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Edited Transcript of NEWR earnings conference call or presentation 6-Aug-19 9:00pm GMT

Q1 2020 New Relic Inc Earnings Call

San Francisco Aug 9, 2019 (Thomson StreetEvents) -- Edited Transcript of New Relic Inc earnings conference call or presentation Tuesday, August 6, 2019 at 9:00:00pm 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. - Senior Manager of IR

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Conference Call Participants

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* Christopher David Merwin

Goldman Sachs Group Inc., Research Division - Research Analyst

* 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

* Keith Frances Bachman

BMO Capital Markets Equity Research - MD & Senior Research Analyst

* Michael Turits

Raymond James & Associates, Inc., Research Division - MD of Equity Research & Infrastructure Software Analyst

* Rishi Nitya Jaluria

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

* Robert Cooney Oliver

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Sanjit Kumar Singh

Morgan Stanley, Research Division - VP

* Sterling Auty

JP Morgan Chase & Co, Research Division - Senior Analyst

* Steven Richard Koenig

Wedbush Securities Inc., Research Division - MD

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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 First Quarter Fiscal 2020 Earnings Conference Call. (Operator Instructions) Mr. Tony Righetti, Investor Relations, you may begin your conference.

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

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Thank you, operator. Good afternoon and welcome to New Relic's First Quarter Fiscal Year 2020 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.

All information provided in this conference call is as of the date hereof and New Relic assumes no obligation and does not intend to update these forward-looking statements except as required by law. 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-K and subsequent filings with the SEC. Copies of these documents may be obtained by visiting New Relic's Investor Relations website or the SEC's website.

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 operating results and trends, but note that these measures may 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 insights into our business or results. These 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, supplemental materials that accompany our earnings release, periodic SEC reports, a webcast replay of today's call or 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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Thank you, Tony. The first quarter of fiscal 2020 closed with year-over-year revenue growth of 30% driven largely by our continued focus on moving upmarket by leveraging our expertise in application code visibility and cross-selling into our significant installed base. While revenue was above our guidance for the quarter, we did not execute well enough to meet quarterly sales and headcount targets. This resulted in a lower-than-expected deferred revenue balance and net dollar base expansion rate. We are not pleased with these results. But we do believe they are an anomaly, limited to the first half of the fiscal year and largely the consequence of our moving aggressively to complete go-to-market and product-related organizational transitions. At the same time, this was compounded by the release of a new product and user interface platform against the backdrop of a seasonally soft quarter. Longer term, we anticipate the benefits of these initiatives which will align our operations to a common powerful platform, New Relic One.

The culmination of nearly 2 years of engineering time, we view the New Relic One platform as the foundation for the next decade of New Relic's innovation. We reimagined the user experience and developed a pan-enterprise, entity-centric data model that makes visualizing up and downstream dependencies possible across a customer's entire environment. The opportunity cost of this effort was a delay in revenue-generating product introductions as well as future -- fewer feature and integration releases over this period. This is having an adverse impact on the customer lands and expansions in the first half. But we believe the investment in New Relic One was compulsory for durable growth over the long term.

The logic underpinning our strategy with this platform originated from the early recognition that our user base would gradually adopt open-source standards, microservice architectures and containers. As it turns out, this trend, which we call observability and is an expansion of our current monitoring market, emerged at a faster rate than we initially projected with a different competitive landscape. We believe New Relic One enhances our competitiveness broadly to date with much of the future benefits being derived by users adhering to observability trends. Developers operating in this fashion prefer compostable and configurable dashboarding, distributed tracing, metric and logging tools, in conjunction with the application instrumentation data that only New Relic can provide.

To address the needs of this group, we plan to continue increasing both the extensibility and the programmability capabilities of our platform.

Expanding our access to third-party telemetry through extensibility will augment our out-of-the-box instrumentation and act as a first step to giving our customers a single platform for observing their entire environment. We released monitoring for AWS Lambda in May and expect to deliver logging in AI-ops products in the next quarters. All 3 of these products leverage our strategy of ingesting telemetry from an increasing number of sources from New Relic agents, cloud providers and from open source technologies.

We also envision New Relic One's programmability capabilities as being a differentiating feature whereby customers and partners create their own applications on top of New Relic One. And those applications drive digitally transformed businesses. As we expand New Relic One's extensibility and programmability capabilities with additional products, we are advancing our ability to deliver a single platform for managing the performance of our customers' digital businesses.

On the operational side of the business, we accomplished 2 critical objectives during the first quarter. One, we completed an operating model change in the product organization which, after a few quarters of transition, resulted in a General Manager structure consisting of 5 entrepreneurial minded teams focused on core revenue-generating groups: application monitoring; client-side; infrastructure; logging; and AI-ops. We expect our innovation velocity and accountability to increase under this model and thereby further enabling us to address a larger share of a growing multibillion dollar market. Two, the sales organization is now under a regional hierarchy with unique strategies shaped by local leaders. This has been an ongoing effort for approximately the past year and included establishing new offices and the expansion of our European region as well as bringing in new leadership to EMEA. Our international markets, EMEA and APAC, are key growth drivers for us and are expected to demonstrate the most significant improvement as a result of this initiative, by the end of fiscal 2021.

We believe these operational initiatives, combined with our investment in New Relic One, will improve our potential for future growth. However, the training and enablement associated with the new platform release in conjunction with operational changes and record headcount growth from the second half of fiscal '19 resulted in companywide dislocations that are expected to impact productivity throughout the first half of the fiscal year. We are maintaining our full year top and bottom line guidance ranges based on the stability we expect in the second half of fiscal '20.

I'll now turn the call over to Mark 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. Before turning to the financials, I would like to offer the following additional color on sales and headcount attainment. First, the quarterly sales shortfall is primarily attributable to EMEA being significantly soft and partially to underperformance in the U.S. The recent changes to the sales structure and, in particular EMEA, are expected to improve both short and long-term execution. Second, headcount growth in Q1 was lower than expected across the company. I'd like to note that the second quarter of fiscal 2020 will be the first full quarter of regional go-to-market operations and the GM product model. Their respective leaders are moving quickly to build scalable processes and hire appropriately which we anticipate will lead to headcount building steadily throughout the year.

Now turning to the financials. Revenue was $141 million for the first quarter, up 30% year-over-year. We ended Q1 with 881 Paid Business Accounts at ARR over $100,000, up 18% compared to a year ago. This growth represents both new logos landed as well as installed base expansions derived from increased usage, expanded application coverage and the cross sell of additional products.

Our annualized dollar base net expansion rate in Q1 was 109% compared to 118% from a year ago period. The decrease was driven by lower amount of upsell activity this quarter relative to our total installed base. We believe Q1 will be the low point for the fiscal year. And while we expect an improvement in Q2 compared with Q1, we anticipate a year-over-year decline in this metric in Q2 as well.

At the end of Q1, enterprise business was approximately 62% of ARR, up around 55% as of the same period last year. Non-APM bookings during the quarter were greater than 40% of new ARR with a combined contribution from New Relic Insights and New Relic Infrastructure above 20% of new ARR.

In terms of geographic split, U.S. revenue was $96.6 million for the quarter, up 30% year-over-year while non-U. S. revenue for the quarter grew to $44.4 million, also up 30% year-over-year.

For Q1, our non-GAAP gross margin was 85%. Non-GAAP operating income was $7.4 million or 5% of revenue compared to $8.7 million or 8% of revenue in the same quarter last year. Non-GAAP operating income was ahead of our expectations primarily because of lower-than-expected headcount growth, lower sales commissions and lower bonus payments. Overall, our non-GAAP net income attributable to New Relic per diluted share was $0.19 compared to $0.15 in the same quarter last year.

Turning to cash flow. Cash from operations were $36.5 million. Free cash flow, defined as cash from operations minus capital expenditures and capitalized software development costs, was $18.9 million.

Turning to our balance sheet. We ended the first quarter with approximately $769 million of cash, cash equivalents and short-term investments, up from last quarter's $745 million total.

Elsewhere on the balance sheet, our total deferred revenue ended the quarter at $255 million, up 40% year-over-year but down 6% sequentially. This result was slightly below our expectations.

Now I will turn to our outlook for the second quarter and full fiscal year 2020. For the second quarter ending September 30, we expect revenue to be in the range of $143 million to $145 million. We expect non-GAAP operating income of $5 million to $6 million. This would lead to non-GAAP net income attributable to New Relic per diluted share in the range of $0.14 to $0.16. We expect deferred revenue to decline on a percentage basis in the low to mid-single digits sequentially. Please note that Q2 '19 results included an anomalous payment covering 2 years and totaling $16 million, that equates to $8 million deferred headwind in Q2 of fiscal 2020.

For the full fiscal year 2020, we expect revenue to range from $600 million to $607 million, which is unchanged from prior guidance. We expect non-GAAP operating income of $20 million to $25 million, also unchanged from our prior guidance. This would lead to non-GAAP net income attributable to New Relic per diluted share in the range of $0.55 to $0.63.

Before moving to Q&A, I'd like to provide the following to assist with modeling the remainder of the year. We are maintaining our 84% to 85% gross margin outlook and updating the following cash items to reflect lower-than-expected first half-deferred revenue. Cash from operations, we expect to be between $100 million and $110 million which is down from $115 million to $125 million. And free cash flow, we expect to be between $40 million and $50 million which is down from $55 million to $65 million. Capital expenditure expectations remain between $50 million and $55 million.

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 come from the line of Sterling Auty from JPMorgan.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [2]

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We've heard from a number of companies, Pluralsight, PTC and others, about being behind schedule in terms of hiring. Are we getting to a point where just the unemployment rate is actually making it more difficult to hire the candidates that you normally would expect to get?

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

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I think for a company at our scale, that's not the #1 factor. It's really an issue of focus and discipline which we need to apply more of and we have -- we've started on that effort to really get serious about executing on our hiring plans. So I think this is more under our control.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [4]

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Okay. And then one follow-up is with that net expansion rate, given where you are with New Relic One, why should we not read into this that instead of execution, it's actually a competitive issue that you need all these elements of New Relic One in the market today and you're at a competitive disadvantage until they get out there?

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

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We certainly have multiple factors that are contributing to that net expansion rate. It -- the sales distraction that we had in Q1 around moving to a geo model and the operational distraction moving to a GM model on the product work was a factor. We had execution challenges broadly, in particular in Europe. But yes, the third factor is that the competitive environment has evolved as, as the market has become more dynamic. And so there's more for us to do, more work involved in winning a deal today than there was a couple of years ago. But we still feel great about our long-term competitive position. We think New Relic One has unique capabilities and that the customer feedback on it is very encouraging. And yet, we recognize this is -- this can't help us. As we're introducing a new user interface to our customers, we want them to adopt it at a pace that's comfortable for them, rather than to force it on to them on our time frame. And so we've been thoughtful on how we introduce it into market to make sure it works well with how our customers are approaching using our software. So that all adds up to we're managing this transition to a new platform, I think, with a lot of focus and with a lot of enthusiasm for where we'll go. But in Q1, there was attrition -- that transition that we went through and it had impact on our short-term performance.

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Operator [6]

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

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Jon Philip Andrews, Needham & Company, LLC, Research Division - Senior Analyst [7]

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Wondering if you could just shed some more light on in terms of where you are, I guess, educating your customer base regarding the benefits of New Relic One. And is this more of a self-discovery journey on their part? Or are there specific things that you're really doing to highlight the capabilities around this and specifically maybe around the programmability feature which you felt was very differentiated?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [8]

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I'm glad you asked. So we launched New Relic One in May right around when we had our last earnings call and that was the first release. And we did make it a release that any New Relic customer could use and discover on their own but that we were not aggressively pushing out into the market due to just how big a release this was and how we wanted to make sure it was a natural time for our customers to adopt and we want to observe how customers are using it.

We're encouraged by what we're seeing on customer usage given that it's been one where they've discovered it largely on their own. For example, our dashboarding capability, we see a 40% month-over-month uptake or increase in engagement on that feature in the month of July. So we're encouraged by that. And I remain incredibly excited about the programmability capabilities which we plan to release in the near term but we have not released yet to our customers.

What we have done since the launch of New Relic One is enabled our field, technical field, to build applications on to top of New Relic One for our customers. So we are kind of the first people developing on top of the platform for our customers. And the feedback is resoundingly positive. But obviously, in order for this to work at scale, this needs to expand beyond our own people, developing application on New Relic One to the community and that's what's coming out shortly. So we're heads down on getting that ready. We're excited about its potential. And we got to just focus on making that successful

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Jon Philip Andrews, Needham & Company, LLC, Research Division - Senior Analyst [9]

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Appreciate that. Just as a follow-up, could you shed some additional light on what prompted the operating model change in the product organization into what looks like 5 groups now?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [10]

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Certainly. So prior to that change, we've had a monolithic product organization. So one product leader responsible for all of our products. And as the business has grown and we now have as many SKUs as we do, we felt like, especially with the introduction of New Relic One and having a common platform that can integrate all these products, now is the right time to have entrepreneurial leaders fully accountable for the growth of their products and fully empowered to deliver the product that will compete and will win in their market segments and drive business growth. And so we're already seeing the benefits of that model change. We're early in that, but I'm very pleased with the change and it's an area of focus for us because we've highlighted the competitive environment is evolving and it's time for us to really be far more focused on delivering products that delight our customers.

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Operator [11]

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Your next question comes from the line of Rob Oliver from Baird.

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Robert Cooney Oliver, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [12]

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Lew, one for you and then I had a quick follow-up for Mark. Just I know you mentioned the evolution of the competitive environment and things like open source, microservice architectures and moving to observability. I know those aren't new for your users. So what I'm trying to tease out here is has the buying decision moved away from your core user to somebody up the stack? And is that the New Relic One move? And can you talk a little bit about your lands this quarter and if they were multiple product lands and any other evolution in the market? And then I had a quick follow-up.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [13]

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Sure, sure. So when we think about how the market is evolving, in particular towards extensibility, we feel like it factors into our product strategy in 3 ways, 3 pillars to our product strategy.

The first is extensibility. We need to ingest more types of data into the New Relic platform. Examples of types of data could be open source -- data from open source projects or log data or dimensional metric data. So that's the extensibility part of our strategy.

The second is intelligence, being able to do more with that data and be smarter with it. And our AI-ops capabilities that come out of our acquisition of SignifAI are a real key part of that, part of the strategy.

And the third leg of the stool is programmability, which I've spoken to.

So as it relates to the market, I'd say we've always had a strength with the development -- the developer, the develop manager and the VP of Engineering and the CTO, all the way up that track. The -- what we are developing to complement that is a go-to-market focus on the operations professional and they tend to make decisions around the infrastructure.

We have a strong infrastructure product and it attaches very well. It's our highest attaching product, well over 30% of our customers have purchased it. But the ASPs are relatively low. And we feel like that the best way to focus on growth is ASPs, infrastructure product, is to focus on the operations professional who is a peer often to development leader.

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Robert Cooney Oliver, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [14]

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Great. That's helpful. And then just one follow-up. Mark, I know you've talked a little bit about some of the success you guys have had with parking some technical sales people at larger accounts. And just wondering, is the hiring shortfall in that technical sales area? And maybe to Sterling Auty's question earlier, is that just a harder person to hire -- somebody that is selling much broader visibility platform than APM?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [15]

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Yes. So the hiring shortfall, I would say, was more across the board, wasn't concentrated in one area. I think there's some issue back in the technical sales area. But I wouldn't say any more so than in any other parts of the organization. We continue to see success and we continue to aggressively move to grow out our services capability and to do that with customers. And those folks do take quite a while to ramp up. So the team -- the people we hired at the end of last year and we continue to hire, are getting ramped. And so they are helping. Our seeing is it's taking more effort, more time on our part, on the part of those technical teams to get renewals and to get upsells. So I think they're a higher calorie but we continue to see success there. And in places where we have deployed them, we feel like we've have great success in those accounts.

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Operator [16]

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

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Sanjit Kumar Singh, Morgan Stanley, Research Division - VP [17]

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I want to talk a little bit about guidance. And Mark, I think there was -- in your script, you said that the second half doesn't assume an improvement in the overall business. Given the product roadmap, given some of the challenges you saw in Q1, what gives you the confidence that, that business will, in fact, improve in the second half as you think about the full year guidance?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [18]

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As Lew talked about the product roadmap, we feel like we are delivering what customers want. We've got some of the organizational transitions behind us now. So those are starting to take place. We're starting to see the results of those. In EMEA, as we talked about, it's going to take a little bit longer. But with the GM model, the accountability that comes along with that change, we're starting to see positive improvements already. And so we've given guidance that we feel comfortable with, we feel confident with for the rest of the year. We still feel good about our $1 billion revenue run rate target for the end of fiscal '22. And so we feel like we're on a good -- we feel good with that. There are going to be some bumps along the way, as we've seen in the first half. But we do feel confident in our overall journey toward that milestone.

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Sanjit Kumar Singh, Morgan Stanley, Research Division - VP [19]

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Got it. And then maybe, Lew, as a follow-up. I had a question on the state of how monitoring is conducted out there in the market. And specifically, is in your view the sort of agent-based approach to application monitoring, is that evolving in and of itself? And what do you think the implications are for New Relic if we're going from less of an agent-based model to more of a distributed tracing approach? Any thoughts there?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [20]

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Certainly. Well, I think I -- there's no question that agents have a place in many circumstances, in many environments, including distributed tracing use cases. However, agents are a primary source of data but can't be the only source of data that our customers will rely on in order to observe the entire environment. So that's why when I spoke about our price strategy, step one of our strategy is extensibility. And so we want to embrace data, not only coming from our agents, which is highly valuable, highly differentiated. And let's take for example a large enterprise. If they want to put visibility into as many applications as possible, as quickly as possible, they have no choice but to take an agent-based approach. They're not going to rewrite all their software to instrument it by hand. However, there will be pockets that want to instrument by hand or want to use other sources of telemetry to observe the application. But they don't want to be going to different products and different tools to see that data. They want to see it all in one place. That's why our extensibility strategy is so important. And what I've got the team very focused on is delivering on our extensibility vision within the next couple of quarters. And so you're going to see us make announcements throughout the rest of this year and certainly some in the near term. And that's going to complement the other 2 pillars which are intelligence and programmability.

Once all of that data is in our cloud and presentable to our users, our customers recognize and are demanding that they go beyond simple static dashboards. They want to build applications that leverage this data. And only New Relic One is going to enable our customers to do that. And so we're very excited about what that will do to give us a leapfrog opportunity that should really put some daylight on the differentiation.

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Sanjit Kumar Singh, Morgan Stanley, Research Division - VP [21]

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That's very helpful. If I can just sneak one quick follow-up to that. In terms of New Relic DB, which has been sort of, the architecture behind the platform for several years, has that changed and evolved commensurate with the New Relic One rollout or are you storing and handling data in a dramatically different way and is that capability available today?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [22]

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Well, what I'd say is we have evolved the capabilities of NRDB which is still running at a massive scale and we've had many customers come to us saying they've used us in complement with other monitoring product that may have specializations in other parts of the stack, say, infrastructure or logging. And on big launch days, they've told us that only New Relic could handle the load. So we have what we believe to be the most scalable architecture for gathering this telemetry data at scale.

How have we evolved it? What we've been hard at work on is evolving the data collection technology to also work really well with logs. And as I mentioned in our last earnings call, our early research shows that it's dramatically faster than logging solutions built on open source technologies. And most of our competitors, even if they're already offering logging as a service, are built-on open source technologies that just don't perform well at scale in a multitenant environment compared to ours.

So we've also been hard at work evolving our technology to consume what's called dimensional metric data and that's what open source tools like Prometheus use and other kind of tools that modern -- many modern shops are using. So that evolution is mostly complete. We're tying up the loose ends on it. And then with that, we will have the capability to bring in all of that extra data along with the agent data that we've always been good at collecting.

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Operator [23]

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Your next question comes 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 [24]

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This is Fatima on for Jen. Mark, maybe to start with you on some of the commentary you've shared with respect to EMEA and some of the execution softness there. We're wondering if perhaps there's some macro elements that could potentially have exacerbated that and how are you thinking about some of the higher level macro-related dynamics as it relates to Brexit impacting the demand environment and sales cycle and purchasing patterns there? And then a follow-up, if I may.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [25]

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Our primary focus has been on the execution challenges there. At our size and scale, we feel like there's good opportunity there and that it's more internal issues than external macro issues for us. We had a new leader start in the middle of the quarter. He's come in and made some additional changes. So I think we've got those largely behind us now and it'll take time to rebuild the team. But I feel like it's generally more within our control than macro issues.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [26]

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Understood. That's really helpful. And then just with regards to product uptake. You talked about Insights and infrastructure combined being in excess of 20% of non-APM ARR bookings. And then wondering if you can give us some more specificity or granularity around the infrastructure offering because in the past, I know you and Lew both have talked about the blurring of the lines, if you will, between infrastructure monitoring and app monitoring. So wanted to better understand sort of what mechanisms you have in place to really drive that attach and penetration at a faster velocity?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [27]

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Sure. So we have not broken out anything beyond the over 20%. I will say that Insights is more than half of that although infrastructure continues to sell well. That said, I think we've got to be more aggressive with our infrastructure product. We've talked about going more after the ops buyer. And really, there a couple of things. Infrastructure, as Lew mentioned, is our highest attaching product with over -- almost about 1/3 of our customer base using that. But the spend is -- the average spend was well below we think.

So we've got to do a couple of things. One is we have to expand the infrastructure sales to be beyond just the application environment. We want to cover the whole state. So we've got to be better at that motion and that sales process. The second thing is we've got to lead at some point. We want to develop the capability to lead with infrastructure getting us into new accounts. And so that's something that we'll be working on as we go forward.

So we're very focused on the infrastructure product and making that being kind of a first-class citizen in New Relic's portfolio. And so that's something that we'll be spending a lot of time doing. And with the GM model, I think that really helps us. We now have someone, the GM of that, the infrastructure product, that person wakes up now every morning thinking about how am I getting more infrastructure in our customers' hands? How am I delighting those customers more successfully? And I think that accountability is going to really help.

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Operator [28]

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Your next 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 [29]

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So you described the headcount target shortfall as a reason for maybe the weaker results or perhaps the weaker Q2 guide. Could you touch on how the changes impacted sales headcount retention? And whether you're having to do more backfilling than you'd normally would coming out of a Q1? And then maybe remind us what the typical time is to ramp to productivity for new reps.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [30]

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Sure. The -- typically -- take a run at that first. Typically, we talk about a year ramping productivity from a sales rep standpoint. And I think that also extends to the technical sales folks that support the rep. Obviously, that unit is a critical component in developing both parts of that -- is a critical component to be successful in the field.

In terms of sales rep attrition, that's actually was -- I think that was a strength of ours in the first half -- the first quarter. We saw, I would say, lower than what you would expect in a Q1 in terms of sales rep attrition. So I think that's been going well. On the other hand, we did hire a lot of reps throughout fiscal '19. And so we've got to make sure that they can -- they continue to stay and ramp and that we're successful in ramping them

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James Derrick Wood, Cowen and Company, LLC, Research Division - MD & Senior Software Analyst [31]

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Okay. Nice color there. And again, we talked about kind of the sale structural changes. But I'm curious, how much impact are you seeing from the kind of the demand side? Maybe customers taking longer to make additional purchases? You had a major upgrade, they may want to look to absorb this and look at the new roadmap. I mean do you think that as customers upgrade and these new products roll out, we see this kind of pent-up demand free up perhaps as we move into the second half?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [32]

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I -- it's a strong and healthy market and growing. And with that growth and with the scale that we happen to be at, that does attract more competitors. And so that is impacting, I'm thinking number of calories and days involved in completing the equivalent sale, say, a couple of years ago. And so that's how I'd characterize the impact of it. So I wouldn't say -- necessarily say it's market demand so much as the effort involved in completing the sale.

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Operator [33]

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Your next question comes from the line of Chris Merwin from Goldman Sachs.

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Christopher David Merwin, Goldman Sachs Group Inc., Research Division - Research Analyst [34]

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I just wanted to ask about the log product. I don't believe that's been launched, correct me if I'm wrong. But just based on the feedback you've heard from customers, are you finding that they want a log solution that's really adjacent to some of the vendors that they're already taking? Or is this something that would be more of a replacement? And then I just had a quick follow-up.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [35]

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Well, what's driving it from our customer is they're very interested in our logging product because they don't want to leave New Relic when they need log data to diagnose a problem. It's all about time to repair. So if they have another log product that they purchased for solving production performance or availability problems and that may be an open source offering or may be a commercial offering, they feel real value [seeded] on New Relic especially if those logs are in context. If, for example, we can see the specific log messages that were emitted by an application when that specific application was having a problem. That's often harder to do when you don't have the benefit of application visibility like we have or sometimes even impossible to do. So that's why our customers are excited about it.

Now by contrast, there are some customers that use logging product to keep a year's worth of data so that they might want to handle some kind of security use case or see if whether there was a vulnerability in the past or a compromise in the past. That's not what we're aiming for in the use case. We're not going after the security buyer, et cetera. So we certainly expect to coexist with log solutions in many customers. But we want to deliver the most integrated, fastest time to detect and repair solution by integrating logs with everything else we have in New Relic.

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Christopher David Merwin, Goldman Sachs Group Inc., Research Division - Research Analyst [36]

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Okay, great. And then just on enterprise customer growth, it looks like that slowed a little bit year-on-year. Was that just all related to some of the sales execution challenges you pointed out? And if we do see recovery there, will that be -- show up more in the form of new logos or expansion within the base?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [37]

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I think that was attributable to the sales shortfall that we've mentioned. And going forward, we expect that number to -- the increase to generally slow over time as the base gets bigger. As you know, those are customers that either come into the franchise over $100,000 or grow through that number. But I think what we'll see going forward is we expect the number to continue to increase at a declining -- at a slightly slower rate.

And the expansion rate, we have a situation where a lot of our expansion comes from customers that are over $100,000. So I would differentiate the 2 -- those 2 numbers a little bit. Our expansion rate is driven primarily by growth in accounts that are already paying us $100,000. And so I think that's where -- what drives the expansion rate versus the absolute number of over $100,000 payers.

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Operator [38]

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Your next question comes from the line of Michael Turits from Raymond James.

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Michael Turits, Raymond James & Associates, Inc., Research Division - MD of Equity Research & Infrastructure Software Analyst [39]

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Lew, last quarter, it seems that -- it seemed clear that the non-APM piece of the business were a little bit below the long-term targets in terms of the trajectory and you're making lots of moves to accelerate that. But APM seemed like it was above target long-term goals. What really -- I mean, obviously, there was some execution setup. But what's really changed? Because it seems as if APM has slowed now, too. So what specifically has slowed, I would assume mostly from a competitive perspective? And who are you seeing -- what kind of competitors for APM? And is it really just now people want to buy APM as a multi-siloed product?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [40]

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Well, just to speak a bit about our APM product, Gartner Peer Insights is a mechanism by which customers actually vote for their favorite products and we're rated #1 with our APM products. So it is strong and I feel like there's still a strong and growing market for it. But that -- kind of as I mentioned a little earlier, we need -- our customers are asking us to do APM and extensibility of ingesting more data beyond what APM does automatically. Some parts of an enterprise just want to drop in an agent and see that visibility in an effortless way. Other parts of the enterprise want more control over their instrumentation. They're willing to use manual instrumentation or open-source monitoring solutions to help them with that.

And so, what we're focused on delivering for our customers is a place to put all of that data, the data we automatically surface with our agents as well as data that may come from other sources and put that all into our cloud. And I feel like that's what our customers are asking for and where the market is headed. And that's very different from customers don't want agents in their applications because they do for many kinds of workloads, very important, especially when you want to go strategic with having a story for instrumentation visibility across the entire state, you want to do that with the least amount of cost and effort possible. And so the way to do that as rapidly as possible is with an agent approach. And then you complement it with something a little bit more manual when it makes sense to do that in those instances.

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Michael Turits, Raymond James & Associates, Inc., Research Division - MD of Equity Research & Infrastructure Software Analyst [41]

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Lew, that all makes sense to me. I guess I was trying to get to where -- get you to drill down a little bit more on the competition. Which competitors are you seeing? What do they look like?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [42]

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Sure. I mean, yes, we see competitors from a few angles. There are open-source solutions that our customers are deciding to install on-site and invest the time involved in managing that on-source -- on-premise stuff. We see infrastructure centric solutions that have a historical strength in dashboarding and in collecting data from lots of sources, lots of -- and infrastructure. We've, for many years, had this sort of same list of competitors in the APM space.

I'd say what's evolved has been some of these open-source and infrastructure centric vendors coming in. And as the market's clearly much larger, more interesting, it's attracted more types of competitors. All kind of responding to the customer demand to kind of see inside everything they need to see in real time to deliver great performance and availability results.

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Operator [43]

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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 [44]

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First off, can you give us the headcount and what the hiring was in the quarter? And then secondly, can you talk a little bit about the timing of how long the hiring has been an issue? If it takes about a year for people to reach productivity, it's not clear to me why this would cause such an impact if it just started this quarter.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [45]

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So the -- to answer the first question, the headcount was just under 1,800 people as of the close of June 30. That was an increase of roughly 40-ish or so from our last Q as filed. And so in terms of that hiring rate, that's something that we were certainly disappointed in. As I mentioned, it was across the board.

And how does that impact in-quarter performance? Well, it's -- I think some of the distractions and things, or the transitions we went through organizationally had more of an impact in terms of the performance in the quarter. I think the hiring shortfall was more geared toward the expense needs that we had when we talked about the fact that our operating income was above what we had planned; that was driven by a lower-than-expected headcount.

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Erik Loren Suppiger, JMP Securities LLC, Research Division - MD & Senior Research Analyst [46]

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Okay. So the hiring was not a factor in terms of the pipeline and the billings piece. Is that correct?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [47]

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That's correct. The hiring was not a big impact on the -- missing our sales targets

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Operator [48]

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And 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 - MD [49]

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So a question for you, Lew. You've laid out a really compelling product vision and your roadmap for getting there, what you need to do. So I'm wondering, to get where you want to be in terms of executing to your plan and the numbers, does the new product vision really need to mature with those SKUs being out, and mature to get where you want to be on your financial targets? Or is it more in the near term a matter of educating your customers that their investment in APM will be preserved and getting through the sales reorg that you've done? Or do the products really -- the new products really need to get mature for you to be back on track?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [50]

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That's a great question. I would say, we certainly need to deliver on these products and deliver confidence that these products are on track to meet our customers' needs. And a lot of that we expect to happen out of the gate. For example, our infrastructure product is very strong but we have not put the appropriate level of go-to-market focus on fully leveraging the product we have there with the infrastructure. And so our play is to go from small departments within our existing accounts to full estate. That's largely go-to-market effort that we've recently kicked off with great focus and energy and scrutiny.

Other products like logging are going to be new to the market and that's why we focus it on the use case I described to an earlier question around troubleshooting, which is our strength. We think we're going to offer a lot there. But I really think that the general manager model we've moved to where these general managers are fully accountable not only to delivering great products that our customers love and tell their friends about, but also the business results that come from selling those products. They are entrepreneurs that are accountable for delivering those results and that's a big change for us that I think is going to yield a lot benefit. And they're focused on exactly these questions, like how rapidly can I deliver the very best product that will drive business growth at New Relic.

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - MD [51]

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So that's helpful. I guess if you were to time line the incremental improvements to your results that will come about from, say, the sales reorg, the product reorg, the product organization reorg, getting some of the new SKUs out, like how do those things fall out in terms of a time line? Like what benefits from which of those initiatives come first?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [52]

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Well, I'd say the -- we don't want to get too precise with timelines. But I would say that in the coming quarter or 2, we need to deliver on extensibility, right? Ingesting more data from logs, from dimensional metrics, from these other places. So that's work that have to deliver in the next couple of quarters. When we do, there's a backlog of customer demand that want to use that technology. And that will influence their thinking when they think about standardization decisions, particularly enterprise customers that really want to understand the roadmap before they make a 7-digit commitment. So those are important milestones that we're very focused on and they could have a short-term benefit or shorter-term benefit.

But we -- given the execution challenge we had in the quarter, I don't want to set expectations too high on specific time frames. Rather just show that we are working with urgency to deliver these capabilities because our customers are asking for it and we believe it's going to really help our position in the market.

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Operator [53]

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And your next question comes from the line of Keith Bachman from Bank of Montréal.

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Keith Frances Bachman, BMO Capital Markets Equity Research - MD & Senior Research Analyst [54]

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I'm going to go in a little bit different order given that last question. You've taken down your cash flow targets for the year by, call it, $15 million. And I'm going to assume that that's due to the DR moving lower. But if you could confirm that. And the follow -- the second part of that is if, in fact, you're lowering DR expectations, why not lower the revenue expectations commensurate with that even if it's more back end-loaded?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [55]

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The -- I would confirm that that's largely driven by the decline in DR, that guidance. And I would say the shortfall in the first half of the year has a big impact on revenue for the year, as you know, with ARR coming -- the ARR model.

The second half of the year, we've talked about the guidance for Q2 and then you can interpolate sort of the results for the second half. And those numbers have less -- every quarter, the ARR has less and less of an impact on the revenue for the year. And so I think the guidance we've given we are comfortable with on the revenue portion. And then the -- you can do the math and the gymnastics around the DR to come up with your own view on the timing of when that ARR is going to come in.

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Operator [56]

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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 [57]

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So I'm traveling today. Hopefully I have the math right here, but I think billings guidance implies high-teens normalized growth in Q2. Just how should we think about that growth rate in the second half of the year? Just directionally, same, better or worse?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [58]

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We're not giving guidance beyond the -- what we've given in terms of revenue for the year and the billings for the -- or the DR for Q2. Typically, we are getting -- becoming more and more of an enterprise company. I will say, our seasonality in the past has been such that the first half tends to be a little bit softer than the second half given the enterprise buying cycle in December and then our Q4 in March. We do expect those trends to continue. But at this point, we're not giving further color on the specifics in Q3 and Q4.

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Operator [59]

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And your next question come 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 [60]

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I think, first, let me just start to one comment that you made in the prepared remarks, Lew, was that the adoption of micro services and the like has happened faster than you expected, which has been a little bit of a headwind. Just help me understand, why would greater adoption of something like Kubernetes be a headwind given that you have a natural Kubernetes monitoring product and actual strategy around micro services and arguably, it's less competitive of a space than kind of the core APM. And then I've got a follow-up.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [61]

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Sure. So I think from a macro perspective, it's all great in terms of our market opportunity and our position within the market. But in the last several quarters, while we made the, I believe, the absolute -- the right call but it was a trade-off call to focus on New Relic One, which was a long-term bet for the future. We did that at the expense of doing smaller features, incremental features that could have further enhanced our capabilities in these microservice environments.

Let's take for example, in some microservice environments, customers want to complement our APM agents with more manual instrumentation because the nature of their application just isn't well suited to automatic instrumentation that our agents do. And that happens a little more often in microservice environments because you've got many, many different services, many kinds of services. And so kind of automatic instrumentation is harder to do and we're the best at it but it still may not be sufficient.

So in that case, being really good at flexible, like consuming data from other places rather than just our agents, is really important. And that's why I've spoken to why we're so focused on extensibility in our platform to deliver on that.

Now so let's say we had focused on that earlier at the expense of the kind of more foundational work we did in strengthening our platform for the future. Then we would've had more capabilities in that area and perhaps we would've captured more business in the short term. However, I feel like when we look down the road, we wouldn't have the same strategic position that would set us up for the maximum impact that we now have now that we've got New Relic One in the market.

So that's how we think about the trade-off. I think it is a good secular tailwind, this move to micro services. But it did have some short-term impact to the business while we were focused on the long term.

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Operator [62]

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And that is all the time we have for questions. I will turn the call back over to management for some closing remarks.

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

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Well, thank you all for joining the call. I just wanted to share a couple of thoughts before we sign off. When I founded New Relic in 2008, the founding idea was let's deliver amazing software that end users love and tell their friends about and that will be the foundation upon which we build a great company. And so those founding principles I still keep in my heart today. I'm very excited about the opportunity we have in front of us and I feel like -- and I'm really proud of a lot of the work we have done.

It's great that when Gartner asks their peer insight customers about who their favorite vendor is in the application performance monitoring, we have received the highest rating and the most number of ratings, the highest score, the highest recommendation rating.

So we do good work, really good work in what we do. But as this market is evolving, the call is upon us to up our game again. And that's an exciting challenge for us. But what really excites me about that challenge is how large this opportunity is and how relevant our strengths are in pursuing that opportunity.

So we're not pleased with the results of the quarter. But I'm more excited today about New Relic's vision and roadmap than I ever have been. And we're just getting started in our journey. And so we thank you for your questions and we thank you for coming on the call. And we're excited to keep working on delivering visibility for our customers and help them deliver great digital businesses.

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Operator [64]

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