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

All right. Thanks, everyone, for joining us. It is Day 3 at the 49th Annual JPMorgan Technology Media and Communications Conference. My name is Sterling Auty, Software Analyst here at JPMorgan. Very happy to have with us the team from Dynatrace for our first session of the morning. We have both John Van Siclen, who's CEO; and Kevin Burns, CFO. Gentlemen, thanks for joining me. I really appreciate it.

Thank you, Sterling.

All right. So maybe just to kick it off. John, there's still new investors that are coming into the space. You want to just give a sense of within this umbrella called observability, where does Dynatrace fit in the ecosystem? And where do you focus?

It's a great question. Observability is a relatively sort of new concept that's really been brought about by sort of this dramatic transition to the cloud as moderate clouds become sort of the primary underpinning for digital transformation. But this has been an area that we retooled for 6, 7 years ago and really built a brand-new platform to focus on, radically different than other approaches out there, which are really more targeted at gathering little slivers of data and providing that on dashboards. It's a much more sort of sophisticated AIOps-based approach to the observability challenge. The space itself is, depending on who you talk to what time of day, is considered a $30 billion to $50 billion market space, so it's massive. And it really includes sort of the traditional data center tooling that includes network monitoring, infrastructure monitoring, application monitoring, user experience, all pulled together because the cloud has collapsed all these use cases. You really need to do all of it at once in order to be able to understand and action various issues, opportunities, use cases for modern cloud.

Right. Excellent. And the question we've asked just about every one of the companies in my coverage during the conference this year is, how has COVID impacted your business, both for the positive and the negative?

So initially, COVID had everyone scramble to work from home. So that was a distraction back almost exactly a year ago. But it didn't take long before the pandemic became a tailwind to the digital transformation market in general. And became a tailwind because the pandemic sort of woke everyone up to the fact that they needed more agility and flexibility in their systems and that software was going to need to continue to expand as part of their sort of business portfolio, whether you're a bank or a logistics company, a government or whatever. So it became a tailwind in about 80% of the verticals that sort of drive the world forward. And about 20% of them, like hospitality or early in automotive and things like that, were quite challenged. What we see today is that all the verticals are back, everyone's spending on software as fast as they can, cloud underpins these digital transformations and these are long-term macro trends. This isn't some short-term pop that all of a sudden goes away. This is just an accelerant of long-term macro trends from our perspective. So we're thrilled to see sort of the world opening back up and get back to working in all verticals at once.

So Kevin, is there any part of that, that creates any tough compares? Because we did -- we do have some of our companies that got a little bit of an extra bump in whether it's June or September that created a tough compare this year. Do you have any of that situation?

No, we really don't. If you look at our numbers and the impact, as John said, the COVID impact was minimal. And the COVID impact was really frankly around, Sterling, new logos essentially. So that was a little bit tempered in the first half of last year. So I think that we should hopefully see a nice rebound of that. But the other thing is from existing customer base, our net expansion rates were healthy in the sense of the retention rates were very strong. It was just people put some of those additional investments in terms of expansion on hold a little bit. So overall, I wouldn't say there's headwind or tailwind from a year-over-year comp standpoint. I think we're more excited about '22, given the fact that we've grown the sales organization and have more sort of tailwinds around that than we do things related to COVID.

Kind of along those lines, you guys have managed the business to put it in a little bit of a unique spot in terms of how profitable you are. So how do you think about that balance of investment versus growth -- or I should say margins versus growth?

Yes. So I think our message hasn't really changed a lot over the last 2 years. Now certainly, some of the numbers have fluctuated given COVID. But if you think about our business profile, going back to IPO, we -- and the year before IPO, we're running a Rule of 60 company with ARR growth over 40% and super healthy unlevered free cash flow margin. So -- and we started and we remain invested in the business, trying to keep R&D at 14% to 15% of revenue, sales and marketing at 34%, 36% of revenue. And that's where we ended our fiscal '20. COVID hit, all of a sudden, a bunch of money went down to the bottom line because we're not doing on -- events in person and travel and entertainment has gone down. But if you look at our results over the course of fiscal '21, we're very effectively able to actually go and invest those moneys, right? So we stepped up a little bit in R&D, and we stepped up sales and marketing. But really, with the goal of getting back to that profile of the business that we ran in the fourth quarter of fiscal '20, and -- which delivered sort of the mid-20% operating margin. So overall, fundamentally, I think John and I both believe this is a long, durable, sustainable ARR growth business. We're investing because the market is very large. We're investing because of our platform and the innovation lead that we have. And frankly, if we think about the next couple of years, it comes down to a lot about execution, right? Continued innovation and continued focus on the commercial side of the business. So we like the balance. We will always run a balanced business, and we sort of think the guide where we -- what we put out there is balanced. And the way we think about the guide is, we guide to a Rule of 50. But if you look at our results, we've been operating at a Rule of 60.

Not too shabby, that's for sure. So I think you typically talk about that when you sell into a customer, you sell the entire suite. So APM infrastructure and logging. But how do you view how much of your core customers are really coming to you for each one of those? So not -- if you have the exact percentage, great, but just a general sense, are your customers coming to you for the APM portion, the logging portion? How do you think about that?

We actually think about it a little bit different than that, that we think about it more in tiers of applications. Tiers of environments that support these digital transformation initiatives. The Tier 1 and 2 applications, usually, customers want to have a complete full stack view. In other words, from every tap, click, swipe of any user through all the services and all the layers, all the way through infrastructure, logs and network. And that's what we call full stack. 70% or so of our business is that full stack view and about 30% is what we call emerging modules, okay? So we have a core module and expansion of modules over time. In the core module, it includes infrastructure, logs, traces, user experience everything because that's what the use case requires in the cloud, very different packaging than competition. The other modules, infrastructure only, digital experience, some other pieces are extensions for specific use cases. So when we talk about sort of when people think, oh, well, that's the APM. Well, it's actually a full stack view and always has been. Again, this is all because we reinvented our platform for the specific cloud program. So it is hard to compare sort of our module approach, which is sort of more use case-based than sort of the product approach of others where it's a little slivers of data get charged for. But ours fits our customer base extremely well. They're the Global 15,000 largest companies on the planet, $1 billion-plus companies. They want to solve problems. They're not trying to buying little slivers of observability for different use cases, okay? So I think that's an important characteristic. Now the other piece of sort of our modules and how they sort of work that 70%, 30%, the 30% has been growing. When we IPO-ed, that probably was in the low 20s, so it's been growing gradually. But boy, the full stack view, the amount of application like full view that people want has been expanding as the cloud sort of swells with new cloud-native applications. And that gives us almost a greenfield on that side plus cross-sell on the other side. And that's what's driving that net expansion rate at 120% plus, gives Kevin and I a lot of confidence that we can sustain that over the long term and having so much strength in that full stack piece, which is the primary landing zone for the company, gives us great confidence in our new logo growth. I think that's really the 2 key building blocks of the business.

That makes a ton of sense, and that's probably a good segue in terms of when you talk about that 120% net expansion. If you were to not add even another customer, how much more expansion opportunity exists within that customer base?

Well, we talk about our customers today, our average is a $260,000 ARR per customer. 3-plus modules is almost $500,000 ARR, and we talk about our customer potential being $1 million plus ARR per customer, targeted at a Global 15,000. So that -- if we can continue to add new logos and drive that ARR expansion per customer, that drives a big business. I mean it's the same way ServiceNow has become a $4 billion plus player. Same kind of thing, adjacent market space, but a similar concept and strategy. Kevin, anything you want to add to that?

No. No, I think that's right, I think. So to net it out, right, we have 2,900 customers today. Every customer can be $1 million. That's a $3 billion opportunity just in our installed base today, Sterling, just with the products that we have that we're bringing to market right now. We're not including security, frankly, in that. That's just a whole another addition to that sort of TAM as well.

So I think there was, at the time of the IPO, a perception that the solutions were being used more for, let's say, on-premise applications. How has that mix evolved?

Yes. So that's -- it's a little bit of a misnomer because people have sort of think, oh, on-premise, old. And the old on-premise world was, I saw you software, you go put it behind your firewall. You hardly ever update it, no matter what I do and you basically lose connection with customers. That's -- we took a radically different approach with the new platform. It's much more of a distributed SaaS platform where you can put your data either in a public cloud or you can put it behind your firewall. But everything is tethered through what we call a mission control system, no different than AWS does without posts, Azure does with Stack, Google does and so -- with their distributed cloud platform. And that allows us to be tethered into all of our customers all the time, 25 major releases a year, hundreds of minor sort of currency updates a year and 90% or more of our customer base is on a current release or one back. That means like they're updating within a month. And that's a radically different approach, very efficient from a business standpoint and extremely effective from how do you get new capability and functionality to customers quickly. So they're always sort of getting the greatest value they can from the platform. And so that's our approach. Again, quite different than others who haven't solved it and quite effective for the hybrid multi-cloud world, which characterizes, what, 80% plus of that Global 15,000 target base that we go after.

Got it. A question came in from an investor and just actually as a reminder, if you do want to ask a question, there's an Ask A Question button that you can click and your question there will come to me digitally and I'll incorporate in terms of the session. And this investor asked, how much of your business is digital-first enterprises that grew up in the cloud? Do you have opportunities to expand more there? Or is it better to focus on traditional enterprises that have been on-prem and are shifting to the cloud?

Good question. We really don't make a distinction. We make a distinction more on sort of size because that's where -- that's a complexity factor. So we think $1 billion plus. So we sell to plenty of cloud-native, born in the cloud kinds of players and many transitioning. You will find that if you do the analysis on billion dollar plus companies, the vast majority are going to be more traditional brands digitally transforming, whether they're automotive, like I said, logistics, insurance companies, banks, et cetera. The spend is high, the complexity of their environment is quite radically different than a single app cloud player, by the way. A bank like JPMorgan Chase will have 1,000-plus applications. That's very different than some of these other ones that have a single app on your phone. So that level of complexity and the size of company really characterize sort of best opportunities for Dynatrace and frankly, the most lucrative opportunities as well, which allows us to drive such a nice balanced business.

Yes, I've found I think in my conversations with Fortune 500 companies that I think the least amount that I've ever found is like 3,000 applications and more of them are around that 5,000 application level. And I think investors, that kind of really boggles their mind when they hear like -- because they think about, look, you use Office, you use salesforce.com, but it's all the applications that go into all the different areas of the business to automate different processes. Those are the things that I think that they don't really have a good handle on.

Exactly. Even in something you would think of as, oh, this is e-commerce, like a Walmart. There's hundreds and hundreds of applications. There's supply chains, there's warehouses, there's delivery, there's returns. There's -- all we see is the dot-com site, but there's many, many things that make that up.

Exactly. The true supply chain of it. A couple of other questions came in from investors. First one is, Thoma Bravo continues to be a significant shareholder. How is the relationship there? And are you working with them to wind down their position over time?

Yes. They've been a great supporter of the business. Hats off to them. They've helped shape us into a very efficient growth business. They are winding down. That's not our place to sort of tell them what to do with their investment. But what we are doing is we're making sure we're expanding the Board, the Independent Board on the other side, to take because it's not a controlled company any longer. They've dropped below their 30% threshold. So we're just running a growth business. Decisions are ours. They have stepped back a little bit on -- from a Board level. And like I said, it's all about sort of mature, independent public company, growth-oriented and driven to category leadership in the space that we've targeted here, the observability and AIOps sort of intersection of the market.

Listen, I've joked with you in the past. If we think about the Thoma Bravos and the Vistas, et cetera, as private equity and what, the perception of how they would think about running and managing business, and then I think about you going in, in 2013 and say, all right, guys, really what needs to happen is we have to write the whole thing over from scratch.

It was -- it sort of went like [puff], it has. But to their credit, they said, carry on. After a couple of months of really sort of working with us was carry on and let's go. And it's been a great success story, obviously, for them and for us, and they never looked back, never questioned it and huge fans of the business.

That's great. Another one from same investor says, given your significant free cash flow generation, your attractive unit economics, any plans for shareholder return through buybacks?

So yes. No, right now.

I'll let Kevin talk about that for a second, then I'll maybe give him -- give a view.

No. Certainly interesting over the last 2 years how we delevered the company, obviously, very, very, very effectively. So our net leverage ratio is down to essentially 0 at this point. So look, I think if you think about the near term over the next 2 years, we'll build up that cash reserve on the balance sheet, just give us a little bit more breathing room there, not that we're -- we don't have sufficient cash, given our cash-generating capabilities. But we'll build it up. But we'll also probably look at a few more tuck-ins along the way, right, and think about it as things that can accelerate our road map, right? So we obviously have a pretty good road map over the next 3, 4 years, and are there some small tech tuck-ins that we can do along the way that brings some good talent and also bring up some good IP that we will frankly just take and re-rate back into our platform and bring it to market a little bit quicker. So I think over the next few years, that's how we think about the capital use.

Yes. That makes a ton of sense. I'm sorry, John, go ahead.

I was just going to say, we're thinking about how to use it for growth in the business, because that -- it's such a great opportunity right now with a hot market, great macro trends behind us and frankly, just a phenomenal organic innovation engine. If we can just sort of keep fueling a little bit here and there and keep pushing it forward a little bit faster, it's -- that's the right -- that we believe is the right approach for long-term shareholder value.

Yes. Next question is kind of a follow-on to one that I asked earlier about the on-prem versus cloud. They just want to say, okay, forget about whether you're dealing with a modern born in the cloud or a complex legacy. Any sense -- because I think what they're trying to understand is a question I get a lot, which is how much of the compute workloads have moved to the cloud. So they're just saying, how many of your deployments are really in public cloud environments at this point?

Yes. So because we're tethered in, we sort of know where we are. And the way we look at it is where we're in modern, containerized, cloud-native environments, we believe more than 80% of our ARR is in that zone, in those workloads, in those environments. And that's -- to the very most modern serverless and mesh environments and so on. I mean just the fact that these are big brand companies doesn't mean they lack sophistication. I think some of them are much more complex than, as I said, sort of a single-app environments. And Kubernetes, which is one of the key containerized elements, is -- expands from public to private. And that's why we talk about multi-cloud. And a lot of these folks we work with actually are expanding workloads across multiple public clouds as well as back into sort of their data sources of record. So these are quite sophisticated environments, Kubernetes-based container environments and that's -- that characterizes the core of our opportunity. And when we land and when we go out, we look for the most complex cloud opportunities because we're purpose-built for it and our competition is not. And they come from 15-, 20-year-old platforms. And so that gives us a leg up when we can find the more complex environments. And yes, do some people want us to do other workloads because we can once they've sort of tasted the AIOps capabilities? Of course, and where we're more than happy to help them consolidate various things on the back end. But most everything we do is modern cloud, and that's been a big part of our transformation.

So that might be a good dovetail into competitive landscape. When you mentioned the 15- to 20-year-old platforms here in your competition, who do you view as your primary competition at this point?

Primary competition, what we call, do it yourself, and that may sound a little odd, like what do you mean by? It's that -- early in the cloud, people tried to use their old tooling. They tried to use whether it was second-generation APM tools or extend BMC and other kinds of networking tools and infrastructure tooling, and the cloud has -- it's gotten more dynamic and complex and really sort of punctuated with Kubernetes and that dynamic orchestration environment, boom, those tools don't work. It's not like they sort of work, they don't work. And so that's brought this rise of lots of different slices of tooling and sort of this -- every developer has to find something to use to figure out how at least their services are working or not working. And when we come into an engagement, we just sort of look for those, like I said, modern cloud environments, and you'll find dozens and dozens of tools being used, lots of blind spots, lots of sort of confusion because everybody has a different view from their little point of view. And there's no comprehensive sort of source of truth or situational awareness across the broader landscape. And that's -- we talk about and our customers talk about a complexity wall that they start to hit when the cloud really starts to mushroom and they're still using all these separate disparate tooling. And that's what we find most of the time, this do-it-yourself approach, hitting a complexity wall, requiring something more, and we have the something more.

No, that's a great framework. Next question is, why is landing full stack the right strategy to enter an enterprise compared to landing with a single module to gain distribution and add full-stack capabilities over time?

Well, so our full stack is a module -- is one of the modules. It just happens to have all these other capabilities, like I said it's a packaging kind of thing. And why is that sort of the best landing zone because it has the most attention. Tier 1 applications that drive revenue, touch customers, think about it as home banking, think about it as an insurance application to brokers, think about it as sort of the logistics application for a trucking company. These are things that actually are core to how the business runs. It has the attention of the CEO and definitely the CIO and CTO. They care that it works flawlessly all the time. We have the best platform for assuring that software works perfectly all the time. And so it's an easy place to go get the most attention. Everybody cares about the precision of those environments. And it's a great proving ground and once you prove yourself at the toughest, highest visibility areas is pretty straightforward to cross-sell and expand to additional environments. And that's what we found works well for us and why we continue to drive from that standpoint.

So this PM actually said that Dynatrace has actually come up in a couple of meetings that they've had with other software companies as a great partner. Can you talk about your partnership that you have with some of these leading software companies and your prospects to further deepen and monetize those relationships?

Sure. Well, we actually -- the way we view the world of partners is sort of twofold. One of them are system integrators because they actually do the implementations for AWS, Azure, for Google, for ServiceNow, for even the IBM OpenShift folks and so on, and so that is a key piece. The second one are the tech alliances themselves. The 3 big hyperscalers and some of the other folks, whether it's, like I said, OpenShift, the VMware, Tanzu folks, ServiceNow, others. And so it's that combination we work with back and forth, and there is a symbiotic relationship between them. The strategic alliances, sort of those hyperscalers and so on, those are in order to get some leverage and advantage, you have to treat each one sort of separately, which is what we do. We actually have a team that focuses driving that and intersecting with our sales organization. That's been going well. It's been scaling. We talked about sort of a rapid expansion in marketplace deals, private offer deals through those 3 big hyperscaler marketplaces. And then our system integrator program has been expanding as well. Now 40% or more of our opportunities are influenced through these system integrators around the world. Some of them are global, like Capgemini, Deloitte, those kind of folks, and some are sort of regional-based and many of those. So that's that combination we see giving us some great leverage from a productivity standpoint in our sales organization and, again, has given us confidence to expand our sales organization at a 30% rate, up from 25%, which we were expanding the organization in last year.

Actually, on that point, can you -- for those that are newer to the start, when you talk about that expansion rate, so what's the baseline? What are you expanding off of?

Yes, 2 years ago, it was 20%. Last year, we did a 25% growth year-on-year. This year, we're on track to do a 30% growth year-on-year. We have -- 90% of our sellers are outbound. There's 10% that are inside, very different than the mid-market players and the freemium players. Think of us more in that sort of enterprise class, it fits the go to market, going after the Global 15,000, fits the unique value proposition we have, which is quite different. It's observability plus AIOps intertwined and unified. So it fits us, and it also fits really well with the system integrator approach and the high end of the hyperscaler go-to-market as well.

Excellent. Next question for investors. Can you help size the security opportunity? And what are the biggest hurdles in terms of which competitors you would bump into?

Yes. So our feeling is that the security opportunity is definitely as big as the full stack application opportunity, maybe as big as the observability opportunity itself, and it's just underway being disrupted again by cloud and being disrupted by multi-cloud containerized environments. Our view is that these applications need to be smart enough, the services need to be smart enough to know when they're under attack, know when they're vulnerable, know when they're under attack and remediate those attacks themselves, that the ring-fencing approach which will always go on but it's not enough. So we entered the space with our first module approach 6 months ago -- less than 6 months ago. It's going extremely well. We sort of tampered down everybody's expectations on ARR expansion this year because this is a minimum viable product, maturing, understanding the market, understanding any competitive dynamics out there and the rest. And to date, we've touched and trialed with 5% to 10% of our customer base, which -- that's -- you're talking 150 to 300 customers. The feedback has been universal that this is a greenfield space. Nothing solves the continuous production scanning environment for vulnerabilities. And we think we're in a great space. We have a little more work to do before we're really ready to talk about rapid ARR expansion. But think about this as a fiscal '23 expander and a maturing of the approach here in fiscal '22. But this is a long-term opportunity. I mean, this is a 5- to 6-year, 5- to 10-year run at what will be a big space. And we believe that with our technology platform and our AI approach, we can have a significant impact on this emerging space.

And last question, how do you sell into security groups? Or do you need to, because are you still just selling to DevOps?

Great question. You need to sell to both, but the folks with the pain happened to be -- and this was part of our thesis, happened to be the people we talk to anyway, which are the app architects and the DevOps teams, who are trying to drive innovation faster into production, but they hit the CECL wall, which is smart because you can't compromise security, but it does throttle the speed of innovation, unless you can solve that friction, and that's what we're targeted at. So the DevOps teams have -- are picking up sort of a DevSecOps approach. And as they do that, they need solutions like our cloud app security module to help them sort of bridge sort of that friction with the CECO. Now we've hired an overlay team, a specialty team to deal with the CECO discussion. But the beauty of this is that every one of our customers, the folks we talk to are either responsible or they know one step removed, who's responsible for driving DevSecOps movement within their organizations and our solution appears to be spot on to what they need to solve these this growing sort of tension between the 2 groups, if you will.

Well, that's a perfect way to end it. John, Kevin, thank you so much for joining us. We really appreciate it.

Thank you very much, Sterling. Appreciate it as well. Cheers.