Dynatrace, Inc. (DT) Earnings Call Transcript & Summary

All right. Great. Good morning, everyone. Thanks for joining us on day 2 for Barclays Virtual TMT Conference. I'm very pleased to introduce the Dynatrace management team, John Van Siclen, the CEO; and Kevin Burns, the CFO. Hey, guys, it's great to have you here. Always enjoy the conversations with you guys. So thanks for joining us at our conference.

Great. Glad to be here.

So you guys have been a very exciting story over the years and have been on a product and business model transformation, John.

So maybe let's start with product, right? So few years back, and I'd love to hear the story over and over again. So a few years back, you were sitting, pretty, right? So you were ahead of the curve in terms of APM but still you have decided to go ahead and disrupt yourselves, right? So help us walk through that journey. So what were the motivations? And how that has positioned you even with more strength at this time?

It was actually, 6 to 7 years ago, when people could barely spell cloud or if they could spell it, they didn't know what it meant. And we were doing the same, trying to figure out what was it going to do to the monitoring business at large. And so we put a team together to take a look. And to my surprise instead of telling me how they were going to modify what we were doing and evolve it this way or evolve it that way, they said, it's going to change everything. It's going to be too dramatic. We need to start over. Not a lick of the same code and rebuild for where the puck is going. And some of the things that they took me through were that the cloud was going to be all software. Today in that -- or yesterday in the data centers, you had a nice network layer that was physical. You had the hardware layer, infrastructure, physical and then you had your apps on top. Everything nicely stacked up and organized. And in the cloud, it's going to be shared services everywhere and just a ball of software, software networking, software infrastructure, et cetera. They said because of that, the scale is going to go through the roof. It's not going to be 10x, it's 100x to 1,000x more complex. They said that it was going to be dynamic, nothing static anymore. We're going to be changing things ephemerally all the time. So all of our instrumentation, throw it out. All of the way we're thinking now, throw it out, rebuild from the ground up. Build in automation and AI to deal with the dynamic complexity that would exist. And that led to the new Dynatrace platform that we brought out 5 years ago. We made it enterprise robust 3.5 to 4 years ago, and that's really catapulted us to the growth rates required to be a public company. And we're still riding that same -- those same trends. They're only more and more important now than ever, the automation and AI in this world of pandemic and post pandemic because nobody has enough resource, the complexity is through the roof and everyone wants to go faster.

Understood. Understood. That definitely can be case study in disrupt yourselves rather than be disrupted. So thanks for that background. So let's fast forward to today, right? And this notion of observability, right? I'm assuming some of the themes you mentioned about that product transformation. You could also sort of like see this coming, but this notion of observability is now front and center. So help us understand as to where you fit in that market landscape and what that means to you from both a competitive positioning angle and also the product road map angle.

Yes. Well, when we were reinventing, we called it a full stack view and to do a full stack view you couldn't just do the application layer with code instrumentation. You had to do the infrastructure layers with log and metrics and the network layer with log and metrics. So we always had the notion that you needed to sort of pull it all together in order to understand sort of what was going on in these dynamic web scale clouds. So we've been doing observability for a while. We just didn't have the label for it that the market is now put on it. But we never have felt that observability alone or what we used to call visibility was the end game. That's a starting game. What matters are the analytics, what you do with the data to actually solve customer problems, make them more efficient, give them insight where they didn't have it before, help the humans be more effective over a wider landscape. So these are things we've invested in. So the observability market, which is great to have a label on it now and sort of have momentum because it actually makes our sales cycles a little bit easier and faster, especially when we get higher up. These are strategic decisions, more and more often now platform decisions. But our differentiation continues to be strong against everyone else. Where they're trying to pull observability together, we're advancing our analytics, which is where the difference and the value really is made.

Great. So also just digging into your core offering, right, your flagship offering, so full stack, but APM is the use case where you expected the most thing, right? Help us understand that market opportunity. I mean, we hear all the time that even though it's like a fierce competitive landscape, there's a whole lot of greenfield out there, especially in APM because enterprises only monitor a small subset of their total applications. So help us understand the market opportunity, the penetration rate and how you see that evolving in the near future?

Well, we've always believed that the application layer is the most strategic. It's the high ground. It's where the business meets IT. You don't have a CEO asking about the infrastructure, how is the network today. They're asking about how the most important applications that drive their digital business are going. So it's a really important layer, and it's very hard to do, which is why there's very few players in Gartner Magic Quadrants or anything else, if you look around, it's a rocket science kind of game. Because you have to not only have deep visibility all the time, but you also have to do it at super low overhead. So it's a pretty tricky spot, and we excel at it. And it is our landing zone because we are so different, and we look for modern cloud environments, the ones that are the most dynamic. The most important apps, the ones that are changing the most frequently because then our continuous automation, self-discovery, automatic base lining, automatic detection of anomalies and degradations, automatic answers, very precise root cause, all these kind of capabilities and characteristics really shine. So that's a great landing zone for us. Yes, there's usually some alternative there. But we've been competing for 15 years for that space, and we know it really well. And it's still -- when you have 70-plus percent win rates, it's a great place to be landing. One of the things that I think is important here is that the discussion has been over the years that APM is only instrumenting 5% to 10% of the application load even if companies want more. Because of our automation that we provide, we're almost automatically going well past that. So our penetration is much greater, which drives our net expansion rates, a big chunk of the net expansion rates in ARR growth. But we don't stop there. We now, with the infrastructure, module go all the way down from the Tier 1, Tier 2 apps, all the way down through the broad Tier 3 and even environments that don't have any apps at all, which are vast. So with the extension and sort of generalization of the platform over the last couple of years as we've sort of segmented into modules and expanding, we cover that entire landscape for a company. And that's impacted when you start doing the use cases like security. People need it everywhere. So...

Yes. And that's a great segue to my next question, right? So the cloud application security module that you recently came out with. You had previewed it at your Analyst Day earlier, but now it's generally available. So help us understand what is the motivation behind entering that market? I mean, we have seen competitors follow a similar playbook, but maybe into another subsegment SIM, right? But cloud application security, what it means to you, how you see the TAM, give us the high level there?

Yes. No. So the first thesis of this entire space is that the cloud really is collapsing use cases. These IT operation management use cases, which were very sort of separate and siloed. The cloud collapses them there, just a requirement because of all these virtualized layers of software. There's no hardware anymore, all software. And security is another one of those use cases that is getting collapsed with observability due to just cloud dynamics. And just as we foresaw the dynamic nature of cloud sort of disrupting monitoring and creating an observability requirement, we see the same thing with security. And in particular, for us, we thought because we have code level detail, we have a very sort of automatic and intelligent platform, what better place to enter than the RASP side of things, where it truly is greenfield in the production side of RASP in modern Kubernetes clouds. All the old ways of doing things, which were ring-fencing with firewalls fall apart with dynamic multiclouds. Everyone else who's trying to get into this space, whether it's Rapid7 with tCell, whether it's some of the new players that are coming in, NEWSTAR and some others, they're all focused in preproduction, full scan of code, but nobody has the instrumentation to do it continuously in production. So imagine now having that continuous capability, any code entering production or that's already there, always watched across the entire landscape for vulnerabilities using the sneak database as that sort of data set of record is pretty compelling. And we've had some great feedback from early customers who've adopted and now paying customers. We see this as the first entry into the security space and one that we, in particular, are well equipped and uniquely equipped to go after in a broad way.

Understood. And a follow-up there, right? So obviously, I'm assuming this is another module, helps you across cell motion with your existing modules, right? I wanted to take a step back and talk about your pricing and packaging strategy, right? We have seen competitors take both sides of the spectrum, somebody like Datadog is coming up with modules quite often. And somebody like New Relic is actually simplifying their pricing and packaging structure with only limited number of skills, right? How do you think about -- what's your philosophy behind the sort of the cross-sell motion and the packaging vis-à-vis your competitors?

Well, the way we think about pricing at sort of the enterprise level and maybe I'd level set for some of the folks out there, we do focus on the global 15,000. That's a $1 billion-plus kind of company, not -- we don't focus on the mid-market. Our go-to-market motion is direct sales, enterprise kind of approach, which we think fits our sort of unique characteristics of our product extremely well. So when we think about pricing and packaging, we think about covering a set of use cases for a certain buyer or persona in the enterprise. We don't think about fragmenting on data sources. We think about solve the problem. So for example, our APM module includes infrastructure, which are logs and metrics because you need the full stack view in order to understand cloud applications. Security is going to be the same kind of thing. It's going to cover a set of use cases. For that set of use cases, as long as a customer has a predictable model and transparency into the future if they buy more at the enterprise, they're happy. The last thing they want are surprises with overages or not to be able to see what the cost is going to be if I go wide. If you can solve predictability, transparency and have a fair price, the enterprise is happy because they don't buy on price, they buy on value.

Understood, loud and clear. All right. Let's switch gears to -- a bit and talk about your recent performance, right? So we -- I mean, we -- pandemic, nobody could have predicted, right? And then you guys have actually executed and held up pretty well despite that uncertain macro environment among your customers. So talk us through as to what you saw over the last few quarters, right? Give us the high level and what allowed you to really be not just resilient but actually execute pretty well despite the macro. And Kevin, it will be great to also bring you into this question.

Yes. So why don't I start and I'll hand it over to Kevin to help sort of quantify maybe some of the pieces. So early on, we figured out that our thesis was that we would continue to be resilient because when companies get challenged, especially financially, they're going to lean into things that provide agility, speed and efficiency. And that's software. And that's cloud software. In this world and digital transformation really early on, boom went up and yes, those projects were going to continue and other sort of enterprise or tertiary sort of things dropped off the list. So we've actually seen more predictability in our sales cycles than we had prior to the pandemic. The impact we're having is just really an impacted verticals, transportation, hospitality, those kinds of verticals. But the vast majority, 80%, maybe a little bit more than 80% of those verticals have been quite strong, resilient and leaning into software and digital transformation. So that's given us this resiliency. This has given us the confidence to step up our sales expansion from a 20% kind of level. We started the year with to 25% now, maybe take it further. But we see a great opportunity ahead, resilient value proposition and just some -- both in new logos and net expansion rates, solidification of the business and strong momentum.

So if we think about the historical ARR, Mohit, and we exclude the impact of converting our customer base from our classic products at Dynatrace, our historical ARR growth rate has been in that high 30% range, 37%, 38%, 39%. This quarter, our ARR grew 35%. And I think it's worth noting 2 primary headwinds, and we think these are near-term headwinds. The first what John mentioned was the COVID impact. So on a year-over-year basis, we saw an impact in our first quarter where we had new logos decline pretty significantly. We did see a nice rebound in the second quarter, and we think that should start to come back online a little bit in Q3 and Q4. But certainly, the number of new logo adds were impacted by COVID. In addition, we segmented our customer base into those industries that were impacted by COVID and those industries that were not. And about 20% of our ARR was in impacted industries, retail, hospitality, travel. And then we looked at those net expansion rates, and they were dramatically lower than the cohort that wasn't impacted and actually had some tailwinds in it. So the combination of a lower net expansion rate for that 20% of our ARR, that has impacted verticals combined with a slowdown in the new logos, had a headwind of about 3 to 4 points of growth in the quarter -- over the last 2 quarters for us. So it's a noticeable impact. We're excited, obviously, is it 9 months? Is it 12 months? Is it 15 months, but those impacted verticals will certainly come back on line in the near future. The other headwind that we had as well is this perpetual license runoff. We signed some perpetual deals a couple of years ago. We recognized them ratably over 3 years. And it's now -- we're winding down the rev rec on those. In the quarter, it was about 1.5 points of headwind to ARR growth. And if you think about the next 6 quarters for fiscal '21, there will be about 2, 2.5 points of headwind. Next year, it will be a little bit over 3 points of headwind, and then it just eliminates. So if you think about these headwinds, COVID, right? I think there's line of sight that to a rebound there. It might be a year out, might be a little bit longer. But certainly, those impacted industries will rebound and the perpetual license runoff is a near term headwind. So that's how we sort of think about the headwinds to ARR growth. It's in that 4.0 to 5-point range. On the flip side, though, if you don't mind, if I can continue, we have a lot of tailwinds in the business. And the first one is sales capacity. We didn't take our foot off the gas when COVID hit. We continue to hire in our sales organization. We stepped up our plan actually twice over the last 6 months, and our current goal for this fiscal year is to add 25% quota capacity -- headcount quota capacity. If we can go faster, we're going to go faster. The other thing that we're seeing, which is really nice is productivity improvements. It's -- we're seeing a maturing of our sales organization. I think some of that's related to COVID. People are staying on board longer. As reps become more mature, as we all know, they're more productive. And we're seeing that productivity, and we think that can continue for the next couple of years. And also, we're now working on converting our customer base. And that's freeing up capacity to go after new logos and expansion in our customer base. So those 2 things, we think, can drive higher productivity going forward. And the final component, John talked about on the last earnings call, we can do a better job with the cloud partners. Some of the larger global SIs. We have relationships with them now, but we think we can make those deeper and broader, and we think that can be a tailwind. So you sort of put all those in a bucket. And we certainly have the building blocks to maintain 120% net expansion rate to grow our new logos, 15% to 20%. And if you do the math on that, that certainly is a 30-plus percent ARR growth. That's not our guidance, Mohit, but we certainly have the building blocks in place to maintain solid growth here.

Perfect. I mean that's a great sort of like a high level on the ARR because that's the metric most people focus on, right? And there have been some moving parts. So really appreciate the level of detail here. One thing, though, I mean, perpetual license runoff, I've got to be honest, right. So there was a whole lot of debate after the quarter. We got a lot of questions around what is perpetual doing in the same sentence as ARR, right? And we have been conditioned as people who were with you guys through the IPO process, we were conditioned, and we were very much aware as to what the dynamics are, but maybe give a high level of what is this perpetual license runoff? And why is it in ARR?

Sure. So if we go back to the beginning days of the Dynatrace platform, we did sell Dynatrace perpetual licenses. And given our product and how many updates we do and how many fixes we do from a compatibility standpoint, there's -- we treat this revenue ratably. So if we saw $1 million perpetual deal, it gets recognized ratably over 3 years. So since it's a recurring element in that standpoint, we elected to include it in ARR. We try to be very transparent about this and talk about this it being included in ARR being included in subscription revenue. And over the last 3 or 4 quarters, we've also been talking about the impact to long-term deferred because as we recognize those revenues, it's drawing down that long-term deferred revenue component. So today, it's about $50 million of our total ARR number. So it's not a significant portion. And if you think about it unwinding, really over the next 6 to 8 quarters, it's not a huge headwind, but we thought it was noteworthy to share with investors because what we're trying to get investors to understand is that what are the building blocks? And what are the near-term impacts to the growth of the business? And what is the long term trajectory? And we view this as a near term sort of headwind to ARR growth. But we've got a lot of great building blocks in place, as we mentioned, add new logos and keep that net expansion rate pretty healthy.

Yes. Let me just -- let me add to that also that, that perpetual license model has pretty much been outlawed. It's -- and the other piece, I think is important is that term licensing because of the characteristics of our platform, how many releases are required for currency, et cetera, that has the same sort of treatment as any kind of subscription item just like SaaS. It's not something that we take the bulk upfront for term, it actually is a piece of the subscription business as well. Okay. So I just want to clarify those. So everybody is clear on the other pieces.

Understood. So in the last minute or so, I guess, just -- and you guys can both chime in here, right? So looking ahead, I mean, hopefully, we're looking at the end of the tunnel in terms of COVID-19 with all the vaccines, right? Help us understand, I mean, you guys were still investing as you talked about sales capacity growth this year, but how you're thinking about that investment cycle next year? And what are some of the priorities in terms of investing for next year?

Yes. So we've had our foot on the gas. And as long as we can continue to keep the pedal down, maybe accelerate it some more without breaking things, we'll do it. R&D is a really important area for us. Our innovation engine is alive and well. We're fueling that aggressively as well, 15% of revenue, we think is a good place, especially since most of that R&D is done in Europe, where it's close to a 2:1 resource to Silicon Valley. And then, of course, the sales and marketing expansion, which we've talked about, which we think of as let's get that thing back to the 35% of revenue kind of range that we had in fiscal '20 and keep the pedal down on that. We think with a reasonable growth rate in the business, strong growth rate. That it can certainly fuel a lot of sales and marketing expansion. So that's where the money is going. That's -- we're not going to take the foot off the gas on those. And with the cash buildup, we're starting to starting to see here, who knows me, we'll find some things to tuck into the business and accelerate the platform development along the way.

Perfect. Perfect. We'll leave it at that, guys. We are out of time. So really appreciate you guys being here and always enjoy our conversations. So have a great holiday break, and we will touch base next at your Q3 earnings.

Very good. Thank you very much.

Thank you, guys. Bye.