New Relic (NEWR) Thesis

Company Background

New Relic (NEWR) was founded in 2008 by Lew Cirne. New Relic is an Observability platform that allows engineers to collect, visualize, and apply intelligence to their metrics, events, logs, and traces to understand the current state of the health and performance of their systems. New Relic's roots began in Application Performance Monitoring (APM), a segment of the Observability category. APM tools are used by engineers to track an application's performance and the digital experiences of end users. New Relic went on to expand into additional Observability segments, including Infrastructure Monitoring, Network Monitoring, and Log Management among others, to deliver a full suite of 30+ products, all available under their New Relic platform offering.

Situation

New Relic experienced several missteps between ‘19-’21 in product, GTM, and corporate culture, leading to its previous CEO and founder, Lew Cirne, stepping down as CEO and moving into an Executive Chairman role. Bill Staples, then-President and Chief Product Officer, was appointed CEO. Shortly thereafter, in June 2021, HMI Capital, New Relic’s largest institutional investor, with support from activist firm Engaged Capital, reached a settlement with New Relic, leading to HMI Partner, RK Mahendran, joining the board. As part of the settlement with HMI and Engaged, the company agreed to certain shareholder-friendly initiatives, including a board declassification to begin a de-staggering process. Come June 2022, activist investor JANA Partners' involvement became public as the activist came to a settlement with New Relic, resulting in JANA obtaining two board seats, including Kevin Galligan, a Partner at JANA, joining the board. On July 20th, Reuters reported that New Relic had begun a process to hire financial advisors to explore strategic alternatives.

As activists collectively own approximately 10.7 million shares, or 14.6% of the 73.2 million NG FD shares outstanding, per our calculations, and have three board representatives pushing the company to maximize shareholder value, we believe a sale is the likely outcome. We highlight JANA’s recent track record with takeovers in software and IT services with three recent campaigns that resulted in an average of 208 days from JANA’s involvement becoming public to an acquisition being announced. From a timing perspective, we believe it is noteworthy to highlight that it has been approximately 206 days (as of 12/29/22) since reports surfaced of JANA's involvement. We highlight three recent JANA campaigns below to help illustrate what a timeline might look like if a transaction is eventually announced.

Additionally, we discuss New Relic’s fundamentals and our take on their future prospects. We believe this is beneficial to understand as it is ultimately the rationale for why acquirers will see value in New Relic.

JANA Partners Recent Campaigns

Peer and Transaction Comps

We believe the most appropriate comps for New Relic are their observability peers (DT, SPLK, ESTC, DDOG). Because NEWRs' observability peers have different growth and profitability profiles, we find using the peer group average is the most reasonable approach. Furthermore, we use prior PE software transactions to validate our valuation assumptions.

Valuation and Scenarios

To account for NEWR's below-average growth, we apply a 1x turn revenue discount to the peer average TEV/NTM Revenue multiple in our base case. Our upside case assumes the acquirer believes in management's medium-term target of 25% growth and values NEWR at a par multiple to its observability peers' TEV/NTM Revenue multiples. The downside case assumes NEWR forgoes pursuing a transaction and shares trade down to a 1x turn discount to the current multiple in line with the 52-week low.

Our views on NEWR

New Relic’s all-in-one platform provides customers access to all their products, including APM, infrastructure and network monitoring, log management, and all the others, helping customers achieve two objectives: cost savings and improved engineer productivity. Engineers enhance their productivity by utilizing one platform for all their observability needs instead of having to toggle between a sprawl of monitoring tools to find answers, ultimately slowing them down. Instead, NEWR’s platform provides engineers a single pane of glass for all their monitoring tools that runs on a common underlying data platform and serves all of their monitoring needs. The knock on observability vendors historically has been the high-cost of ingesting data. New Relic helps resolve some of the excess costs associated with ingesting large swaths of data by utilizing a cost-plus model for data ingestion that leverages their economies of scale to pass savings onto customers. Finally, customers are able to consolidate all their vendors onto a single-platform that naturally provides scale and negotiating power to optimize their spend.

Focus may be a competitive advantage. The latest buzzword in observability is DevSecOps, where observability companies are attempting to enter the cybersecurity market by rolling out SIEM, cloud, and application security products. This is especially prevalent with NEWR's main competitor, Datadog. We question the ultimate success that observability vendors will have in cybersecurity for a number of reasons, including different buyer personas requiring a shift in GTM and a lack of credibility and brand awareness in a product category that is 100% dependent on customer trust. It’s difficult for us to see why observability vendors have a "right to win" in the category. NEWR's approach to cybersecurity is more of a partnering route with best-of-breed security vendors to provide the integrations necessary to achieve the same outcome without losing focus on being a true observability platform. The CFO made this very clear at a recent Barclay’s conference: "I’ll tell you where we’re not going to go, we’re very comfortable with our knitting in terms of the developer community. We won’t become a cybersecurity company. We think we work really well with cyber security companies, and again, we’ll create APIs and integrations so that our customers get the best of both in that respect." We believe NEWR's focus on observability will likely give New Relic a leg up vs. Datadog as they continue to focus their R&D efforts on enhancing core products with new features and rolling out additional functionality vs. allocating R&D dollars to security products.

Management's focus on observability will allow NEWR to continue reaccelerating growth and ultimately achieve management's goal of achieving topline market growth rates of 25% or greater. Customer checks suggest NEWR has largely achieved product parity with peers in previously non-APM categories, including infrastructure monitoring. The Companies more recent PLG GTM approach shift will likely yield S&M efficiency that will become even more evident in the numbers as the legacy non-cash CAC costs roll off. Finally, we can rest assured that there will be more than enough market for competitive solutions as the number of developers grows; according to recent analyst reports, the developer count will increase to 34 million by 2025, up from 25 million today. Data will also continue to grow exponentially, with reports suggesting growth of 181 ZB (2025) from 97 ZB today.

Risks

Q3 Earnings: Q3 earnings present both a risk and an opportunity, as the third quarter is the second largest for renewals. The upcoming renewals are particularly challenged due to not only macroeconomic headwinds, but also because management has also enacted a price increase that was rolled out at the beginning of Q2 but largely won’t affect most customers until their renewal in Q3/Q4. The price increase is on data ingestion per GB ingested, increasing to $0.30GB from $0.25GB. The price increase will likely have meaningful but not substantial impacts on contract costs, as data ingestion only represents approximately 1/3 of a customer's cost, while seat licences account for the other 2/3. By our calculations, a 20% increase in data ingestion will increase their overall bill by high single digits (20% on 1/3 of the total bill). In addition, there have been recent management changes, with a new CFO getting settled and a new CRO being hired in the quarter. As with many other companies, the CFO guided down for the second quarter, but it is difficult to have 100% confidence in guidance because the CFO is still getting his arms around the business. In addition, a new CRO was hired during the quarter, and there is always some turbulence when changing GTM leadership.

Such chaos, would likely cause us to position short in anticipation of an expectations miss and guide down. However, "this time is different." Numerous recent transactions in software have been announced on earnings day, and it just so happens that most of those prints were very weak (go figure!) We believe this is not a coincidence, but rather the catalyst for management to finalize a negotiation because they are acutely aware that earnings disappointments will be met with a lower share price. This is also likely the primary risk if we are wrong and the Company decides not to pursue a transaction after earnings are announced. If our risk/reward scenario proves somewhat accurate, we believe the potential upside makes such a risk stomachable if sized correctly. Additionally, if such a risk is intolerable, one can likely hedge some of the potential downside risk with puts.

Investor Pushback: HMI Capital is on the board and owns a meaningful portion of the shares outstanding. HMI recently released a public letter addressed to Coupa (COUP) management in response to market speculation of a potential deal being announced. HMI made it clear that they would not support a transaction unless they received a substantial premium, well above the later announced deal price. HMI is a long-term investor, and we believe other frontpage shareholders including Eminence Capital, will not be afraid to voice their opinions if they feel a transaction price does not accurately reflect the value they see. We believe this outcome is less likely if an appropriate premium is paid, as it appears both investors' cost basis, per 13F data provider Whale Wisdom, is approximately $60. If a deal price is above our base case, that would likely represent a return of 45%+, which we believe would prove adequate, especially in this market where locking in a substantial gain on a large position can have a meaningful impact on P&L.

JANA Selling Stake: Regulatory filings showed JANA sold approximately 10% of their stake on November 15th, which took their ownership slightly below the 5% threshold. We are not experts on the rules of 13D/G filings; however, our amateur interpretation of the rules suggests such a move could provide JANA flexibility. We believe this could potentially have been the reason for the sale and/or was caused by fund flows. What gives us comfort beyond our elementary interpretation (likely wrong) of the regulatory rules is that Mr. Galligan, a Partner at JANA, remains on the board and has not relinquished his position. In the event that Mr. Galligan resigns from the board or there is evidence of JANA exiting their position it would likely pressure the shares, as investors speculating on a potential deal would likely sell their positions.

Timeline of Events

CEO TransitionOn May 13, 2021, New Relic announced that Founder and CEO Lew Cirne would be stepping down from his role as CEO and stepping into the role of Chairman. Mr. Cirne would hand over the CEO title to Bill Staples, then-President and Chief Product Officer. Media outlet Protocol noted that the departure followed cultural clashes at New Relic.Protocol Article on CEO Transition: https://www.protocol.com/enterprise/new-relic-ceo-bill-staples
Activist HMI Capital Gains Board RepresentationIn June 2021, the New Relic board settled with HMI Capital and Engaged Capital, agreeing to replace existing director and previous President and COO, Michael Christenson, with RK Mahendran, Partner at HMI Capital, as a board member appointed by HMI Capital. As part of the settlement, NEWR agreed to seek shareholder approval at the 2021 annual meeting for board declassification to begin a de-staggering process.HMI Partner Board Appointment: https://newrelic.com/press-release/20210625
Activist JANA Partners Gains Board Representation In June 2022, NEWR welcomed Kevin Galligan as a partner at JANA Partners, and JANA appointed Susan Arthur, CEO of CareerBuilder, to the board. JANA had subsequently increased their stake to 5.3%, according to Reuters.JANA Partner and Board Representative Appointment: https://newrelic.com/press-release/20220606
Reuters Reports NEWR to Explore Strategic AlternativesOn July 20, 2022, Reuters reported that NEWR was preparing to explore a sale following interest from private equity firms and was in talks to hire financial advisors to explore a potential sale.Reuters Reports New Relic Exploring Sale: https://www.reuters.com/markets/deals/exclusive-new-relic-explore-sale-options-amid-takeover-interest-sources-2022-07-20/

*NOT INVESTMENT ADVICE, DO YOUR OWN DUE DILIGENCE.