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

All right. Thanks, everyone, for attending our conference. I'm Kingsley Crane, one of Canaccord's analysts in the software space, excited to host Dynatrace, in particular to host Kevin Burns, Dynatrace's CFO.

Kevin, perhaps you can start us off with a quick overview. For those that are less familiar, what does Dynatrace do and what kind of customers can use your software?

Great. Well, thanks for having us, Kingsley. Appreciate it. Glad to be here. So Dynatrace has been around for about 14, 15 years, and we've been a leader in APM and Observability over the last couple of years or actually over the last decade. What we really focus on is helping companies understand their technology environments, what's happening with their applications, what's happening with their networks, what's happening with their logs and also, more importantly, what's happening with their user experience. So a newer term in the space, which is called Observability. And what we do is we help organizations understand and observe everything that's going on in their technology environments and how an impact in their infrastructure could impact somebody's user experience on the outside. So that's what we've been focusing on. We rebuilt our platform about 5 years ago to focus on enterprise customers, but more importantly, the market changed significantly over the last 5 years. If you go back 5 years ago, people were focused on APM. They were big applications on-prem the world's changed dramatically over the last 5 years. There's -- people are moving to the cloud. There's microservices, containers, environments today are much, much more complicated than they were 5 years ago. We redeveloped our platform to deal with today's modern cloud environment. So our focus today is on the Global 15,000 enterprise accounts. We find these are the most complicated environments in the industry out there today. So the more complex nature of the environment for our enterprise customers, the more value that you will receive from the Dynatrace platform. So in summary, we work in the observability space. We focus on the Global 15,000 large enterprise customers, and we've had a very successful financial track record over the last 5 years in particular.

Thanks. That's a great overview. So you reported fiscal Q1 last week. What are some key things that are on your mind following the report, any common threads in your conversations with investors?

Sure. So we had another successful quarter of ARR growth. That's our key leading metric in our organization. First quarter over $1 billion. We reported $1.031 billion of ARR in the quarter. And on an adjusted ARR growth rate basis, that was a 34% growth. So over the last 2 years, we've been growing in that mid-30% range. And if you think about the building blocks to our growth in the business, it really consists of 2 components. One is the addition of new logos to our customer base. And the second is a healthy net expansion rate. So I'll talk about our net expansion rate briefly here, which is over the last 17 quarters since we first introduced the Dynatrace new platform, our net expansion rate has been above 120%. So we have super healthy growth retention rates. Customers love the product. They understand the value that they receive from it. And they also continually expand and add more use cases and cross-sell opportunity. So very resilient customer base out in the marketplace. And then the second component to our growth is new logos. And this past quarter, we added about 135 new logos. That was flat on a year-over-year basis. We have about 3,500, 3,600 total enterprise customers. And so those are the 2 core building blocks of the business. We were pleased with the performance in the quarter. That was also combined with healthy profitability. So we generated on a trailing 12-month basis, 29% free cash flow margin. So top line ARR growth is 34% -- I'm sorry, free cash flow margins of 29% on a trailing 12-month basis. So operating at a Rule of 60. So pleased with the performance. Now if I think about some of the issues that we did have in the quarter, the economy changed slightly from where we were when we first started to plan the business for our fiscal year. We were pleased with the overall trend and trajectory of the business through the middle of June, but definitely saw some increased macro pressures in the back half of June, elongated sales cycles resulted in some lower new logo deals in the quarter on a little bit lower ASP as well. So we did an extensive review of the business for the next couple of quarters, and we did adjust our guidance down by about $20 million. So right now, our forecast for FY '23 is 27.5% adjusted ARR growth, down about $20 million from previous guidance, really due to what we perceive will be elongated sales cycles and acquiring some new customers.

Thanks for that. So looking ahead, how do you see those building blocks working together of the net expansion, high initial lands and the new logo growth?

Yes. So again, if we think about the 2 building blocks, this year, we're going to grow net new ARR by about $275 million. $200 million of that will come from existing -- our existing customer base and cross-sell, upsell opportunities there. So when you think about the different modules that we sell in observability, we've been very strong with applications and microservices. Also digital experience monitoring, so I think real user IoT devices things at the edge. And then we introduced another module called infrastructure, our infrastructure module, which has seen significant growth over the last 2 years. That grew to about $100 million portion of our $1 billion in ARR, half of our customer base is now using it. So when we think about how we maintain our net expansion rate going forward, it's additional applications and workloads. I think we all appreciate how many new applications are being developed on a daily basis and how many are getting refactored into the cloud. It's a little bit of an evergreen opportunity for us. We think we're monitoring about 20% of the applications in our customer base today. So significant opportunity to expand there. Infrastructure module, the way we think about that is for every dollar they spend monitoring applications and microservices, there's another dollar opportunity in our customer base for infrastructure as well. Today, we're only realizing about $0.15 on the dollar. So significant opportunity for additional workloads and applications in infrastructure. And then over time, we're evolving into a new segment -- into the Security segment, and we think that can be a growth driver that I don't know if you want to cover that now Kingsley or cover that in a little bit.

Well, I just want to touch quickly on logging. So you mentioned strength in APM and infrastructure, leasing some updates to that product in the next few quarters. So what are you hearing from customers to drive that road map? And how do you think that will be differentiated?

Yes. So great question. So in order to provide true observability across an enterprise, there are 3 primary components. It's metrics, it's logs and its traces. We provide all this functionality today, but I certainly think the log use case for Dynatrace is one that we had not invested in over the last couple of years, but we did make significant investments over the last 6 quarters. We are introducing a new log monitoring -- a new log platform. It's called Grail. It will come out in our third -- in the third quarter of this fiscal year. The benefits to the new Grail platform will be, there's going to be no hot or cold storage. There's going to be no data rehydration which means the data is available consistently sort of on demand, and we believe it will be at a lower cost point. So we are building a new architecture based on hypergraph technology for our new log platform. Now our go-to-market for the log product will be the following: we believe that log is a core component of observability. So when we expand with our customers, they're going to expand with apps and microservices and infrastructure but they'll be taking logs in as well. And those logs will enable our customers to get better intelligence and better root cause identification of issues in their environment. So this really will round out sort of pulling in the core elements of observability, and we think we can do the log component at a much more cost-efficient and structure. And our initial entry points will be additional workloads and use cases in our existing customer base.

Right. So now let's tie that into security and cloud automation. Does the logging piece enhance that? And then how do -- like all this -- how does all this complement observability, does it bring new users and new data to the platform?

So at the end of the day, if I think about the cloud automation, I think we're still definitely sitting over in the observability side. And what this is going to do is help developers deliver product to market faster. So cloud automation is going to make sure they have the right checkpoints before they put code into production. And if there are any issues, it can revert back to prior code so that there's no anomalies or no disruptions in service from cloud automation. So I think continuous innovation, continuous delivery pipeline and our product will help our developers bring product to market faster. So that's sort of one component. And then when I think about security, one of the big reasons that we think security is a big opportunity for Dynatrace is, we collect a tremendous amount of data. We're highly instrumented in our customers' technology environments. We're taking all this data and we're storing it. Then the question is, from a security standpoint, what use cases, what modules can we build upon all this data to help our customers not only provide great experiences for their customers but to do it securely as well. So our initial foray is vulnerability detection. So we have information on what our customers use all the way from the application down to the code level and we match that to find any vulnerabilities in their deployments. And then we -- more importantly, we also rank and stack those vulnerabilities so that our -- the technology companies for our customers, our users can prioritize. If there's a Log4j instance, that's not getting called, it gets deprioritized. If there's 1 that's getting called consistently, they know to go and remediate those vulnerabilities immediately. So we -- in production, we're monitoring the vulnerabilities and we're prioritizing where the security organizations need to go and fix those. So that's one example of how we're taking the data that we're capturing in observability and using it to build security use cases. And that's what we've announced so far, Kingsley, and there will be more to come over the next couple of years as we emerge and build more modules. And what can be a large market, probably as large as the observability space is for us, again, over time.

Right. So in order to support all of this innovation and growth, you have to keep building out the team. Rick is now 9 months in, taking over for John, you're going to be retiring at the end of this calendar year. So what does Dynatrace done in the past doing now to build superstructures to scale the team and then how are the right pieces in place now for growth in the future?

Yes. I think it's a little bit more of the same. We've been growing, as I mentioned earlier, top line ARR growth north of 30%. And over the last 3 to 4 years, we've had to put in the right leadership levels. We've done that through, obviously, nurturing and helping people in the organization come up and get promotions. But we've also augmented that with additional leadership outside the organization. So I think we've done a very good job of that. We'll continue to nurture those employees internally, and I think we'll augment it appropriately with people who have scale from $1 billion to $3 billion and bring some additional experience to the Dynatrace leadership team to help us scale a little bit more effectively.

Right. So just to touch again on macro, some changes there, but how does your operational rigor allow you to be nimble during this uncertain time?

It's -- I hate to use the expression, but it's a little bit more the same as well, Kingsley, in the sense of we are constantly thinking about where this business is going to go in the next 4 to 6 quarters. We are constantly modeling different scenarios in terms of robust growth, periods of a healthier growth but also periods where there's macro pressure. Over the last couple of months, we definitely took a relook at our operating plan for the year given the pressures that we had in Q1. And we're -- we adjust plans appropriately. So our goal, we are very committed to a balanced company. And when I say a balanced company, that means balance ARR and revenue growth combined with profitability. As I mentioned, we have been operating at a Rule of 60. We think that's a great sort of great area for us to be, and we want to adjust our operating model to reflect that. So this past quarter, in particular, we maintained our guidance of 23% operating margin, but we did need to reduce some operating expenses because of some pressure on our revenue due to headwinds -- primarily headwinds in the business. Our growth plan from a headcount standpoint, we're originally slated at 1,100 new people to the business this year. Ballpark, we're around 3,400 employees today. So pretty significant growth in the organization. We did reduce that down to 800 new employees for the balance of -- for fiscal '23. There's 2 things that we wanted to remain at an elevated level in terms of our investments. One was our go-to-market engine. We've been hiring sales capacity at 30% growth this year. We are committed to maintaining that 30% quota capacity growth this year. We think that puts us in a great position to emerge much stronger into fiscal '24 as the economy returns to somewhat healthier growth going forward. The second that remains near and dear to our hearts is continuous innovation. If you do not continually innovate in this market, you'll become a laggard and you'll be a market donor with your customer base. We've reinvented the company essentially over many times over the last 1.5 decades that we've been in business. And in order to do that, we need to make sure we have the right R&D organization. So -- as I mentioned earlier, about 1/3 of our organization is focused in R&D. That's an area that we're going to continue to invest in because, as I mentioned, if we can invest in go-to-market, continue to invest in innovation. We do believe that we're going to be in an even better position when the economy and the macro pressures alleviate. So we definitely made some adjustments. We've reduced operating expenses generally a little bit more, but we focus on our 2 key strategic areas.

You mentioned investing in go-to-market, you've been leaning on the channel more. And so whether it's a great relationship with Deloitte or a great relationship with every public cloud, how can that create leverage for you? And then what's been most exciting there?

Yes. So historically, we've been growing net new ARR greater than our sales capacity growth, meaning in fiscal '22, we grew net new ARR by about $270 million. That was a 33% growth over the prior year, coming off about a 20%, 25% sales capacity growth. So growing net new ARR faster than the rate of growth of our sales capacity. We love that model. It's fantastic. As we get larger, it gets a little bit more difficult to drive those types of metrics. So an area that we are focused more intensely on is the partner community. And we break that into a couple of different areas. One would be our resellers. They do a great job, and we'll continue to invest there. The second area would be the hyperscalers. We have great relationships with AWS, GCP and Azure. We're driving more and more volume through the marketplaces. And we think that can be a source of new logo and expansion opportunity for us going forward. And finally, I think more importantly is the GSIs. The GSIs are involved in significant digital transformation initiatives for major corporations around the world. We just announced or as one example, a relationship that we have with Deloitte. Deloitte went out and looked at all the different observability players in the marketplace. They selected Dynatrace as the observability partner for them. So when they go out to do digital transformations with their customers, we are going to be part of that ecosystem. So that's great. We announced that on our Q1 earnings call. We just closed our first deal there. We're working on dozens, dozens of new logos with them and also them helping expand our existing customer relationships as well. When these large SIs, global SIs, embark on these initiatives. They're not looking at this for $5 million, $10 million, $20 million businesses. They want to build a franchise around it. Deloitte, for instance, just -- we just trained about 40 of their engineers on the Dynatrace platform, and that's just Phase 1. So super excited about that. We have a few others that are in the works. I can't talk about them publicly at this point, but we're very optimistic we can have a couple of global SIs on board. And look, this can take a couple of quarters to play out, but we think this can really have a flywheel impact on our sales organization. We can do a good job of growing things 30% with a direct model. But in order to accelerate that growth as we move forward, which we think is achievable. We think the partner momentum and partner support can be really additive to the business as we move forward.

All right. So we're about 20 minutes in. I want to make sure if we have any questions from the audience, they can ask them.