Aug 11 2020 - New Relic: Still Attractive

Summary

New Relic's pricing and product innovation will drive sustainable long term growth.

The trend for enterprises to demand more optimization and product simplification is inevitable. New Relic's early prioritization of open-source will drive future success.

The simplification of product usage and flexibility offered via its programmable platform will reduce churn while driving sustainable ARR.

The current valuation offers a compelling entry point as the growth factor rebounds heading into 2021.

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Source: Devoteam

New Relic (NEWR) has grabbed the bull by the horns by redefining its competitive landscape in the coming years.

New Relic's response to innovative moves from competitors includes the deployment of a series of tactics to simplify the way its brand is conceived. The bulk of these tactics were implemented over the past four quarters. The execution of these moves extends beyond coming to parity with new capabilities introduced by competitors. Therefore, expecting growth outperformance in H1'20 is asking for too much.

Going forward, New Relic isn't just cleaning up its game; it is writing a new game plan which can change the way DevOps solutions are consumed in the future. By embracing open source as a growth hacking tool, it is making the customer onboarding phase of its marketing funnel as touchless as possible. Touchless lead generation and conversion are good for renewals and new logos. This will allow the sales team to focus on upselling and cross-selling new capabilities to drive ACV. The newly introduced offerings will reduce churn during product refresh. This will reduce the volatility of near term growth metrics reported during the quarterly conference calls.

New Relic's conservative ARR guidance isn't supportive of its growth factor (near-term) when you consider the headwinds from COVID-19 impacting its SMB customers and clients in the hospitality vertical. Regardless, it is important to understand the long and short term implications of its new moves. In the SaaS space, solid revenue growth is how you enjoy lofty SaaS multiples when your GAAP margins are still volatile. Therefore, the rerating of valuation multiples is expected. This rerating is expected to be short lived as the ease of product consumption drives ACV.

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It is reassuring that New Relic is now at parity with its major competitors from a DevOps standpoint. To further differentiate, New Relic is relying on the programmability of its platform. It is also innovating with pricing. It is adopting a user-based pricing model that cleans up the inevitable consumption bloat as customers monitor more enterprise apps. This is likely the outcome of a thorough margin analysis to optimize consumption cost while driving customer lifetime value. This helps balance growth and growth sustainability as a more attractive pricing option will make customers less willing to churn.

While this move is partly inevitable due to the growth of hosts and apps needed to complete and maintain modern tech projects, it also points to potential weaknesses beyond pricing that need to be examined. These weaknesses include sales execution effectiveness, product usability, and customer satisfaction. If churn stabilizes in the coming quarters, sales execution effectiveness should be analyzed in depth.

The pricing update is good for IT managers who will be pushed by their CFOs to optimize the total cost of ownership of their IT tools. This trend will be a tailwind for future consumption of New Relic's offerings amongst cost-conscious enterprises. It isn't hard to fathom that enterprises care about cost, given the recent concerns about cloud usage optimization highlighted by Datadog (DDOG) during its last earnings call.

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Elastic (ESTC) is the closest reference when it comes to leveraging open source as a critical go-to-market strategy. Dynatrace (DT) appears to be focused on being the best of breed monitoring and observability platform. It further differentiates by bundling its capabilities to simplify consumption. Datadog (DDOG) is about granularity and coverage. App Dynamics gains from superior network monitoring capabilities due to Cisco's leadership in IT networking. Other top DevOps platform either gain from the huge salesforce or the brand advantage of their parent company. Going forward, while competitors are also embracing open source, it's not clear if they are placing as much emphasis on open source as New Relic.

Another advantage of the open-source focus will come from New Relic's push for standardization. Achieving this goal will improve New Relic's brand prospect as it will be favored by developers if it succeeds in building with them. This is inevitable as these developers build the next generation of enterprise businesses.

Going forward, some competitors will respond to New Relic's pricing move and its open-source innovation forays. Competitors with great product usability will be less worried as usability plugs the fear of customer churn and downgrades. Though, it appears New Relic will be challenging and redefining what passes for "best of breed" as it continues to work with developers. In this regard, the playing field might be leveled heading into 2021.

New Relic's margins are already stretched. The pricing update has sent gross margins (GAAP) to the lower end of its long term target. Opex has also been accelerated to land large enterprise deals. Since a combination of pricing and COVID-19 headwinds will drive cash flow volatility, it is easy to understand why there was less emphasis on billings curing the last earnings. Investors have to be patient for the growth of bets around pricing to drive consumption and product stickiness. In the bull case, this will be achieved via a flurry of deals from enterprises adopting a cloud-first approach when designing their IT strategy. In the bear case, New Relic might not attract enough businesses with the potential to grow product usage to the point where New Relic benefits from margins expansion. The bearish scenario has a low probability because expanding the lead generation funnel, while simplifying the conversion journey, is like funding a million startups.

Conclusion

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The market has priced in the near term headwinds to growth. New Relic has disrupted the way DevOps products will be consumed. While all players will maintain customers, who are attracted to their unique capabilities, "swing users" will find a new abode in New Relic. This will drive a new era of growth. New Relic's depressed valuation is a good way to bet on this opportunity.

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