New Relic (NEWR) has reported disappointing earnings with deceleration in revenue growth and substantial deterioration in profitability margins. Customers are not expanding their use of the company’s products as in previous years, and the competition seems to be heating in the APM space. The former factors are making the company’s numbers erode. The company’s guidance for the next quarter and full year implies continued deceleration in the top line and weakness in the growth of deferred revenue. The valuation, although lower than most software stocks, could be considered fair or even a little expensive to other peers with similar growth profiles.
The Quarter In Numbers
The revenue for the quarter was $153 million, a growth of 23% Y/Y. This signifies 4-point and 12-point declines in the growth rate from the previous quarter and the same quarter of the prior year, respectively.
It is difficult to show strength in revenue growth while small-size businesses are leaving the company. The growth in customers reporting more than $100,000 in ARR is not strong enough to offset the former, and the net expansion rate is at historical lows.
NEWR ended the quarter with 926 of such customers, representing a soft growth of 13% Y/Y, when compared with the 30% growth rate that the company reported in the same quarter of a year ago. It gets worse on a Q/Q basis, with a tiny growth of 2%.
The net expansion rate for the quarter was only 109%, a significant decline from the 122% of the year-ago quarter, and a historical low for this company (the same as in Q1 2020). This is a result of customers reducing their spending on the company’s products (literally a higher churn) and a decline in upsell activity. But, everything is “fine,” here is the CEO on the quarterly earnings call (emphasize the last two words): “We believe we have the most complete observability platform in the market and our customers are responding favorably.”
The truth is that weakness in net expansion rates is a red flag for SaaS companies when combined with fierce competition. See, over time, this ratio tends to fluctuate, and a one-quarter weakness is no reason to worry. But, this is not an isolated quarter, this is the third consecutive quarter of net retention weakness at NEWR (Q1 109%, Q2 112% and Q3 109%).
In addition to this, Dynatrace (DT) and Cisco (CSCO) – through its acquisition of AppDynamics – are pushing hard in the competitive environment. A few days ago DT reported that its net expansion rate was at or above 120%, in line with previous quarters, and showing that it is strong in the market.
If NEWR is not able to improve its net expansion rate over the next few quarters, the revenue growth will decrease rapidly. Although the company is taking steps to turn the situation (new executives and the recent New Relic One platform), this writer doesn’t expect the numbers to improve.
Moving to profitability, the company saw its margins worsen sequentially and on a Y/Y basis. During the quarter, the gross margin was 82.8%, almost 100 bps lower Y/Y and flat Q/Q. The operating margin was (16%), down from (7%) Y/Y and (12%) Q/Q. This decline was influenced by an advance of 400 bps in both S&M and R&D expenses, on a Y/Y basis. Non-GAAP operating income remained positive at $3 million, representing a margin of 2%, which was substantially lower than 6% Y/Y and 8% Q/Q.
After achieving positive free cash flows for two fiscal years, the company has returned to red numbers. The free cash flow margin for the quarter was a disappointing 22% (see the table below).
Declining growth rates and profit margins is not a good sign for a growth story. As a company matures and its growth rate slows down, operating expenses should decrease relative to revenues, and hence, profit margins should increase. Investors may not be happy with the underlying performance of NEWR over the last year, and the stock price certainly has reflected this:
Looking forward, the company’s guidance for the next quarter and full year is as follows:
That outlook means revenue growth of 17-18%, or a five-point deceleration on a sequential basis. It also means a significant recovery in the FCF margin in Q4. Also, the sequential growth of 30% in deferred revenue means only a growth of 13% when compared with the same figure of Q4 2019.
After the earnings report, NEWR remains one of the lowest valued stocks in the SaaS space. As I write these lines, the stock trades at $62.63 per share. With a net cash position of $315 million, the enterprise value is $3.5 billion. The expected revenue for the next twelve months is $669 million (17% growth), so the forward EV/S multiple is 5.2x. The average forward EV/S for a SaaS stock is around 10x, so it would be reasonable to expect some price appreciation as the multiple expands. But, when compared to other software stocks with similar growth expectations, the valuation seems rather in line (see the table below).
(*) The Rule of 40 for this table was calculated by adding the growth (NTM) and the FCF margin (TTM)
And, to say “in line” is to be soft on NEWR. The table below offers some insights on how it stacks up against some of its software peers. NEWR has a superior gross margin (at least by 800 bps), but has an inferior FCF margin, thus, a significantly lower Rule of 40.
As a reminder, the Rule of 40 for software companies is sort of a benchmark that states that a financially healthy company must have a balance of growth and profitability of at least 40% (which is the average across the SaaS sector). In other words, the sum of the revenue growth rate and the FCF margin should be no less than 40%. In this case, the ratio is not only lower than peers’, it doesn’t even get to 20%, while the peers above are in the 30%s.
In conclusion, the valuation is fair at most. If you think that it can go up to 6-8x, bear in mind that it may go down to 3-4x as well, or even lower.
In conclusion, the quarter was disappointing with overall deceleration in revenue growth and net expansion rate. The growth in the number of top customers is slowing down, and the company needs more of them as SMBs are leaving. Deteriorating profit margins are not benefiting a growth story that is fading away. Free cash flow, that was positive for two fiscal years, is back to red territory. As a result, the stock has been underperforming as of late. Furthermore, the guidance implies further deceleration in the growth rates of revenue and deferred revenue. Do not get caught in a value trap. The valuation remains low for a SaaS stock, but this name may sink deeper.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in NEWR over 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.