New Relic (NYSE:NEWR) released mixed fiscal third-quarter results on Tuesday. Revenue exceeded guidance, but losses were wider than anticipated. In addition, management reduced its projections for fiscal 2020 cash from operations (cash generated by operating activities) and free cash flow (cash left after operating expenses and capital expenditures) for the third consecutive time despite higher forecasted revenue.

Should investors view this update as a short-term distraction or should they fear the cloud-based software specialist won't reach its long-term goals?

No economies of scale yet

Over the last several years, New Relic has developed software tools for companies to monitor their on-premises and cloud applications and computing infrastructures. And in May, it released its New Relic One platform that regroups all these functionalities into one unique and consistent environment, which simplifies the prevention and troubleshooting of computing issues. In addition, New Relic One's programmability -- a differentiating feature in the competitive monitoring market -- allows customers to build applications based on the platform.

Person using a futuristic head up display interface screen with data and key performance indicators for data monitoring and analytics.

Image source: Getty Images.

Thus, the company's fiscal third-quarter revenue of $153 million, up 23% year over year, above the guidance range of $148 million to $150 million, seems encouraging. But despite the larger revenue base, losses from operations (using generally accepted accounting principles (GAAP)) increased to $24.2 million compared to a loss of $8.5 million a year ago.

Management explained during the earnings call that this negative development was due to strong hiring during that quarter to boost the company's revenue growth. It also discussed how it would keep on prioritizing revenue growth over profitability. But this is not a new strategy. And yet management decreased its cash from operations and free cash flow guidance for the third time this fiscal year, which indicates the company needs to ramp up its expense projections to better coincide with its revenue growth.

Guidance Date Forecasted 2020 Revenue  Forecasted 2020 Cash From Operations  Forecasted 2020 Free Cash Flow
Q4 2019 $600 million-$607 million    $115 million-$125 million    $55 million-$65 million    
Q1 2020 $600 million-$607 million   $100 million-$110 million   $40 million-$50 million  
Q2 2020 $588 million-$593 million $90 million-$100 million  $30 million-$35 million  
Q3 2020 $594 million-$596 million $67 million-$72 million  $3 million-$8 million  

Data source: New Relic.

Should investors worry?

These weak results seem worrying since they take place shortly after the company released its New Relic One platform, which was touted as something to help drive company performance over the next several years. Instead, it seems to be generating higher-than-expected expenses and the dollar-based net expansion rate reveals underwhelming execution.

The dollar-based net expansion rate, which shows the evolution of spending from existing customers, decreased from 112% a year ago to 109%. Since it remains above 100%, it suggests existing customers are consuming more New Relic products, which seems positive. But the rate fell year over year, despite the boost the New Relic One platform should represent. At the same time, competitors like Datadog and Elastic N.V. are generating much higher dollar-based net expansion rates -- above 130%.

Management explained that this disappointing outcome was related to reduced spending from a few customers, including one large one. It expects the indicator to improve next quarter. But it still appears to be an indication that the New Relic One platform doesn't seem to lead to better performance with existing customers, which should worry investors. 

Looking forward

Despite these initial challenges with its New Relic One platform, management indicated the company's long-term goals highlighted during its Investor Day presentation in mid-December remained valid. It still expects to grow revenue from $571.9 million over the last 12 months to $1 billion in fiscal 2023, and it still plans to improve non-GAAP operating margin to a range of 10% to 12%.

Investors should worry about the extra uncertainties related to the latest quarterly results, though. Even if the company delivers according to management's long-term expectations, the valuation of this growth stock right now remains rich.

Based on the midpoint of medium-term guidance, the market values New Relic at 37.8 times its forecasted 2023 non-GAAP operating income. And that doesn't take into account that non-GAAP operating income ignores some important costs (such as share-based compensation), which amounted to $25.9 million during the last quarter (16.9% of revenue).

Given the significant uncertainties and the high valuation of New Relic at the moment, investors should probably stay on the sidelines.