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Edited Transcript of NEWR earnings conference call or presentation 7-Aug-18 9:00pm GMT

Q1 2019 New Relic Inc Earnings Call

San Francisco Sep 13, 2018 (Thomson StreetEvents) -- Edited Transcript of New Relic Inc earnings conference call or presentation Tuesday, August 7, 2018 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jonathan Parker

New Relic, Inc. - VP of Strategic Finance and IR

* Lewis Cirne

New Relic, Inc. - Founder, CEO & Director

* Mark Sachleben

New Relic, Inc. - CFO & Corporate Secretary

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Conference Call Participants

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* Derrick Wood

Cowen and Company - Analyst

* Gray Wilson Powell

Deutsche Bank AG, Research Division - Research Analyst

* Gregory Ryan McDowell

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

* Jennifer Alexandra Swanson Lowe

UBS Investment Bank, Research Division - Analyst

* Jon Philip Andrews

Needham & Company, LLC, Research Division - Senior Analyst

* Kevin Kumar

Goldman Sachs Group Inc., Research Division - Associate

* Rishi Nitya Jaluria

D.A. Davidson & Co., Research Division - Software Analyst

* Robert S. Majek

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

* Sanjit Kumar Singh

Morgan Stanley, Research Division - VP

* Steven Richard Koenig

Wedbush Securities Inc., Research Division - Analyst

* 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 First Quarter Fiscal Year 2019 Earnings Conference Call. (Operator Instructions) Thank you.

Mr. Jon Parker, Head of Investor Relations, you may begin your conference.

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Jonathan Parker, New Relic, Inc. - VP of Strategic Finance and IR [2]

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Thank you. Good afternoon, and welcome to New Relic's First Quarter Fiscal Year 2019 Earnings Conference Call. Joining me today are New Relic's Founder and CEO, Lew Cirne; and Chief Financial Officer, 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-K filed with the SEC, particularly in the section titled Risk Factors.

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 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.

And 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, Jon, and good afternoon to everyone joining today's call to review New Relic's first quarter fiscal 2019 financial results. We had a strong start to the year with Q1 revenue of $108.2 million, up 35% year-over-year, and non-GAAP operating income of $8.7 million, both of which exceeded our guidance ranges. My thanks to the 1,400 Relics who worked tirelessly to help deliver these solid results.

As we shared during our recent Investor and Analyst Day in June, our vision is to be the dominant DevOps platform that companies of all sizes use to monitor, manage and operate their digital applications and systems.

Today, every organization needs to increase its pace of technical innovation, whether it's by migrating to the cloud, delivering compelling digital customer experiences or adopting DevOps methodologies. Our customers are all on a mission to move faster. By definition, this means increasing the rate at which they introduce change into their production environments, resulting in more organizational and technical complexity as well as higher levels of risk.

New Relic empowers forward-thinking organizations with the visibility and the data they need to overcome this complexity, reduce risk and increase their speed of innovation. This ultimately helps these companies improve business outcomes, including driving revenue, increasing productivity and building brand value.

We're viewed as an integral part of the technology value chain for teams who are tasked with creating and releasing software into production without disruption. These developers, operations professionals and business executives are focused on 3 critical technology initiatives to drive their digital transformation: the first, cloud adoption to enable teams to have more autonomy in scaling their infrastructure; second, DevOps to offer teams greater agility to deliver products to market; and third, delivering a flawless digital customer experience. By aligning our go-to-market efforts with these foundational components to digital transformation, cloud, DevOps and digital customer experience, we are driving larger deals with broader product adoption.

In Q1, the percentage of new ARR from non-APM products remained near the record levels from Q4, with New Relic Infrastructure contributing its strongest ever percentage of new business. Impressively, after just 18 months in the market, New Relic Infrastructure has already become our highest attaching product. In our view, this reflects the pent-up demand for the unification of application and infrastructure performance data in a single pane of glass. Having said that, while the speed is incredibly encouraging, we still see our customers at earlier stages of adoption for this product and we have meaningful runway ahead.

Part of our confidence stems from the conversations I have with companies across the globe who are increasingly focusing on how we can help them instrument a broader portion of their environment. As we have highlighted before, Gartner estimates that only 5% of application workloads are currently monitored by any APM product but that this could grow to 20% by the year 2021. While we see our addressable market as much higher than just the APM portion, given the breadth of our platform, we do believe this helps underscore the immense opportunity we see in front of us.

From a go-to-market perspective, it was a solid start to the year as enterprise ARR grew to 55% of total ARR, while both our enterprise and SMB businesses had their best ever Q1s. Underscoring this momentum, in Q1, we signed our largest ever federal deal as well as our largest ever SMB deal, both 7-figure ARR transactions.

One of the most exciting customer stories from the quarter was with Epic Games, developers of the smash-hit phenomenon, Fortnite. I don't know a single parent that I talk to that doesn't have a child who is obsessed playing this game. It has truly taken the country and, dare I say, the world by storm.

Now, if you have young adults in your household, I know I don't have to tell you about Fortnite. It's one of the most popular and fastest-growing online games in the world today. It launched a year ago and now has a stunning 125 million registered players. Hosted in Amazon Web Services, they've had to scale quickly while maintaining reliability of a rapidly growing infrastructure. Epic Games relies on New Relic to support the global operations of Fortnite, utilizing New Relic APMs to understand the health of their services. They are also focused on optimizing and enriching the user experience of their players, working closely with New Relic to achieve these outcomes.

Now I bring up this story because it exemplifies the challenges facing so many of our customers. Every company today needs to ensure that their digital systems can stand up to their busiest days because that's when your customers are counting on you the most. We believe that instrumenting at scale required by modern businesses can only be achieved in the cloud, in part, because it would be cost-prohibitive to stand up and process this much data inside your own data center. I'm confident that if we can scale up to Fortnite's needs, there isn't an enterprise in the world that we can't service, and we're just getting started on this mission.

And speaking of happy customers, we're thrilled that New Relic was recently recognized as the Gartner 2018 Peer Insights Customers' Choice for Application Performance Monitoring Suites. Peer Insights is Gartner's online platform of ratings and reviews of IT software and services that are written by IT professionals and technology decision-makers, designed to help IT leaders make more insightful purchase decisions. And as of last week, New Relic has received the highest score for this distinction in the market.

This recognition from our customers matters deeply to me. Since the founding of New Relic, my priority has always been on delivering a flawless end-user experience for our customers, our end users, the people who work every day to make sure their systems are running at peak performance. For too long, our industry was rife with expensive and hard-to-use products that only a couple of people in an enterprise could actually use. New Relic prides ourself on our ubiquity throughout our customer base, meaning how widespread our software is adopted across the teams responsible for building and running modern software. Our most successful customers have hundreds and sometimes thousands of users who get value out of our platform. Our job is to make our category a joy to use.

To maintain the pace and high win rates needed to realize our win-the-cloud strategy and become the dominant DevOps platform, we continue to deliver innovations across our product platform. Over the past few months, we've launched deep support for Kubernetes and, most recently last week, distributed tracing. We continue to be focused on making it a no-brainer to deploy New Relic everywhere in modern environments. Our teams are hard at work, and we expect to have some exciting announcements throughout the fall at our FutureStack event series.

Earlier this year, we celebrated our 10-year anniversary as a company. And while we're still early in our journey, we continue to see strong demand for our unified platform from companies looking to modernize their digital business. We had a great start to fiscal '19, as evidenced by the results I just shared.

And now I'll turn it over to Mark to run through additional numbers.

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

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Thanks, Lew. As a reminder, during today's call, our first quarter fiscal year 2019 financial results are presented under ASC 606, which we adopted using the modified retrospective method. To help aid with comparability versus the prior year's results under ASC 605, we included a reconciliation table in the earnings press release and investor presentation accompanying today's call, which is available on our Investor Relations website.

Now turning to the financials. Revenue was $108.2 million for the first quarter, up 35% year-over-year. We ended Q1 with 748 paid business accounts paying more than $100,000 per year, up 35% compared to a year ago and an increase of 45 from the prior quarter, our best ever Q1 performance. The growth of this figure represents both new logos and customers expanding beyond that threshold.

Overall, our total paid business accounts remained over 17,000, relatively flat from last quarter. As we've discussed the past few quarters and, in particular, at our recent Analyst Day, we are programmatically focusing more of our resource both upmarket and our expansion business given the significant opportunities we see here. We are pleased with the early results of this focus, which are reflected both in our $100,000 ARR paid account additions and continued enterprise paid account growth.

Our dollar-based net expansion rate in Q1 was 118%, which increased 6 points from the year-ago figure and also reflects our current strategic efforts to focus more on our installed base. Given the expansion of our base over the past year and Q1 typically being the low seasonal point for this metric in the year, we are particularly pleased with this result. At the end of Q1, our enterprise business was approximately 55% of annualized recurring revenue, up from around 49% in the same period last year.

Turning to our geographic split. U.S. revenue of $74.1 million for the quarter was up 35% year-over-year, while non-U. S. revenue for the quarter grew to $34.2 million, also up 35% 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 the expense and profitability metrics I will be discussing going forward are non-GAAP and as reported under new accounting standard, ASC 606. A full reconciliation between historical GAAP and non-GAAP metrics can be found in our earnings release issued today and available on our Investor Relations website.

Our gross margin was a record 85%, an improvement from 83% in the year-ago period. As we look at the full fiscal year, we do expect this to come back down towards 83% as the European region comes online and we add additional domestic capacity.

With regard to operating expenses, sales and marketing costs were $52.3 million compared to $44.7 million in the same quarter last year. Sales and marketing costs included a roughly $1.7 million benefit compared to the comparable figure under the prior accounting standard, about $700,000 more than contemplated in our previous guidance due to slightly higher capitalization levels.

R&D expenses were $19 million compared to $15.2 million in the same quarter last year and reflected a particularly strong hiring quarter. G&A costs were $12.3 million compared to $11.9 million in the same quarter last year. Overall, we experienced our strongest ever hiring quarter to start the year. Looking ahead, we expect another particularly robust hiring quarter in Q2, reflecting our continued confidence in the market and investment opportunities.

On a non-GAAP basis, we achieved record operating results and profitability with operating income of $8.7 million or 8% of revenue compared to an operating loss of $5.4 million or negative 7% of revenue in the same quarter last year. Overall, our net income per diluted share was $0.15 compared to a net loss per basic share of $0.09 in the same quarter last year.

Turning to our balance sheet. We ended the first quarter with approximately $721 million of cash, cash equivalents and short-term investments, up from last quarter's $248 million total, much of the gain coming from our convertible debt offering, which closed in May, as well as strong cash flow generation in the quarter. Also, on the balance sheet, our total deferred revenue ended the quarter at $183 million, up 46% year-over-year and down 4% quarter-over-quarter, which compared favorably to our guidance for a mid- to high single-digit decline from last quarter. As we look into Q2, we anticipate deferred revenue to decline low to mid-single digits from Q1.

Turning to cash flow. Cash from operations was $50.4 million, driven by significant collection activity following our seasonally strong billing in Q4. Free cash flow, defined as cash from operations minus capital expenditures and capitalized software, was $41.5 million. For all of fiscal '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 expect a pick-up in physical CapEx beginning this quarter and our seasonally lighter quarters for operating cash flow in Q2 and Q3.

Now I will turn to our outlook for the second quarter of fiscal 2019 and the full year. For the second fiscal quarter ending September 30, we expect revenue to range from $110.5 million to $112.5 million. We expect non-GAAP operating income of $4.5 million to $5.5 million. This would lead to non-GAAP net income per diluted share in the range of $0.11 to $0.12.

For the full fiscal year 2019, we now expect revenue to range from $457.5 million to $462.5 million, an increase from our prior guidance of between $452 million to $458 million. We expect non-GAAP operating income of $18 million to $22 million, an improvement from our prior guidance of between $15 million to $20 million. This will lead to non-GAAP net income per diluted share in the range of $0.39 to $0.46, an improvement from prior guidance of between $0.29 to $0.37. This revised guidance also reflects expected interest income as a result of our convertible debt offering.

Overall, as our guidance implies, we expect to reinvest a portion of our profitable growth to investments that will continue to ramp in the second half, which will result in lower levels of profitability in Q3 and Q4. We believe this will set us up for continued success as we enter fiscal '20.

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 Michael Turits from Raymond James.

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Robert S. Majek, Raymond James & Associates, Inc., Research Division - Senior Research Associate [2]

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This is actually Robert Majek on for Michael today. So you recently rolled out support and integration for Kubernetes. Can you just talk about the importance of that initiative and what the customer response has been so far?

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

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Certainly. I imagine that one's going to be for Lew, not Mark.

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

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I'll let you take it.

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

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Yes. So we're excited about Kubernetes and what it does for our customers and enabling them to really adopt containers technology at scale and to really reduce the cost and toil involved in these highly dynamic microservice environments. And so it allows our customers to orchestrate a highly dynamic environment using largely open-source technology and -- but it does involve new visibility requirements that our customers have been asking us for, and we're delighted to deliver that visibility into the entire Kubernetes environment. Due to the breadth and strength of our platform, that was something we could add directly into New Relic, integrated with all the other data we collect.

So our customers love that they can see the Kubernetes data right alongside the application health data and the other data that we provide out of our other products. And so response has been very strong. And we have a healthy road map of more that we want to do in Kubernetes. So certainly, there's more to be done but we're getting great feedback from the market on what we've done in our first offering.

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Robert S. Majek, Raymond James & Associates, Inc., Research Division - Senior Research Associate [6]

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That's really helpful. Maybe just one more from me. Just at the Analyst Day, one of your customers highlighted the fact how he has to use competing products for certain use cases when it comes to log monitoring. Do you plan to get more capability in that area?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [7]

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We do see that log monitoring is a complementary source of data from the data that we collect, which is particularly coming directly out of the applications as they are running or from the infrastructure. And so where we are today is that's a complementary technology and we have integrations with many of the leading logging providers, and that's our strategy at this point in time. And so we've got a lot of opportunity in the market we serve today, and we feel like that's where we're focused on for now.

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Operator [8]

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Your next question comes from the line of Derrick Wood from Cowen and Company.

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Derrick Wood, Cowen and Company - Analyst [9]

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The -- at the Analyst Day, you mentioned you're starting to see more legacy APM displacements, and I just wanted to drill down on that. First, is the reason to rip out legacy generally due to a shift in cloud? Or are there other catalysts that you're seeing?

And then second, when you do a legacy displacement, do they tend to be larger initial deals? Or is it a similar land and expand to a greenfield environment?

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

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Yes, great question. And the 3 things that will stimulate a transaction where someone might leave a legacy on-premise monitoring vendor for New Relic are the 3 areas of focus to our business that we highlighted in the prepared remarks: cloud adoption; DevOps; and digital customer experience. And so when any of those 3 initiatives become strategic for a company, they recognize that their previous generation on-premise tooling is not well-suited to help them be successful in migrating to cloud or developing a DevOps culture or in focusing on digital customer experience, and that's when they turn to us.

And then -- and that's often a land-and-expand strategy where we start -- where we have such a strong advantage in those core areas. And then the customer prefers our ease of use and TCO, total cost of ownership, and then we have the opportunity to replace more and more pricing environment that might be the domain of a legacy vendor today.

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Derrick Wood, Cowen and Company - Analyst [11]

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Okay. And Mark, if I could squeeze one in. The -- you put in the earnings slide deck a comparison of gross margin relative to peers. You guys are the highest out of anyone. And I'm just curious, what drives such cost efficiency relative to peers? And what's been the factor behind the move from 80% to 85% over the last couple of years?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [12]

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So it's -- I appreciate you noticing that. It's always nice to be on the left-hand side of that slide. So a number of things and it starts with the fact that when Lew started and Jim, and when we started, we worked on efficiency from day 1. And so I think the attitude on our team was always that you don't just worry about efficiency later and worry about gross margins later because later never tends to come. So from the get-go, we were very focused on an infrastructure that could support our customers and support large amounts of data in a very efficient manner. And so that continues to pay dividends for us.

Another factor is just the ease of use of our product. When you look at our services costs, our support costs, even as we've expanded into the enterprise which generally has a higher support burden, we've been able to increase those gross margins because the product is very easy to install and deploy and has a quick time to value. So those are a couple of the factors that have helped drive that.

Also, just we've had a bit of a tailwind. As our business has migrated more toward the enterprise and larger transactions, even things like credit card fees, which, in the old days when we were more SMB-focused, tended to be more significant, those are tending to be a lower number. And so all those have helped drive the gross margins to the levels they're currently at.

That said, as we mentioned, we do see -- we'll see -- we do see pressure coming on that number and that migrating more toward an 83-or-so percent level as we go forward due to the investments that we continue to make in our infrastructure and additional capacity.

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Operator [13]

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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 [14]

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So is there a rough way to quantify the percentage of deals, whether it's landing a new customer or expanding with an existing customer that are greenfield versus replacement?

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

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The vast majority of our deals are greenfield. And that stems, in large part, I think, because of our land-and-expand strategy. Generally, we first get involved with a customer at what is for an enterprise [5], relatively modest number, $50,000 to $150,000 a year in ARR. So -- and that will typically be on a new digital initiative or someone will be kind of dipping their toe in the water with a migration to the cloud. We'll get involved there, and that's how we enter the account.

From there, we expand as that account -- as that grows, we'll go to different -- they will bring more and more workloads to the cloud. So our environment will -- or our -- will expand. They'll add new products. We'll expand in that direction. And then as they see the -- as Lew mentioned, they see how easy it is use, what kind of value they can get from New Relic, we'll go into other parts of the organization and other applications. But the typical land for us is in a greenfield opportunity.

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Gray Wilson Powell, Deutsche Bank AG, Research Division - Research Analyst [16]

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Got it. That's really helpful. And then just one more if I may. I know you've already answered a couple of cost questions, but you guys really did outperform pretty nicely on both the gross and operating margin lines. And in fact, you flowed through more than 100% of the revenue beat on each metric. So was there any main particular driver there this quarter?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [17]

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We were helped from the bottom line with the revenue obviously, outperformance, that helped. And we're seeing improvements. We've been investing in the business for quite a while now, a number of years. We're seeing operational efficiencies come from those investments. We also had, as we mentioned in the script, a better-than-expected benefit from the move to 606. I think it was about $700,000 of incremental expense improvement because of the capitalization of a higher percentage of our commissions than we had expected.

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Operator [18]

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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 [19]

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This is actually Ugam Kamat on for Sterling. So Lew, in your prepared remarks, you mentioned about the record infrastructure quarter but -- and it is one of the highest attaching products. Just wanted to understand whether infrastructure is more of like an upsell product where you are seeing customers already owning APM or other solution go and buy infrastructure. Or is it that it just leads the way and helps you gain new business? Or is it just like an upsell product?

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

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It is predominantly the former scenario you described, where given our 10-year history as a leader in APM, virtually all of our customers are APM customers and virtually all of our prospects come to us with APM in mind as a minimum part of the problem they're solving. And then they love our infrastructure product and they love the idea of having 1 vendor provide all that in 1 place. And so that's why it attaches so well.

But we believe the application is the center of gravity. At the end of the day, what people are spending all this money on cloud and on infrastructure for is to run applications, to build and run applications. And so with an application-centric view and strategy, we believe we have a very important strategic role to play, and that it's a natural add-on for products like infrastructure to increase our value to our customers and help us with our business goals.

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Ugam Kamat, JP Morgan Chase & Co, Research Division - Analyst [21]

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Got you. And Mark, one for you. You mentioned about higher capitalization of sales and marketing expense to the tune of $700,000. Is it because of higher billings versus, I would say, amortizing over a larger customer life?

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [22]

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No. It's -- I mean, a lot of that's driven by the commission numbers and just the assumptions we made on -- and as to what percentage of our commissions would be capitalized.

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Jonathan Parker, New Relic, Inc. - VP of Strategic Finance and IR [23]

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This is Jon. Just to be clear, we're not -- as we say in our filings, we don't actually capitalize 100% of the commissions. There are certain pieces that don't get capitalized due to certain requirements. So it just is related to certain assumptions we had made going into the year around what percentage of our total incurred commissions would actually be capitalized relative to what actually played out.

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Operator [24]

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Your next question comes from the line of Jennifer Lowe from UBS.

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Jennifer Alexandra Swanson Lowe, UBS Investment Bank, Research Division - Analyst [25]

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I wanted to touch a little bit on the product innovation around distributed tracing, Kubernetes support and then obviously, a long train of innovation over the years. And as you roll out this functionality, do you see that as sort of benefiting adoption, driving uplift to higher-price SKUs? How do you think about monetization opportunities attached to some of these innovations versus just being table stakes to stay relevant in an evolving world?

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

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Well, first of all, we think that we're in an incredibly large and growing and exciting market. And the Gartner quote of 5% of applications under monitoring -- monitored by APM vendors today and that could grow to 20% by 2021. We're in an abundant market to pursue. And so distributed tracing, we're very excited about because as companies move to more and more microservice architecture, they want to see the health of an action like, say, for example, somebody logging in, that might touch 10, 20, 30 services all running in concert in production. And so distributed tracing allows you to see the relationship as that transaction runs through all 30 of those services.

And what's cool about it is if you're only instrumenting 1/3 of those services, then you've got a visibility gap that distributed tracing will stop short of, until you install New Relic on those other services. So we believe it has the potential to perhaps provide more incentive for our customers to instrument more of their environment as it becomes more interconnected. And that will certainly drive growth for our business. So our customers are subscribers, and we have healthy dollar net expansion rate. And so we just believe by delighting them, we believe the business results will continue to be favorable.

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Jennifer Alexandra Swanson Lowe, UBS Investment Bank, Research Division - Analyst [27]

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Okay, great. And maybe just one more from me. On the last call, one of the things you talked about was the opportunity to expand the role of technical sales as an added lever for growth. I'm just curious sort of what the early feedback on that is. Are you seeing the productivity out of the effort that you hoped for? Just any color there would be great.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [28]

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Sure, yes. So we -- that's been an emphasis for us. We've been doing that. As we mentioned, we had a record hiring quarter this last quarter. And we have been pushing out the folks who go out in the field to help our sales or account executives both before the sale or particularly after the sale to help with -- help customers learn, understand how to use New Relic.

Our best customers are the ones that know us best, know the product best. And so we're seeing nice returns from those investments. It's something we expect to continue to do. We're constantly looking at the ratios of technical to account rep folks we have, tweaking those. And at different levels, as you get more toward the larger accounts, obviously, higher ratios there tend to be more attractive. So we are seeing good returns there and something we expect to continue to do as we go throughout the rest of the year.

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Operator [29]

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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 [30]

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Lew, you opened your prepared remarks, you made a comment about how your opportunity extends well beyond APM, but that's still an underpenetrated opportunity. I wanted to get your thoughts on what -- over the long term, what the size of this customer base might be. I mean, if you look at other infrastructure companies in the past, whether it's VMware or Citrix, those guys have been able to get to 400,000, 500,000 type customers.

I guess my question is to what extent do you see your products and your solutions as that ubiquitous in terms of the mass market for infrastructure software?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [31]

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It has the potential to be that. We're most focused at the moment on the largest enterprises in the world, particularly those enterprises that are most aggressively adopting cloud, DevOps and digital. And we believe that while I love the idea of democratizing this category and that's one of the reasons -- one of the strengths of our product, how easy it is to use -- from a business perspective, we see the greatest growth opportunity on the high end of the market. And so customer count may be the wrong way to think about success, although we always love it when more people use our products.

The other way to think about it is ubiquity within an enterprise customer. So you probably remember, I said this a couple of times before, but the sad history of this category before New Relic was that most APM customers had 2 or 3 specialists that knew how to use these hard-to-use, arcane tools. One of them, I created in a prior life. And so -- but with New Relic, we wanted to make this easiest that hundreds or, in some cases, thousands of people use our products within these enterprises.

And so I like to think in terms not only of number of companies using our product but number of people using our product. And that's important, the way we think about changing our category.

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Sanjit Kumar Singh, Morgan Stanley, Research Division - VP [32]

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And maybe just a follow-up to sort of -- to dovetail on your last comment. When Microsoft acquires GitHub and you start to think about the greater strategic performance of the developer community, can you talk to us about how New Relic tries to maintain its relevance and maintain its enthusiasm within the developer community? I think one way might be to look at it is the strong non-enterprise growth that we've seen in the last several quarters. But can you talk to us about what you guys are specifically doing to drive that level of engagement with the developer community?

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [33]

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Sure. So the big change really that we're seeing and particularly on companies that are adopting DevOps is that the silo between building your software and operating your software is breaking down. So as companies move from big, monolithic architectures and teams to smaller teams that have responsibility for their service and their piece of the broader application, and those teams have responsibility not only for building the application, but making sure the application delivers high availability. And that's why you see this explosion in the number of people using our type of software. It's because developers, primarily they're writing code but they're also -- if there's a problem in production, they need to quickly be able to resolve it so they can go back to writing code, right.

Now in traditional IT operations organizations, there was this central operations team that tried to keep applications running. And when you have that organizational structure, the only way to manage risk was they said no to production change, right. And that's why previous generation tools aren't a fit for where the world is moving and why there's this need to move faster. In order to move faster, you need developers to be more rapidly introducing change to production, and that means pushing out responsibility for the health of the system to those people. And that's why we're so relevant to that community.

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Operator [34]

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Your next question comes from the line of Greg McDowell from JMP Securities.

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Gregory Ryan McDowell, JMP Securities LLC, Research Division - MD and Senior Research Analyst [35]

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One for you, Lew, and then one for Mark. Lew, I want to go back to infrastructure for a minute. You mentioned it was the highest attaching product and the strongest ever percentage of new business. And I was just wondering, it feels like we've hit an inflection point with this product, and I think you mentioned the words, pent-up demand. And I was just hoping you can expand on whether that's something you've made -- or changes you've made in the way you're selling the product or additional functionality you've put in the product, or whether or not the market has just finally come to you and some of the other players out there. So I was just hoping you could expand a little bit on just what happened in the last 3, 4, 5 months with infrastructure. Then one quick follow-up for Mark.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [36]

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It's a great question. And it's really the combination. So what we've been doing in the product with things like the Kubernetes functionality and we continue to deliver more and more integrations and points of visibility in the infrastructure product, so we're -- our investments in the product are resonating well with the market. But then it's also, I think, the market dynamics.

It's a well-known fact that most enterprise customers have dozens of tools to try to watch production and they're -- they don't like that. They don't want to have to kind of tab between a bunch of browsers and windows to try to have a complete picture of production. They certainly don't want to have to switch between tools to figure out whether it's the application or the infrastructure or both, right. And the application health and infrastructure health are interrelated, and they belong in the same platform and that's an easy thing for our customers to understand and get behind.

They love our APM product. We -- I talked just earlier in this call about how the application really is the center of gravity for these things. And so it's a natural thing to add infrastructure visibility to that. So it makes sense and the market's understanding that, and that's why we believe we've got this broader platform play in front of us.

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Gregory Ryan McDowell, JMP Securities LLC, Research Division - MD and Senior Research Analyst [37]

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That's helpful. And Mark, I'm just anticipating a question we may be getting later today or tomorrow on the paid business accounts metric. I get the mix shift. I think most investors appreciate the mix shift to enterprise and the tremendous success you've seen in the enterprise. But maybe just a little explanation on why a company with this type of growth rate would have flat paid business accounts from quarter to quarter. That would be helpful.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [38]

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Sure. So I mean, you nailed it in terms of where our investment focus has been. We've talked about how this is -- this number's fairly volatile and that our focus has been much more on the enterprise side and on the larger accounts. And we did have a record quarter, a record Q1 in terms of the number of over $100,000 accounts we added. We had a great quarter in terms of the number of enterprise accounts we added. And so I think that's where our energies are focused, and we're very pleased with the results we're seeing there.

On the low end, there's a lot of volatility and variability. Just as an example, half of the accounts that turned out last quarter paid us less than $2,500 a year in ARR, and nearly 3/4 of those accounts paid us less than $5,000 a year in ARR. And so that segment is something that is not going to be driving top line, but it's something that -- when we look at that segment, over time, it's something that we're going to -- we've got to work on in terms of being super-efficient at, but it's not really critical to driving top line economics.

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Operator [39]

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And your next question comes from the line of Jesse Hulsing from Goldman Sachs.

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Kevin Kumar, Goldman Sachs Group Inc., Research Division - Associate [40]

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This is Kevin Kumar on for Jesse. Looking at your ARR mix, our math implies some acceleration in your mid-market business during the quarter. Can you talk about what's driving that top line strength and what you think the sustainable growth profile for mid-market is over the next couple of years?

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

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Sure. I'll take a stab at that. This is Lew, and then Mark can provide some color. We're really pleased with how our mid-market and SMB business is developing and how we are focusing on with this platform strategy we're pursuing of APM surrounded by these other products. The high-growth, high-potential companies that we focus on tend to invest more with New Relic. And so we mentioned that we had a nice 7-digit transaction in the quarter from our SMB commercial segment. And that's just representative of us doing well in delivering value into that part of the business and being efficient at operating there.

So the team has done excellent work, and I feel great about that part of our business. And so it's just a lot of hard work we've been doing over the last few years that's really starting to show nice results.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [42]

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Yes. And I guess when we look at where we've been investing and the go-to-market engine on that -- for that side of our business, it has been more focused on the 100- to 1,000-person companies. It's sort of more mid-market as opposed to SMB. And I think over time, when you look at where we've migrated, you go back 5, 6 years ago, we were focused just on getting accounts in.

I think now, we are focused on getting the right accounts in, the ones with the highest potential. And so that could be some relatively small companies. And then a lot of companies in that 100 to 1,000 base, where we look at the lifetime spend for them with New Relic, can be meaningful. And we've been more targeted at approaching the market, going after them. And I think those results have been -- we've been very pleased with the results we've been able to achieve.

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Operator [43]

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

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Steven Richard Koenig, Wedbush Securities Inc., Research Division - Analyst [44]

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I'll just ask one question for you today. I'm wondering as you penetrate your enterprises with more and more projects, is this a sales motion in a market that can lend itself to a standardization decision where the enterprise says for the standard default assumption for any new application development is going to be the use of New Relic. Is that someplace this market can go? Or are you going to continue to kind of knock it off and expand really project by project, winning each decision at a time?

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

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We've already gotten there with a few of our customers where we are the declared standard, not even de facto but declared standard from, like, the CTO level. I like how we get there. Typically it's by proving ourselves time and time again, proving the value we deliver, get -- building a wellspring of demand internally from the end users, the people that rely on our software to deliver great software within their enterprise.

And often, it may be something like you're a standard for anything running in a cloud. Well, we believe that's virtually all future software for many companies. So there may be some guardrails around that and say you're not the standard for running in an older environment or something like that. But we love earning that position with our most advanced customers, and we'd like to get better at doing that faster with our customers over time.

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Operator [46]

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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 [47]

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Just wanted to follow up maybe on Steve's last question a little bit. You talked about this movement in terms of -- to try to move customers from their initial deal sizes towards closer to this $1 million-plus in revenue. And as you think about the -- I guess, the sales process around that, at what point do you need to engage with somebody higher up in the organization just because of the sheer dollars involved here? Just what does that process look like? Does it help if you engage with perhaps a Chief Digital Officer early on in the process? If you could just kind of shed some light on -- in terms of the dynamics of the budget dollars around purchasing your software.

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

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Sure. So if you look at what we've said in the past about our average customer spend in the enterprise segment, it's about $100,000 a year per enterprise customer. And those are subscriptions, right. So the total lifetime value of those customers will be attractive. But at that spend level, that's rarely at the C level for an enterprise. And that's fine with us. That's an average number, too. So there are many customers that are below that. So we'll often get in on a departmental level, a specific project, prove our value and then, over time, we will often need to have a conversation and love to engage in a conversation at senior level.

Those senior level conversations are invariably around the 3 themes I talked about in the prepared remarks. CTOs, they care about cloud adoption. They care about becoming more agile and embracing DevOps, and they care about their digital strategy, right. And so whereas at the departmental level, they may ask about instrumentation and what are we doing for Node.js or Kubernetes, right. That's what our end users and departmental people care about, and we'll have those conversations.

But when we get to the C level, we help them transform their organizations to be successful with DevOps or by migrating to the cloud faster. And so our ability to have the right conversation at the right level is a big part of why we're seeing the nice improvement in large deal sizes.

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Operator [49]

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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 - Software Analyst [50]

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Lew, in terms of the expansion with the new European headquarters, can you give us a sense for what sort of investments you expect over the near and medium term in terms of really solidifying that expansion? And then alongside that, maybe if there's any different sort of sales motions that you need to consider in terms of that. And then I have a follow-up for Mark.

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Lewis Cirne, New Relic, Inc. - Founder, CEO & Director [51]

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Sure. And I may ask Mark to chime in on the European one. We are excited about our European opportunity, certainly by opening up a European-hosted presence of New Relic that'll -- there are many customers, we believe, we'll be able to attract to New Relic who just feel more comfortable with their data being in Europe rather than being in our U.S. data center. So that's being well received by parts of the market.

And of course, we're always investing on the go-to-market side in Europe, and we're excited with the team and the people and the talent we have on the ground there. I was just in our European office last week, and I was very impressed with the people there, the energy and how our products are resonating with that region.

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Mark Sachleben, New Relic, Inc. - CFO & Corporate Secretary [52]

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Yes. And I guess I would say that it's a comparable go-to-market strategy that we've seen in the U.S. Our feeling is prove something out in the U.S., then bring it to the rest of the world. And we did that with our Dublin -- opening our Dublin inside sales team a couple of years after we started the U.S. The enterprise team in Europe is a couple of years behind the U.S., but it's a similar strategy.

We tweak here and there. Certain markets, we'll test different ratios or different things, but it's overall fairly similar to the U.S. And we take a fairly deliberate approach to Europe, where we'll be entering countries at a measured pace once we see demand there and things. We don't want to overextend too quickly, but we see great opportunity there going forward.

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Rishi Nitya Jaluria, D.A. Davidson & Co., Research Division - Software Analyst [53]

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Okay. That's helpful. And then, Mark, it was a strong cash flow quarter. I understand Q1 is a strong collections quarter. But given how much you outperformed on cash flow and the raised operating income guidance for the full year, can you maybe help us understand why you're maintaining cash flow guidance on a full year basis and not raising it?

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

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Sure. So if you look back historically, the patterns the last -- that evolved the last couple of years, particularly last year, and you look into Q2 and Q3, where you tend to see cash flow dip down into negative territory, and we've got some investments coming up in some physical infrastructure that are going to be coming due in the next couple of quarters. So we do expect that to go negative the next couple of quarters. And then in Q4, we expect it to come back to the positive realm.

But overall, we are looking at -- as we mentioned in the remarks, looking at additional investment as we head out into the -- toward the second half of this year. We want to set ourselves up for success going forward in fiscal '20 and beyond. And so we're looking at some incremental investment in the next -- in Q -- in the rest of Q3 and Q4.

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Operator [55]

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

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Jonathan Parker, New Relic, Inc. - VP of Strategic Finance and IR [56]

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Thank you, everyone, for joining the call today, and look forward to talking to you all soon. Thanks.

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Operator [57]

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