There Are Challenges Behind New Relic's Encouraging Q2 Earnings

After underwhelming results over the last couple of quarters, software analytics company New Relic (NYSE: NEWR) released encouraging fiscal second-quarter earnings thanks to its new cloud-based monitoring and logging solutions. Management also expressed its confidence in reaching $1 billion of revenue by 2023. But significant uncertainties remain on the way to this ambitious goal.

Encouraging fiscal second-quarter results

Over the last several years, New Relic's strong revenue growth was due to its application performance monitoring (APM) solution. However, the company's year-over-year revenue growth has been decelerating from 113% in 2014 to 27% over the last quarter. The higher revenue base explains a part of this growth deceleration, but intensifying competition also contributed to the negative trend. For instance, rival Datadog (NASDAQ: DDOG) has developed an integrated broader monitoring offering that includes logging and infrastructure monitoring in addition to APM capabilities.

In May, New Relic released its New Relic One platform to catch up with its competitors. The platform integrates the three key monitoring components (infrastructure, logging, and application), and its programmability allows customers to develop their applications based on New Relic's solution.

As a result, fiscal second-quarter revenue increased to $145.8 million, up 27% year over year and above the high end of management's guidance range. Besides the contribution from new customers, the increase in dollar-based net expansion rate from 109% during the previous quarter to 112% indicates existing customers' consumption of New Relic's products is increasing faster than the previous quarter, which was not the case one quarter ago.

Person using a futuristic heads-up display interface screen with data and key performance indicators for data monitoring and analytics.

Image source: Getty Images.

Challenges against an ambitious goal

With the strong second-quarter results, management indicated the company would reach the symbolic threshold of $1 billion of annual sales in 2023, which corresponds to 19.2% annual revenue growth, based on the midpoint of the fiscal 2020 revenue guidance range of $590.5 million.

This multiyear revenue forecast seems strong, but it remains below the revenue growth some competitors have been reporting. For instance, during their latest quarters, Datadog and Elastic N.V. (NYSE: ESTC) grew their revenue by 82.2% and 58.4%, respectively, compared to the year before. Given its much lower revenue growth, New Relic is unlikely to gain market share against these competitors even if their revenue growth decelerates over the next several years.

Besides, New Relic's competitors aren't idling. For example, Elastic announced last month its expansion into the endpoint security market, and Splunk entered the APM market in August with its acquisition of SignalFx.

Also, New Relic's improved net expansion rate of 112% compared to the previous quarter still pales in comparison to its competitors. Elastic and Datadog have reported expansion rates above 130%, which indicates New Relic is not capturing the full growth potential from its existing customers.

In addition, New Relic's fiscal second-quarter deferred revenue -- a leading indicator of revenue -- came in below expectations, up 22% year over year but down 9% sequentially. During the earnings call, management explained some customers were reluctant to pay one year in advance for the company's services, which contrasts with previous three-year contracts. Despite management's confidence in retaining these customers anyway, this development reduces incentives for them to stick to New Relic's solutions.

Cheaper than competitors but still risky

Based on the last 12 months, New Relic's enterprise value-to-sales ratio of 6.6 seems low compared to Elastic's and Datadog's ratios of 17.3 and 36.7, respectively.

Even taking into account New Relic's lower revenue growth, the company looks cheap compared to its competitors. Yet given its challenges, investing in this tech stock at this price remains risky. Besides, the company has yet to post a profit under generally accepted accounting principles (GAAP). And during the last quarter, its GAAP losses increased from $5.5 million one year ago to $16.9 million because of its increasing sales and marketing and research and development expenses as a percentage of revenue.

Management will provide more details about the company's long-term potential during its analyst and investor day on Dec. 12. But prudent investors should stay on the sidelines until the New Relic One platform leads to strong growth and improved financial results.

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Herve Blandin has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Datadog, Elastic N V, New Relic, and Splunk. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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