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

Okay. Why don't we go ahead and get started here. My name is Adam Tindle. This is part of my infrastructure software coverage here at Raymond James. I'm very thrilled to have the team from Dynatrace here today. Rick McConnell, who is new CEO at Dynatrace and a lot of opportunity ahead for a great business. It's been a great story, profitable growth, industry leader. We've got a lot of topics to hit today. In terms of our format, just an open format fireside chat. We'd love to keep it as interactive as possible. I promised Rick no questions around Tom Brady, Boston base or Tampa base. So we won't discuss he who shall not be named. But with that, Rick, thank you so much for joining.

Tom is going to the 49ers.

We're already starting there. At least Noelle said no safe harbor, so we can skip that one. But we do have a very broad array of investors here at our conference today, some that are newer to the story. So maybe you could start with the history of the company, the core market, the size and competitors and the competitive differentiation for Dynatrace.

Sure, sounds good. So what Dynatrace does is we deliver answers at enormous scale in huge complexity from ridiculous amounts of data. And that really is the value proposition. And what we do, therefore, is enable billions and billions of interactions, digital interactions to occur every single day seamlessly. The observability market is, as we would define it, in terms of our position in it, is more than $30 billion market. We've only tapped the service, and most of it is today, DIY. And most of it today is being done by companies internally with their own software, their own monitoring capabilities, maybe open source, and it is shifting very rapidly toward more production-ready systems that really provide very sophisticated observability capabilities for companies to manage their infrastructure. The overwhelming movement here is around digital transformation. And as companies are digitally transforming, you need to not look further then some of the hyperscaler growth that we see, AWS, Azure, GCP, to see the potential of this industry. And what happens is you might deploy on one of the ecosystem providers. And then you discover, "Oh, my gosh, my system is down. Where is the problem?" You have no idea. So Daynatrace's origin was actually out of dynamic tracing. And what we do is we can trace through an entire infrastructure to isolate where issues might be in that infrastructure, whether it be on-premises or in the cloud. And that enables very, very precise action and moving toward automated action. So that's a quick summary.

That's a great summary. And I think years ago, there was a stat, application performance monitoring is obviously a key market for you. And maybe remind us of where we stand in terms of the penetration rates of that market, how underpenetrated it is?

Well, if you just take the numbers that I talked about a little bit earlier. So Dynatrace is rapidly approaching $1 billion in ARR, pretty close to it, just even in terms of our guidance over the next quarter or so. And it is we believe a $30 billion-plus market. So we've got long ways to go in terms of market penetration. As we say, the vast majority of that we believe to be really on-premises in DIY format at this point. And what we're finding, we're targeting -- we at Dynatrace target the Global 15,000. We've got, let's say, a few thousand customers currently, rough numbers. And so we're about 20% penetrated in the target market. And then within the customer base that we have, we figure that we're maybe about 20% penetrated because you put your most complexed, hardest, most critical workloads on Dynatrace today. But then you discover, wow, this is adding enormous, enormous value. And when you discover that, the next step is, I want to add more workloads. And so I've talked to -- even in my 90 days as CEO, all of 90 days, I've talked to dozens of customers. And the common retort is, Rick, please help me. I've got too many tools, too much internal sprawl, let's consolidate it on Dynatrace, let's figure out how to go and attack it and get bigger, larger and more compelling deployments. And so there is a substantial opportunity within the installed base in addition to expansion. And then one other factor is that we have multiple modules. APM, you mentioned, Adam, is just one of those modules, application performance monitoring. This is where we have a very, very strong leadership position in applications and microservices and monitoring and observability for that. But we've seen very, very broad expansion into infrastructure as well as digital experience, which is really real user monitoring and then now expanding into application security.

Perfect. So a rapidly growing market in total and then even within your existing customer base, lots of room for expansion, so lots of growth opportunities. Now I wanted to translate that, again for investors not familiar into financial metrics. If you could cover some of the key ones because you stand in some very high-value categories in terms of rules that you're hitting in financial metrics, not a lot of companies out there do this. So maybe you could summarize the key financial metrics for investors.

Sure. The way that we tend to look at the business is the way that vast majority of our investors look at the business is on adjusted constant currency ARR growth basis. It adjusts for what we call a perpetual license runoff, probably more detail than I would want to cover in the room, but it basically just normalizes, normalizes compound growth to where we wanted to be looking at in the future. And that number is in the mid-30s for percentage growth of ARR on that basis. And then we're running at around about a 25% operating margin. So we sort of look at it as a rule of 60 company or thereabouts with the addition of those 2 elements, which puts us, I think, in pretty elite company. Certainly, in my evaluation and coming out of Akamai where I was previously as President, it certainly was one of the things that I looked at Dynatrace, these financials are incredible. And then you look at the market and you see there's enormous upside in market potential, good profitability, very solid cash flow in terms of unlevered free cash flow as well. So when you put the story together in terms of the opportunity plus the growth numbers, plus rule of 60 kind of performance, you get pretty excited about it.

Yes. That's a unique financial profile. Not a lot of companies have that level of growth and the profitability. So this probably dovetails into the next question. But we do have, like I said, a variety of different investors in attendance, many of them are new to the Dynatrace story. You recently went through a diligence process yourself in deciding to accept the CEO opportunity. And congratulations again on that. Maybe you could talk investors through your own diligence process on Dynatrace as they're doing diligence themselves and the key learnings that you had?

Sure. I had 3 or 4 reasons why I joined Dynatrace. I wasn't looking for a role. I was pretty happy where I was. But Dynatrace came along, took a look at it. You start with the market. Is the market -- does the market can be of size that enables substantial growth for as long as you can see in the future, the answer that we've covered already is yes. Secondly, you look at the products. I've been on the product side in my career, I've been on the sales side, I've been on the finance side, I've actually been on all 3 of those legs of the stool, so to speak. And you look at the products and the products are exceptional. We have deep product leadership oriented to our installed base of customers and target addressable market in the Global 15,000. So that is substantial. I talked to analysts, customers, partners, even talked to salespeople. It's pretty rare that you talk to salespeople at a company and they say, "I love the product as always. If you just did this, I could sell more." But even the sales people are sort of like these products rock. They deliver against customer requirements. So in talking to customers, they're very, very positive that continues today. Financials we talked about and then culture, really, really solid culture. People really want to be there. So those are some of the elements.

Perfect. Well, I'm going to go to audience here in a second, and please raise your hand if you have questions. But I want to make sure to cover since it's so topical, maybe you can touch on your exposure to the Russia region?

Yes. Obviously, devastating, devastating situation globally for the world. Our hearts go out to all the people in the Ukraine, in particular. It is a very, very tough spot. We announced yesterday that we're going to be supportive of the sanctions, U.S. and EU sanctions. So we have withdrawn business from Russia. It is a very, very modest impact for us, just about $5 million or so of ARR, talked about sort of roughly coming up on $1 billion ARR run rate. So it's very small, but we did elect to make that decision. And we think that it's our ethical responsibility to have done so. We have no employees in the Ukraine or Russia. So no exposure there. We've actually got 24-or-so employees who have families there. So we're working with them. But overall, the exposure for us to Russia and the Ukraine is quite small.

Perfect. I'm going to go into some of the chapters of Dynatrace. We're going to talk about investments, some of the M&A that you talked about on the last call. But does anybody have any questions so far. I know it's usually a quiet crowd. Hopefully, you had your coffee. There's got to be one question. This is a packed room. So come on guys. Noelle one has a question?

We could go on a run round the complex 3 times. I did it yesterday, yes. You have to go around a lot.

We'll coach you up on the Dynatrace story, and we'll get you to warm up to questions. And as I thought about the story, there's multiple chapters. We're obviously entering a new one under your tenure. But as I think about the previous chapter, this was scaling the business to around $1 billion in ARR, which is a very difficult thing to do. Maybe you can take us through the core thesis during that transformational period alongside key investors like Thoma Bravo, who's still in the stock and on the Board. So let's start with kind of that rise to $1 billion, and then we're going to talk about the next step?

Yes. Well, what I love to do and one of the challenges or opportunities that I saw in the company was to build a multibillion dollar business. And I did it as part of the Unified Communications team at Cisco and as part of that leadership team taking it from $1 billion to around $5 billion in revenue. I did at Akamai, I started at Akamai at about $1 billion in revenue back in 2011, grew that to around about $3.5 billion. So part of the leadership team is present there. That was that growth. We took the application security business of Akamai from $2 million when I started to about $1.3 billion. So I really like building world-class teams to grow sizable enterprises. That's what I get passionate about. Back to the reasons why I joined is sort of like, do you see your way clear to doing that. And it's market performance, products, those sorts of things, all that panned out. To put it in context, it took the company 13 years to get to $1 billion in ARR. We'll do the next $1 billion in 3 or at least at current run rate growth and speed. So this obviously is a huge opportunity that is accelerating in terms of absolute dollar close to really scale this business. And it's going to take some different things to achieve that. The way that you get to $1 billion isn't the way you get to $2 billion, $3 billion, $4 billion, you need more leverage, you need more scale. So for example, this year, we'll grow our sales force by around 30% in terms of overall personnel growth. But we need to supplement that with partners, partner capabilities for even enhanced leverage. We need our brand, brand awareness, brand leadership. I'm not going to just go in and through brute force, close accounts. You need more drag along of, okay, I'm doing a cloud ecosystem deployment on AWS or Azure or GCP, I need to have Dynatrace and I want it out to shoot suppose to some number of years later or months later. So the kinds of elements that are there are important, also different modules. We're not just going to be in application performance monitoring. Our infrastructure business is about $100 million today of the total, but it's growing at 75%. We believe that the infrastructure business which is, today, about 20% of the APM business could be 1:1. So that at 75% growth on a sizable number, substantial growth opportunity, logs are an area where we're investing significantly as another data type that we can bring in that we can then analyze, process, consume and provide observability measures against. So that's another area. And then app security. So many, many dimensions of growth to be able to go drive this, in some sense, next billion dollars.

Perfect. Maybe you can talk about the current state of the competitive landscape. You just mentioned a variety of different modules and markets. And as I think about infrastructure that's some different competitors than the core APM market. So maybe you could just give us a summary of the core competitive landscape and how that's changed as you've expanded into these other areas?

Yes, sure. Happy to talk about it in more detail as well. The way to think about it is we sort of break the market into the Global 15,000 and then the SMB space with the departmental sale, if you will, of larger companies, we are targeted at the Global 15,000. We have a strong leadership position in that space, and we expect to continue to be driving aggressively to develop and invest in the products and portfolio, the go-to-market strategy, the sales force, productivity and needed to maintain leadership in that space. Other participants in the market are focused on the SMB space, and that we don't really run into them nearly as much. All the competitors that are in the Global 15,000 that target it, for example, like an AppDynamics, we believe that they've missed a technology transformation around Kubernetes and containerization, and we're taking share materially.

Maybe you can talk about the new customer acquisition strategy and key sources of leads for your direct sales force?

Sure. Leads come from -- everything from search engine optimization, SEO, to an increasing inflow just based on website, based on brand awareness. But increasingly, they're also coming through partners. I mentioned partners earlier as a really core go-to-market strategy. This isn't something that is we're dreaming of. This is something that's happening today. In fact, today, already more than 50% of new ARRs are coming through partners. So we have a sizable opportunity there. And in fact, with hyperscalers themselves, we saw in Q3, our fiscal Q3, which is the last reported quarter, a more than 3x jump in ARR coming from the hyperscalers. So that's one component of the partner strategy that we're very excited about continuing to grow.

And as investors think about the Dynatrace story, it's often kind of industry leader in APM and known for APM and then growing very fast in these other big markets. Talk about how important it is to start in APM. If you were to be able to start in one of these silos and come into the others, which would you prefer to start in and why?

Yes. I think you could start in multiple places, but I love the fact that we are the leader and started in APM. And we think about it, we've all lost as consumers. We have all lost complete patience near as I can tell. I don't have to look beyond my 17-year-old daughter to see if a page on her mobile device doesn't load within like 2 seconds, she's sort of like, this is unacceptable. And then she leaves and goes to another provider.

My 10-year-old daughter is the same.

Good. You've got 7 years runway for it not to change if that will be longer than that.

I have more questions about what to do...

What to do? Yes, I we'll take that offline. But it is -- I mean, we all expect -- we -- I don't really expect, but again, my kids expect to be able to download and watch a full-length video over crappy cellular in high definition with no rebuffering. We expect our applications in microservices as components of those applications to be working perfectly all the time every time with amazing performance. And so imagine the difference in a scenario where you have a dashboard that basically says, "Oh my god, I got a problem." You've got zillions of customers potentially or end users calling you saying, "I can't get to my financial app. I can't buy by the shoes that I wanted. I can't transact business in some way that I needed to be able to check something." And then you're inundated and then you're scrambling, trying to figure out where the problem is. By contrast, what Dynatrace is all about is on immediate isolation proactively with instant answers of when you have an issue, what to do about it, where it is and how to occupy it. And so you are put in a situation where you are proactively ensuring that software works perfectly. And that's the end goal. And so some of the things that we're doing that I would add on are things like the industry term is sort of shifting left, moving into the DevOps cycle, where you're integrating Dynatrace directly into code. And so therefore, the answers we're providing on where you might start being out of band and delivering against particular objectives. Like I'd say, you set an objective, a page load of 2 seconds and all of a sudden you did a new application build and it was 10 seconds. That's going to be out of band, you immediately triage it, you roll it back automatically, and then you proceed fourth, and you never got that array of huge number of customer calls that there was an issue in the first place. You resolved it, you resolved it in an automated way. That's where we're headed. That is the power of Dynatrace, and that's what we're working to deliver.

You talked about increased investments on the last earnings call. And I think there was some misunderstanding around that. I guess maybe first, if you wanted to double-click on how you're going to allocate those dollars inside the organization to start with. And then secondly, sorry to give you a 2-parter, but there was also some fear that this is going to cause a more difficult competitive environment. And then we subsequently learned after 2-year competitors reported that they're also increasing investments. So maybe you could first talk about how you're allocating those growth within the organization? And second, how you think about the competitive response and the fear that this is going to be a tighter market?

Yes. So several things to unpack in that, Adam. The first is that we don't believe that there's any increased OpEx requirement or allocation needed to maintain growth at the current run rates. Our objective -- while any OpEx targeted investments take a few quarters to gestate, it's not like you increase R&D investment and then in the next quarter, you see growth. We do believe that now is the time. Now is the time to go after the opportunity in the market to accelerate growth. And that's exactly what we're working to do over the course of the next period as we exit '23 -- fiscal '23 into fiscal '24. The investments that we came up with, I didn't come up with on my first day, 75 days ago or 80 days ago. These were well underway that we decided to pull the trigger on based on the timing of where we are in the market and its evolution. And they are very modest and very targeted. So we're talking about a couple of hundred basis points of OpEx, incremental OpEx and resultant operating margin impact over a very short period of time against the 25% operating margin. So it's pretty de minimis. Last part of the question was where. And the answer is we're not just throwing things against the wall to see what sticks here. We have a very, very precise allocation plan for any incremental OpEx in R&D and in go-to-market. On the R&D side, I talked about infrastructure, logging and application security. Those are all elements right for expansion infrastructure. As I mentioned, $100 million business growing at 75%. We believe that there's substantial uptick there. Logs, a huge opportunity for disruption of that market. We're well on the way to -- by the second half of the next fiscal year, delivering against logs. And then application security, when Log4j hit as a vulnerability in December, we went from -- with a nascent product, a couple of dozen POCs to more than 350 POCs over a few weeks' span. So that was pretty exciting. On the go-to-market side, I talk about partners, brand, SEO. Those would be the areas there.

Perfect. We've got a little over 5 minutes left. Just pulling to see if anybody has questions. Go ahead.

I was just going to ask in terms of customer mix, any major concentration? How much [Technical Difficulty] private cloud versus public cloud, hyperscale and any sort of major differences in financial metrics, profitability, hyperscale [Technical Difficulty]

Great questions. No major difference in financials in terms of the way that we transact, same infrastructure with the same cost structure is used to provide capabilities, whether it's in on-prem environment or otherwise. The movement is clearly that the vast majority of new deployments are cloud ecosystem-based deployments and that's the expectation. In the several dozen or so customer or meetings I've done and many of those customers are, "Please, Dynatrace help me to complete my cloud ecosystem migration." And so if anything, it's moving from -- even those customers are moving from managed environments to more SaaS-based environments. So I'd say new deployments generally in the cloud, existing deployments, there's a mix, but even those tend to be moving over the course of time. We're agnostic as it turns out, but the vast majority of our cloud deployments.

Do you want to?

On the APM side, financial [Technical Difficulty] existing customers, where do you think that percentage grows?

I would like to think it continues to accelerate, but there's just such enormous white space that I'm not -- I don't know that you ever get to 50%. And the reason is not because we can't capture the workload is because the number of workloads are expanding faster than they deploy on Dynatrace. I talked to one of the top 4 Australian banks the other day by way of example to the CTO, they're already doing a couple of million dollars of ARR on Dynatrace fairly early in deployment, and they have 3,000 applications. Now some of those applications, they're trying to mothball so that they can reduce number of the application. So let's say they get to 2,000 and we've got dozens, you've got a lot of runway in these accounts. And if anything, the digital transformation of migration to the cloud is facilitating because of the ability to use containers and other elements to accelerate code development is creating more applications even faster at an accelerating rate. So it's not even a static 20% or 30% that the denominator is based on. The denominator is exploding as well. And so I'm not sure that the dynamics result in that number really ever growing to the point where you start evaluating, oh, jeez, we're out of white space.

Good questions. Any other questions? We've got less than 5 minutes left. Yes?

Where are we in the logging product. [Technical Difficulty]

Great question. For those of you who didn't hear it was, where are we in the logging product. Our logging capabilities today. We do have logging capabilities. We're looking to leapfrog where the market is through graphing technology, that gives us enormous, enormous scale, which is what Dynatrace is known for at substantial complexity at far reduced cost. So that's kind of what we're after. We believe that the players in the market are overpriced and that the market is speaking loudly about that. And the result of it is that we believe there is substantial opportunity for disruption. So that's part 1 is the logging market specifically by itself. But if you add in the notion that our customers are telling me, I want a broad-based software intelligence platform that spans the gamut of data sources. So you want data coming from your apps, you want data coming from your infrastructure, you want data coming from logs and you want to be able to process and observe and manage that data through an application security lens. If you put all that together, that gives you an extraordinarily powerful platform that you can be managing against. So we believe logs are core to that. And where we are is the plan to release those capabilities in the second half of our fiscal year, which is really around the end of this calendar year.

Yes. I think the term Splunk tax has been said so much. It's added to the dictionary at this point. Sorry, I said that...

You said it. I didn't say it. But yes, it is substantial. And I was a customer of that technology at Akamai. And I saw how it worked and what its pitfalls were. And frankly, it's cost. And I do believe that there is a substantial opportunity to make a step forward with Dynatrace.

Let's wrap up with another area, I think that was maybe a little bit misunderstood on the last call. You talked about M&A as an accelerant to already a healthy core growth opportunity. I wondered if you could maybe talk about your learnings as a key part of the active deal team at Akamai? What makes a good acquisition or a bad acquisition and why? And how do you think about bringing those learnings to Dynatrace to create incremental value?

Sure. I think that I owned and was responsible for M&A at Akamai and the entire time I was there, we did a couple of dozen deals. My guess is that, that created some concern for Dynatrace. Dynatrace is a different story. It is an organic growth play. That's where we're focused. We are not thinking about transformational M&A. We are thinking about tuck-in M&A. And where we can use M&A on a selective way at a low dollar cost type of an amount to accelerate road maps by 12 to 18 months in certain of the key markets that we described, like infrastructure, logging, AppSec, for example, then we're going to explore those. We'll be very, very disciplined buyers, as I always have been through my career, and we'll do deals that are smart, but they're going to be in that tuck-in sort of area. And that's I think is the learning. I mean in the past, we have been responsible for doing deals that were pretty modest, one deal in one area in AppSec was a couple of million in revenue, $20 million in cost at the time several years ago, resulted 4 to 5 years later in a $250 million business. So we do want to be looking at these areas and looking at them with discipline, but looking at them broadly to evaluate where those kinds of acceleration elements in plays can be made.

Well, hopefully, this was a helpful high-level discussion. We're going to get much more into detail on some of these areas downstairs and a breakout. If you'd like to join we'd love to have you. Rick, thank you so much.

Thanks very much. Thank you all for coming. Appreciate it.