New Relic: AIOps And Edge Will Drive Client-Base Expansion
Summary
- We see growth opportunities through client-base expansion, driven by the adoption of New Relic Edge and AI in FY 2021 and beyond.
- New Relic also onboarded four new executives, demonstrating a full commitment to fixing the sales execution issue in Q1 2020.
- As we see potential growth and margin expansion opportunity in the medium term, we are upgrading our neutral rating to overweight.
Overview
In our recent note on New Relic (NYSE:NEWR) in Q1 2020 last September, we highlighted the potential investment risk considering the management shakeup in the company. We rated the stock neutral at the time as we continued to believe in the business's potential and strong positioning in the attractive APM (Application Performance Monitoring) and observability spaces. New Relic has since continued to perform above our expectations, which increases our conviction in the stock further.
In Q4, New Relic beat the guidance as it grew revenue by 21% YoY and announced new executive hires to strengthen its leadership team. The company also introduced two new offerings, which demonstrates its commitment to continue investing in its platform despite the ongoing macro uncertainties that have reduced the visibility for the full year. The stock has only been up ~7.5% from last September when we published our first coverage. As such, the price level provides a good entry point and we are upgrading the stock to overweight.
Catalyst
We have a long-term bullish view of New Relic, which we think will continue to be a dominant player in the APM and observability spaces. There are two key catalysts we have identified as of Q4:
We expect a client-base expansion growth opportunity through continuous R&D investments in AIOps and Edge technologies. Throughout FY 2020, the company has been tweaking and improving its New Relic AI offering, which reportedly came out of the successful beta phase in Q4. The newly-launched New Relic Edge in Q4 is also a differentiated offering that complements AI. We expect the combination of AI and Edge to drive top-line growth, primarily through strong client base expansion.
(Source: company's earnings call slide)
By having AI, New Relic now has the right asset to enter the AIOps (AI for IT Operations) category and a more comprehensive offering, which we think is highly appealing to its client base. For context, its enterprise peer Dynatrace (DT) even considers AIOps as the most critical piece of technology across its product stacks. We believe that the AIOps expansion should allow New Relic's dollar-based net expansion rate to recover to where it was around one to two years ago. Conservatively, we expect a long-term target of 120-130%, considering Dynatrace's current 120% net expansion rate and New Relic's 130% in Q4 2019.
We further view New Relic Edge as an equally interesting offering, which can boost the expansion rate further. New Relic Edge leverages multi-tenancy technology, which allows more efficient and faster data computation, considering the cloud deployments closer to the clients' location. Overall, it is a similar model to the increasingly trending Edge Computing practice in the IoT (Internet of Things) space.
(source: company's earnings call slide)
Given the promising potential of the offerings that will drive client expansion, we expect New Relic to maintain its single-digit FCF (free cash flow) margin in the near term, with a potential expansion towards the end of FY 2021 and beyond. Likewise, sales and marketing expenses as a percentage of revenue should also decrease to account for the stronger client base expansion.
The strengthened executive team to improve overall go-to-market execution. Considering the sales-related issue around the beginning of FY 2020, the decision to onboard new executives to fill in the strategic positions demonstrates the management's commitment to fixing the problem once and for all. In Q4 2020, there are a handful of additions to the executive team:
- Wayne Purboo in the CSO (Chief Strategic Officer) position
- Bill Staples in the CPO (Chief Product Officer) position
- Jay Snyder in the CCO (Chief Customer Officer) position
- Seema Kumar in the CMO (Chief Marketing Officer) position
Most of these names have held key positions in larger enterprises and channel partners such as Dell, EMC, Salesforce, Accenture, and VMWare, which we feel will benefit the overall sales cycle and client-base expansion. Furthermore, we believe that these strategic additions are in line with the introduction of AIOps and Edge offering and the renewed objectives in Q3 to focus on onboarding more +$100k ARR clients and increasing renewal yield.
Risk
On the other hand, we feel that there is a risk in onboarding too many C-level executives at the same time, especially following the disruption seen earlier in the fiscal year that still requires more careful planning. In that sense, throwing new and drastic changes upon these executive appointments can potentially undermine the ongoing recovery. In Q4, we have seen signs that the team still needs to adapt better to remote work format as the sales cycle lengthened. However, the pandemic has also affected the company's SMB and mid-size clients severely, as paid business accounts declined to 16,300 from 17,000 in FY 2019, leaving the company with no visibility for the full year as it will see a potential increase in delayed renewals.
Valuation
New Relic has a strong reputation and brand name in the APM space, and the expansion into AIOps will strengthen its positioning further, which should drive growth and margin expansion, primarily through increased client base expansion and reduced outbound marketing expenses as a percentage of revenue.
(Source: stockrow)
Despite the slowing revenue growth from +50% to 25% over the last three years, followed by an expected decline to +11% in FY 2021, we have an optimistic view that growth should reaccelerate further in the next fiscal year. Given last year's 25% growth and 4.7% FCF margin, New Relic is about +10 points shy of the rule-of-40. It is also likely that it will still not pass the score of 40 this year. The recent macro uncertainty has also put some pressure on the valuation, which we think is attractive enough at ~6.8x P/S. Given our conviction in the New Relic's differentiated technology asset, we believe that it can trade at 9-10x P/S beyond 2021. Accordingly, we are upgrading our neutral rating to overweight.
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Analyst’s Disclosure: I am/we are long NEWR. 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.
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