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

Okay. I think we're about to get started. If everyone can just please take your seats. My name is Noah Herman. I'm a software research analyst here at JPMorgan. Thank you so much for coming today to JPMorgan's 50th TMC Conference. We're really thankful to be having Dynatrace here to present today. CEO, Rick McConnell; CFO, Kevin Burns. Thank you guys so much for being here today. We really appreciate it. If you could just maybe spend a little time just introducing yourselves and also just the company and customers you serve.

Sure. Of course, I'll start. Thanks very much, Noah. My name is Rick McConnell. I'm Dynatrace's CEO, been in seat now about 5 or 6 months, coming up on 6 months. Delighted to be here. Talk a little bit about Dynatrace in a minute, but Kevin, do you want to take it away?

Kevin Burns, CFO, been with Dynatrace coming up on 6 years, spent 30 years in technology companies and help scale the business from $25 million of Dynatrace AR 5 years ago to $1 billion today.

Great. Thank you, guys. And before we get started, if you have any questions, you can submit through the conference website towards maybe the middle of our session. I'll take a quick pause to see if there are any questions in the room, and you can just raise your hand and someone with a microphone will come and assist you. just to let you know. So with that, Rick, specifically, you've been, like you mentioned, in the CEO position for about just nearly half a year at this point. So how has the business evolved since then? And what changes are you focused on in your new role?

Sure. So Dynatrace is an incredibly strong business, great market, exceptional customers. The financial performance is really something that we are quite proud of, 35% adjusted ARR growth, mid-20s operating margin, a guide for FY '23, which just began April 1 of 29% to 30% free cash flow. So very, very solid set of financials. And on top of that, as I say, really strong momentum in a market that's growing around observability as we talk about it. Observability really is focused on making your cloud environment smarter about making it much more effective than it is today without an observability solution. And at Dynatrace, we're focused on not just getting data to glass as we refer to it, or dashboards built. We're focused on delivering answers and intelligent automation from that data that enable your cloud environment to be that much better.

Great. And you sort of kind of touched on the guidance in terms of the growth outlook. And I think you also said you've highlighted the opportunity to accelerate beyond the mid-30s for growth in fiscal year 2024 through targeted investments in R&D and sales. Can you sort of elaborate on this and how you're balancing both future growth and profitability?

Sure. So this -- we run Dynatrace to be a very balanced business in revenue and profitability, as I indicated. We have been operating at around about a rule of 60 based on the metrics that I just described. And as we look to the future opportunity, we believe that it's right there for us right now. And despite macro headwinds, which I'm sure, Noah, you'll probably ask me about in a minute, if our one-on-ones are any indicator of questions to come. It is an environment where we believe observability is ready for prime time. And observability is something that should be deployed in your cloud environments to make your clouds work better. And Dynatrace is, we believe, the best answer for the Global 15,000 to do precisely that. So we are focused on getting deployed with the Global 15,000 to make your overall IT ecosystems work better.

Great. And if you can kind of focus a little bit on where are we at in terms of penetration with your customers? And what are some of the next areas of growth that you see?

So these days, we have about 3,300 customers, as I said. We are focused on the Global 15,000, but we really view that we've only just begun. In many ways, the 3,000 is 20% by definition of the Global 15,000. But on top of that, we view that more and more cloud workflows are getting generated every single day from our existing customers. And this leads us not to just an opportunity to add new logos or new customers but also to create net expansion from our existing customers that's quite material. So we would view that our penetration into our existing installed base, maybe in the order of 15% to 20% of cloud workflows today. And so there is a lot of runway in existing workflow expansion, number one; number two, a lot of runway with regard to new logos, new customers; and number three, we're adding new modules all the time as well, including areas like application security as well as logging that will be forthcoming. Our infrastructure module went from 0 to $100 million in growth. It's growing still on the order of 2x, the overall ARR growth of the company, $100 million business, it grew to that in 8 quarters. So we have a lot of opportunity around new module expansion and growth as well.

Great. And sort of following up with that, I mean, how much of what you sell each quarter would you say is at this point being used for on-premise applications versus private cloud applications and maybe also public cloud applications?

So we have a high percentage of customers that use us in a managed environment on-prem, but the vast majority of new sales are cloud workflows. So these days, we are focused on selling clouds done right. And we think of Dynatrace in the Global 15,000 market as cloud ecosystems done right and that's how we're positioning the company as we look at it.

And you've also talked about some developments in your logging offering. Can you give us some more detail on what you've come to like what is so differentiated about it versus maybe current logging solutions in the market today?

I think that the logging market or log-based use cases are very ripe for disruption. Pricing in the logging environment is very high. And I believe that we can deliver using graphing technology we've been working on for some time to deliver against an opportunity for logs to be more performant at higher scale and lower cost. Moreover, logging is not just about delivering logs. It is really about integrating logs into an overall observability, end-to-end solution. And that's where the power of Dynatrace really comes in. So we view traces, logs, metrics, real user data down to a very granular level, metadata, behavioral analytics. All of these elements get combined together in terms of an element that we can process through our AIOps engine and that AIOps engine is really where the secret sauce is to define specifically what is happening in your IT ecosystem, how it is performing and how you can improve it as you look forward. So that when there is an issue, you can precisely identify where that issue is and improve things like mean time to repair and improve uptime. And this is really why we see Dynatrace's clouds done right because we provide the situational awareness associated with your cloud that is so fundamental in ensuring your cloud environment is working well. And that's what's leading to the growth that we're seeing in our market.

And as we sort of think about the whole DevOps process, what are your thoughts about shifting left, moving back within the DevOps process. You already provide a lot of key information that goes to developers. So why not maybe own the distribution or maybe some of the other segments within the CI/CD tool chain.

DevOps, I think, CI/CD tool chains, overall shift left becomes more and more important to us at Dynatrace day by day. The way to think about it is Phase 1 of observability was really simple monitoring. Monitoring was about dashboard's data to glass. You just wanted to know what's happening in your environment. And if alert fired and went red, you could see it. And then you could go get sometimes an army of people working on it to figure out how to resolve that particular issue. Phase 2 was observability where you could identify using AI capabilities through Dynatrace a much more precise analytical environment of where the issues are occurring so that you could identify and then rectify those issues more rapidly. Phase 3, as we see it is the shift left environment where you're integrating those answers directly into code. And that's where you can create auto remediation. And if you can automatically correct issues based on what's happening in code, then you can do even better. So this is the directional heading that we're on is to simplify the incorporation of Dynatrace directly into code using developers as a way to integrate them.

Great. And I sort of want to maybe focus a little bit more on the financials. So maybe...

That's great.

Yes. Just to get Kevin maybe a little bit more involved. What would you say are maybe the main drivers at a high level for the long-term growth of the company?

Sure. I think -- so overall, the fundamental building blocks of our business are pretty straightforward. First is our existing customer base. We have about 3,500 customers using the Dynatrace platform. And over the last 4 years, those customers have been expanding north of 120%. So building block 1, and if you look at our growth over the last couple of years, 2/3 of our growth is coming from expansion in that base. And as Rick said, that's more workloads, that's infrastructure monitoring, digital experience has a great attach rate and upcoming modules like cloud automation and application security. So we think that there's durable sustainable growth in that customer base to continue to have 120-plus percent net expansion over time. The second part of the formula is new logos. And over the last couple of years, we've been growing new logos in the range of 15% to 20% a year. This past year, we grew -- we added 700 new enterprise logos to the Dynatrace platform. We've landed those at an average of about $125,000 initial land. So that added about $80 million of ARR to our overall $1 billion ARR platform. So as we think about the building blocks going forward, it's going to be more of the same, growing new logos 15% to 20%, maintaining the 120-plus percent net expansion rate. And some of those investments that Rick mentioned earlier in terms of the go-to-market and innovation will help us sustain that.

Got it. And so when we kind of look at the customer base and just contracts, in general, could you maybe touch on the nature of contracts, the duration, pricing and maybe when those contracts are up for renewal, are you taking price? Are you taking further modules? If you could just elaborate on that?

We've done a great job from a customer standpoint of, as I mentioned earlier, expanding those customers over time. And the other thing we've done a nice job as well is extending the duration of the contract. So if you go back 3 to 4 years ago, our average contract duration was a little north of 1 year. Today, our average contract duration is north of 2 years. So people as they become familiar with the Dynatrace platform, they see the ROI, they see the Davis AI engine finding root cause issues and identifying issues instead of data on glass, they're signing up for longer and longer duration contracts. And what they're also doing is getting into budget cycles and planning the expansion of additional workloads over time. So super healthy net expansion rate. I'd say the other thing that we did from a pricing and packaging standpoint over the last year is we introduced what we call the Dynatrace platform subscription agreement. And for a fixed dollar amount, on an annual basis, you have access to our entire portfolio of applications. And our customers love it because during peak periods of time, maybe they want to monitor what's going on with the real users. Other times, they want a little bit more insight into the application or they need some more log monitoring. So they can mix and match our -- the applications -- our modules in their environments to optimize the use of the portfolio. So fixed rate card, they draw down on it and what this is also leading to is better use of the system. They don't have shelfware, and it's leading to faster and faster renewals and upside and growth opportunities on top of that.

Perfect. I think I'll take a quick pause here just to see if there are any questions. If you do, you can just raise your hand. Over here.

Can you tell us a little bit about the progress you're making with your security vertical and the competitive landscape you're seeing there? Is it more competitive than you expected moving into that market? And do you see security being a bigger part of Dynatrace's story moving forward?

Yes is the short answer to the question. The way we look at AppSec is that AppSec over time is going to converge with observability in terms of its value and importance to customers. And the starting point for us has been vulnerability management. In the case of vulnerability management, not a lot of competitors in that space specifically. It will probably get more competitive as we expand into other module dimensions around AppSec. But at least for now, it's pretty greenfield in our attack. As we think about AppSec, the way we think about more -- most of these modules is that they need to be sort of $100 million opportunities in a pretty concrete span of time. So for example, I mentioned that infrastructure is growing quite rapidly, $100 million business in about 8 quarters or so. We would expect that logging could be something similar. AppSec probably takes a little bit longer because it's more of a specialty sale but maybe it's a few year span. And it's coming off of a very small single-digit number. It will grow to multiple this year, starts to become more material in FY '24.

Two questions. Just on the pricing. So if you can clarify, so you don't have a consumption-based model. It's fixed pricing because one of your peers is as a consumption-based model, which has led to a pretty impressive growth numbers. So I was wondering why do you price the way you price. And just there are many publicly listed observability companies, and they're all growing at fairly decent rate. So is this kind of a market that's so underpenetrated that everybody benefits? Or when do you win when do you lose, if you can explain that?

Do you want to take the first one and I'll take that second?

Absolutely. From a pricing standpoint, working with the Global 15,000 largest enterprises in the world, what we've learned and what we realized with our customer base is, they don't want to be surprised. They want to sign up for a fixed annual commitment, and they want to use to that amount. If they know they're going to go over, then they want to sign an extension. Overages, excess billing in the enterprise marketplace is not very well received. So we found it very successful with our CIOs and CTOs and folks that we sell to. They will sign up for a multimillion dollar commitment and they will use up to that level. And when they're -- if they're going to hit that level, they want to sign an expansion opportunity after that. They don't want to get a bill in the mail afterwards. The SMB market, I think, is a little bit different, right? I think they may be used to more consumption, more overages, but I'm sure that's probably not well received in a recessionary environment as well.

On the second question, I would say that the market is consolidating based on growth rates to a couple of players. We're targeted at the higher end of the market. Other competitors I'm sure you're referring to are targeted more to the SMB space or departmental sales in enterprises. We don't run into them too much. The rest of the market is a contributor of share to others at this stage, I would say. So it's largely consolidating down to, I think, a couple of players.

Got it. And does it -- piggyback off of that, does it make sense to go into the SMB space? Or I guess, how are you really positioning maybe the go-to-market motions for both SMB and for enterprise?

Well, our view of that is that there is so much opportunity in the market in which we serve along all the dimensions that I talked about earlier, penetrating new workflows at existing customers, new expansion in the Global 15,000, new module deployment that we're going to play to our strength. And our strength is a differentiation when the data is of high scale at significant complexity. So that's where we win, that's where we win and focus all the time. And so that's what we're going to continue to do. There are, however, ways to accelerate growth that we absolutely believe are upon us. For example, global system integrators, hyperscalers, these are routes to market that are there. We also want the Dynatrace brand to be associated with, as I talked about earlier, cloud done right. This notion that if you're a Global 15,000 customer, you are thinking about Dynatrace when you're thinking about your cloud deployment, your cloud migration. And if we can incubate that sort of thinking in that drive, then I think that there is a really significant opportunity as we look at.

A lot of focus is really paid to the partnerships with some of the hyperscalers. Can you maybe walk us through your current relationship with some of them or if all of them?

So the first part is very strong relationship with AWS, but we just deployed the Dynatrace platform in a SaaS, a cloud-based environment on Azure and GCP this past quarter. So the result of that is that we are now native in the cloud SaaS environment for each of the 3 major hyperscalers and the result of that is joint selling, co-selling, those capabilities now really expand to all 3 of them rather than just in AWS. So we believe that those partnerships will strengthen. The numbers, considering we grew for the last couple of quarters, our hyperscaler ARR growth at more than 3x year-over-year in each of the last 2 quarters. That is an area of very strong growth and an area that's getting the attention of the hyperscalers as a result of that more and more. So we are in discussions with the hyperscalers at increasingly senior levels to figure out what else we can do to accelerate there.

And as we sort of think of the 3 -- like 3 legs, APM, infrastructure, logging, could you maybe touch on how your solutions are competitively differentiated maybe some of your peers or where you think your strengths are relative to them?

Sure. So the biggest strength, as I talked about, of Dynatrace is really in the AIOps engine from a differentiating point of view. This is where we process ridiculous amounts of data and incorporating billions of interactions on a daily basis, petabytes of data to, in some sense, find the needle in the haystack, assess precisely where there are issues in your infrastructure whenever something goes wrong, and we can evaluate and process that for you. And that is the secret sauce. That is the differentiator for Dynatrace relative to others in our space. That translates through modules that we're providing like the application performance module, APM or as we call it full stack. There's the infrastructure module I talked about earlier. You've got our digital experience management module, which is targeting the real user monitoring, and then you've got application security with logging to come. So these are the dimensions that we process against AIOps engine, key differentiator. We sell modules that sit on top of that platform and leverage that software intelligence platform. And then we'll continue to expand those modules and those capabilities as we look at.

I think I'll take another quick pause if anyone has any.

Recognizing you have some significant competitive advantage, can you just talk to the current kind of operating environment? There clearly been some signs of deceleration both from a high level as well as a lot of companies. So what are you seeing?

Yes. So from a macro perspective, at this stage, this is a pretty common question for us through the course of the last week or so since we did earnings. The short form from our perspective is we're not really seeing a slowdown as of yet. We did, however, incorporate uncertainty into our guidance. We believe we've delivered prudent guidance for FY '23, which we submitted last week. And that's how we're going to look to it. One other important factor is that, as I mentioned at the outset, we are very focused on balanced management of our financials. And so the result of it is, if we were to see a bigger slowdown than we've expected, our expectation is that we would manage top line to bottom line. So we will maintain operating margins at the level that we've described in our guidance. And in fact, it is our expectation that we will plan -- we do plan to accrete operating margins back a couple of points higher as we enter FY '24. So over the next 4 to 6 quarters, you should expect us to reaccrete operating margins by 200 basis points or so.

I was just going to add to that. All the leading indicators and metrics that we evaluate in our business remain very healthy. We look at pipeline, we look at win ratios. We're looking at renewal rates and conversions. We're very well instrumented and have pretty good visibility in terms of where we think the business is going in the near term. And so far, so good, right? We're obviously keeping both eyes wide open in terms of the operating environment. But enterprise software seems to be very resilient at this point, and we're optimistic. But as Rick pointed out, we put some prudence into our guide at this point.

I guess within the -- on the topic of operating margins, what sort of assumptions are you making for the impact of wage inflation on the business?

So it's all incorporated. As you can imagine, when the company is growing 30% plus on an annual basis. That gives us a lot of flexibility in terms of where we are making investments. Over the last 4 months, we have been subject to wage inflations as most of our peers have as well. And we went through a thorough exercise for all of our employees across the organization, and we took into account sort of where their cash compensation is and also their equity and the value of their equity. I'd say we have made some nice -- we've made some healthy adjustments on the cash side. I'd say more importantly though, we took a broad -- a little bit of a refresher look at our equity program and are putting that out to a larger percentage of our employee base. We're doing that, and we also made some larger grants this year. So historically, our stock-based compensation has been running well below peers. Last year, it was 11% of revenue. You can expect to see that trend up a little bit, probably closer to 13% or 14% of revenue as we make sure we provide the right incentives from an equity standpoint for 3,600 employees that we have around the world.

And just maybe a follow-up for Kevin. How would you sort of frame your capital allocation policy at this point?

So as many of you know, when we came out, we were one of the first IPOs that had a significant portion of debt on our balance sheet. That's a little bit of unheard of at the time. And we've essentially reduced that and our net cash position is positive, a couple of hundred million dollars at this point. With 30-plus percent or 30% free cash flow margins, we're going to be adding to that balance a lot over the next couple of years. So priority #1 is finish off paying down that debt. It's about $200 million on the balance sheet. Second priority will be putting additional cash on that balance sheet to focus on small tech tuck-ins over the next couple of years. We have a very robust product development plan, and we believe there are some small tech tuck-ins that we can bring into our portfolio to help accelerate time to market. So I'd say that's number two. And then the third piece, continue to build that cash on the balance sheet. We will probably take a look at making sure that perhaps our -- the equity program that we have is nondilutive going forward. More to come on that in the future. But that's just as we scale our cash number to north of $1 billion that may be something that we and the Board look at going forward.

And as for those tuck-ins, is there any particular area that you currently serve? Or would want to newly serve where it makes sense to make those strategic acquisitions...

We look at them now across the board, I would say AppSec, certainly logging, infrastructure, those areas could be a ripe for our development as well as M&A tuck-in. You also have CI/CD, DevOps those kinds of areas. So those are the ones we look at.

And typically, when you are acquiring new logos or you're expanding within your existing customer base, which competitors are you seeing most frequently, if any? Or is the opportunity so large that you're usually maybe not seeing as many competitors as you would think?

The -- not as many as you would think. The biggest competitor by far is DIY, biggest competitor by far is DIY. When you deploy on the cloud or in the cloud, you are typically looking at open source tools, internal development, dashboarding, simple dashboarding that you're putting up. And when I talk to customers, I've talked to now dozens of customers in my tenure so far at Dynatrace, the answer is more often than not, Rick, I've got 16 tools. I've got 30 tools. One customer told me they had 60. So they have lots and lots of tools that have sparked up departmental deployments or app-specific deployments and what IT groups are trying to do is they're trying to get their arms around this, consolidate it and go with a standard-based solution. And that's where they want Dynatrace to help them out. And even if we're deployed, they want us to help consolidate them. So this is the biggest greenfield area for us to go after is to capture the DIY space.

And when you land with the new logo, are you approaching that new customer at the C-suite level? Or is it at the department level? Where are those conversations initially happening?

I wouldn't say necessarily C-suite always, but certainly in IT, the focus. So centralized IT as opposed to a departmental sale.

Right. Got it. I think you have another question here.

I was wondering you came from a security background before joining Dynatrace. So what did you bring with that kind of background to the company? So obviously, you mentioned AppSec as one of the modules, but just as it applies to your observability TAM, what does it bring to you?

What does AppSec bring to us?

No, your background in security. You came from security like when you were at Akamai and now you're doing observability, which is kind of a broader infrastructure monitoring. So how does -- what you did at Akamai is applicable to what you're doing at Dynatrace...

We were focused at Akamai on delivering solutions that enabled exceptional user experiences globally to in many ways, achieve the same vision that Dynatrace has, which is to make software work perfectly. In Akamai's case, we wanted to make delivery work perfectly. We wanted to make sure that every user experience is perfect. Dynatrace is focused on doing the same thing. We're focused on making every digital interaction work perfectly, whether it's machine to machine or machine to individual. The user base, the customers are the same. I'm calling on the same people that I talk to in many cases when I was engaged with customers on a global basis at Akamai now at Dynatrace. I called many of those customers before I took the role. And many of them, interestingly, one of them, JPMorgan, as it turns out, was a customer of both Dynatrace and Akamai. And they said, wow, we love Dynatrace, great. It's great that you're going over there. And so that is a great opportunity as well. So there are many customers that are overlapping. And in security, this is a business when I joined Akamai back in 2011, security was $2 million of revenue for Akamai. When I left, it was $1.3 billion. So not signaling what the AppSec revenue is going to be at Dynatrace in 10 years, but that would be okay if it went that way. But I am signaling that I do think that there is an opportunity for observability in AppSec convergence here in the same way that there was for Akamai. Did I convince you?

Any other questions? Well, I guess before we sort of wrap up here, and both of you can definitely answer this, but is there anything you'd want investors to leave away here, really knowing something that -- just your main message that you would want to relay to investors?

Sure. Of course. Look, Dynatrace, I joined Dynatrace coming from what was a great position at Akamai 5, 6 months ago because I saw an opportunity that was absolutely enormous. The market is giant. The customer base is exceptional. The product portfolio is awesome. Customers tell me time and time again, your products are indispensable. They just work. and they work great. And the result of that is we end up with NER, net expansion rate greater than 120% for 16 quarters because they continue to buy more. They add more workflows, they add more modules, they add more capabilities over time, and the financials are quite impeccable actually. That is a great foundation and yet I'm impatient. I think that there is an opportunity for even further growth into this market to take advantage of it or not signaling greater ARR growth. We're just looking at it as an opportunity in the market that is ripe for further expansion. I think that if we can construct Dynatrace as the model for cloud done right, targeting the Global 15,000 that there is a lot of opportunity to come. And through the combination of new modules, new capabilities like logging, infrastructure, AppSec, combination of go-to-market capabilities like partners, we didn't talk about our Deloitte partnership that we announced last week, but that sends a big signal that global system integrators are now thinking about observability as a fundamental practice that needs to be integrated in their cloud environment and the Dynatrace fulfills that requirement, fulfills that need. So whether it's hyperscalers, GSIs or other routes to market in terms of establishing the Dynatrace brand to mean clouds done right for our target market, I think that it's a really compelling opportunity. I'm thrilled to be here. and we look forward to working with you all, hopefully, in the future. So keep us posted. Thanks very much.

Yes. Thank you guys for coming. Appreciate it. Thanks.