Educating Wall Street - a task that's going to consume a lot of time for New Relic as its shift to a consumption model kicks in

The changes New Relic made to its go-to-market strategy last year, to shift from a subscription to a consumption model, are seeing traction among customers, says CEO Lew Cirne, but the transition is taking time:

Over the past year, we've made important changes to our go-to-market and product strategy, all in service of simplifying the observability market. And our financial results for the third quarter reflect the early response from customers to these changes…while we're pleased with our early momentum and feel good about our path forward, it's important to note that we're just getting started executing on our consumption model.

But the firm yesterday disappointed Wall Street with Q3 2021 numbers that fell short of expectations, compounded by cautious forward Q4 guidance. Revenue was up 9% to $166 million, compared to $153 million for the same period last year, but the non-GAAP net loss was $8.4 million, against a profit of $3 million for Q3 2020. 

In a letter to investors accompanying the results announcement, Cirne re-stated the company’s new approach: 

We are no longer mandating that our customers fully commit to us up front with an annual subscription, where the onus is on the customer to get as much value as they can from their subscription. Instead, we are offering our customers the ability to pay as they consume and derive value from our products, thereby placing the burden on us to make sure that all of our customers are deriving value every day. The move to a consumption model is a significant change to the way we build, sell and deliver software, and it’s a significant change to the way our customers are used to buying and consuming software.

Consumption trends

One of the learnings so far in this shift is around how users consumption needs and behaviors vary, he said later on the post-results analyst call:

Some customers love to consume, to step up to a large commitment that would show up in ARR [Annual Recurring Revenue], because they have a good understanding of what their consumption will look like over the next year and they like those unit economics. However, there's a meaningful portion of our customers that have full intent to continue to grow with us, but would prefer to sign up for a smaller upfront commitment. 

There are a couple of key factors driving that second group of customer, he explained:

First off, they have an easier internal approval process for that. Second, they say no, they're not going to overpay. It's important to note that in our model, unlike some other models in our space, there is no penalty for over-consuming.

In the new model, if a customer exceeds their expected consumption, they go into an auto-billing situation with no need for what Cirne called “nasty conversations”. For example, if they exceed their annual consumption in month six or month seven, they receive an invoice and New Relic then recognizes that revenue. 

The customer can see their ongoing expenditure and keep on top of it, said Cirne: 

It's not like if you go above your credit amount, all of a sudden the unit economics get a lot worse. So it's a customer -friendly model, where they can have confidence that if they do sign up for a lower commitment…they won't get penalized for consuming at a higher rate. Given the uncertainty that's going on broadly, it's really hard to predict what their consumption may be a year out or further, so they prefer to just pay-as-they-go for that overage.

As it stands, Q3 ARR was $669 million, up from $607.9 million last year, with 79% of that coming from paid business accounts greater than $100,000. There were 1,051 paid business accounts greater than $100,000 at the end of the quarter, up from 927 in Q3 2020.

One change underway within New Relic is to structure around a Chief Customer Officer organization whose primary responsibility it is to drive growth and consumption of the platform within the customer base. Cirne explained: 

One of the things I continue to say internally is [that] the real account management and ‘selling’ happens the day after the customer's ARR commitment happens. So we're going to have a dedicated organization that [acts] on that, so the line is blurred between what is ‘pre-sales’ and 'post-sales', just continuing customer education to help them understand the value of consuming more, adding more users, adding more data.

This is very much a period of transition for New Relic, emphasised Cirne: 

During those times transition, some people may decide not to take the next step in the journey, whereas others will be excited to continue on that journey. So we're managing through the changes and we're prepared for that. But we absolutely are focused on setting ourselves up for success next year, in particular as we align our [sales teams] compensation plans with the consumption model that we're committed to.

And there’s also a commitment to adapt the ongoing strategy based on experiences en route during the transition, he concluded: 

We are continuing to make adjustments as we innovate. As we progress through this important transition, we will continue to learn from our customers and use those learnings to refine our products and go-to-market. We fundamentally transformed our product, sales and customer success strategies and we continue to make changes in the name of better serving our customers.

My take

What disappointed Wall Street as much as anything was the flat guidance for Q4. This setting of expectations was in fact a pragmatic piece of transparency on New Relic’s part. Q4 is the firm’s biggest renewal quarter, with 25%- 30% of business is coming up for renewal. According to CFO Mark Sachleben, the shift to the consumption model is going to have an obvious impact here, but one that is factored in when it comes to planning:

You look at last Q4, we had 116% dollar based net expansion rate and that says…that $200 million in ARR is growing to $230 million in ARR. What we're saying is now as we move to this model, that $200 million in ARR is going to renew at $200 million in commitments, so that's a $30 million delta right there. 

The working assumption however is that customers may commit upfront to more conservative numbers, but are going to engage with the products and the platform and their spend will grow:  

But it's going to be on their terms - they’re going to be paying for what they're using, a much more customer-friendly and focused model. Their spend will increase over time, but unlike ARR where we'd see that bump in revenue right away, starting in April, we're going to recognize the revenue according to how they're consuming and will recognize the revenue until they hit their commitment level. And then it will be exceeding the current level [and] we’ll get most of that bump in revenue in the latter half of the year.

In other words, it’s something of a game of patience here, not a trait that profit-hungry stock chasers on Wall Street have been shown to possess in abundance - see, for example, impatience with the likes of Oracle passim as it made its move to the cloud.

Back in August, I suggested that Cirne and his colleagues would have to spend a lot of time articulating and re-articulating their thinking to investors and that: 

...it’s going to take time to get across to many, particularly those whose already instinctive short term-ism has been accentuated by the stresses of wider COVID-19 uncertainties.

Nothing I can see today changes the validity of that assessment. As such, educating - handholding? - Wall Street as the operating model shift kicks in is going to be a huge priority for New Relic in calendar 2021.