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

Yes. That's what I was kind of thinking as a doubling. And that's, in my mind, certainly an interesting source of durable or if you will. Let's dig into security a little bit. And it certainly comes up today. Let's focus on what you have today and where do you think the target-rich environment will be for your security solution? Obviously, I would argue within your installed base. But maybe if you could provide some additional attributes about where you think your target market will be for the security solution today? And if a customer is going to spend on your security solution, are they not going to spend on something else because of it?

Yes. So we think there's a big gap today in the cloud application security, right? It's really hard given the environments that we're developing, our customers are developing applications and it's hard to ring-fence those and sort of put security around the application. So that's our thesis. So what we're starting with is the Dynatrace platform. So again, you sort of -- you think about all the data we're capturing their metrics logs, traces, and we're putting that through the AI engine. We have an enormous amount of data down to the code level. So how do we optimize that and use that technology and that data in the security world. And what we're starting with is cloud application security. And what we're trying to do is help companies innovate faster, bring their products and applications to the market more rapidly. Today, there's a little bit of friction between the DevOps groups and security to get code into production and our cloud application security product is focused on minimizing that. So what it does is it scans the technology, the applications in production -- in preproduction and in production to find any vulnerabilities. Than using the AI engine, it prioritizes those and it helps the security organizations assess whether or not they need to go out and remediate some of those things. So it's accelerating time to market, it's helping companies be more agile, and it's breaking down some of those barriers into the security organization. Equally important, what we're able -- what we found is that we're able to get into those organizations more rapidly, right, because there's that friction between DevOps and Security. They obviously all have an aligned interest to get code and applications into production. So we're getting that introduction. And the reception so far for this product has been phenomenal. There's -- it's a greenfield market. We're not competing with with other folks in the marketplace at this time. It's something new that the CISOs are looking at. Early reads on the prospects and on the POCs have been phenomenal. And we think over the next couple of quarters, the adoption is going to start to accelerate nicely.

And remind me on if you have a dollar of APM, what today security could be on top of that dollar?

So today, we think about it as a 15% to 20% uplift on the full stack side. And as you mentioned earlier, with the introduction of more modules on security, we do believe it can be dollar for dollar over the next 3 to 4 years, 3 to 5 years.

Yes, it's exactly where I was going to go with it. Okay. And I'm not going to ask you about what your future security solutions will be because I know you're going to say I'm not preannouncing products that we will skip on that. Because it seems to me this is what Nikesh talks about for Palo Alto is security is a data problem and you guys are essentially at heart, I think, a data or AI company. You know happen to be in observability, but you are a data and AI company. And so there is, I think, opportunities there. Which takes me to my next question. I think John or you as well talked about DT is better -- Dynatracers better positioned in multi-clouds, why?

So when we replatformed, we had that in mind. Our thesis, again, is most large enterprises are not going to want to go in and work with one cloud provider. They're going to have private clouds. They're going to have multiple public clouds. And at the enterprise level, you need to be able to pull and instrument all those different environments and then pull all that information together and build the Smartscape, the dependency map that we have. And in order to do all of that and get meaningful information out of that, you need AI at the course. So it's a little bit easier to develop a platform that just supports one specific cloud provider. But when you think about the complexity, when somebody is operating in 5 different cloud environments, it's much more complicated. And those are -- when we speak to CIOs, and we do the surveys, that's how they're going to operate. They're still going to have some legacy stuff. They're going to spin up new environments in AWS or Azure and built some other clouds. And if we -- the winner in the enterprise space is somebody who can see all of that and bring all that data together and analyze it.

And so it's because of -- and I agree that companies like Bank of Montreal are going to use multi-cloud. I think it's a little overdone because we'll bias 1 way or the other, frankly. We're not going to have equal work across the 3 different cloud vendors. We're a little bit biased on a lot more work to one cloud. But is the genesis of the statement because you can ingest more data from the different clouds and make sense of it, is that where the core competitive advantage lies? Or I'm trying to understand on the technology side, why you would be better than a provider like Datadog and a multi-cloud?

So first of all, we can go and instrument all of those environments automatically. And then we can take all of that data that we're gathering in all those multi-cloud environments and build the dependency map real time. So there are no blind spots. So this is our Smartscape solution. So we have environments where we are continuously monitoring 1 billion, 5 billion, 10 billion different dependencies in real time. And then the final piece of that puzzle, as you know, Keith, is, well, with so many dependencies, you can't, there's no way humans can handle that information. So it's that automation piece of gathering all the data, mapping it altogether and then making sense of it and finding the issues. And we do that no matter what cloud environment you're working in.

Right. Okay. Okay. We'll step up for a second, Ken and go a little bit higher. I started asking about the growth algorithm we did new logos, the second one, which we started on but didn't finish it, it is on the net retention rate. So you've had 120% plus. Is there any puts and takes that we should be thinking about over the next couple of years in terms of sustaining that? Obviously, you're adding to the portfolio, which is a feeder into it, but any kind of a lot of large numbers that you run into in terms of trying to sustain that kind of 120% type of number?

Yes. Well, just to provide a couple of numbers around it. We have over 40% of our customer base is using 3-plus modules per day. That average ARR per customer is $500,000. The penetration rate for those exist for that customer is on average in observability, it's still in that 10% to 20% range. So you sort of think about that, and we're developing new apps and adding more infrastructure over the next 3 to 5 years, that space alone can support 120% net expansion rate, right. And on top of that security and things like that, that's, again, more support for 120-plus percent. I guess the final thing I would say is that 120% net expansion rate plus that we've been reporting on is also has a 4- to 5-point headwind today as we're winding down some of these perpetual licenses that were accumulated over the last couple of years. That wind down will terminate in a few quarters and that 4-point headwind will dissipate as a result of that. So excluding that headwind, you might want to think about net expansion rate is 4 to 5 points higher than the 120%. So pretty healthy net expansion rates add scale as we approach $1 billion in ARR.

Yes, certainly. And just to focus on that for a second, we have you guys running off in, I think, Q1 effectively of next year on the perpetual runoff?

That's right. Yes. Just in terms of Q1, Q2, it will be about a 2-point headwind. And then in Q3, it will be essentially 1 point or below 0 of next year. So it really falls up pretty rapidly in the first half of fiscal '23.

Okay. Perfect. Okay. Okay. Let's switch to go-to-market for a second. And as you're chasing the global 15,000. You've talked about adding 20% to 25% hiring of sales reps this year. How do you think about balancing? Because if we're infinite, you'd hire 100% sales reps and your sales will grow by 100% and 0. But how do you balance making sure that you're getting positive ROI from these hires? Because it's a pretty aggressive sales target. I know someone will say you should do more because it's an immediate return. But there's got to be some kind of balancing act on integrating this. How do you define that? And how do you make sure that you're you're optimizing on these hires?

Yes. It's a great question. And if some people say, "Hey, why don't you double down to your point and invest a lot more in the sales and commercial engine". And our approach has been a little bit different. Over the last couple of years, we've stepped up the investment every year, starting with 15% to 20% growth on sales to 20% to 25%. And now our stated goal is 30% sales capacity growth in fiscal '22. And the reason we're stepping into it is it's a process. And if we make a mistake, it can really destroy a sales organization. So adding in the infrastructure 6 months, adding their RDs 6 months before you hire all the different reps into a territory. It requires a lot of work and we want to get it right. You don't want to hire a bunch of reps and then give them a greenfield new logo opportunity they need a balance of existing customers with some new logo opportunity to really be successful. So we are very methodical in terms of recruiting. We're methodical in terms of our education and training and then obviously tracking all these metrics. And as soon as we can step on the gas and do it a little bit quicker than that 30%, we will. And I think we've got a proven track record of stepping out the gas over the last couple of years. And if we can continue to be successful, we'll continue to step on that gas.

What's the churn been in the sales over the last couple of quarters?

It's a great question. And it's actually been lower than it has been historically. So look, I think, Keith, a little bit of it that has been driven to the COVID environment. I think people have been a little bit more reluctant to switch. But I also believe some of the programs we've put in place over the last 12 to 24 months in terms of getting people educated and trained and the right balance of customers in their territory with new logo opportunity and putting in place the right infrastructure to support our sales organization has been successful, and it's been -- it's led to much lower attrition than we've seen over the last 2 to 3 years. The net impact of that has been great because when people have been here for 2 years, they're much more productive. They have higher quota, they have higher payments and it's that transition sort of period between 1 and 2 years that we've been focused on really over the last 12 months and helping people get through that little bit of a hump and we've been successful at that. So we've been growing a mature organization more rapidly than we have those folks who have been here of 1 to 2 years, which has been great as well.

Okay. And as you continue to this. How do you think about the direct versus the indirect? How might that evolve over the next 1 to 2 years?

Yes. So if you think about just the direct sales organization that's growing 30%, that that should continue to support ARR growth rate in a consistent range. However, we also believe that our partner program is super important. 45% of our deals this past quarter of our expansion deals this past quarter were influenced by the partner. And that can be anything from the partner identified the deal and close the deal and sent chat to we brought them the opportunity and may help us, right? So we call it partner in fluids. That 45% has been growing nicely over the last couple of years. So we're doing a much better job with those global system integrators. We have many more customers that we've been working with them, and they obviously see the value that we bring to those digital transformation projects, and we believe over the next 12 to 24 months, that will become a more meaningful contributor to our ARR expansion. And I think that will just be additive to our -- to some of our growth numbers and it will help our sales team be more productive and it's a good model. We need to balance our direct investments with the partner investments. We've actually invested more in the partner area in the last 12 months than we've been in our direct sales organization. So we're investing in both. But building out that partner community has always been a priority for us, and we've stepped on the gas there a little bit as well.

Yes. It would seem to me that the partners would have a significant influence, particularly on the large deals with the large customers.

That's right. And if you look back at the success we've had over the last 6 to 12 months there with joint customer stories and wins. And they really do see the value that we're delivering to them in terms of resource optimization and the business value and driving those projects. It's been great.

Okay. And given the last 1 on go-to-market is you have a version of free that you can go to your customers with to try to generate pipeline and usage that you assume translate into pay. How has that evolved? And is that still generating a meaningful pipeline, so to speak, even within the G 15,000, Global 15,000?

In terms of the POCs we do, Keith? Or...

Yes. As you try to convert those free trials, so to speak, going on within an organization, is that a meaningful source of pipeline growth as you're trying to translate those free users of limited scope projects into paying customers over time?

Yes. So yes, the way we think about it is for our prospects, we absolutely are trying to get to a POC. And 90% of the time when we go to a POC, we get the technical nod. So it's a super effective way to go to market. Customers love it. We love it because at the end of the day, there's a lot of organizations who say they do the same thing as we do. But when you can actually show them that's working in their environment, that accelerate sales cycles very nicely.

Okay. Okay. Only a couple more questions, and we're going to go to finance for a second. It comes up a little bit, a lot of software companies that had the COVID tailwind, so to speak, on margins. Now we're coming off of that. Your margins are more -- have some contractions in margins more so than most of the companies that we cover when you look at pre- and post-COVID. I assume a lot of this is the sales rep, but what other areas you focus on? If you could prioritize how your spend is changing this year to cause the margin compression at least versus guidance?

Yes. So the biggest areas that we're focused on in fiscal '22 and going into '23, I would say, would be the commercial piece. We just talked about the the investments we're making in the sales organization, the investments we're making in the partner organization are also making investments in our inside sales organization and then doing some more on the go-to-market, marketing programs, brand awareness, things like that. So that's sort of -- I would put that into the commercial bucket, and that hits the sales and marketing line. We're also stepping on the gas a little bit more in the R&D. I think as you probably know, Keith, we spend about 14% of our revenue and R&D, you'll start to see that increase a little bit, probably go over north of 15%. And keep in mind, there's a little bit of secret sauce there. We do generally, most of our R&D over in Central Europe time zone. If we had that infrastructure here in the U.S., we'd be spending 30% of revenue on R&D. We have 1,000 engineers working on the platform. and that's going to grow 30-plus percent next year up to 1,300 and 1,700 after that. So making investments in the commercial expansion and then continued product innovation. And it's not just product innovation that you see, we're also thinking about where the market's going 3 to 5 years down the road. 30% of our investments in R&D are on things that we'll bring to market, as I mentioned, down the road in terms of the platform enhancements so that we don't hit some of those tech walls that some of our peers hit over the last few years.

Yes. Related to that is how do you think about M&A? And how -- the thing I was concerned about with M&A, it's easy to buy something, it's harder to rate it and actually make it work with the rest of the portfolio that you have. Given that your platform the products, how do you think about M&A as a growth or IP expansion opportunity? And then given your platform, how easy it is to integrate it with everything else? And I want to focus on security, but the question is actually a bit broader than that, just a general M&A question?

Yes. So absolutely, over the last -- actually, since inception, we -- it's been an organic growth engine from an R&D standpoint. You will -- it's likely you will see us step into some smaller acquisitions as we move forward. And these acquisitions will be product road map accelerators. And if I had to sort of put some numbers around it, you want to think smaller areas, 10 to 30 people with some core IP that can help us but we will also take that IP and rebuild it into our platform. So we're not -- I don't think, generally, we're looking to do transformative M&A, which would be a bolt-on to our existing platform. We're looking to do some smaller ones that can accelerate product road maps, but fully sort of redone into the Dynatrace platform.

Yes. Yes. It seems like, in my opinion, organic stories always get and deserve more confidence in the durable growth rates and then not coincidentally higher multiples, much like one of your neighbors HubSpot. Maybe we'll finish it up here, Kevin, is that if you thought about -- you've done a lot of conferences over the last couple of months. What's the histogram on terms of the most frequent question you're getting? And what do you think one of the more misunderstood parts of the DT story are, and those could be 2 separate answers?

So I think the biggest item that we've been focused on historically and when I say historically, it was really over the last 12 to 18 months as people view this as a very competitive marketplace. There are so many players in the marketplace. And I think it's evolving, and I think it's emerging that Dynatrace is becoming the enterprise observability market share leader. We think that's been proven and the numbers reflect that. But more importantly, it's our existing customers and how they're expanding on the platform. I mean that just shows that they see the value. They're investing in our platform. So I think some of that noise, a lot of that noise has sort of died down, which has been great. We believe that obviously internally here, Keith. But I think that we're emerging as the absorbability player in the marketplace. So I think that's that misunderstanding has been cleared up. And I think people then focus on was how sustainable as you grow, right? And that's why we're focused on letting investors know what are the core building blocks to grow and when we talked about it, the new logos and expansion. And we think for many -- for the next 3 to 5 years, just with our existing product portfolio, we have ample opportunity to continue to grow this business really nicely. So I think it's been great. A little bit of noise post IPO around classic conversion, the Dynatrace, the model mix shift. That's gone away we're becoming, in our opinion, through better marketing and commercial activity is the dominant player in the enterprise space for observability and the rest of the financials are starting to shine through. And I think people believe it's a good runway ahead of us.

Yes. I think last year, if I reflect on it, the #1 question, actually, the number -- top 10 questions were all competition. We had made the bet that your technology was differentiated therefore, was going to create a durable runway for growth. Now I do agree with you. I think the #1 question we get is on what is the durable growth?

That's right.

And so it's not all competition. It's just what's -- is it 35? Is it 36? Is it 33%? Whatever that right number ends up being. And then -- so the underpinnings of that is how does the technology expand or evolve such that -- so you get a better sense about what the runway of growth is. And I think that's what investors are rightly focused on and then what's the valuation for that. So it really has changed the flavor of the competition because I do think your technology is differentiated and it does create some interesting opportunities. With that said, we are at the double 0 in terms of a time base. So Kevin, I much appreciate your time. Hopefully, we'll be able to get together at some point in the Boston area. Noelle, thank you very much for allowing us this opportunity on behalf of Bank of Montreal. We appreciate your time and wish you the best of luck.