Updated: New Relic Downgrade May Offer Entry Point

(Published July 20, 2017)

The following is an update on Morgan Stanley’s downgrade of the stock.

Morgan Stanley downgraded New Relic (NEWR) to Equal Weight from Overweight after the stock closed at all-time highs Wednesday.

The analyst noted the company still offered a solid fundamental picture, but saw limited upside catalysts on the horizon. Given earnings will be reported on Aug. 3, we can think of no bigger catalyst, outside of a buyout ,on the horizon. The analyst further reasoned New Relic falls in the middle of the pack with Software-as-a-Service (SaaS) peers yield and offers a balanced risk/reward.

While we’d counter not all SaaS companies are created equal, the price of New Relic has become a bit frothy in the short term. Our targeted initial entry remains the lower $40s with the $35 to $40 range as our ideal entry.

While the initial entry price was available a few weeks ago, shares have been a hold only for us the past week. This downgrade may offer an entry point for investors wanting exposure to New Relic. We make no changes to our upside target as Cisco Systems (CSCO) purchase of App Dynamics remains our driving factor in terms of valuation. We’d be patient on shares today in the early going. If New Relic, currently lower by 3%, reverses higher and turns positive, then don’t expect much pause in price prior to earnings. But if shares close on the lows, then we’d target $45 as support.

Below is the initial trade idea first posted July 5:

The Uncommon Idea in Brief

Buy digital analytics company New Relic (NEWR) stock for the long term.

-A strong start to the first half of the year has pushed New Relic to new all-time highs. But the stock appears to be breaking out from the previous all-time high back in 2015, establishing the start of an expected longer-term breakout. Begin building a long position in the mid-$40s and add aggressively in the $35 to $40 range.

The Industry Opportunity

Clearly it’s not enough for businesses to have a website and think they are part of the internet.

They need insight into what people are doing. A downed site can be more damaging than no site at all. It’s essential to detect issues and outages, sometimes before they occur, saving potential lost business.

How long is a page taking to load? What’s slowing a page? Has an error occurred? These are some of the areas Application Performance Management suites address.

Application Performance Management (APM) is transitioning from out-of-date, underperforming traditional in-house operations to those of outsourced companies.

By 2020, it is estimated 70% of APM suite technology buyers will reside outside of traditional IT operations and within organizations. It’s currently 40%.

What New Relic Does

New Relic offers digital intelligence and analytics. The company delivers full-stack (applications have different stacks: front end, back end, infrastructure, etc.) visibility and analytics to more than 40% of the Fortune 100.

The aim of its digital intelligence platform is to provide actionable insight to improve digital business results.

Simply put, New Relic let’s a company know what people are doing with its software and applications. This includes both employees and customers.

The platform can warn of and detect issues and outages. New Relic’s products offer insight into issues like how long a company’s page takes to load, what is slowing the page and alerts when an error occurs. Platform users that can prevent outages and respond to incidents faster, saving lost business while increasing efficiency.

The Uncommon Market Position

New Relic management anticipated current trends to move from in-house offerings. It already stands at the forefront, as its financial results have begun to demonstrate.

The company’s main market had been technology companies and large corporations, but that has expanded over the past few years. While New Relic’s new/expanded most-recent client list included tech names like Adobe (ADBE), LinkedIn, Wix.com and Zendesk, we also saw Bose, Buffalo Wild Wings (BWLD), REI, Under Armour (UA) and Major League Baseball in the list. Major competitor Splunk (SPLK) has also become a partner as the companies project synergies.

Growth for New Relic should also continue across the globe. Revenue from Europe, the Middle East and Africa (EMEA) is up 46% year over year in 2017, compared with an increase of 19% in 2016. There’s currently no reason to expect this trend to slow, let alone reverse.

What Sets New Relic Apart

Perhaps the largest opportunity for New Relic is the one that is mentioned the least.

Unveiled as Project Seymour (reportedly influenced a bit by “Little Shop of Horrors”) in November 2016, New Relic stepped into Artificial Intelligence. It is designed to deliver advanced AI and machine-learning capabilities to help companies uncover the most interesting, relevant and actionable insights to improve customer experience, performance and availability of digital initiatives.

The AI operates under five premises:

Discovery – Uncover trends and issues users care about based on their roles and permissions.

Deep Diagnosis – Provide users with a diagnosis of a problem and recommend a solution. Seymour can highlight the problem for a user and suggest a solution.

Collaboration – Lets users share important information with team members. Members can discuss directly through the interface and those conversations are stored for future reference.

Learning – The system is designed to learn and get smarter as users provide feedback.

Prediction – Seymour reviews massive amounts of data in New Relic’s cloud platform to help predict and prevent future issues. In simpler terms, it’s group learning.

Overall, the market opportunities for New Relic expand far beyond the simple enterprise market and offer a bright future along with a potential boost to the top and bottom lines.

Financials – New Relic by the Numbers

In 4Q, after bullish guidance adjustments, the company reported strong year-over-year revenue growth of 40% of $73.3 million. Quarter-to-quarter growth improved 8%. On the bottom line, it reported a non-GAAP loss of $0.11 per share, or $5.8 million. That narrowed from a loss of $12 million in the same period a year earlier.

The company’s gross margin was an impressive 81%.

Full-year 2017 growth was driven by the enterprise market, as revenues surged 45% to $263 million. That resulted in a non-GAAP loss of $0.49 per share. New Relic increased its paid business accounts to 15,216 as of March 31, 2017, up from 14,538 on Sept. 30, 2016.

Management issued first-quarter 2018 revenue guidance of $77 million to $78.5 million, a year-over-year increase of 31% to 34% and a 4% to 7% quarter-over-quarter increase. Non-GAAP losses of $0.12 to $0.14 per share are expected on losses of $6.5 million to $7.5 million. For the full year, the company anticipates revenue of $341.5 million to $346.5 million, an increase of 30% to 32%.

The full-year loss is expected to decrease from $0.49 per share by as much as half as management guided for a loss of $0.24 to $0.32 per share.

New Relic is poised to turn a profit in 2019.

Why the Stock Is a Buy

In 2016, Cisco Systems purchased privately-owned App Dynamics for $3.7 billion. At the time, the company had quarterly revenue of $60 million, an increase of 18% quarter over quarter and 54% year over year.

All that growth came with solid gross margins of 77%.

New Relic’s most recent quarter delivered $73.3 million in revenue, with gross margins registered an eye-popping 81% and the company is trading with a current market cap of only $2.35 billion.

Although New Relic’s growth rate is expected to slow in percentage terms, the nominal growth is consistent and strong. As revenues grow 30% to 33% annually, the company should find its price-to-earnings ratio dropping quickly as we move to 2019. At the current valuation, we’d anticipate a PEG ratio (Price-to-Earnings divided by Growth) close to 1 in 2019 if price remains constant. A fair valuation would have that PEG ratio closer to 2.

Furthermore, despite a stronger growth rate, App Dynamics received a price-to sales-ratio around 15x at the time of its buyout. Applying the same multiple to New Relic gives us a valuation of $5.16 billion, or $96.60 per share, more than twice the current $2.35 billion level.

Even discounting shares by 20% due to a slower growth rate, despite stronger margins, we arrive at a price target of $77.30.

Our upside price target for calendar year 2018 is $77.30 per share, rising to $88 minimally by mid-2019 based on our expected PEG ratio of 2.

The Technical Analysis — At $45 or lower NEWR is a BUY

New Relic ended 2016 on a low note, but has spent the first half of 2017 making last year’s disappointment a distant memory.

Strong, rising support along the 13-week simple moving average (SMA) has been a staple of the current rise. The recent high of $45 has held as strong resistance and created not one, but two, price patterns for consideration: a bullish flag and an ascending triangle.

There are two approaches to utilizing the bull flag as a trading tool.

-Focus on support and use that area as a price target to acquire stock. The current flag shows support of $41 and resistance at $45. New Relic’s 13-week SMA, what we would consider more support for aggressive traders, sits just below $42 vs. flag support of $41. This would be considered buying the support level of the ascending triangle rather than waiting for the support level of the bull flag to be reached. Mid-January 2017 was the last instance, New Relic shares spent more than one week under the 13-week SMA. In short, support is very strong within this bull flag as well as at its base. Of course, if both support levels are broken, we suspect the 20-week SMA will also break, so investors will have to look toward $37.50 as the next area to add or hedge.

-The second approach to consider is buying the breakout. Investors could choose to wait for a weekly close above resistance, the top of the channel as well as the resistance level of the ascending triangle. Once above the resistance level of $45, shares should push higher. Our initial target on a breakout, independent of fundamental, would be $49 in short fashion with an ultimate upside of $57.50 within 12 to 18 months based on the current price patterns.

New Relic chart, NEWR chart
A bullish flag and an ascending triangle for the stock. CLICK CHART FOR A LARGER IMAGE.

 Catalysts for the Thoughtful Investor

While a takeover can never be ruled out, New Relic’s partnerships and innovations look more likely to propel both business and the stock.

New Relic announced in November that it integrated with Amazon Web Services (AWS) so customers could buy New Relic Infrastructure directly through the AWS marketplace. Additionally, the company announced support for AWS Lambda, a serverless computer platform.

The platform provides customers with live inventory, 13 months of data retention, dashboards and alerting. Lambda enables engineers to run applications and functions without having to configure, maintain and scale underlying infrastructure exposing New Relic to the upside of markets outside enterprise.

In February, New Relic announced updates to its Digital Intelligence Platform that enables digital enterprises with real time visibility and metrics that connect the impact of digital performance with a company’s bottom line. The new capabilities included company-wide dashboards to create a master view, new alert support for dynamic infrastructure and expanded visibility from the company’s application performance monitoring (APM) solution. In short, users can measure the health of their applications across their entire stack.

In March, New Relic announced a strategic alliance with competitor Splunk. While the two firms are competitors in terms of analytics, they approach it from a different basis which creates the opportunity to harness their differences to produce a unique offering. The Splunk app for New Relic allows the visualization of New Relic data in Splunk Enterprise.

The combination of Splunk and New Relic unifies machine data analytics with application tracing and performance metrics. This enables IT and business stakeholders to experience a faster time-to-value through visualizing data across both New Relic’s and Splunk’s platforms. Furthermore, developers and IT operational teams can identify issues, reduce mean-time-to-resolution (MTTR), and proactively improve customer experience. The companies believe the alliance will allow users to troubleshoot and innovate faster.

The Bottom Line

-New Relic is a leader in the digital intelligence and analytics sector of the business software sector, specializing in performance application and software monitoring and reporting.

-The paradigm shift to outsourcing application performance management is expected to increase from 40% of the current market to 70% by 2020. New Relic anticipated this trend and has the first mover advantage of a baseline of products, plus an ever-evolving suite of additions. The market will support multiple players and New Relic is a front-runner.

-New Relics’ expansion into AI should boost not only the attractiveness of the company, but also the bottom line. Neither Wall Street nor investors have priced in any upside potential from the company’s foray into Artificial Intelligence.

-In the range of $40 to $50, NEWR is a long-term buy and hold. Under $40, we would be aggressive buyers. With its small-cap nature, a strong move near 60% year to date, large short interest, evolving nature of its business and potential of new competitors we expect it to be volatile in terms of price movement. From both a buyout and fundamental perspective, we believe shares to be significantly undervalued despite the strong move in the first half of 2017.

At the time of publication, neither the author nor the company held positions in the stocks mentioned, but positions may change at any time.

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