Description

Summary

We believe that current price levels provide an attractive entry point to purchase shares of New Relic (NEWR). New Relic is a IT diagnostics provider offering APM (application performance monitoring) services, infrastructure monitoring services, log monitoring, and other tangential products through their all-in-one observability platform. New Relic (3.7x forward rev) trades at a significant discount to observability peers Datadog (18x forward rev), Splunk (5.3x forward rev) and Dynatrace (11.6x forward rev), and well below recent takeout multiples in a market with many eager entrants.

Late 2019 began a costly, lengthy, and significant shift in their business as they transitioned their pricing model to a consumption-based model and realigned their product offering from an APM focused solution to a full-stack observability platform. The result was a considerable lag in revenue growth compared to their peers.   

We believe their stock has been punished to an unfair degree during their admittedly difficult and lengthy business transition. Today, we believe the worst of the transition pains are over and that New Relic is nearing an inflection point where their product is finally well (or at least much better) positioned for full stack observability and competitive with other solutions in the market, their go-to-market functions are starting to improve and right size, and they have significant near-term revenue opportunities for upsell of recently launched features. We think that product/pricing changes this large take time to digest and that the market is getting ahead of itself in judging New Relic the observability loser. In any regard, we see room in this market for multiple vendors.

We see upside to $87 or 80% from current levels over the next 3 years on a conservative 5x ’24 revenue multiple with 20% revenue CAGR (still below industry growth levels). We see this driven by extremely attractive industry growth trends, a sticky and relatively price insensitive end buyer, and a revamped product offering narrowing the growth gap with peers and offering greenfield cross selling opportunities. We see downside as becoming increasingly limited with New Relic trading well below prior acquisitions in the APM/Observability space and with a host of potential strategic buyers and PE sponsors interested in expanding into the observability market. See room for outsized upside on evidence of a business turnaround with a somewhat crowded long DDOG/DT short NEWR trade.

While you’re admittedly chasing a similar thesis to the one that drove the stock from $80ish/share to $110-$120 in November of ’21 and similarly crashed the stock from $110 to $65 in February of ’22 on poor read through on the turnaround executive, we believe their recovery is delayed rather than never going to happen and that you have a much better r/r setup at $48 and 3.7x forward revenue than you did at $110 and 7.5x forward revenue. We also think they’ve made significant steps in the last 5 months towards having an actual all-in-one observability offering rather than getting ahead of themselves on the marketing.

Company/Industry Background

New Relic was launched in 2008 as a provider of APM (application performance monitoring) solutions. They were the first vendor to offer their APM solution purely as a SaaS, cloud-based offering and one of the original observability providers. A few brief descriptions below to describe the IT monitoring stack. You may be able to find a better breakdown with a quick google search.

APM – Essentially monitoring application performance at the top of the stack (ie. At the application level) where you get the highest level of detail on user facing experience metrics and system level metrics. APM solutions are designed to analyze and debug distributed applications. They generally trace transactions from end to end and they monitor the actual application and the underlying code that implements business functionality. Technically a very difficult solution to create. APM solutions need to inject themselves into the application, pull data from an increasing number of sources and coding languages without being able to use APIs, and all without harming the performance of the application. There are only a few companies that offer a comprehensive solution given the technical difficulties. Given the price point (can be up to $2,000 per server) most companies only monitor business critical applications and revenue generating applications. The original players in this market were New Relic, Dynatrace, and AppDynamics.

Infrastructure Monitoring – Monitoring the infrastructure that supports your applications. A step below monitoring at the application level, infrastructure monitoring offers you some but not all of the insight you would desire around how to debug and improve your applications. Many symptoms that show up when your application is having issues will also show up at the infrastructure level a step below in the stack. You get some insights into how your application is running give, but no direct insights into user behavior and how transactions performed at the minute level. It’s technically a less challenging endeavor to monitor at the infrastructure level than the application level given a less dynamic environment. However, given a significantly reduced price point for infrastructure monitoring, it is often used as a substitute for APM for tier 2 and 3 applications and those that aren’t mission critical to the business. This was where Datadog was originally focused.

Log Management – concerned with aggregating, presenting, and analyzing logs (critical record of historical events for your applications). The log management space has become increasingly complex with the advent of microservices, where logs are now spread out across hundreds of different containers and micro sections of code. Log management is an important data source to run your APM solutions and track app performance over time. Log management is also an important input for security with SIEM (security information in event management) offerings a common use case.  Splunk and SumoLogic are some of the larger players in this market.

Network Monitoring – Tools to monitor traffic, bandwidth, utilization, and uptime between your servers. These tools are largely included when you sign on with a public cloud provider, but still important for hybrid environments and managing multi cloud deployments. I would argue the least critical area of the IT monitoring stack today, but still a necessary offering to include in an all-in-one observability offering. Cisco has traditionally been the big player here, and more so after their ThousandEyes acquisition in 2020.

AIOps – Tools to automate and orchestrate solutions to the application and transaction problems that APM exposes. ROI here comes from reducing IT staff time/$ spent on manually fixing and debugging applications. Splunk, Atlassian and PagerDuty have competitive offerings here. New Relic expanded in this direction with their acquisition of SignifAI in Feb of 2019.

These were for the most part best of breed focused, siloed offerings from different providers up until around 2017/18. APM has traditionally been one of the more lucrative parts of the stack for a few reasons:

1)      Price insensitive buyers – issues and crashes with mission critical applications/functions like customer facing applications, payment processing, and secure transactions can cause immediate loss of revenue and customer trust. Companies really have no choice but to monitor those types of applications at the application level. They rate performance far above price in terms of purchasing decisions.

2)      High degree of vendor concentration given the technical complexities as well as security implications of giving a vendor complete access to the innards of your software. Really only three vendors offered high quality solutions here – New Relic, Dynatrace, and AppDyanmics. This dynamic holds somewhat true to today with a few new competitors

3)      Accelerating demand given industry factors that have been well discussed. Cloud migration, customer touchpoints and sales enablement moving online, rapid pace of new application development, and an increasing number of applications considered business critical

4)      Sticky customer bases

Given those dynamics, APM vendors priced at highest point possible, often around $2000/server. Customers hated how much they spent on APM solutions but had little choice in the matter.

Datadog Distruption

Industry dynamics changed around 2017 as Datadog began offering infrastructure monitoring solutions at a cost 1/10th of the price/server of APM solutions. While infrastructure monitoring is lower down the stack from application performance monitoring and provides less specific diagnostics and troubleshooting, it’s an attractive alternative to get ballpark 75% of the observability an APM solution would provide at 1/10th of the price. Many customers that would have opted for an APM solution to monitor their marginal applications instead opted to use infrastructure monitoring tools. Instead of taking APM customers from New Relic, they offered them an inferior yet cheaper substitute. As a result you saw decelerating demand for APM solutions and the rapid growth of Datadog. Vendors were forced to compete on price.

This disruption to the market was far more profound for New Relic who was focused on the same small to mid-sized customer base that Datadog was targeting, rather than Dynatrace or AppDynamics who were focused on the enterprise. NEWR also had, until recently, a poor-quality infrastructure monitoring solution. New Relic likewise struggled from a rather disparate product set that wasn’t combined into a platform.

It also became clear to most market participants that the market was shifting towards a platform offering around observability. An all-in-one observability offering from the same vendor gives unparalleled insights into application performance and customer tracking, and significantly reduces the friction that comes with combining multiple vendors. Datadog did a great job around this time of broadcasting their development roadmap to the market around their shift towards full observability.

New Relic Business Transition/Current Offering

In response to competitive threats from Datadog and foresight into the shifting demand trends towards full stack observability, New Relic made the difficult but ultimately correct choice to reposition their product offering and change their pricing structure. These were significant changes, and they had a significant impact on the business.

Product restructuring: They launched their New Relic One platform in mid-2019 in an effort to reposition towards full stack observability. Their legacy product set seemed quite disjointed and confusing to customers and New Relic One was a combination of their offerings. It was released earlier than it should have been due to competitive pressures, and it didn’t fully take shape until they launched their revamped version in July of 2020.

Product offerings were distilled to three pillars of infrastructure monitoring, application performance monitoring, and log analytics in mid-2020. AIOps and a revamped data ingestion system were layered over these three pillars. They were arguably late to the market and a little behind with their data ingestion and distributed tracing, but now I think that’s mostly up to par. It was a challenging endeavor changing their model from locking in customers with their custom data collection agents to offering open-source integrations for data ingestion. They also introduced a free tier pricing option and began to model their offering around Datadog’s self-service, top of funnel customer acquisition strategy.

They guided to slowing growth in the coming quarters as they worked to fine tune their platform offering and add in additional functionality. They added an improved user interface in mid-2021 and revamps to their infrastructure monitoring in early 2022 (their infrastructure monitoring was lagging the market). Their most recent investor day earlier this week highlighted the continuance of that product improvement with a 20% increase in their ecosystem built in data integrations, expansion into vulnerability management, improvements to their data ingestion/telemetry system with a fully integrated Pixie solution for Kubernetes environments, and improvements to their logging functions.

Price restructuring: This is the part of their business transition that likely had the most negative impact. They changed their pricing model at the same time as their platform restructuring in July of 2020. They began offering a free tier to appeal to developers and changed their pricing model to a usage-based system plus per seat pricing to lower the basic cost for availability and better build their self-service funnel. This was a significant shift from their original model and required actively renegotiating with each customer to convert them to the new model, leading to further friction points in customer relationships. They admittedly did a very poor job of telegraphing their pricing changes to customers. Customers complained that their pricing structure was misunderstood.

This resulted in falling customer growth, revenue growth, and revenue retention numbers that bottomed out around Q3 of 2021. They likely missed out on a great opportunity in 2020 and 2021 to expand their customer base in a sticky industry experiencing rapid growth. On a going forward basis however, we see that dynamic changing. They currently have over 86% of their customer base transitioned to their new pricing structure. Now that we’re over the hump of converting the legacy customer base, we view the pricing structure (number of seats + amount of data ingested) as being a simpler value proposition to customers once understood and better suited for the types of environments that developers are building applications in.

Sales/Go-to-market: They’ve also transitioned to more of self-service model very similar to Datadog. Strategy has been to build out the top of the funnel and offer free tiers and ease of signup. Their consumption-based pricing model supports this top of funnel strategy. Recent numbers have looked good on self-service model conversion, and we expect that to continue to become a larger portion of revenue and a driver of inside sales motions. S&M has traditionally been the margin killer at New Relic with sales/rev ratios 50% versus 28% at DDOG and 41% at DT (heavy enterprise focus). Look for falling S&M/Revenue as self-service sales increase, better cross sale opportunities drive revenue from existing customers, and with the sales team having an easier time selling an improved product. This could easily add 6-7 points of margin in the short term and perhaps more in the long run with increased scale. Legacy sales unit costs roll off next year which will push it towards 40%ish S&M/revenue.

New Relic Today & Competitive Positioning

New Relic Today

·       Pain points and competitive deficiencies in the product have been addressed with multiple product updates in the last 12 months. These changes will take time for the market to digest. From a purely product perspective, we see New Relic’s offering only slightly behind Datadog but with a better APM offering, which we view as one of the more differentiating parts of the stack.  

o   Looking at the three main pillars of observability, New Relic’s product was historically strong in APM, weak in infrastructure monitoring, and weak in logging. Infrastructure and logging solutions have seen what we view as substantial improvements over the last year. Having a strong offering in those three areas is key to

o   They also struggled with completeness of offering, platform structure, and their data ingestion system NRDB needed work. We see their new restructured offering addressing most of those pain points. We now see them having an infrastructure monitoring solution that’s up to par after the February update, a legacy APM solution that Gardner ranks second only to perhaps Dynatrace, an improved data ingestion tool now geared towards open source, a product suite that’s closing in on Datadog in terms of completeness, and a UI that’s now more intuitive and easier for developers to use.

·       Transition to self-service model should make New Relic more appealing to developers throughout the application development life cycle, help bring them closer to Datadog in terms of time to value and ease of use, and should lead to a rightsized S&M cost with better mid funnel conversion rates. Initial numbers look good and are trending well, but changes like this to a customer funnel take time to trickle through to bookings/margin. We believe this last point is overlooked.

·       Significant opportunities for upsell with an improved product set and a more cohesive platform. Only 26% of New Relic customers have adopted the full platform – a number that’s been steadily increasing since mid-2021 and still lagging peers like Datadog and Dynatrace. We see this platform adoption accelerating in coming quarters. We view it as a leading indicator to how well this thesis is playing out.

·       While there are pros and cons to the various pricing structures in this space, we see their current pricing strategy as an advantage in converting top of funnel developers to try New Relic and makes it more frictionless to expand usage of the platform. Customers don’t have to cut a new PO to increase usage. It also puts New Relic in a good technical position of being able to use whatever source of instrumentation customers want given price isn’t impacted by deployment of their agents. Not true of other vendors. With other pricing structures you may be hesitant to add additional instrumentation and data sources.

o   Slightly positive outlook on recent price increase ($.25/gb of data ingest to $.30/gb) and further simplification of their pricing tiers

·       Extension into cybersecurity with their recently announced Vulnerability Management solution is a logical move and flying somewhat under the radar. Customers are increasingly seeing value in getting their cybersecurity solutions from a platform provider and we see observability providers as being well positioned for certain cybersecurity solutions.

Competitive Environment and Positioning

The APM and observability space has become increasingly competitive over the last few years. However, vendors are still mainly focused on their niches. Channel partners indicate that you would almost never see all four vendors considered by a prospective customer and would rarely see more than two. Pricing can get competitive, especially in the enterprise and around price renewals, but there is still a high degree of stickiness in this industry and vendors are rarely displaced unless there’s an obvious failing in the service or if it’s an extreme price difference. The market is growing so fast that vendors have multiple avenues for success here.

Datadog – All in one observability offering, mid quality player in all categories, but master of none. Small and mid cap customer focused, but with achievable ambitions in the enterprise. Has displaced AppDynamics and New Relic in many deals over the last few years. Has clearly done the best job of innovation in the space and should continue to grow faster than the market. Fast time to value. Users love the product. Pricing based on number of hosts you install their software on.

Dynatrace- Spun out and IPO’d by Thoma Bravo in 2019. Best of breed for APM, strong in AIOps, handles complex and hybrid work environments very well; the go to solution for the enterprise and those with complex workloads. Premium price point to the rest of the field. Like New Relic, they have also struggled with transitioning towards a full observability platform, but their strong position in the enterprise has given them more time to figure it out. Pricing based on the amount of memory in hosts you install their software on.

AppDynamics – a disaster since their acquisition by Cisco a few years back. Once an innovative solution, it’s now being displaced faster than any other vendor. Pricing based on CPU cores in hosts you install their software on

Hyperscalers – most offer a built-in observability option and it’s a fine choice for single cloud deployment, but difficult/incapable to utilize in multi cloud environments. I question whether or not they can gain significant traction here and whether they would want to support multi cloud environments to the extent other players do. It’s also an awkward positioning for your infrastructure provider to be reporting on the failings of their infrastructure.

Splunk/Elastic – Elastic has not gained much traction here. Splunk has a viable route to success in Observability with a strong core competency in logging.

Outlook & Valuation

Current share price of $48.13 with $330mm of net cash gives NEWR an EV of ~$2.9 billion on LTM revenue of $786mm at end of fiscal year ’22 on 3/31/22. We anticipate revenue CAGR of 20% through fiscal ’25 ending 3/11/25 (versus 11% growth in ’21, ‘18% growth in ’22, and guidance of 17.5% growth in ’23) based on industry growth trends, accelerating cross sell, and a more competitive product as outlined above. We see the industry growing closer to 25-30% over this same period.

We value them at what we view as a conservative 5x fiscal ’25 revenue of $1,358 billion, or $86.95/share factoring in share dilution and small cash loss in ’23. This is below their long-term trading multiple of ~6-7x/revenue and several turns below peers Datadog and Dynatrace which we view as fair given respective growth and margin profiles.

You don’t need New Relic to return to its glory days at $48/share, just get the ship somewhat back on track. Could see it going as high as $120-140 on a return to historical multiple if you see some combination of better-than-expected observability industry growth, better than expected platform adoption, or if margins rebound faster than expected. We believe downside is becoming increasingly limited given the persistent takeout rumors around New Relic.

Strong Acquisition Candidate

New Relic has long been a takeover candidate and the narrative has only accelerated on the recent share decline. Seemingly new rumors of acquisition every week. There have been quite a few acquisitions in this space. We think the takeover narrative is especially relevant for NEWR given their core competency in APM is one of the harder areas of the observability stack to replicate and given prior business mismanagement and an inflated cost structure.

-          Cisco acquired AppDynamics in 2017 for 17.5x LTM revenue

-          Cisco offered ~6-7x forward revenue for Splunk earlier this year

-          IBM acquired Instana in November 2020 for undisclosed terms

-          Splunk acquired SignalFX for $1.05 billion in 2019 on less than $25mm of LTM revenue

-          Thoma Bravo acquired PLAN for 11x forward revenue (not observability but relevant for current market narrative around a PE put on software names)

Concerns/Threats

-          Platform improvements fail to gain traction with customers

-          Time/effort spent getting their platform offering up to par keep them perpetually behind the 8 ball in R&D and improvements in a dynamically changing industry

-          Observability ends up becoming a winner take all market or reaches an end state earlier than expected

-          Peripheral solution providers including but not limited to the hyperscalers end up displacing legacy solutions to a greater degree

Catalyst

- Takeout offer

- Evidence of increased platform adoption

- Margin improvement/recovery story starts getting more traction as management commentary begins moving past improvements to the product and transitioning customers to the new pricing strucutre