New Relic (NEWR) Q3 2021 Earnings Call Transcript

New Relic (NEWR)
Q3 2021 Earnings Call
Feb 04, 2021, 5:00 p.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good day, and welcome to the New Relic third-quarter fiscal-year 2021 earnings conference call. [Operator instructions] Please note this event is being recorded. I would now like to turn the conference over to Peter Goldmacher, vice president, investor relations. Please go ahead.

Peter Goldmacher -- Vice President, Investor Relations

Thank you, operator. Hi, everyone. Thanks for joining our Q3 fiscal '21 earnings call. We published a letter on our Investor Relations website a little less than an hour ago, and hope you all had a chance to read our letter together with today's earnings press release.

Because of the level of detail we provided across these two documents, today's call will begin with Lew providing brief opening remarks, and then we'll dive right into your questions. During the call, we will make forward-looking statements, including about our business outlook and strategies, which we based on our predictions and expectations as of today. Our actual results could differ materially due to a number of risks and uncertainties, including the risk factors in our most recent 10-K and upcoming 10-Q to be filed with the SEC. Also, during this call, we will discuss certain non-GAAP financial measures.

We have reconciled those to the most directly comparable GAAP financial measures in our earnings release. These non-GAAP measures are not intended to be a substitute for our GAAP results. And finally, this call in its entirety is being webcast from our Investor Relations website, and an audio replay will be available there in a few hours. With that, I'd like to turn it over to Lew.

Lew Cirne -- Chief Executive Officer

Thanks, Peter, and good afternoon, everyone, and thank you for joining us for our third-quarter fiscal '21 earnings call Joining me today are CFO Mark Sachleben; and our president and chief product officer, Bill Staples. Before we get to Q&A, I wanted to make a few comments about the quarter and the journey we're on as a company. I encourage you to read our investor letter, which we published today in conjunction with the press release. In it, we described some important updates that we're making across our company to better serve our customers.

From the beginning, New Relic has existed to help developers build more perfect software. That's an important and noble mission, and we're just getting started. We want to empower every professional developer around the world, estimated to be 28 million today and growing rapidly, with easy access to the power of observability as part of their daily workflows. Over the past year, we've made important changes to our go-to-market and product strategies, 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.

Specifically, there are three key areas I want to highlight. First, we are orienting every part of our business to focus on the customer. Every team across New Relic has a renewed focus on delivering increased value to our customers. Our product teams have completely reimagined our entire platform experience.

Our go-to-market teams introduced new pricing, packaging and sales motions, and our customer success teams have transformed our onboarding and training, all in the service of making it easier for our customers to try, buy and grow with the New Relic One platform. The second item. Beginning with the launch of New Relic One pricing last July, we are transitioning to a consumption business model. In this new model, customers love that they are paying for what they use and that they have complete visibility into their spending.

No surprise bills or penalties, no shelfware and a very high correlation between price and value. This is resonating with our customers. And third, 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 product 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. On a personal note, I want to congratulate Bill Staples, who is recently promoted to president in addition to his responsibilities as chief product officer. Since joining New Relic a year ago, Bill has had a tremendous impact on our business, serving as the chief architect of our product and corporate strategy, including the launch of New Relic One last summer and our transition to a consumption business model. I also want to thank Mike Christenson, who, after serving for president and COO for the past year and a half, is moving into an advisory role and remaining a director of the company.

In 2019, I asked Mike to step into an operating role to help me in the day-to-day operations of the company. His main focus was to add more structure into our business and to help us build out our business strategy. With this complete, he has decided to step down from the day-to-day operations role at the end of Q4. He will remain on our board and continue as a strategic advisor to me starting in April.

In summary, while we're pleased with the 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, and we'll continue to focus on making it easier for our customers to do business with us and get more value from New Relic One. With that, let's move to Q&A.

Questions & Answers:

Operator

[Operator instructions] The first question today comes from Kingsley Crane of Berenberg. Please go ahead.

Kingsley Crane -- Berenberg -- Analyst

Good afternoon. Thanks for taking my questions. I just have two, so really appreciated the extensive detail in the letter, addressing the transformation from a subscription model to a consumption model, and why it's so much more than just a revenue model transition. But while it's still early days, could you share with us some of what you've learned over the past few months that has either most surprised you or that you found most valuable?

Lew Cirne -- Chief Executive Officer

Certainly. I think one of the key learnings is, for some customers, they love to consume -- to step up to a large commitment that would show up in ARR 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, which shows up in less ARR. But they have a few things that they prefer that leads in that decision.

First off, they have an easier internal approval process for that. Second, they know they're not going to overpay. And it's important to note that in our model, unlike some other models in our space, there is no penalty for over consuming. It's not like if you go above your committed 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're still going to get -- they won't get penalized for that for consuming at a higher rate. And given the uncertainty that's going on broadly, it's really hard to predict what their consumption may be a year out or further. And so they prefer to just pay as they go for that overage. So that's one of the things we learned, and we're fine with it, again, because to our point on the consumption model, as we continue to focus on driving customer value, our customers are going to send us more data, and they're going to add more users.

And those are the primary mechanisms by which we recognize revenue. And so we like that. And to the extent we focus on those fundamentals, we expect to see our customers grow with us and that to show up in our top line.

Kingsley Crane -- Berenberg -- Analyst

That makes perfect sense. Yeah. I like the example in the letter, too, about the nontraditional applications like parking meters and pricing scanners. I thought that was interesting.

So last question would be the commentary on the changes to sales incentives in fiscal '22, including eliminating incentives for upfront commitments. I thought those were important. So how quickly can we expect the sales force to adapt to these kinds of changes? And should we be expecting any dips in productivity, per rep?

Lew Cirne -- Chief Executive Officer

Well, we've been signaling to our sales force for some time that we're moving up, but we obviously have been signaling -- more than signaling that we're moving to this model. But we've been signaling to the sales force that the compensation plans for next year will really align well with our -- with the customers' success and New Relic's success. So we've been preparing them for that. That having been said, we're still in a period of transition.

And during those time of transition, some people may decide not to take the next step of the journey, whereas others will be excited to continue on that journey. So we're managing through that change, 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 compensation plans with the consumption model that we're committed to.

Bill Staples -- President and Chief Product Officer

And if I could just add to that, Lew. And it's not going to be abrupt. We've done some modifications this year, and this is the fourth quarter -- at the end of the fourth quarter, where we're kind of softening the cliff, if you will, the abruptness of it, by starting to transition those plans into what they'll be next year. So we -- as we've said, we've been educating on this for quite a while, and we've already started that transition as we go through the rest of this year.

Kingsley Crane -- Berenberg -- Analyst

OK. It's very helpful. All right. Thanks again, guys.

Operator

The next question comes from Sanjit Singh of Morgan Stanley. Please go ahead.

Sanjit Singh -- Morgan Stanley -- Analyst

Thank you for taking the questions, and hello to everyone on the team. Good quarter in Q3. I had a couple of questions that I wanted to work through. First, I want to get prepared for what we should expect over the next several quarters in terms of this consumption model.

And so Mark, I was hoping you could walk me through what do you think the impact is going to be in terms of revenue, maybe it's in terms of ARR, in terms of customers coming to a lower level of initial commitment? And then what is the team's hypothesis on how long it will take for actual consumption to exceed contracted exemption? Any sort of modeling or simulations you've done around that behavior? That would be very helpful.

Mark Sachleben -- Chief Financial Officer

Sure. Happy to go through that. And I guess I'll start with just the ARR guidance in Q4, as -- that we mentioned, is going to be flat versus Q3. And that's -- I'm sure people have some questions around that.

And even internally, we, too -- when you first look at that, I think it can be surprising when we look at our business, we say we just came off a good Q3. We look at our business, how we're doing relative to our objectives, where we want to be in this transition, etc. It feels like things are going well. And relative to last Q4, etc., why is that number flat? And kind of what's going on? And first of all, I'd say there are three primary reasons why that -- the guidance is flat for Q4.

The first is the change in model. The second is large deal dynamics. And the third is entitlements. And let me go through all three of those a little bit.

And it's a long-winded answer to the question, but I think it's important for folks to really understand this. And so when we look at the change in model, if you think about our business, we just reported, call it, $670 million, $668.7 million of ARR, Q4 is our biggest renewal quarter. And so you say 25%, 30% of our renewals, our business is coming up for renewals in Q4, $175 million to call it $200 million of business that's going to be renewed in this quarter. Under our old model with -- that would have renewed at a higher rate, a higher level of subscription.

If you look at last Q4, we had 116% dollar-based net expansion rate. And that says that that $200 million in renewals would have grown by $32 million, call it, $30 million, again, round numbers. That $200 million in ARR would have grown to $230 million in ARR. And 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.

And so that's a $30 million delta right there. And we're fine with that because customers are more comfortable committing to less than they expect to spend. We're confident that these customers are getting in, they're using the product, they're embracing the platform. And we're confident that their spend is going to grow over the course of the year, 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. And so their spend will increase over time. But unlike the 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 we'll recognize the revenue until they hit their commitment level, and then it will be exceeding the commitment level.

We'll get most of that bump in revenue in the latter half of the year. And so we think it's Q3, Q4. So second half of the year, where that consumption revenue starts to tick up and really starts to improve the overall economic and start to improve the overall revenue line. And we think that's where it starts to kick in.

Now the second bullet point I mentioned around the ARR number for this quarter was -- has these large deal dynamics. This quarter, we have two large customers. And for various reasons, they want -- they're not comfortable because they want to reduce their overall level of commitment. This happened last quarter.

We mentioned in the investor letter, they're about $4 million. And in this quarter, we have these two customers just in the low eight figures. And these are two customers that are huge users of New Relic. They're going to continue to be New Relic users in fiscal '22.

And in fact, over the last 12 months, their consumption has actually been increasing. But they're just not comfortable with that commitment. So these are customers where the ARR is going to be down, they're going to be consuming that commitment. And then any increases will be back-end loaded in the year that gets reflected on the revenue side of things.

And then the third factor affecting ARR is -- the guidance, is entitlements. And if you remember, we opened up our platform, where we announced the new platform in August, and we said everyone can use as much as they want for free through December. And that had the effect of depressing results in Q2 in September, as people said, why would I pay for more when I can use it for free. So that depressed Q2 a little bit, added a bit of a boost into Q3.

It also pulled forward some of the deals that may have happened in Q4 into Q3, into the December quarter where people wanted to take advantage of that entitlement and the -- what we had said was going to be an expiration. So those are the factors. But overall, I think it's the latter half of this year where we think this transitionary period will kind of have worked its way through, and we'll start to see the benefits and the ongoing consumption increases hit the top line.

Sanjit Singh -- Morgan Stanley -- Analyst

Thank you, Mark, for that detail. I had a couple of just follow-ups based on your answer. In a hypothetical customer, like in a traditional subscription model, if they sign a 12-month contract, it was sort of recognized straight line. So let's say that actual consumption on a run rate basis happens in month three or four of a 12-month contract.

Should you expect the revenue recognition to be accelerated that early? Or do they have to sort of surpass their total initial commitment before any sort of excess revenue is recognized?

Mark Sachleben -- Chief Financial Officer

This gets into -- you're starting to get into the details of revenue recognition and variable consideration, which we put a little bit about that in the letter and happy to talk to anyone about that separately. But in general, we would recognize -- we have to estimate what we think their usage is going to be over the life of the term, so over the 12-month term, and recognize it roughly in connection -- try and smooth it out over the course of the remaining contract. So with a customer in month three or month four, really starts exceeding their planned usage, we would probably recognize a portion of that starting in month three, month four. But we -- of course, we don't know, is it going to go down to the future and things.

So it's really toward the end of the contract where we get a lot more confidence of what their actual spend is going to be. So in general, I would say the bulk of the increases are recognized late in the term. They don't have consumed their full commitment before we start to do that. But in general, it's back-end-loaded.

Sanjit Singh -- Morgan Stanley -- Analyst

I appreciate it, Mark. And then the last one, and I promise I'll yield the floor. In terms of how you guys are thinking about metrics in this sort of transition period, have you guys given any thought to giving things like user accounts or data ingest or something to give a sense of how the consumption behavior is happening? Because it seems like the metrics, whether it's ARR or revenue might be -- might not be giving the true picture of the underlying growth of the business.

Mark Sachleben -- Chief Financial Officer

Yeah. We've thought a lot about that. We are -- we've got a lot of new metrics in the company since we've done this. And from a public standpoint, we talked about net revenue retention, talked about that in the letter a bit, and we gave an example there for our larger customers.

We will be including that for our customer base as we go forward as a key metric starting next year in next -- in Q1 in the spring. Otherwise, it's really about data ingest and users. And the data ingest, we've talked about that. I gave some information about that last quarter.

This quarter, we, again, talked about that. Data ingest year over year grew about 70% last year. And when you look at the chart in the investor letter, you can see that there was an inflection point as it is growing once we introduced New Relic One in the summertime. And just last quarter, it grew in the 15% range in the quarter.

And so that's something we look at very closely. And then the user growth, what's happening with user growth. We haven't made any definitive decisions about which of those metrics we're going to be disclosing publicly. We have to do that.

We recognize those are important things, and we want to do -- we want to -- just want to do it right, and we want to make sure we have enough data to be comfortable with the underlying trends. We're still pretty early in the model. And so we're still continuing to learn, but we definitely have to figure out and make sure that we disclose enough to get people comfortable with the underlying trends.

Sanjit Singh -- Morgan Stanley -- Analyst

Understood, Mark. Appreciate the thoughts.

Operator

The next question is from Jennifer Lowe of UBS. Please go ahead.

Jennifer Lowe -- UBS -- Analyst

Great. Thank you. Maybe just to follow up a little bit on Sanjit's question and how we should think about this playing out through the next -- into the next fiscal year. It sounds like we should -- if we look at the growth guidance for Q4, it sounds like it's probably still a couple of quarters after that before we'd really see any meaningful inflection in the growth rate as these contracts take time to season through.

Is that a reasonable expectation? Or could we see it happen sooner? How should we just think about when the growth rate bottoms and when it starts to climb back up?

Mark Sachleben -- Chief Financial Officer

I would -- I think it's the second half of next year before it starts climbing back up. And once we're there, it's similar to the transition of folks who went to a subscription model from the license and on-prem. You go through the transition period and you have this dynamic of the ARR based revenue falling off and the consumption revenue not yet picking up. So there's that trough.

And I think it depends on how quickly folks are consuming and relative to their upfront commitments and things like that. But we feel like it's the second half of fiscal '22 where that starts to turn upward.

Jennifer Lowe -- UBS -- Analyst

And then just in the shareholder letter, there was a reference that in the September month, you talked about last quarter that there was a 15% expansion on conversion to the new contract, and that was a little -- it was less 0% in Q3. And I'm curious, I know there's a lot of variability in that. How much of that difference is due to just big numbers averaged across the bigger population, causing a different result versus something strategically different in the way you were approaching customers on those conversions?

Mark Sachleben -- Chief Financial Officer

I would say there's something to -- a couple of large customers had a big impact there. On the other hand, we are seeing something across the board. And this is one of the learnings Lew alluded to in the first question, and where we've realized that customers are much more comfortable committing below their projected spend, particularly when the penalty for committing more is you have shelfware. The penalty for committing less is you pay at the same rate, which is logical -- logically, it's going to drive people down to committing a little bit below what they expect to use.

We went in thinking that customers would commit to between 80% and 120% of their expected usage. What we're finding is some customers commit more, but only in the case where they're already blowing through what they've already contracted for. And those customers then will commit to a higher number. In other cases -- in most cases, they're going to commit to a lower number than they expect to use.

In Q2, I think we were more involved in learning, and we were pushing still to get that uptick. We had just rolled it out. We still had a go-to-market organization, and even internally in the senior levels, we were still kind of focused on this let's get an uptick. What we realize is when you're looking for transactional efficiency and customer friendliness, it's much better to basically let the customer decide and help them understand the dynamics and work through that.

But ultimately, let the customer decide, and customers are more comfortable under committing. And I think that is -- that's in keeping in line with what we want to do, which is be customer friendly. We're OK with that because the key thing is what happens after they sign that agreement? How does their consumption track? And that's what we want to follow, and that's what we want to keep seeing grow.

Jennifer Lowe -- UBS -- Analyst

OK. And just one last one for me. Just looking at the operating income guidance for Q4. I know you -- there were some references to being a bit behind plan on AWS spending and maybe catching that up in Q4.

You also referenced maybe some sales compensation designed to make them hold given the transition. How should we think about the puts and takes feeding into the operating margin guidance for Q4 and how that might play out even beyond Q4?

Mark Sachleben -- Chief Financial Officer

Yeah. So the primary driver there is our cloud -- migration to the cloud and the cloud spend. So in Q3, we were -- we slightly had a better gross margin than we had anticipated. There are some pre rec work that we needed to do to continue to accelerate the move to the cloud, and that held up some of that migration.

Now as we get into Q4, we'll be spending to kind of catch-up what we didn't spend in Q3, as well as the increase in Q4. So that will put pressure on our gross margin in Q4. As we go forward, we are migrating to cloud. We've got this double bubble where we're paying for the cloud spend, as well as our internal data centers.

There's not much -- you look out a couple of months, and there's not much that's going to be happening there. Unfortunately, we're still paying for them. And as we talked about when we first announced this last spring, the gross margins, I think next year, are probably going to be comparable to the second half of this year. And then as we get into fiscal '23, toward the second half of that year, they'll start to improve and get back to closer to where we were as the cloud migration is completed and the old data center spend is completely rolled off.

Jennifer Lowe -- UBS -- Analyst

Great. Thank you.

Operator

The next question comes from Rishi Jaluria, D.A. Davidson. Please go ahead.

Rishi Jaluria -- D.A. Davidson -- Analyst

Hey, guys. Thanks for taking my questions, and appreciate all the detail in the shareholder letter. I wanted to ask, first, starting on NRR. Can you maybe walk us through a few of the puts and takes? I guess, a, does that capture churn to the extent that there are 6-figure customers who, in the span of a year, do churn off, either completely offer downgrade to the point that they're no longer in the $100,000 bucket? Mark, I believe you had said you plan on disclosing this metric for all customers, not just $100,000 customers in the future.

I just wanted to make sure I understood that correctly. And maybe wanted to understand, if we look at the historical trend in that, I mean we've seen this -- the NRR metric for even the six-figure customers decline about 20 points in the span of six, seven quarters. So maybe walk us through that, and then I've got a follow-up.

Mark Sachleben -- Chief Financial Officer

Sure. And just one clarification. We expect to use NRR for -- I don't think it will be all our customers, but more likely our customers over $25,000 or some threshold as we go forward, just because at the low end, there's so much back and forth, and they're pretty transient in the pay-as-you-go segment and things. So just more to come on that one as we get into next year.

But that number does reflect customers who were paying -- if they came in and out in the last 12 months, they would not be in there. So six months ago, a big customer came in and then a month ago, they left, that would not be in that number. But if they were a customer in the prior three to 12 months and they dropped, that would be captured in that number. So that number is more of a historic looking -- historical backward-looking number.

And it tends to follow overall revenue performance. But I think it's -- it breaks it down a little bit better. So we recognize it's been declining. I think as we go forward, that will follow our overall revenue trends where it's likely to be a little depressed for the next couple of quarters and then start to turn up as we get into the back half of fiscal '22 and beyond.

And once we've made -- once we've completed the transition, where we have the vast majority of our customers on the consumption model, I think then it starts to give a real accurate view of what's going on and then it will be reflective of, OK, what's going on with overall consumption.

Rishi Jaluria -- D.A. Davidson -- Analyst

Great. That's helpful. And just on the consumption versus subscription, I'm sure an overwhelming majority of the business today is subscription. What's kind of the ideal mix shift? Is this -- you're looking at getting 100% of customers on consumption, be it with some level of commitment upfront? And what's the general time line for how long you would expect that to take? Is that a matter of four quarters where it would go from being a vast majority subscription to a vast majority consumption, longer than that? Anything there would be helpful as well.

Thanks.

Mark Sachleben -- Chief Financial Officer

Sure. We would like to get -- we feel like we'll have more than half our business on consumption by the end of this fiscal year, so by the end of March. That's a target of ours. And then as renewals are coming up, we would -- our goal is to get every renewal on a consumption model.

And so there are certain reasons you can't do that. But by and large, I think we're going to be able to do that. So you go through the renewal cycles, we have some multiyear deals that are going to take some time. But you fast forward a year from March, by then, more than two-thirds, more than three-quarters of our business should be on consumption.

You've always got -- you've got some site licenses at the high end, some other things that will prevent us from getting 100%. And but we -- our goal is to get as much as possible. In terms of commitment levels, I think what's come across probably already very clearly is we're not concerned with the upfront commitment level. What we would like, rather than us going to customers and asking for that, we want our customers coming to us and saying, I want to commit more because I get a better deal.

I am so confident that I'm going to be using a lot more New Relic, I should get a better deal. And that's a better position to be in. It's customer-driven. And then when we visit -- when we're having -- and negotiating with the rest, it's, look how much money I'm going to save you.

And so I fully expect that a fair amount of our business will be committed going forward. But the difference is, I'd like to have it being customer-driven commitments as opposed to our internal battling back and forth, pushing the customer to make commitments.

Rishi Jaluria -- D.A. Davidson -- Analyst

All right. Great. That's helpful. Thank you.

Operator

The next question is from Robert Majek of Raymond James. Please go ahead.

Robert Majek -- Raymond James -- Analyst

Great. Thanks. It's good to see your data ingest increase quarter over quarter. Can you just help us understand what's driving the uplift in data ingest, specifically is it more tracing and increased application monitoring coverage? Or are customers adjusting more metrics and logs, and that's driving the bulk of the increase?

Lew Cirne -- Chief Executive Officer

I'd like Bill to take that one.

Bill Staples -- President and Chief Product Officer

You bet. Thanks, Robert. Yeah. It's actually really exciting to see the growth in data ingest.

This quarter, the product team released several new capabilities that unlock more data ingest and increased usage of the platform, including our partnership with Confluent and availability of a New Relic connector for Kafka. It allows customers to ingest Kafka topics into New Relic One without writing a single line of code. We announced a partnership with Kentik to provide network insights, Snowflake integration, Syslog ingest for logs, Lambda runtime logs integration, improvements to Synthetics that allow proactive monitoring of non-HTTP connections, real-time Java profiling and dozens and dozens of other improvements as the product team is really focused on accelerating that data and user growth. So really, it's across the board.

We see growth in dimensional metrics, a lot of expansion in logs and across the board. And 70% growth in the first three quarters of this fiscal year, we're really proud of.

Robert Majek -- Raymond James -- Analyst

Great. And just one more question for me, if I can. And this question will overlap with Jennifer's. But you mentioned that existing customers who were renewed on the new model this quarter showed no ARR uplift.

Instead of ARR, can you share what the uplift was in terms of total spend, if we annualize the increase in Q3 spend? Or is it just too early to do that at this point?

Mark Sachleben -- Chief Financial Officer

It's too early to do that. What we're saying is their ARR -- the total amount they committed was flat. So if it had been $100 million in ARR, they committed to spend $100 million. Now what will that spend be over the next 12 months? It's too early to tell there.

But that's what we're very focused on is aligning the whole company of driving that consumption. So we fully expected to be more than 100 and just how much more is up to us to drive and for the customer to get -- see the value and really expand their consumption.

Robert Majek -- Raymond James -- Analyst

Great. Thanks a lot.

Operator

The next question is from Ittai Kidron of Oppenheimer. Please go ahead.

Ittai Kidron -- Oppenheimer & Co. Inc. -- Analyst

Thanks. And thanks again for the letter, a lot of detail there. Clearly, we'll have to digest that later. But Mark, I just want to go again into the -- trying to make sure I understand the time line for you to get really good clarity whether this is working or not.

You've talked about the second half of fiscal '22. But in reality, at the end of the fiscal '22, you still are going to have, I don't know, 30%, 40% of revenue that hasn't converted to consumption. And you won't even know the expansion patterns of the customers that will expand in this -- in the next two, three quarters. So it's really second quarter or second half of fiscal '20 -- well, first half of fiscal '23, I guess, late calendar year next year, right? Will you really going to have better insights whether the consumption is working, whether the expansion of the consumption is working as you think it should.

Mark Sachleben -- Chief Financial Officer

I think the -- obviously, the longer the time, the better visibility we'll have. But if you -- there's this couple quarter delay between when you -- the time of commitment and the time when you get a lot of that revenue increase. And so if you think about a portion of our business, given that increase in the Q3 and other portion of Q4, I think that the amount of that impact grows each quarter. And so when will it be fully realized? I think it won't be fully realized for -- you're right, probably until we have the vast majority, a year -- three quarters after we have the vast majority of our customer base moved over.

That's when you'll really see the true model kick in and the true performance. But before then, you'll see -- I think we'll see the characteristics start to impact it and the curve start to shape upward. When you talk about how much we're seeing and when can we get data, we've got a cohort of customers that signed up in September of last year. Now this is a smaller cohort, but we've got -- it's in the meaningful -- in the many hundreds of customers that were in -- that signed up in September.

We now have four months of data around what their pattern has been. And we've got this concept of running cold or running hot or -- and I would call it Goldilocks in the middle. Are they on target to use less than their commitment? Are they on path to hit their commitment? Or are they running hot, are they on path to exceed their commitment? Obviously, as we expect over time, the vast majority of customers to run hot and exceed their commitment. When we look at their behavior, in that cohort of September customers, when we look at their October/November behavior, and then we look at their January behavior, the ones that were running very cold are running cool.

The ones that weren't cool, are now running neutral. The ones that were running neutral are running warm, etc., they're moving up that stack, if you will. And so we're seeing that type of behavior. And when you get to next September, we'll, at that point, have a 12-month period where we'll see, all right, what did they commit? What was their consumption pattern and how they do relative to commitments? So we're going to get good data in the next few quarters.

And in the meantime, we get all these interim data points that we see to see how we're doing. So -- and we can adjust depending how things are going and then make modifications along the way. So we'll get some indications along the way. But you're right.

I look forward to the day a couple of years from now where our entire customer base on this, we've worked through all these and we have great data about how our customers consume. But before then, I think we'll still have enough to really -- to understand our business.

Ittai Kidron -- Oppenheimer & Co. Inc. -- Analyst

Got it. I guess I'm trying to tie what you said now to Lew's first point that you mentioned that the focus is on the customer and reduce all friction and do whatever it is that the customer needs to try, buy and grow. If I remember, that was a commentary. I'm trying to think, can you give us some color as to when do you think you're going to be more firm on your demand from the customer? And what I mean by that, it sounds like you're letting them blow through their capacity commitments, and we've unnecessarily going right away to taxing them.

Like at what point do you say, all right, enough is enough. And at this point, move to the left, you'll have to pay this. Or move to the right, you have to pay that? Because I'm just wondering whether over the next 12 months, if you're going to assume a very lax attitude toward customer behavior, again, the true upside here of the long-term expansion of bandwidth in your platform, it's going to take time for that to show in dollars.

Lew Cirne -- Chief Executive Officer

OK. I'll take that one, Ittai. So in this new model, when a customer exceeds their consumption, they automatically go into an auto billing situation. So that there is no firm conversation required as part of their agreement with us.

So if they exceed their annual consumption in month six, on month seven, they receive an invoice. I mean we recognize that revenue. So -- and this is why we love that. It's customer-friendly, like the customer will observe how those bills grow.

And then they may say, hey, that New Relic spend is growing, but I'm seeing more value. Now is a good time to reach out to New Relic and ask, if we commit more today, will we get better unit economics. And so we just think that's a far more healthy relationship than having our -- in our model today. And I think this is generally model -- the model is, broadly in our space, is having a rep chase the customer to try to force them to work on the vendor's time frame.

This is a natural win-win. We're going to obsess on delivering the value so the customer grows their consumption, and that will, at some point, turn into some level of overage. Now it's important to note that that overage is not punitive, right? It's not like when you go over, there's this like heavy fee that makes them feel regretful in the relationship or in not having overcommitted to the relationship, and that is different from what others have done in this market. So I hope that helps you better understand the situation.

There is no need for a nasty conversation or a difficult conversation.

Ittai Kidron -- Oppenheimer & Co. Inc. -- Analyst

Got it. Maybe, Lew, on that, you talked about the two large customers that decided to start with a lower commitment. Can you tell me how common that behavior was with $100,000 customers or even smaller customers? Was that something that was common or rare?

Lew Cirne -- Chief Executive Officer

I'm going to have Mark answer that one.

Mark Sachleben -- Chief Financial Officer

I think it's specific, customer-specific and situation-specific. But we have, I think, most customers are willing to come in at the level of their current spend. In normal course, that's an easy budget process. They go, we were spending that this year -- last year.

Let's spend that again. So that's -- if you look at the mode, that's probably it. But if you look at the mean, it's -- I mean the mean was flat, I guess, we gave that number. But you have some customers who are just a little concerned, budgets are tight, and they say, it's easier to spend a little bit, commit a little bit less.

And I'll look good because I saved some money. Now at the end of 12 months, did they actually save money? Maybe, maybe not. Our goal is to hopefully, we've convinced them of the value, and they've seen the value, and they end up spending more, but that's up to them. So it's hard to say.

And I think we see that behavior throughout the stack of customers. It's not only the large ones. We do have some small customers. We have small -- some customers who said, I'm going to make zero commitment, I'm going to go to 100% pay-as-you-go.

And the economics, the unit economics, are much worse for the customer. But they're more comfortable doing that.

Ittai Kidron -- Oppenheimer & Co. Inc. -- Analyst

All right. Very good. Good luck, guys. Thanks.

Operator

The next question comes from Yun Kim of Loop Capital Markets. Please go ahead.

Yun Kim -- Loop Capital Markets -- Analyst

Thank you. So obviously, there's a lot of focus on this new pricing model and the impact on the models that we all have to maintain and track your transition. But the pricing change was done to attract new customers and more successfully ramp with existing customers. So can you just talk about any change you made in your go-to-market plans to market this new pricing model to the right customers and also to the right people at those target customers? And for instance, are you targeting the individual developers and departments? Or are you also, at the same time, targeting the C-level people, including CIOs with this new pricing model? Just kind of curious on what the plan is in the near term, at least? And what are you learning out there as you market this new pricing model?

Lew Cirne -- Chief Executive Officer

Bill, I'd like you to speak to this, please.

Bill Staples -- President and Chief Product Officer

Yeah. The short answer is we're targeting both. For our existing customer base, as renewals come up, we are focused on converting them to this new consumption, this new pricing model and consumption. And as Mark and Lew talked about, that's going well so far.

We're also targeting individual developers and new customers, and that starts with our new perpetual free tier that we introduced last July. This is a really generous offer because we believe that the power of observability should be available to every developer. And it's a generous free tier, gives 100 gigabytes of ingest and a full stack user for free. And we -- as we reported last quarter, we've seen incredible engagement with that free offer.

I believe we said last quarter, 10x the number of customers who previously were in that $1,000, $2,000 spend are now engaging in that free tier. This quarter as well, we saw continued demand for that free tier offer and increased conversion to that pay-as-you-go model by those small individual developer and small business customers. In fact, we just passed our 1,000th newly converted pay-as-you-go customer just this week. So we're excited by that emerging opportunity to acquire new customers and really build developer mind share around our platform.

Yun Kim -- Loop Capital Markets -- Analyst

Great. So in those renewal situations, obviously, there is a new pricing changes and structural changes in the deal. Are you able to bring in the C-level executives to kind of introduce exactly what you guys are doing and try to get maybe a bigger wallet share of other projects that's ongoing or being planned? Just kind of trying to understand exactly what the initial responses from those customers are when you're renewing with existing customers and whether or not you're able to communicate this new pricing model effectively to the C-level people.

Lew Cirne -- Chief Executive Officer

Yeah, I'll take that one. Sorry, as you can imagine, as the spend level increases, so does the seniority of the people we engage with. And we've got a good history of working at the senior level to drive strategic relationships. And in fact, if you look at some of the results from the quarter, including deferred revenue, you can see we did quite well in some large deals that drove some of those numbers.

I'd say that what they like about this new model is, first of all, the predictability of the spend, the tool consolidation value proposition. CTOs love that they have a single place for all the telemetry data, and it's cost-effective to have all their telemetry data in one place. They love standardizing on one per user product, full stack observability that combines the capabilities of many, many products often from many vendors. So it's a great story that resonates with CTOs.

But what we like about the model we're embracing is we can grow our way there naturally. And so that -- such that we can enter that account at a relatively low spend, grow naturally with them. And then at the appropriate time, have that executive conversation, which is a far easier one to have than when you're just coming in directly into the top without that history and context.

Yun Kim -- Loop Capital Markets -- Analyst

Great. So do you expect a ramp in perhaps your professional services headcount to help your customers ramp and increase usage?

Lew Cirne -- Chief Executive Officer

We are organizing around a chief customer officer organization, whose primary responsibility is to drive growth in consumption of the platform in our customer base. And so one of the things I continue to say internally is the real account management and selling happens the day after the customer ARR commitment happens. And so we're going to have a dedicated organization that obsesses on that. And so the line is blurred between what is called presales and post sales.

It's just continuing customer education to help them understand the value of consuming more, adding more users, adding more data.

Yun Kim -- Loop Capital Markets -- Analyst

OK. Great. Thank you so much.

Operator

The next question is from Michael Turits with KeyBanc Capital Markets. Please go ahead.

Michael Turits -- KeyBanc Capital Markets -- Analyst

Hey, guys. Thanks. One for Mark, one for Lew. Mark, the two large customers that are reducing their commitment, how much visibility do you have into why? In the past, and we've -- so this has happened, it's included a sense of then simply having overcommitted in terms of how much they just thought they'd use their product.

So what do we really know about why they're reducing here?

Mark Sachleben -- Chief Financial Officer

It's -- in every one of these, we talked about having that occur in Q3. We are expecting that to carry in Q4. Everyone is a little bit unique. But it generally comes down to, I think, a, more often not just uncertainty around their budgeting process or internal budgeting issues that they have as opposed to anything else.

And it's just -- it's a lot easier to get smaller numbers committed upfront. And if they're asked to reduce a budget, you do that and then you end up -- you say, either I'll do something, or I'll go back for forgiveness later on because inevitably budgets would free up or somewhere along the line. So I think that's a big part of it is just the perception, depending on what goals they have around how they procure and things. I think that's a big part of it.

And then just the notion that people feel like, wow, I'm going to get more efficient. And they want to get more efficient. And they think, you know what, we're going to be able to be more efficient with this. And I think some people go into the year thinking that's the case.

And sometimes it is. If we're doing our job well, really making sure they understand the value, selling the new use cases, making sure they understand all the capabilities of our platform, we're confident that, you know what, they're going to increase their consumption, and they're going to realize, I want to get efficiencies by using more New Relic and I'll get efficiencies across other parts of the organization because I'm using more New Relic. Not that they're going to ultimately consume less New Relic.

Michael Turits -- KeyBanc Capital Markets -- Analyst

Did you quantify for us the dollar impact of those two reductions?

Mark Sachleben -- Chief Financial Officer

We said -- I said low eight figures ARR.

Michael Turits -- KeyBanc Capital Markets -- Analyst

OK. And then for Lew, something that's not about pricing or contracts. Some of your competitors have broadened into areas, including further left in development cycle, workflow, security. You've got -- Lew, you've got a lot on your plate right now, but are you thinking that you'll be rolling out those kinds of answers, some types of ancillary services and expanding the offering? Or are you really focused on being a very pure-play observability company right now?

Lew Cirne -- Chief Executive Officer

I'm going to let Bill speak to that because he's been doing a lot of internal communications of our three-year strategy. We're very excited about it. But Bill, why don't you answer that question.

Bill Staples -- President and Chief Product Officer

You bet, yeah. I get asked that question all the time, as you can imagine. And if there's one thing I've learned after 25 years in this business, if you chase competitors' tail lights, you never win. We're really focused on executing our strategy because we believe it holds more value for customers and investors over the long haul.

And we believe we're in the early days of observability. We're focused on empowering every engineer on the planet with data-driven engineering practices that help them plan, build, deploy and operate their systems faster and with higher quality of service. We have the world's most powerful telemetry data platform. It's capable of ingesting petabytes of data with incredible economics, providing blazing performance in analytics and intelligence services that correlate and action data with very low upfront investment.

We have a single user experience that spans everything from infra, to APM, to synthetics, to logs, and we deliver it with a radically simple pricing model that's easy to understand, plan for and manage, and gives customers the flexibility to commit to only what they want and pay for only what they use. That's the strategy. And the benefits of our technology and approach, we're confident, are going to become clear every quarter ahead. So we're really focused on driving innovation that helps our customers grow their usage, that's expressed through more data in the platform and more engagement by more users over time.

Operator

The next question is from Rustam Kanga of JMP Securities. Please go ahead.

Rustam Kanga -- JMP Securities -- Analyst

Hi. Thanks for taking the question. So we appreciate the disclosure of the data ingest growth in the investor letter. And in regards to the margin pressure stemming from the AWS data center transition, is there a certain point of inflection where that would begin to be offset by improved unit economics kind of similar to the data overages with your own customer base, as Lew alluded to earlier?

Mark Sachleben -- Chief Financial Officer

So the biggest factor weighing on our gross margin is the migration fact that we're double paying right now. As we migrate to the cloud, we're paying for that full cloud spend because we have a data center in the cloud that we're paying for and we have a data center, a number of them around -- in the country that we're paying for. And so the biggest positive impact on our gross margins will be once we roll off the expenses associated with those retiring internal data centers. In terms of the overall economics, there are a lot of things we can do to improve the processing cost of our data and our data costs.

And we continue to do those. Right now, we're focused on enhancing the customer experience and more focused on getting data in than the specific -- so if it comes to spending $1 to attract more data or optimize our data center, we'll probably err on the side of attracting more data right now. But over the next couple of years, we're going to continue to improve that and do those efficiency improvements. We look at it over the long term.

We ingest a massive amount of data now, two years, five years from now, we're going to laugh at how much we're doing now because it's going to be such a big number. And at that point, we want to make sure that the unit economics at that point are better than they are today. And so we're confident we can get there. But in the near term, we're going to invest where we think it's most appropriate, and that's to grow the overall data we get in.

Rustam Kanga -- JMP Securities -- Analyst

That's helpful. Much appreciated.

Operator

The next question is from Sterling Auty of J.P. Morgan. Please go ahead.

Sterling Auty -- J.P. Morgan -- Analyst

Yeah. Thanks. Hi, guys. One just real quick question.

If you look at the pace of migration to the new pricing platform, how would you characterize that pace relative to what you were thinking even a quarter ago? Is it on track, faster or slower?

Lew Cirne -- Chief Executive Officer

Mark, why don't you take that one?

Mark Sachleben -- Chief Financial Officer

Yeah. Yeah. I think it's -- I think we started a little slower. When I look back at September, when we just introduced it, and last quarter, and I think we're getting -- we're accelerating.

So that we're -- by the end of this quarter, we'll be about on track and then I feel good about our ability to even exceed perhaps our initial impressions of -- and we're getting better at selling it. The customers are now understanding it. And so I think that's helping. And we're even seeing cases where people have signed multiyear deals.

And initially, we had thought, you know what, we're going to have to wait for three years because they just signed a three-year deal. And when we start talking to the customer, we're realizing, wow, we could potentially change out that deal, better for both parties to get on a different arrangement. And perhaps, we'll be able to migrate that customer over before three years. So I would say it started a little slower, but pretty much on track now.

And longer term, I think we're -- we'll be able to exceed initial thoughts.

Sterling Auty -- J.P. Morgan -- Analyst

Got it. Thank you.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Lew Cirne for any closing remarks.

Lew Cirne -- Chief Executive Officer

Well, we thank you all for participating in this quarter's call. We look forward to seeing many of you in the upcoming conferences and reconvening next quarter. Thank you all.

Operator

[Operator signoff]

Duration: 62 minutes

Call participants:

Peter Goldmacher -- Vice President, Investor Relations

Lew Cirne -- Chief Executive Officer

Kingsley Crane -- Berenberg -- Analyst

Bill Staples -- President and Chief Product Officer

Sanjit Singh -- Morgan Stanley -- Analyst

Mark Sachleben -- Chief Financial Officer

Jennifer Lowe -- UBS -- Analyst

Rishi Jaluria -- D.A. Davidson -- Analyst

Robert Majek -- Raymond James -- Analyst

Ittai Kidron -- Oppenheimer & Co. Inc. -- Analyst

Yun Kim -- Loop Capital Markets -- Analyst

Michael Turits -- KeyBanc Capital Markets -- Analyst

Rustam Kanga -- JMP Securities -- Analyst

Sterling Auty -- J.P. Morgan -- Analyst

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