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We’re Getting Back into New Relic (NEWR)

By Jeff Brown on January 25, 2017

Today, I want to add New Relic (NEWR) back to our portfolio as a “bonus” recommendation.

As longtime readers know, I recommended New Relic back in December 2015. The company is a key technology provider helping companies manage their software application performance in the cloud. (Think of cloud computing as a way for tech companies to deliver their software via the internet.)

And the cloud is a very big business. The market is expected to exceed $160 billion by 2020.

New Relic’s technology is critical in helping companies who deploy software applications in the cloud monitor the performance of those applications. This is necessary to ensure that certain performance levels are being met, as well as to monitor and reduce costs associated with running applications in the cloud. From my perspective, New Relic is the most progressive player in the industry and continues to lead the market with the most innovative features and functionality.

But the timing of the recommendation was unfortunate. Just days before the New Relic recommendation came out, the Federal Reserve announced a 25 basis point (0.25%) increase in the federal funds rate. While it didn’t seem like much, it was devastating to the market. Take a look at what happened to the tech-heavy NASDAQ Composite Index in the weeks that followed:

It fell about 16.5% in just a matter of a few weeks, and most high-tech companies fell with it… especially software-centric companies.

While it was a healthy market adjustment, we were stopped out of our position in New Relic in February. That’s precisely what stop losses are for, to provide a cap to any downside risk in any one position.

Important to know, New Relic’s drop in stock price had nothing at all to do with the company, and everything to do with the market pullback.

And our original investment thesis remains completely intact, which you can see here. Since all the details are in the original write-up, I won’t duplicate them.

But in short:

  • New Relic is a “pure play” cloud-based technology provider.

  • It continues to lead the market in terms of new product development and innovation.

  • The market has not yet recognized the value of its expansion into the larger enterprise market.

  • Nor has the market realized the value of the new products that it has introduced.

  • It has a proven management team with experience building a business to scale and then effecting a buyout.

And things have only improved at New Relic since 2015. Take a look at the brief comparison below of New Relic from December 2015 versus January 2017.

New Relic beat the previous estimates for its fiscal year (FY) 2016 revenue by $6.3 million (note: New Relic’s 2016 fiscal year ended on 3/31/2016). Its gross margins have expanded to well above 80%… revenues are up… it has made progress towards reaching profitability… and it has improved its net income margins from a negative 37.8% to only negative 11.4%.

The future is looking even better. Here is its revenue outlook for FY 2017:

FY 2017 revenues are forecast to come in at 2.33 times FY 2015, more than doubling over the two-year period.

Now, take another look at the previous comparison table. As you can see, New Relic’s stock price today is a few dollars less than it was in December of 2015. And even more interesting is that its enterprise-value-to-sales ratio has dropped from 13 down to a current value of about 6 for FY 2017.

So despite all of the great progress that New Relic has made, its valuation has dropped in half with respect to its annual revenue. Given New Relics’ high margins, exponential revenue growth, and improvements towards generating free cash flow, I would expect this valuation multiple to be in the 8–10 range.

This alone makes a strong argument for getting back into New Relic. But there is something else interesting going on that you should know about.

Just a few days ago, I discovered that one of New Relic’s two key competitors, AppDynamics, was scheduled to go public. At the time that I was finalizing my research on Monday and Tuesday, the AppDynamics IPO was expected to price today and have its IPO on Thursday, January 26 under the ticker symbol APPD.

But things got interesting last night…

Less than 48 hours prior to the IPO, Cisco Systems announced that it would be acquiring AppDynamics for an incredible $3.7 billion.

It may seem crazy to have an acquisition take place just days before a planned IPO, but it’s not as unusual as you might think.

Private companies often use the pursuit of an IPO as a negotiating tactic to elicit a higher price from possible acquirers. In other words, my belief is that AppDynamics has been speaking with Cisco for months, was not happy with the buyout offer, and “threatened” to go public. The risk for Cisco was that AppDynamics would go public and become even more expensive to buy. Generally, it is much better to acquire a company when it is private.

Now, while I like AppDynamics and I believe the IPO would have done well, I was not going to recommend it. The IPO was already many times oversubscribed and I believe the price would have jumped on the IPO, not giving subscribers good entry points into the company… assuming you could have gotten access to the shares. I also believe that New Relic represents a better value in comparison.

Aside from having a more attractive enterprise valuation, New Relic’s gross margins are higher, it has no debt, nearly $200 million in cash, and is forecast to be generating free cash flow for its full 2018 fiscal year (ending 3/31/2018). This will be a major turning point for the company.

Now, let’s consider the valuation that Cisco Systems is paying to acquire AppDynamics. Cisco’s offer of $3.7 billion results in an enterprise-value-to-sales ratio of 18. At an equivalent valuation, New Relic would be trading around a 2.6 times higher valuation… the potential to return about 160% on valuation alone.

As a result of the acquisition news, I wouldn’t be surprised to see New Relic valued closer to an enterprise-value-to-sales ratio of about 10-12 over the following weeks. The AppDynamics acquisition will act as a catalyst for higher valuations for New Relic… similar to the way that I believe an IPO for Cloudera will lead to better valuations for last month’s Exponential Tech Investor recommendation HortonWorks.

I believe there is potential for an increase of 30%–40% in New Relic’s stock price within a matter of weeks, and that there’s an increased potential for a buyout offer. Obvious potential acquirers would be companies like Microsoft, Oracle, BMC, Hewlett Packard Enterprise, IBM, CA Technologies, or a private equity fund. In the event of such an offer, I would expect another 40%–50% premium on top of the then-trading stock price.

Let’s take advantage of this window now. This is a unique opportunity for us to take advantage of what is essentially and arbitrage on valuation for an industry leader.

Action to take: Buy New Relic (NEWR) up to $37. We will implement a 25% trailing stop loss on this position.

Regards,

Jeff Brown
Editor, Exponential Tech Investor

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