Following better-than-expected fiscal third-quarter earnings results, New Relic's (NEWR +0.00%) management recently warned investors of temporary headwinds over the next few quarters because of the company's transition to a new pricing model. As a result, the tech company's stock price plunged by 16.25% late last week.
Despite the mix of news, investors shouldn't consider buying the dip, as the performance tracking software company's challenges may expand beyond the short term.
From a subscription to a consumption pricing model
With the release of its new cloud platform New Relic One last year, New Relic has become an observability specialist. That means it provides developers and engineers with an integrated and complete look at an enterprise's operational data which helps it anticipate issues and improve the performance of computing infrastructures and applications.
At the end of 2020, the company announced a transition from a subscription to a consumption pricing model. This new model allows enterprises to commit to some minimum volume for a better deal. And extra consumption won't be overcharged compared to base pricing.
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That change offers customers more flexibility. According to management, it will also shift New Relic's focus. Instead of paying extra attention to customers only when signing or renewing subscriptions, the company will be looking to constantly improve its offerings and relationships with customers to encourage more consumption.
However, with that new pricing model, a negative development started to materialize during the last quarter. Some customers preferred to lower their upfront commitments relative to their expected consumption to take advantage of the customer-friendly pricing when exceeding committed volumes. That means New Relic will recognize less revenue over the short term, with potential upside as customers' consumption increases.
As a result, management expects revenue to grow by only 4% year over year to a range of $166 million to $167 million during the current fiscal quarter ending on March 31.
Competitive challenges
During the earnings call, CEO Lew Cirne expressed confidence in seeing customers increasing their consumption above their lower-than-expected committed volumes over time. However, customers' lower commitments may be an early sign of long-term competitive challenges that go beyond pricing decisions.
New Relic has been generating lower -- and declining -- revenue growth over the last several quarters compared to many competitors, such as Dynatrace (DT +0.97%), Datadog (DDOG 2.08%), and Sumo Logic (SUMO +0.00%). Indeed, these observability players have been enjoying strong results as they have been enhancing their cloud platforms with new features and cybersecurity capabilities.
NEWR Revenue (Quarterly YoY Growth) data by YCharts
Besides, with its subscription-based business that represented 93% of revenue during the last quarter, Dynatrace posted better-than-expected quarterly earnings results and strong guidance. That shows cloud-based observability platforms can thrive with subscription-based pricing, which was not the case with New Relic.
Also, New Relic's recent customer-friendly decisions suggest the company lacks pricing power. In addition to the absence of extra fees for overconsumption in its new pricing structure, the company released in July a generous free tier to attract new small customers.
Finally, New Relic's efforts to develop and market its observability platform contribute to diminishing operating margin. During the last quarter, operating losses under generally accepted accounting principles (GAAP) reached $54 million, compared to a loss of $27 million in the prior-year quarter.
Granted, the company is facing temporary extra costs with the move of its computing infrastructure to Amazon Web Services (AWS), which diminishes its gross margin. But more troubling, operating leverage isn't materializing despite increasing scale, as New Relic must keep investing a large -- and growing -- part of its revenue in research and development and sales and marketing expenses to update its offering and improve its performance.
NEWR Gross Profit Margin (Quarterly) data by YCharts
Looking forward
Given management's optimism beyond the short term with forecast increased consumption from customers, the 16.25% drop in the company's stock price following the release of the quarterly results looks like an opportunity to buy the dip.
But the stock is still trading at a high price-to-sales ratio of 6.4, based on the midpoint of full-year revenue guidance. That suggests the market is anticipating revenue growth to accelerate through 2021, which may not happen given the company's recent underwhelming performance in an increasingly competitive environment.
Thus, investors should wait for growing consumption from customers to materialize beyond the next couple of quarters before considering buying the tech stock at that valuation.
This article represents the opinion of the writer, who may disagree with the "official" recommendation position of a Motley Fool premium advisory service. We're motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
