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Edited Transcript of NEWR earnings conference call or presentation 6-Nov-18 10:00pm GMT

Q2 2019 New Relic Inc Earnings Call

San Francisco Dec 27, 2018 (Thomson StreetEvents) -- Edited Transcript of New Relic Inc earnings conference call or presentation Tuesday, November 6, 2018 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Lewis Cirne

New Relic, Inc. - Founder, CEO & Director

* Mark Sachleben

New Relic, Inc. - CFO & Corporate Secretary

* Tony Righetti

New Relic, Inc. - IR

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Conference Call Participants

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* Erik Loren Suppiger

JMP Securities LLC, Research Division - MD & Senior Research Analyst

* Fatima Aslam Boolani

UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software

* Gray Wilson Powell

Deutsche Bank AG, Research Division - Research Analyst

* James Derrick Wood

Cowen and Company, LLC, Research Division - MD & Senior Software Analyst

* Jon Philip Andrews

Needham & Company, LLC, Research Division - Senior Analyst

* Jung Ho Pak

BMO Capital Markets Equity Research - Senior Associate

* Keith Weiss

Morgan Stanley, Research Division - Equity Analyst

* Rishi Nitya Jaluria

D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst

* Robert S. Majek

Raymond James & Associates, Inc., Research Division - Senior Research Associate

* Steven Richard Koenig

Wedbush Securities Inc., Research Division - SVP of Equity Research

* Ugam Kamat

JP Morgan Chase & Co, Research Division - Analyst

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Presentation

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Operator [1]

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Good afternoon. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the New Relic Second Quarter Fiscal 2019 Earnings Conference Call. (Operator Instructions)

Mr. Tony Righetti of Investor Relations, you may begin your conference.

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Tony Righetti, New Relic, Inc. - IR [2]

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Thank you, operator. Good afternoon, and welcome to New Relic's Second Quarter Fiscal Year 2019 Earnings Conference Call. Joining me today are New Relic's Founder and CEO, Lew Cirne; and CFO, Mark Sachleben.

Today's conference call contains forward-looking statements. Any statement that refers to expectations, projections or other characterizations of future events, including financial projections and future market conditions is a forward-looking statement. Actual results may differ materially from those expressed in these forward-looking statements. For more information about factors that may cause actual results to differ materially from forward-looking statements, please refer to our earnings release issued today as well as the risks described in our most recent Form 10-Q and subsequent filings with the SEC.

Our commentary today will include non-GAAP financial measures. We believe that the use of these non-GAAP financial measures provides an additional tool for investors to use in evaluating ongoing operational, operating results and trends, but note that these measures should not be considered in isolation from or as a substitute for financial information prepared in accordance with GAAP. Reconciliations between GAAP and non-GAAP metrics for our reported results can be found in our earnings release issued today.

At times, we may offer incremental metrics to provide greater insight into our business or results. This additional detail may be onetime in nature and we may or may not provide an update in the future on these metrics. I encourage you to visit the Investor Relations section of New Relic's website to access our earnings release issued today, a presentation that accompanies our earnings release, periodic SEC reports, a webcast replay of today's call or to learn more about New Relic.

With that, let me turn the call over to Lew.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [3]

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Thanks, Tony, and good afternoon to everyone joining today's call to review New Relic's Second Quarter Fiscal 2019 Financial Results.

I'm pleased to report second quarter results that exceeded our guidance ranges with revenue of $114.9 million, an increase of 36% from the prior year, and non-GAAP operating income of $9.7 million, an improvement of over 1,200 basis points year-over-year. These top and bottom line results, along with another quarter of steady sequential growth in enterprise ARR and accounts paying more than $100,000 are outcomes of the investments we made to further penetrate enterprise and mid-market customer accounts around the world.

Overall, we continue to build on our momentum from last quarter throughout Q2 as we've maintained a relentless focus on becoming the dominant DevOps platform for monitoring, managing and operating digital systems. Sales execution during the quarter was outstanding and underscored by record non-APM bookings, which totaled more than 40% of new ARR. Once again, New Relic Insights and New Relic Infrastructure led the contributions with at least 10% from each product. We feel this demonstrate the advantage of being application-centric 100% multitenant Software-as-a-Service platform.

Let me explain. Being application-centric places us at the most strategic layer of the digital stack, the closest to the customer experience. Visibility into this complex layer is paramount for our customers looking to drive topline growth for their digital investments. We do this better at scale than anyone in the market.

Now what's really interesting today is that our target customers are rapidly adopting modern technologies at the infrastructure layer: Microservices, serverless computing, containers and cloud computing, all of these technologies in service of running their application code. And it's critical that they have complete visibility all the way from the mobile application or browser through the application running on cloud and down to the underlying infrastructure. New Relic uniquely connects all of these data points into a single platform. In essence, our non-APM products work in concert with our APM product to provide a valuable, holistic view of our customer's entire environment.

From a go-to-market perspective, we continue to believe our greatest opportunity lies in activating the segment of the market that is not currently using a monitoring platform, which is -- as we covered on previous calls, is the majority of software in production today. Our investments in sales capacity are heavily skewed towards the activation and expansion of enterprises and driving ubiquity amongst developers, operation professionals and business executives responsible for enterprise-side digital transformations.

We believe the return on incremental investments made in our customer solutions team over the past year have had more than favorable impact and is reflected in the highest Q2 dollar net expansion rate since fiscal '13. When you factor in the significant ARR growth of our install base during the same period, 124% dollar net expansion rate at our scale is quite an achievement, and it underscores how valuable our customers find our offering.

At a high level, our customer solutions teams have been having success by focusing on 3 common yet critical technology initiatives that every company encounters today: the first, cloud adoption, to enable teams to have more autonomy in scaling their infrastructure; second, DevOps to offer teams greater agility to deliver great products to market; and third, delivering a flawless digital customer experience to build their digital brand and impact their bottom line.

By aligning our go-to-market efforts with these foundational components to digital transformation, cloud, DevOps and digital customer experience, we are activating the nonconsumption market by reaching new buyers. And because we're attaching ourselves to their most strategic growth initiatives, we're driving larger deals with broader product adoption, which is illustrated by the quarter-end totals for enterprise ARR, now at 56% of our business as well as in accounts paying more than $100,000 per year, which grew at 34% year-over-year and now stands at 786 accounts.

One of our enterprise customers that is consistently modernizing to stay ahead of the media industry is USA Today Network, which is having their digital moment of truth tonight, election night. They joined me on stage at our FutureStack event in San Francisco and we discussed how their team had prepared for peak traffic moments like tonight, in order to share second by second updates with their readers as election results come in.

Inside the USA Today Network war room, New Relic dashboards help their team monitor their customers' experience on mobile, browser and video-on-demand. On election night and every day, USA Today Network is deeply focused on the integration of technology and business performance metrics. They have turned to New Relic's rich data to provide insight throughout their business, monitoring everything from modern technologies like Kubernetes, to getting visibility into their advertisers' performance on over 100 media properties. USA Today Network differentiates itself by delivering superior content and a modern digital experience, and New Relic underpins the technology innovation at the core of this strategic effort.

An ongoing customer journey such as this is a natural outcome of product fit, sales capacity and market demand alignment. In order to capture more of these opportunities, we have set an aggressive hiring plan for fiscal '19 and added a record 235 team members in the first half of this year. The bulk of these hires and those forecasted for the second half of the year are designated for areas that have shown the largest returns, namely customer solutions and sales reps as well as key product development hires. We continue to work hard to bring in world-class talent throughout the organization.

In closing, we are excited about the continued prospects of growth for our platform. We see no end to the trend of software being used more and more often to improve business outcomes, from driving revenue to increasing productivity, to building brand value. Our multitenant SaaS model has the flexibility required to provide our customers meaningful value to these continuously evolving modern digital applications.

This drives an opportunity for us that is much larger than Application Performance Management as we help our customers understand and connect data points from across their entire environment. In this scenario, our application-centric strategy positions us favorably within the technology value chain to continue moving upmarket and capturing an outsized share of the growing multibillion-dollar market for monitoring, managing and operating digital systems.

I will now turn the call over to Mark to provide more color on the financials.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [4]

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Thanks, Lew. During today's call, fiscal year 2019 financial results are presented under ASC 606. A reconciliation table to prior year's results under ASC 605 is available in the earnings press release accompanying this call.

Now turning to the financials. Revenue was $114.9 million for the second quarter, up 36% year-over-year. We ended Q2 with 786 paid business accounts paying more than $100,000 per year, up 34% compared to a year ago. This growth represents both new accounts landed as well as installed base expansions derived from increased usage, expanded application coverage and the cross-sell of additional products.

Our dollar-based net expansion rate in Q2 was 124%, which is a slight uptick from the year-ago period, an encouraging result given the increase in our installed base over the same period. At the end of Q2, enterprise business was approximately 56% of ARR, up from around 51% as of the same period last year. Our total paid business accounts remain over 17,000, relatively flat again sequentially.

This metric is expected to continue to fluctuate moderately in the near term as we focus resources toward opportunities upmarket within our install base and optimize for economical growth at the low end of the market. That said, beginning in fiscal year '20, we will only provide fiscal year-end updates to this metric.

Turning to our geographic split. U.S. revenue of $78.3 million for the quarter was up 35% year-over-year, while non-U. S. revenue for the quarter grew to $36.6 million, up 37% year-over-year. Non-U. S. revenue represented 32% of revenue in the quarter.

Before moving to profit and loss items, I would like to point out that, unless otherwise specified, all of the expense and profitability metrics we'll be discussing going forward are non-GAAP. A full reconciliation between historical GAAP and non-GAAP metrics can be found in our earnings release issued today.

Gross margin was 85%. For the full fiscal year, we expect gross margin to decline modestly to around 84%, driven by expanding capacity in our U.S. data center and our new European region. With regard to operating expenses, sales and marketing costs were $54.9 million compared to $47.2 million in the same quarter last year. R&D expenses were $19.8 million compared to $14.8 million in the same quarter last year. G&A costs were $13.4 million compared to $11.8 million in the same quarter last year. Overall, we had another strong hiring quarter. And as Lew stated earlier, we expect hiring in Q3 and Q4 to be robust as well.

Operating income was $9.7 million or 8% of revenue compared to an operating loss of $3.5 million or negative 4% of revenue in the same quarter last year. The outperformance to our second quarter expectations was primarily the result of revenue upside, nonlinear start dates of new hires and a larger portion of expenses being capitalized than anticipated. Overall, our net income attributable to New Relic per diluted share was $0.20 compared to a net loss per basic share of $0.06 in the same quarter last year.

Turning to our balance sheet. We ended the second quarter with approximately $731 million of cash, cash equivalents and short-term investments, up from last quarter's $721 million total.

Elsewhere on the balance sheet, our total deferred revenue ended the quarter at $191 million, up 55% year-over-year and 4% quarter-over-quarter, which compared favorably to our guidance range by approximately $14 million. One contributing factor to our deferred revenue result was a 2-year expansion deal with an existing $1 million ARR paid business account, which included full payment upfront. This deal increased noncurrent deferred revenue by roughly $8 million. As we look into Q3, we anticipate deferred revenue to increase on a percentage basis in the mid-single digits from Q2.

Turning to cash flow. Cash from operations was $7.8 million. Free cash flow, defined as cash from operations minus capital expenditures and capitalized software, was a $600,000 outflow. For all of fiscal year '19, we continue to expect cash from operations to be between $70 million and $80 million and free cash flow to be between $30 million and $40 million. We now expect physical CapEx to be $40 million to $45 million, up from earlier expectations of $35 million to $40 million primarily due to office buildouts related to consolidation of our San Francisco offices and additional data center capacity.

Now I will turn to our outlook for the third quarter and the full fiscal year 2019. For the third fiscal quarter ending December 31, we expect revenue to range from $118.5 million to $120.5 million. We expect non-GAAP operating income of $3.5 million to $4.5 million. This would lead to non-GAAP net income attributable to New Relic per diluted share in the range of $0.12 to $0.13.

For the full fiscal year 2019, we now expect revenue to range from $466.5 million to $469.5 million, an increase from our prior guidance of between $457.5 million to $462.5 million. We expect non-GAAP operating income of $22 million to $24 million, an improvement from our earlier guidance of between $18 million to $22 million.

This would lead to non-GAAP net income attributable to New Relic per diluted share in the range of $0.42 to $0.48, an improvement from prior guidance of between $0.39 to $0.46. As our guidance indicates, we expect headcount and CapEx investments to ramp up in the second half, which will result in full year operating margins at the upper end of the expectations we signaled at the time of our Q3 fiscal '18 earnings call of low to mid-single digits.

And with that, I would like to open the call for questions. Operator, please go ahead.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And your first question comes from the line of Derrick Wood from Cowen and Company.

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James Derrick Wood, Cowen and Company, LLC, Research Division - MD & Senior Software Analyst [2]

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I wanted to ask on the net revenue retention rate. You've seen now 5 quarters of year-over-year improvement on that calculation. What are the drivers behind why this is getting better? Is it really just the mix of enterprise going up? Or is there something within the enterprise that is also trending higher, whether it's renewal rates or upsells, et cetera? Maybe give a little bit more color.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [3]

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Great question, and I do think it's a multifactor -- multiple factors that are driving the improvements that we're delighted to see. First is yes, the enterprise mix is now 56% of our run rate. And of course, as that increases, enterprises have much more demand, and we're just such in the early innings of our enterprise journey within these customers that there's just much more upside in those accounts. And so that helps immensely.

And then what we're also seeing as a secular trend in our market is a desire to standardize on a single platform to see everything. So our enterprise customers are frustrated with having to switch between multiple tools to have a comprehensive view of what's going on in these digital environments. They want to standardize on a single platform, and they love that our platform is application centric. It's easy-to-use. It's Software-as-a-Service. It works well, and so that gives them more confidence to increase their spend, and we think there's great opportunity in front of us.

We're delighted that our average customer spends, what is it, about $26,000 per year, $26,500 per year per account. That's wonderful news and that it's up substantially again this quarter. But just think how much more room that has to run. That's still only a little over $2,000 a month per customer, and we believe we deliver much more value than that to our enterprise customers or potentially. So there's a lot of room to run.

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James Derrick Wood, Cowen and Company, LLC, Research Division - MD & Senior Software Analyst [4]

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Great. And I guess just a follow-up to that. I think that you guys have been focused on adding more technical people or SEs to support quota-carrying reps. I'm curious how much that's impacting deal sizes or sales cycles or overall sales productivity. Is it too early? Or are you starting to see the impact of that?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [5]

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Well, we're seeing enough to know that we're on the right track. And again, it relates to your -- the [previous] answer in that because our customers want to standardize on a single platform to see the entire environment, the more completely they understand the breadth and depth of our platform, the more successful they'll be doing that and the more comfortable they will be stepping up to larger investments. And so that makes -- obviously makes life easier for our quota-carrying reps.

And so -- and that's been the thesis, and what we're seeing so far is that thesis is bearing out into results. And that doesn't mean that we're done with that work. There's more to do there. But our goal is to get our customers to completely understand the full potential of this incredibly sophisticated platform. And when they do, they step up to investing substantial amounts in our platform because it delivers substantial value.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [6]

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Derrick, this is Mark. I'll just jump in on that. Our best customers are our most educated, the ones that know us best. And we believe that and hiring those -- more and more of those technical folks is a great way to help educate our customers.

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Operator [7]

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And your next question comes from the line of Sterling Auty from JPMorgan.

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Ugam Kamat, JP Morgan Chase & Co, Research Division - Analyst [8]

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This is actually Ugam Kamat on for Sterling. So I just wanted to dive deeper into the multiyear deal that you signed with the customer. As you penetrate enterprise and that becomes a larger portion of business, are you seeing more interest from the customers to lock in multiyear? And should we consider this to be like a normal course of business going forward? Or is this just a onetime item?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [9]

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That's more of a onetime item, I would say. What we see is we see customers, and you can see in our enterprise space, our customers are stepping up. They're expanding. But generally speaking, our customers still -- our enterprise customers still pay us annually upfront. Occasionally, we'll take -- we'll get a deal that's multiyear, but that's relatively rare, and we don't necessarily push for that. And I think that's not a direction the market's going generally.

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Ugam Kamat, JP Morgan Chase & Co, Research Division - Analyst [10]

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Okay. And as a follow-up, can you talk about the Japanese joint venture that you announced in your press release? Any impact to financials or any other go-to-market partnership that you have with them?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [11]

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That's -- it's very early days as you can -- we just announced that relatively recently. So we think the impact in the short term is going to be very modest, but we're very excited about that opportunity. We've got a great partner that we're in that joint venture with, and we look at that market as being very attractive.

We have a fair number of customers already in Japan. But we think in order to really penetrate the market, to really penetrate enterprises like we would like to do and like we think we can do, we felt it was best -- we're best served going at it with a partner, and thus, we set up that joint venture. So long-term, we think that -- we have great expectations for that venture, but the short-term impact we think will be very modest.

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Operator [12]

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And your next question comes from the line of Jack Andrews from Needham & Company.

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Jon Philip Andrews, Needham & Company, LLC, Research Division - Senior Analyst [13]

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I was wondering if you can talk about how -- if there's an update in terms of how things are going with your IBM partnership and then maybe just what the potential implications could be to you given IBM's pending acquisition of Red Hat?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [14]

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Sure. So we've been fortunate to partner with IBM for quite some time, and they're also a substantial customer of ours, and I think that's one of the reasons why the partnership has worked so well. They've a deep appreciation of the breadth and depth of our platform and what can do for them because they -- thousands of IBMers use our software to deliver on their digital projects. So the partnership is going well, and we feel like they're going to help us in particular reach certain enterprises that may be more difficult or expensive for us to reach on our own.

We think Red Hat -- the Red Hat acquisition, the interesting thing about that to me -- and I remember talking to Arvind a bit about this -- about his vision of Switzerland of being like this independent or service provider that helps people on their journey to the cloud.

And in a way, we service Switzerland in our particular space, too, in that our customers value the fact that an independent company is providing the visibility and monitoring they need as they run more and more workloads in multicloud environments. They recognize that, in order to be successful with the cloud, they have to measure it, and it makes supreme sense for the measurement to come from an independent party from the platform itself. So if anything, it's just to draw a little bit of a parallel view to that.

We run great in Red Hat environments. Many of our customers run their workloads on Red Hat. So we believe that there's just only more technical synergy as a result of the combination of IBM and Red Hat.

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Jon Philip Andrews, Needham & Company, LLC, Research Division - Senior Analyst [15]

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Great. And then can I also just ask, Lew, what type of interest you're seeing in terms of the New Relic developer program you discussed at FutureStack? I mean, I'm just wondering if there's specifically an appetite for companies who maybe are not currently New Relic customers but they do want to use the same APIs and tools that you're using to develop your own software, whether this could essentially serve as another, I guess, lead generation mechanism for you.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [16]

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Well, the way I think of the New Relic development platform is it really came out of us observing our customers and, frankly, ourselves even. But every customer I visit, particularly enterprise customers, staffs small -- small teams to build internal tools to round out the complete visibility of what they need to see in the production environment. Because particularly in enterprise, every enterprise customer has something unique in how they report or what they do that ultimately requires a bit of custom development.

And we recognize that there is so much in our platform that could accelerate that custom development to help our customers provide that complete solution to see exactly what they need to see, measure exactly how they want to measure it, present it exactly how they want to present it, to evolve from being a tool to being a solution. And so we wanted -- we've begun our journey on making that -- making it possible for DevOps and internal developers at our customers to customize New Relic to become that full solution rather than have to reinvent the entire wheel on how to collect and analyze and present performance data.

So that's the vision developer platform. And while it's early days, it's resonating with our customers, and we believe that it's laying the groundwork for something that we think will result in much healthier and stronger customer relationships, higher value that we're delivering for our customers and, ultimately, better economics in the long run.

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Operator [17]

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And your next question come from the line of Jennifer Lowe from UBS.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [18]

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This is Fatima Boolani on behalf of Jen. Maybe a question for you, Lew, around the non-APM bookings contribution. That continues to be very strong. And I want to better understand if there's specific incentives you're giving the sales organization in the form of quota retirement or additional kickers to really be able to sort of sustain that level of non-APM level contribution. And then I have a follow-up as well if I may.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [19]

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Sure. No, we're not introducing any incentives or spiffs or anything of that nature to incent our customers or our sales reps to drive specific SKUs. This is a pull from the market. What we aren't -- what we are responding to is the market demand to go from a collection of tools to a unified platform. And so often, customers first discover New Relic because of our world-class and leading APM product. But then they recognize, hey, I would love to see other stuff in addition to the application performance and health.

And so it's an easy conversation for our sales reps to have to explain to them the breadth and depth of our platform and for them to -- they may start dipping their toe in the water with a product like Insights, but then they quickly see how powerful that product is and they grow their investment in that product over time. The same can be said for our other products. So it's great because it's organic and it's natural and it's in alignment with where the market demand is.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [20]

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That's very helpful. And Mark, maybe a question for you on the deferred revenue. I appreciate you sort of walking us through the onetime nature of the outperformance on the long-term side. But if I think about the multiquarter effort around user pruning, if you will, the SMB or lower-level customer base, can you help us think about sort of the go-forward inputs into the complexion of deferred revenue as those types of lower economic customers sort of fade out of the model and you increasingly move upmarket and penetrate more and more into the enterprise?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [21]

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Sure. So I mentioned the onetime $8 million benefit that we had this quarter on the multiyear. In general, you go back a few years ago, and you have -- we had a significant SMB base that paid us monthly. And that, over the last few years, that's been changing so that we have our enterprise business is much bigger now. And even the high end of our SMB and commercial business, many of those customers have migrated to paying annually.

So over that period of time, we've seen a drift upward in our -- well, for the first couple years, it was more than drift, but it was a climb upward. But we've seen an upward drift in our duration. At this point, really starting I think probably a year or so ago, we mentioned that most of those impacts had run their course. And at this point, we generally have -- we'll see that -- we'll see durations increase but very slowly as our business mix shifts. But we don't see any real meaningful impacts on deferred because of the duration and the timing of the difference in the SMB versus enterprise customers.

That said, there are -- every quarter, there are puts and takes about early renewals or someone renewing next quarter or co-terms, things like that. We tend to caution around using billings as -- or deferred revenue billings as too big an indicator of underlying -- of the health of our business. It's getting better but there's still a lot of puts and takes in that number. We tend to highlight the ones that are most meaningful each quarter, but we think it'll get better over time. But again, it's still -- there's still some oddities to it every quarter.

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Operator [22]

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And your next question comes from the line of Gray Powell from Deutsche Bank.

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Gray Wilson Powell, Deutsche Bank AG, Research Division - Research Analyst [23]

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So maybe just a couple if I can. Starting off at a high level, how do you feel about the pace of demand as calendar 2019 approaches? And then do you see any changes in the macro environment or cloud migrations or anything at all that can influence growth in either direction?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [24]

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It feels as strong as it has been historically. The demand is there. The demand is rich. Enterprises recognize that, in order to be relevant and to win in their various areas of business, they have to succeed with digital. It's not an option, and it's increasing of their brand. And so that's driving immense demand for cloud computing. It's driving them to adopt DevOps. And it's driving them to invest in digital customer experience.

So those are the 3 themes that we attach ourselves to when we go to our customers and help them succeed in each of those. So that's largely unchanged, and that is healthy, and we feel like we are certainly not constrained by market opportunity for the foreseeable future.

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Gray Wilson Powell, Deutsche Bank AG, Research Division - Research Analyst [25]

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Got it. And then maybe a competitive question. As an APM player that's moving into the infrastructure market, what do you feel is your biggest advantage versus an infrastructure player that's moving into the APM space?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [26]

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Well, we believe that the whole purpose of infrastructure is to run applications. You don't buy a computer unless you want to run software on it. And we believe the hardest, most complex thing of the production environment is the software, especially if it's custom software. The thing that changes most often in the production environment is the software. In fact, as I just stated earlier, businesses are competing on how effective they succeed on digital. And in order to succeed on digital, you actually have to change software as rapidly as possible.

Like I talked about USA Today Network on election night. They spoke on stage a year ago about how on the election night 2 years ago, they were literally changing production in real time as the election results were pouring in, in order to respond to what they are seeing in real-time, and that's what helped them deliver a flawless election night 2 years ago for their customer experience.

And so if you think about it, you're not changing your infrastructure at that rate, right. So infrastructure visibility is super important, but we believe the harder, more important problem to solve is the application. And so we've got a clear market leadership position in there. It's where the most business value is. It's where the most complexity is. And then we round it out with the relatively easier problem to solve of watching all the various pieces of infrastructure that throw off some data.

And so it's not to be too dismissive of the technical challenge of monitoring infrastructure. We're investing a lot in it. But we believe it's -- we're kind of working downhill from a -- and whereas a company or technology that is infrastructure-centric, moves the application, they're going uphill.

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Operator [27]

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And your next question comes from the line of Rishi Jaluria from D.A. Davidson.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [28]

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I guess, let me start, Lew, as you talk about your value with APM and infrastructure and all the different products that you've expanded to, you've talked about how New Relic's value prop is kind of having everything all together on one common platform.

Let me ask about log management. Because that's kind of, to me, another area that's tangential to what you're doing. You're partnering now with the likes of Splunk and Sumo and whatnot on that. But why not have a log management product of your own if that value prop kind of sticks out in having it on one platform versus partnering? And then I have a follow-up for Mark.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [29]

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Sure. So what we've done to-date is prioritize our product road map on what we feel like have been the most important problems to solve for our customers that leverage our strengths and capabilities and then partner in places where there are complementary sources of data that can further round out the visibility story. And of course, logging -- log messages are a complementary source of data that we believe support the primary source, which is what's going on in the applications. So we believe we collect the primary data, and then we augment it with some secondary data that come from log management solutions, and we partner with many, many log companies.

So that's where we stand today. We're continually asking our customers where they'd like us to go next. We recognize there are many interesting adjacencies, and it's just a little too early to say which adjacency we'll pursue next.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [30]

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Okay, great. Mark, more of a housekeeping question. But you saw a pretty big benefit from 606 this quarter, especially relative to last quarter, I think, about 3% on the operating margin side. Just how should we be thinking about what sort of benefit you're getting from 606 for the rest of the year until we head into FY '20, and hopefully, it doesn't matter anymore then.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [31]

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I'm trying to think what we've said. Historically, I think we talked about coming to the year, we talked about it being a couple million dollars a quarter. And I think that's probably going to be fairly consistent throughout the end of the year. The big benefit for us is on the, actually, on the commissions -- sales commissions, the fact that we now capitalize them. And so sales commissions tend to be a little bit larger in the third and fourth quarters, particularly with the enterprise focus we have where that -- those quarters tend to be relatively strong.

So we'll have a slight uptick, I would say, in the 606 benefits as we get into Q3 and Q4. But I don't think it's going to be materially different than it's been in the first half of the year.

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Operator [32]

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Your next question comes from the line of Sanjit Singh from Morgan Stanley.

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Keith Weiss, Morgan Stanley, Research Division - Equity Analyst [33]

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This is actually Keith Weiss sitting in for Sanjit. Given -- even given Mark's warning not to look too closely at billings, when we look at current billings and adjust for like long-term deferreds, we still see your business doing extraordinarily well and, if anything, perhaps accelerating from sort of what we saw over the past couple quarters. I want to ask 2 questions along that line.

One, is there anything kind of turning on in the business, anything that you guys could point to that's materially getting better that could be leading to that acceleration or is at least sustaining really good growth at scale?

And then two, more broadly on the competitive environment, there was a lot of discussion over the past quarter particularly around the IPO of Elastic about a more competitive environment out there for you guys in the overall APM space. But what are you seeing in reality? What's kind of like the view on the ground? Is the competitive environment really changing very much for you guys?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [34]

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Well, the first question, Keith -- it's great to speak with you again -- is we'd say what's really kind of cranking for us or showing a lot of strength that is turning into business results we're very proud of is, in particular, the enterprise capacity. You recall when we went public, that was very early days. We had a small number of enterprise reps, and we had to build an enterprise brand, enterprise sales motion, the capability to support them and grow those accounts. And we're never done on that journey.

But I think it's pretty clear, especially with 56% of our business being enterprise. We've demonstrated our ability to execute well there and succeed there. And that's working well for us. And yet we're just so early into that enterprise opportunity. We see that there's plenty of growth in front of us if we continue to execute. Part of that is competing effectively.

I think that the other thing that's really been a great tailwind for us is we were very disciplined about our commitment not to have an on-premise offering. I can't tell you how many deals we said no to 5 years ago that would have said if you can only build an on-premise New Relic for me, then we'll bring you on, and we felt like that would be short -- might give us some short-term benefit, but we'd regret it over the long term.

Well, we're glad we had that focus and that discipline to do that because the market has now moved from -- moved to a place where they won't even consider on-premise offerings when they do RFPs, many of these enterprise customers, particularly, if it's a modern workload running in a cloud environment. So that all works in our favor, particularly in the APM space.

And then as we go forward, we think being application-centric matters a lot to our customers. We believe running at our scale is a big deal to our customers. Our ability to support our customers in their digital transformations is quite well differentiated from our competitors' offerings. So there's plenty of reason for us to remain excited and confident in our competitive position. And there's no deal we don't feel like we can win, particularly, if it's running in a modern environment.

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Keith Weiss, Morgan Stanley, Research Division - Equity Analyst [35]

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Got it. That's super helpful. And maybe if I can sneak one in for Mark. And related to that enterprise motion now becoming a much, much bigger part of your overall business, can you give us an update or some additional color on how you guys are seeing sales productivity trending? Any kind of sort of milestones you can give us on how that's been ramping up over the course of the year?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [36]

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I think as Lew said, it's been a great journey for us. We've learned a lot, and we continue to learn a lot in terms of how best to hire, how best to ramp reps and what to look for as we bring on board; everything from making territories and to how we structure the teams. So I think those are things that we continue to learn. But those are things like we feel like we've gotten better at. And so as we've done that, we see productivity increasing. Some of that comes from just duration of the sales team.

Obviously, when your first 10 reps, you hire them, day 1, your average duration is pretty low. They're not that productive. As you get to the point we're at now, where we're growing that team pretty quickly. But percentage-wise, it's not nearly what it was in the early days. And so the duration starts -- it starts to increase as long as you can retain folks, and those durations lead to nice productivity gains. So we've still got work to do here, but we're comfortable with where we are.

You can tell by the focus we've had over the last couple quarters on investing in technical support, technical services and technical personnel to supplement the reps that we feel good about those kind of investments. So I think we're as we've said, we are -- we feel good about what we've accomplished, yet I'll be the first to admit, we've got plenty to learn and still have a lot to do.

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Operator [37]

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Your next question comes from the line of Steve Koenig from Wedbush Securities.

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - SVP of Equity Research [38]

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So I was really intrigued by your comment, Lew, near the start of the call where you talked about aligning your go-to-market efforts with the customer needs around cloud adoption, DevOps and customer experience, and you said thereby activating nonconsumption market by reaching new buyers. So there's a lot -- I'm sure there's a lot in that statement. Can you maybe just unpack that a little bit for us? What kinds of buyers are not consuming that you're reaching more of now? Or any other aspects of what you're calling that nonconsuming market right now?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [39]

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Yes, let me clarify that a bit. I think primarily, it's not necessarily new buyers in sort of different roles. It's more there are so many applications still today running production that do not have any APM product in place. And so the Gartner statement of something like, what was it, 20%...

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [40]

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5%. Currently 5%.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [41]

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Yes, 5% growing to 20% of application workloads. It's at 5% today or was as of when they said that about 6 months ago and growing to 20% over the next several years. So that's just such a massive opportunity in front of us, just -- we believe we're a big part of driving that growth.

Now if you -- when we survey our customer advisory board, it's -- the vast majority of their production environment is deployed with APM because we're democratizing the category. This isn't something that people should choose to put on some of their applications. It just should be standard just like every driver should have car insurance, right. They shouldn't just choose to have car insurance for 5% of the population. And so the reason why we're democratizing that category is our products are easy to use and they are cost-effective to deploy.

And we figured out a way to do that in a profitable way with industry-leading margins, right. So that's -- we're going to leverage those strengths to democratize the category and recognize that that's a massive growth opportunity for us.

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - SVP of Equity Research [42]

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And that suggests that your customer advisory board is in the vanguard, I mean, they're the early adopters in this wave of democratizing --

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [43]

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They are.

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - SVP of Equity Research [44]

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-- the [product of the] category. What are -- just my last follow-up question. What are the attributes of the early adopters that should give way to increasing mainstream adoption of the -- of APM and more specifically of SaaS-based APM?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [45]

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Well, these are the types of companies that were the earliest adopters of cloud technologies. These were the first companies who recognize that the more effectively they compete on software the more successful the whole business will be. These are the companies that bought into digital as a strategy that will drive the top line of their companies. The type of people that think of playing offense with technology. Technology is the top line -- can enable top line growth as opposed to just reduce the costs of operating in the back office.

And so that mindset 5, 10 years ago was a bit avant-garde. It's becoming more mainstream, and that's why so many companies are moving to the cloud now. But people who have that mindset tend to adopt New Relic, have adopted New Relic earlier and more completely adopt New Relic today.

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Operator [46]

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(Operator Instructions) Your next question comes from the line of Michael Turits from Raymond James.

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Robert S. Majek, Raymond James & Associates, Inc., Research Division - Senior Research Associate [47]

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This is actually Robert Majek on for Michael today. As you go from 5% to 20% application workload penetration over time, how do you see pricing evolving just so we can get a sense of the potential revenue growth from that?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [48]

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Well, I would say, we're continually running experiments with pricing, little experiments here and there to use that as a way to fully optimize our business. When we first launched our product, we offered a dramatically less-expensive product, and that opened up a much larger market opportunity that grew the oversight of the APM markets. So if we believe -- if we have enough data that suggests that adjustments to our pricing can help grow our top and bottom line substantially and really redefine the space to our favor, then we'll consider that. But we'll always do that with a lot of experimentation and thought and certainly discipline around anything that might impact our financial model.

As it stands today, we're a value-based solution. Even though we've got attractive pricing, we always sell on the value. And the customers who adopt New Relic -- and are serious with their digital operations, they see the value and that's reflected in the dollar and expansion rate.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [49]

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Yes, I guess I can just add on there that we want to make it easy for our customers to consume New Relic. And a couple years ago, we introduced now our cloud-friendly pricing. We were the first ones to come out with something like that where we offered another way to buy so that we thought that it was neutral to New Relic but just made it a lot easier for customers to deploy New Relic everywhere.

And when we think about pricing, we think about really account spend and how we can optimize the dollars coming from an account our per -- to grow this -- we look at our gross margins. They're very attractive. We want to maintain those. But we think of, over the long term, what we want to do is we want to see customers spend more because then the converse of that is they'll be getting a lot more value out of New Relic, and we'll become more important to them.

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Robert S. Majek, Raymond James & Associates, Inc., Research Division - Senior Research Associate [50]

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Maybe just one more from me. Can you just give us an update on what you're doing to expand internationally?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [51]

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Sure. So we mentioned the joint venture in Japan that we've just set up. Otherwise, we continue to expand in Europe as well as Australia. Our APAC business headquartered in Australia continues to grow.

Our strategy internationally tends to be relatively focused. I think we are, I would say, somewhat conservative in terms of entering new markets. We like to see a pretty good path to a market where we can deploy resources and deploy them effectively and efficiently before we really jump into a country. And so we've got customers all over the world.

But when it comes to really focusing on a country, we can look at what customers we have already in the base, we can look at that market; then we will go after targeted countries where we'll put feet on the ground, including both sales and the technical resource. And so we continue to do that primarily -- in the near term, it'll be primarily in Europe. But we're investing -- overall, we're investing internationally. We expect that to be a good driver of our growth going forward.

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Operator [52]

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And your next question comes from the line of Erik Suppiger from JMP.

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Erik Loren Suppiger, JMP Securities LLC, Research Division - MD & Senior Research Analyst [53]

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I want to come back to the sales expansion. How -- what kind of expansion percentage-wise in sales force are you expecting over the course of fiscal '19? And what assumptions are you making in terms of the time required to reach full productivity for your new hires?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [54]

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So we do not disclose the specific growth rates of the team or the size of the team. But obviously, we've put a path to $1 billion out there. March of '22, we want to be at a $1 billion run rate. And so you can imagine we're growing our sales team fairly aggressively to help us get toward that target. For our enterprise sales reps, we assume about 1 year to 4 quarters to full productivity. For the commercial and SMB teams, it's a little bit quicker than that. But generally, those are the guidelines.

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Erik Loren Suppiger, JMP Securities LLC, Research Division - MD & Senior Research Analyst [55]

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Can you comment how your growth this year would compare -- in the sales organization would compare to the growth that you made last year?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [56]

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Not getting into specifics. I mean, that gets to a question around productivity as you can imagine. But if productivity stays the same, obviously, your sales capacity has to grow basically the same rate as your top line. We're investing in nonsales resources aggressively as well. So I don't want to get into too many of the details there.

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Operator [57]

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And your next question comes from the line of Keith Bachman from BMO Capital Markets.

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Jung Ho Pak, BMO Capital Markets Equity Research - Senior Associate [58]

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It's Jung Pak for Keith Bachman. A question on international opportunities. You talked about Japan JV being very modest help. But when can you expect revenue from Germany to ramp in a meaningful way?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [59]

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We just announced -- recently announced opening an availability zone in Germany. I'm trying to think if that was a -- couple months ago, I guess.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [60]

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Pretty recent.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [61]

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Pretty recent. So I think that certainly is -- it's good publicity. I think it as well gets our name out there. And so that could help. We do have feet on the ground, and we've made an investment in Germany. We continue to grow that investment. So we don't give a country breakout of our international business, but we certainly look at that market as being attractive. You can see, you look at the cloud spend there, it's obviously a big market. So we expect to continue to invest there. And anywhere we invest, obviously, we'd like to see returns.

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Jung Ho Pak, BMO Capital Markets Equity Research - Senior Associate [62]

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Great. And a follow-up on the competitive dynamics. Are you increasingly seeing Elastic in the competitive process? Or any change in the type of vendors that you're competing against?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [63]

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No, we're not seeing Elastic at all, to be honest. It's a great search database. But it's just different enough from what we do and how we do out-of-the-box specifically tuned for performance availability. That's just a very different thing from how we engage in the market. So -- and I would say, in general, there's not been a substantial change in the competitive environment aside from what I had just shared earlier in that. But the market trends towards favoring SaaS delivery, favoring ease-of-use and favoring a platform that can go beyond just the application to see the entire environment. Those are all things that we think the market is continuing to ask for that, that further tilts the market in our favor.

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Operator [64]

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And there are no further questions at this time. I will turn the call back over to Lew for some closing remarks.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [65]

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I just want to thank everyone for joining the call. And my hat's off to the 1,500 Relics for the exceptional work they've done in delivering a great quarter for our customers and our shareholders and a great first half to the year. It's obviously an important night in this country. And so we're delighted that on election night we're helping USA Today Network deliver a great flawless experience for those who want to see what's going on in real-time with the election, so that's great.

We just encourage all of our customers and partners to come see us at the Amazon Conference, AWS re:Invent coming up later this month where we can meet you face-to-face and talk about helping you succeed with digital cloud and DevOps. And thanks and have a great evening.

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Operator [66]

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This concludes today's conference call. You may now disconnect.