New Relic: No Better Than An Old Relic

Introduction

This has been a good year so far for profitless tech firms. As bank crises and the like erupt, the market expects the Federal Reserve to soon stop raising interest rates further. However, a pause is not a pivot, and I expect rates to remain high for a long period of time in order to wring out the excesses of monetary policy over the last decade. Companies will have to show profits in order for investors to buy their stock versus other alternatives like a Treasury note yielding close to 5%. Stung by the market reaction in 2022, many unprofitable companies are making a step in the right direction by cutting costs and improving their margins. However, they continue to rely on all kind of adjusted metrics, conveniently ignoring a large part of their compensation expense – the part that is paid in stock.

New Relic (NYSE:NEWR) is an unprofitable company whose growth is reasonable but not spectacular. Investor expectations of where it can take its margins appear to be misplaced.

Company background

New Relic is a software-as-a-service company that allows IT professionals to monitor their network and applications from a central dashboard. Its website details its services, with the usual buzzwords like hyper-scalable and AI. The company was founded in 2007 and is headquartered in San Francisco, with the attendant high costs that accompany being in coastal California.

The company’s customers include other unprofitable software firms like MongoDB (MDB) and Fastly (FSLY). There seems to be some kind of giant loop in Silicon Valley, where everyone uses everyone else’s software to run their business, pay their employees handsomely in stock, lose money on a GAAP basis, and constantly dilute their shareholders.

The company has been unprofitable for the last ten years, with modest losses growing bigger along with revenues. Although the revenue growth over the last decade has been commendable, it is now slowing down as the company is now much larger.

New Relic quarterly financial overview

For the latest quarter ending December 31, 2022, the company did $239.8 million in revenue, up 18% YoY. Operating income was a loss of $29 million (-12% operating margin). I would give the company credit for $4.5 million of amortization of intangibles, putting its adjusted operating margin at -10%. Note that I do not ignore stock based compensation, as I believe this is a real and recurring expense. The company declared a non-GAAP profit by excluding $40 million of stock compensation.

The company currently has 68 million shares (up from 65 million a year ago) and a market capitalization of $4.8 billion. It has $500 million of debt and $800 million of cash. It thus has an enterprise value of $4.5 billion, amounting to 5x its annual revenue.

An analysis of the balance sheet and cash flow statement revealed that nothing was amiss. The company has cut some costs in the last year, decreasing its cost of revenue, and keeping marketing costs approximately flat.

The company guided to $240 million to $242 million in revenue for the next quarter, and I believe this is achievable. Thus, on an annualized basis, the company is doing about $960 million in revenue.

NEWR stock valuation and recommendation

In New Relic’s mind, the company is profitable even though it is not on a GAAP basis. So I see limited urgency on its part to drive an increase in margins. However, in valuing the company I will assume that they will get some leverage over time, and the operating margin will ultimately reach 7% from the current -10%.

A 7% margin on $960 million of current annualized revenue would result in normalized annual operating profit of $67 million. Recognizing the company’s substantial net operating losses (accumulated deficit of $900 million), I will assume that the company will never pay taxes. Thus, it would generate $67 million in after-tax operating income or $1 per share. To this, I will apply a generous 35x multiple in recognition of its revenue growth, to come to a per share value of $35 for the business.

Then I will add back the approximately $5 per share of net cash on the balance sheet to arrive at fair value for the shares of $40. Thus, I believe there is more than 40% downside from the current share price of $71. There are no meaningful comparables for the company as most of its competitors are in a similar loss-making position. A high-quality software company like Microsoft (MSFT) that is valued on GAAP figures, trades at 30x earnings.

I will offer a bull case in which the company attains a 10% operating margin, similar to what Salesforce (CRM) did in its latest quarter. This would result in normalized annual operating profit of $96 million. I will apply a 45x multiple on the per share operating profit of $1.40 to come up with a value per share of $63 for the business. Adding back $5 per share of net cash would result in fair value for the shares of $68.

Thus, even in this case I am unable to get to fundamental upside for the stock. Bulls may argue that the company could get to more than a 10% operating margin, but that would be tough sledding and ignores the company’s current unprofitable state even after being in business for sixteen years. Moreover, most holders ignore the company’s substantial stock compensation, which the company would find hard to reduce if it wants to hold on to its employees.

In a bear case, the company will get to only a 5% operating margin (still a substantial improvement from the current-10%). This would result in operating profit of $48 million and EPS of $0.70. A 30x multiple would result in business value of $21 per share. Adding back $5 of cash would result in fair value for the shares of $26, for more than 60% downside from the current share price. Those who think this is too pessimistic should keep in mind that during the tech bust of 2000-2002, many stocks fell 90%+ (and those were the ones that didn’t go bankrupt).

I recommend that investors sell any existing positions in NEWR stock before employees continue to sell the stock they are compensated with (3 million additional shares YoY), or short the stock. If you own the stock, be prepared to keep increasing your position and buying the stock that employees sell. The short interest is low at 1.5% of float. With a professional account, your broker will pay you a short rebate linked to the prevailing short-term interest rate. Thus, you can get paid more than 4% a year for holding the short position. Since the company does not pay a dividend (and is likely not to), there is no additional cost in holding a short position.

Mispricing/variant view

I believe the primary source of mispricing here is people ignoring the large amount of stock compensation. We also have many investors who pay no attention to a company’s financials or attempt to determine how much in profits a company could generate in the future.

Over time, any investment method that ignores fundamentals should fail to deliver. However, this takes time, and we have not had a similar situation of overvalued profitless technology firms since 2000. An additional wrinkle is that private equity funds raised a lot of capital commitments in the last few years, and are now itching to deploy the capital. A stock that has halved looks cheap. Financial projections with revenue ever-rising, non-cash costs ignored, and a healthy exit multiple, will show reasonable upside. We have seen a few such deals announced, the latest being Qualtrics International (XM). I believe the private investors will end up losing most of their money on these deals, although the P/E firms will still do okay with the fees they charge.

External ratings

Seeking Alpha’s quantitative system gives New Relic a composite rating of 4.8, equating to a strong buy, with a D+ for valuation and C- for profitability, offset by an A+ for growth. Wall Street analysts are surprisingly less positive, with a rating of 3.4, equating to a hold.

Risks are manageable

Shorting a stock has many risks and you need to be able to stomach mark to market losses. I recommend a large number of small positions. The main risk here is the company potentially being acquired by a larger firm or a private equity fund.

Aided by investment bankers and their comps, it is easy for a large firm to want to buy some growth. I believe in this environment, the acquirer’s shares will take a hit, and there will not be too many deals. Private equity is a trickier proposition in the absence of an immediate market feedback mechanism and the firms’ need to do deals.

The fundamental risk here is that the company could continue to show impressive growth, while improving its margins to a level far above what I have projected. I don’t see this as likely, but it is a possibility.

With tighter money and a low short interest, I do not see much chance of a short squeeze.

Pre-emptive disclosure

Writing a short thesis on a stock on a public forum is an invitation for blowback from employees and holders of the stock. I welcome respectful comments from eponymous readers. If you are a holder or employee, you would be better off directing your energies towards having your company become profitable.