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

My name is Kamil Mielczarek, and I am the equity research analyst here at William Blair covering the data and analytics space. For a complete list of research disclosures or potential conflicts of interest, please visit our website at williamblair.com. We have with us today Dynatrace CFO, Kevin Burns. Thank you for joining us, Kevin.

Thanks.

Dynatrace is a leading provider of observability solutions. The company is generating near $1 billion in ARR, while growing more than 30% and delivering high 20% free cash flow margin, which positions the company very well to be a long-term winner in the space. And with that, I'll pass it off to Kevin, he has a few slides to share.

Great. Thanks, Kamil. Will you move the slides forward. Okay. So I'll go ahead and start and let me know when the slides are ready. But as Kamil mentioned, we're a leading software intelligence company. We focus on the observability and security marketplaces. For those of you who are new to this Dynatrace story. What we do is we help enterprise companies monitor their technology environment so that they can ensure that their digital interactions with their customers, with their employees are optimized. We brought a new product to market, our Dynatrace platform about 4 years ago. And our focus is on global enterprise accounts where these organizations are very complex and dynamic in nature. So the more complex dynamic environments, the more -- the better automation and intelligence that Dynatrace can provide to ensure a digital presence for our customers. So today, what I'll quickly do is I'll talk about our mission, a little bit about our TAM and talk about our platform go-to-market and a little bit on the financials, and I think we'll do a little Q&A after that as well. So from a mission standpoint -- our vision standpoint, our vision is a world where software works perfectly. And think about the implications of that. If you're out and you want to take a plane trip, there are so many applications and infrastructure that needs to work. The ticketing system needs to work, the baggage system, the catering, the scheduling, the crews, all these different applications need to work. And if they don't work properly, planes don't fly, companies lose revenue. So our vision is to help enterprise companies ensure that their software works perfectly all the time. The way that we do this is we want to deliver answers and intelligent automation from data. So we gather a lot of information on what's going on in our technology customers environment, and we help them automate that data and then we help them to identify root cause analysis of issues in their technology stack. Old school monitoring was taking data, putting it on glass, getting alerts and then the engineers had to figure out what's going on. Our platform actually automates all of that, takes that data, turns it into answers so that our customers can optimize their digital presence for their customers. So our purpose then is to enable flawless and secure digital interactions. I'm sure many of you have gone to websites. If they don't -- if it's not working, you're going to go somewhere else to buy a product or do something. So our customers, especially in today's economy, their digital presence is super important to them. So a world where software works perfectly is our vision, and that's our goal to help our customers get there. From a macro trend standpoint, this is what we're seeing in the marketplace. Digital transformation is accelerating, right? I know over the last couple of years, especially with COVID, people doubled down on their digital transformation initiatives. It's the number one investment area for CIOs in terms of transforming their businesses to make them more efficient and automated. We also believe that dynamic clouds are the platform of choice. It's the world's going from on-prem static applications to modern cloud-native applications built for the cloud. These environments are becoming more and more complex over time. However. As a result of the complexity in our customers' environments, AI needs to be a core feature and solution to help them deal with the complexity in the environment. So a lot of tailwinds for growth -- sustainable growth for many years to come in this environment. From a TAM standpoint, we size our TAM at $50 billion and growing. This is about $32 billion in observability. It's about $18 billion in security. And if you think about some of the other marketplace players, the hyperscalers are at a run rate of $150 billion, and that's growing 40%. There's going to be 750 million new applications developed over the next 5 years. All these applications need to be monitored. So the -- so the -- our customers understand what's going on with them. Digital transformation spending is going to be $10 billion. So a large market today, growing 40-plus percent. And it's an evergreen market given the fact that there's more and more infrastructure getting spun up every day, especially in the cloud environment, and there's more and more applications getting developed every day. So evergreen market, early innings from a penetration standpoint. We target the Global 15,000 enterprise customers. We are -- we work in every vertical. Our largest vertical happens to be financial services, which accounts for about 10% of our $1 billion in ARR. However, every company is a software company, and every company's digital presence is super important. So we provide value to companies across many different verticals. Today, we have about 3,400 customers, so we're about 20% penetrated in the Global 15,000. Our average ARR per customer is about $300,000. Customers that have 3-plus modules with us, their average ARR is about $500,000. We believe in observability, every customer can be a $1 million customer. So again, as I mentioned, still early innings from a penetration standpoint. Here's a quick snapshot of our platform. The key here is we've rebuilt this platform to work in modern cloud environments. This is not monitoring from 5 years ago. We threw out all of our code, built this from scratch to deal with micro services, containerized environments because that's where the world is going. So the more complex in environment, the better and the more value we deliver to our customers. We have 6 different modules that we monetize. The core of our business today is focused on the applications in the microservices piece. So that's a majority of our ARR at this point. Infrastructure module, we introduced about 2 years ago. And over 2 years, that grew to about $100 million in ARR. Digital experience monitoring. There's a lot of things happening at the edge, IoT, mobile devices. And we want to monitor what's happening from a real user standpoint there as well. So that continues to have a super healthy attach rate. Cloud automation, application security and digital business analytics are relatively new modules, which we think can be growth drivers for the next couple of years. A little bit on our secret sauce here for a quick minute. In order to deal with today's complex environments, we do a couple of things that are very unique in the marketplace. The first is we have a solution called OneAgent. This is embedded in the platform. And with one line of code, it deploys these agents to collect all the data in the technology environment. So it's automatic. Old school was you had to manually instrument the environments and that required a lot of resources and overhead. And as these environments change, they had to go in and reinstrument. So today, we have OneAgent automatically collects all this data. The second -- then what we do next is we actually build the dependency map. So up and down the technology stack, all the way from the applications through the infrastructure of the network down to code level, we are modeling what's going on, and then we're also modeling it across the technology stack in terms of how it changed here and the application impacts a real user experience as well. So we create this dependency map, it's called Smartscape that's modeling billions and billions of dependencies for our customers in real time. Now when you have billions of dependencies that you're modeling in real time, you cannot put the data on glass to try and figure out what's going on. So we've built AI at the core. And our AI at the core, as I mentioned earlier, it actually identifies the root cause issue of what's wrong in your technology environment. So instead of the engineering groups having to figure out through alerts and looking at code, our AI engine pops up and says, this is what happened in your environment, and this is what you need to go fix. So for a large enterprises, we gather -- we capture the data. We build the dependency map and then we apply AI engine to identify the root cause and it provides a tremendous amount of value to our customers in terms of automation and providing answers instead of data on glass. So here's -- from a competitive standpoint, people will say, hey, this is a super competitive market. And our view is it's not that competitive. Today, CIOs, what they've done is they've cobbled together sort of second-generation legacy monitoring tools. They put some resources to try to cobble these things together and try to put it in a database, and then maybe they try to put an AI engine on top of it. So they're spending, in some cases, hundreds of people, resources to build a monitoring solution when Dynatrace has built this. So from a competitive standpoint, we believe the market is ripe. It's a lot of do-it-yourselfers, CIOs who are trying to develop themselves. And we've built a solution. Our analogy is the iPhone. It's all in one, and it provides a tremendous amount of value. From a competitive positioning standpoint, what makes us differentiated and where we think we -- our strongest suit is, it's 2 things. One is it's the enterprise place, enterprise marketplace. So Global 15,000 customers. These are customers that had -- they have information on-prem. They have information in private cloud. They have information in public clouds. They have apps here, infrastructure there. It's a complicated environment to monitor given our technology, that's our sweet spot. So we target the global enterprises. We think we're well suited there. We think competitive differentiator for us is the AI engine that we've built because again, we're identifying the root cause of the issue as opposed to giving them more alerts and data on glass. So from a competitive standpoint, we think we're well positioned there. Industry analysts. I won't spend much time on this, but we've gotten -- we've been in the marketplace for over 15 years. We've reinvented the platform to stay ahead of market changes, most recently 4 years ago, thinking about microservices, containers and whatnot. And we've been recognized as the leader in this space for many years. Our go-to-market model is pretty efficient. It's primarily a direct sales organization. We typically land with a proof of concept where we prove the value of the automation and the intelligence and the answer-driven piece of it. Target the Global 15,000. Our average land zone is about $100,000, $125,000 initial ARR rate. So we land and they're trying to monitor some 5-or-so applications in an environment and then we expand very nicely with our customer base because once they've gone through the POC, we've proven the value to them. And then we've seen a healthy net expansion rate of north of 120% ever since we introduced the Dynatrace platform, and there's no reason to believe that we can't sustain that for many years to come. Overall, our customers, the larger customers, we do have 8-figure customers. many, many million dollar customers, our average ARR, as I mentioned earlier, is $300,000, and those customers with sort of the 3 core modules is $500,000 in ARR. We are invested in the business. We run a balanced business. It is super important to Dynatrace to continue to run a balanced business, but we're also investing in the future. I'll break the investments down a little bit. First is the commercial investment. We're growing our direct sales organization 30% a year. We've been stepping that up every year for the last couple of years. We are making additional investments in our partner community, and I'll break the partner community consists primarily of 2 sort of focus areas for us. One would be the global system integrators. These are organizations that drive $100 million projects, digital transformation projects with Fortune 500 clients. Deloitte is a perfect example of one of our partnerships. We just announced this or Deloitte just announced this 2 weeks ago and Dynatrace was selected by Deloitte to be the observability partner. So when they're going and working with their customers to work on cloud transformation initiatives and cloud-first initiatives, Dynatrace is the partner, the observability partner that -- we're going to go to market with Deloitte. And we believe there's other GSIs that we can get here over the next 12 to 24 months. So making some incremental investments there, focus on accelerating ARR growth as well. And from a partner standpoint, I will say we also have healthy relationships with all of the hyperscalers, AWS, GCP and Azure and we've increased bookings from those partnerships threefold over the last 12 months. So those continue to help us build momentum in the business as well. As I mentioned earlier, we are focused on continuous innovation. We have 1/3 of our workforce. We have about 3,500 employees. 1,200 of those employees are in our engineering organization. So it is a continue to innovate. We can't be behind the curve. We need to -- we think about where the market is going, and we've proven over the last 15 years, we can maintain that competitive advantage from an innovation standpoint. And again, we focus on customer success. We developed great products. There's a low-cost overhead to support that product because when we do put code out into the marketplace with our customers, it works. Quickly on financials, and I think we may open it up to a few questions at that. But just in terms of framing the business from a financial standpoint, this past quarter, Q4, our March quarter, we ended with about $995 million of ARR. Five years ago, Dynatrace ARR was $25 million. So we've had really strong growth on the Dynatrace platform over the last 5 years and been able to sustain 30-plus percent adjusted ARR growth for quite some time. From a predictable model standpoint, subscription revenues, 93% of revenue. That's been growing a little bit every year. I think that will continue to grow. Our services is only about 6% of revenue. There's a sort of a low cost to implement the platform because it's super-efficient. As I mentioned earlier, from a growth standpoint, our growth model is pretty simple. We grow our customer base with 120% net expansion. And we have 15% to 20% new logo growth every year, and that's a 30-plus percent adjusted ARR growth business. Our guide this year, we guided for fiscal '23 which ends in March of '23. We guided to 29% to 30% ARR growth. And hopefully, we have a nice beat and raise model throughout the course of this year. So durable sustainable growth. The other thing that is very important to Dynatrace is it's a balanced story, which means we're not investing for growth at all costs. We want to run a profitable business. We've been profitable for the last 5 years as an organization. We think it's very important to run a durable business and a balanced business. And this past year, our operating margins were 25% and our unlevered free cash flow margins were 25%. Next year, we're guiding to a free cash flow margin of 29% to 30%. So super healthy growth in the business. What I'll wrap up by saying is just a few takeaways here, which is. This is a large market. We think about it as a $40 billion market, but it's also growing dramatically. So we -- this market, it's an evergreen market, more and more applications, more and more infrastructure is getting spun up every day. So large market opportunity, but it's early innings. Companies generally are only monitoring 20% of their applications. We have customers who are monitoring 70%, 80% of their applications. And we think over time, that's going to provide a continued runway for growth. Second, from a platform standpoint, we replatformed a handful of years ago to deal with today's modern cloud dynamic environments. And we do this at scale. So we think we've got this enterprise scale advantage in the marketplace. And when we rebuilt the platform, we put AI at the core. So this -- the AI at the core, given the volume of data that customers are capturing today and we're capturing in our platform, you need AI at the core to deliver answers. Data -- getting the data out of your system is irrelevant, we need the answers, and we do that. Finally, from a financial standpoint, it's a balanced business. I talked about that just a moment ago. We believe we can sustain healthy growth rates. The building blocks are pretty simple, add new logos at a rate of 20%, maintain 120-plus percent net expansion rate, and that's a 30-plus percent growth business for many, many years. So overall, we're super pleased with the performance of the business since we introduced the Dynatrace platform 5 years ago and excited about fiscal '23. And with that, we'll do some questions.

Yes. Great. So maybe we could start talking about something that's kind of top of mind for a lot of investors, the macro environment. What have you seen in the most recent quarter? Have you seen any changes in the past few weeks? And how is Dynatrace positioned to kind of work through any potential issues we might see over the next 12 to 24 months?

So I think I'll start by saying, we look at our customer base and we break it into 2 pieces in terms of the growth. The first is the enterprise customer base. And during COVID, we maintained extremely high gross retention rates and even a very healthy net expansion rates because once our customers are on the platform, they understand the value and the efficiency and the answers that we deliver to them. And they know they can lower costs in other parts of their organization by implementing Dynatrace. So in an environment where there may be some pressures from inflation or recessionary movement, we think our customer base is very resilient because we're helping people become more efficient and we're automating their organization. From a new logo standpoint, that may be an area, Kamil, that there may be some pressure if things start to turn south a little bit. But when you think about our business next year, we're going to grow net new ARR by about $290 million, $200 -- over $200 million is going to come from our customer base. And we think that's pretty solid because they see the value there. The $90 million from new logos, I think our reputation in the marketplace and the value we deliver, we feel good about that, but there may be some pressure there going forward that we took into account in our guide. What I will say, however, though, is we haven't seen any pressure yet. So we're monitoring our new pipeline. We're monitoring -- we moved to a weekly forecasting rhythm in our business, and it's been a very predictable linear business in our organization. Our pipeline, pipeline coverage remains healthy. We look at it across verticals. So no leading indicators in terms of any pressure in the business at this point, but we're also very mindful about it. And we did take some of the comments about the market and potential recession into account when we provided our 29% to 30% ARR growth, just to be a little bit more prudent and in a little bit of an uncertain macro environment.

That's great to hear. You're also very well diversified by geography, almost half of your revenue is coming from outside of North America. Can you just update us on some of the investments you're making? How potential macro risks might impact those investments? How you're thinking about them? And what are some of the geographies where you do have the most exposure today?

So we are truly a global business. As I mentioned, 3,400 customers at this point, about 3,500 employees. We actually have more employees outside the U.S. than we do have inside the U.S. And the nice thing about our business is we continue to grow. We're expected to grow our head count over 30% next year. From an investment standpoint, we are making investments on a global basis. So over the last 3 years, we've stepped up our sales -- direct sales model growth from, I think, quota capacity growth from 15% to 20% to 25%, and this past year, we did 30%. And our goal this year again is to grow our sales organization 30% at a much larger scale. And that will be done on a global basis. So we're investing across the board. And over the last couple of years, we've seen healthy growth in all of our geos. I think a little bit stronger perhaps in LatAm and APAC just because they're coming off a smaller base. But overall, very healthy growth across the board.

Great to hear about the progress. Maybe moving on to the platform. For investors that are new to the story, can you tell us how you define some of your solutions and specifically the full stack, which makes up close to 70% of your revenue. Relative to some of your competitors, you have a little bit of a different definition of what's included in this product. So any color you can provide there would be helpful.

So historically, people thought about the market as APM, application performance monitoring and infrastructure monitoring and digital experience monitoring, right? So there are a bunch of different tools addressed at each different part of your technology stack. And we're different. We didn't -- we're not breaking out these separate modules. What we're doing is we're selling a technology module that provides coverage from the application all the way down through the infrastructure, so it's called full stack. So when we're out in the marketplace, you don't need to buy 5 different modules from different vendors. You can buy 1 module that addresses the entire technology stack, all the way from the application down to the infrastructure. So as you mentioned, about 70 -- 65%-ish of our revenue is focused on full stack. And then when they have environments where there's no applications on it, we sell our infrastructure module alongside of that. And then as I mentioned earlier, digital experience monitoring, super important, right? Our customers want to understand if something happens in their application, what's going on with the real users and making those connections is super valuable and sort of that -- those are the core 3 pillars when you think about observability.

It's a great overview. You're investing more heavily into security now. Historically, when you've launched new modules, you've kind of set out a goal of $50 million to $100 million in revenue within 3 years of launch. Is that the right way to think about security? What are some of the next investments you're going make to get there? And what was the cadence of that ramp over the next few years?

So from a security -- so our thesis in that as the developer and operations community have converged over the last handful of years, security is going to emerge as well. So you start to hear the term DevSecOps. So people want to produce code. They want to innovate rapidly. They want to do it in a secure fashion, and they want to get it into production as quickly as possible. So we see -- our thesis is we see a convergence of these markets over time. And given our platform, our observability platform, we're capturing a lot of data, and we're capturing this all the time. So a natural adjacency for us is to actually move over into the security area where we can utilize this data to get a strong foothold and make sure that when people put the code into production, it's doing it -- they're doing it securely so that we have flawless and secure digital transactions. So our initial foray product module that we introduced was about 6 months ago, vulnerability detection. So it's -- I've taken a look at the code and figuring out if there's any vulnerability issues in that. it -- Log4j happened in December, I believe. And for our customers, it was a flip of the switch for them to scan their entire environments in a matter of minutes to find these vulnerabilities. We had customers call us up and say, we didn't -- they scanned it, they found it and then they prioritized what they -- where they needed to go fix first in terms of what was getting called. So we really -- we found these issues. Customers didn't believe that we could actually do it. They spent like a couple -- some of them spent a couple of weeks making sure we found all of the Log4j instances, and we did. So that was our -- that's our initial foray into that area. I think you want to think about the next step in that natural evolution probably going into a runtime application security and production. Those are sort of historically been high overhead items in production from a security standpoint, which is why -- it's a little bit of a greenfield opportunity. So we're investing more and more in the security area. I think over the next 5 years, security can be as big of a business for us as observability, excuse me.

It's great to hear about the initial traction. Just given you've seen that strength over the last few months, are you at a point where you could start leaning more heavily into sales and marketing to drive more of that security demand? Or is there still a lot of heavy lifting to be done on the R&D front?

So right now, we have a direct -- we go to market, as I mentioned earlier, with the direct sales organization. We do have a security overlay organization helping our direct sales organization do 2 things: one, become more knowledgeable about the security market and helping them get these initial footholds in our customers from a security standpoint. We will continue to do that. I think we want to introduce a few more modules over the next 12 to 18 months in the security area before we make further investments from a sales and marketing standpoint. So what -- as you mentioned earlier, we think when we introduced a new module, we think $100 million of ARR in 2 years, I think the security, given it's an adjacency, and it's not right down the line with observability that may be 2.5 to 3 years, but we're super excited about that opportunity.

Got it. That's helpful. And I have just a few minutes left, so maybe kind of a high level one. Quota-carrying headcount is growing more than 30%. You've seen improved productivity. You have the perpetual license rolling off, new security model ramping, your lands are increasing in size. When you add up all these things, it's easy to get to a growth rate that's well above your guidance. And I understand macro is a big factor, but -- and constant currency weighs on that a little bit as well, but is that the right way to think about the math, at least maybe longer term? Or am I oversimplifying it?

No, but that's a big number. No, we are super excited about it. And you're absolutely right. We grow direct sales organization 30-plus percent. That leads to a sustainable growth rate there. If we are more successful with the partners in the global SIs, we believe that can create a much more effective flywheel approach to our sales organization and accelerate ARR growth as we go into fiscal '24 and beyond.

Great. And it's a great place to end it. Thank you, Kevin, for joining us. Just for everyone in the audience, we will have a breakout in the [ Maher ] room right after this. So look forward to seeing you, and thank you for supporting William Blair.

Thank you.