a rebound in the coming quarter, 2020 Q4.
When you look at our guidance for the year you can impute, we expect cash flow to rebound in Q4. And then we are confident in our ability for that to rebound or to increase next year as we head towards the targets we set out for our fiscal 2023.
Is New Relic Struggling?
It appears to me that New Relic is struggling a little bit and I dare say the company has had "sales execution issues". New applications have been introduced prior to a ramp in sales rep hiring and training.
And here is what may turn out to be a very prophetic statement by Kayode Omotosho back in December:
In 2018, New Relic was the second-fastest-growing APM player behind Cisco (CSCO) (AppDynamics). It also had the second-largest market share. The APM space is getting increasingly competitive. Dynatrace (DT) is investing heavily to gain market share while Datadog is establishing a strong foothold in the space. New Relic used to outspend Dynatrace on both R&D and SG&A. The opposite is now the case.
If the trend continues, New Relic might struggle to gain market share as new players enter the APM space. As a result, I'm not confident about New Relic's ability to rapidly expand its market share.
In response to the recent drop in the net expansion rate, the company has brought in new management to help strengthen the company. The changes include a new President/COO and also a new Chief Product Officer.
Not only has the net expansion rate been impaired but the company's annual growth rate is slowing rapidly.
Annual sales growth of 28% has dropped from a 5-year average of 50%. And in Q3 2020, the growth of its coveted large customer base was pretty anemic.
We ended Q3 with 926 paid business accounts with ARR over $100,000 up 13% compared to a year ago. This growth represents both new logos landed as well as installed base expansions derived from increased usage, expanded application coverage and the cross sale of additional products.
Free Cash Flow
New Relic has a free cash flow margin of 2.7%, down from 13% less than one year ago.
The drop in free cash flow margin is due to two factors: increased spending and lower net expansion rate:
And we want to see growth in an acceleration, in fact, in our ARR growth as we go into next year and we're going to be investing to do that. And so that is having an impact on our bottom line. Q3 was a very strong hiring quarter. Many of those folks were in place in early in the quarter.
Additionally impacting the cash flow for Q3 was the deferred revenue came in a little bit lower than expected due to the down, drop in the in the net expansion rate. So that had an impact on the cash flow shortfall as well.
The Rule Of 40
One industry metric that is often used for software companies is the Rule of 40. It is an industry rule of thumb that attempts to help software companies ascertain how to balance growth and profitability. For a further description of the rule and calculation, please refer to one of my previous articles.
In New Relic's case:
Revenue Growth + FCF margin = 28% + 2.7% = 30.7%
The calculation comes out below 40% which is disappointing because New Relic scored well above 40 when I calculated it 8 months ago. Most companies that score below 40 never recover to achieve the Rule of 40.
Cash burn is one area of concern that I have for New Relic, especially since revenue growth is decelerating. I evaluate cash burn based on the SG&A expense margin. Note that the SG&A expense margin includes R&D.
Anaplan (PLAN) has an SG&A expense margin of 95%, meaning that it is spending almost all of its revenue intake on SG&A expenses alone.
The following scatter plot of enterprise value/forward sales versus estimated forward Y-o-Y sales growth illustrates New Relic's stock valuation relative to the 152 stocks in my digital transformation stock universe.
(Source: Portfolio123/private software)
A best-fit line is drawn in red on the scatter plot and represents a typical valuation based on next year's sales growth. As can be seen from the scatter plot, New Relic is very undervalued relative to its peers based on forward sales multiple.
Summary and Conclusions
New Relic has been struggling for the last three quarters as revenue growth has slowed and the net expansion rate has dropped fairly dramatically. The company management has been promising that this is a short-term issue for some time and to expect a rebound. However, I am somewhat skeptical as competition is fierce in the APM market given the alternative offerings from AppDynamics, Dynatrace and Datadog (DDOG) among others.
The future of New Relic really depends on how well its new applications are received by customers as it attempts to transform into a Platform-as-a-Service. I believe that the jury is out and we may not find out the answer for some time yet. I wouldn't expect the ramp in sales reps trained on the new products to be kicking into high gear until late in 2020. In the meantime, I am somewhat discouraged by the drop in free cash flow margin, failure on the Rule of 40 and decreasing sales growth and net expansion rate. The company's cash burn is high for its growth rate. For these reasons, I am giving New Relic a neutral rating.
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This article was written by
I have been trading stocks, commodities, and options for more than 25 years. I have honed my skills in quantitative analysis and various stock investment tools for 15 years at Portfolio123 and offer services as a consultant in stock portfolios. I also own the financial data service Equity Analytx which provides aggregated fundamentals for a wide range of industries.
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