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

Good afternoon, everybody, and welcome to the afternoon session here at Credit Suisse, our annual -- our 26th Annual Technology Conference. My name is Fred Lee. And I cover small and mid-cap software companies for the firm. And with me today is Rick McConnell, CEO of Dynatrace. Welcome. And thank you for joining us.

Hello, Fred. Thanks very much for having me.

Listen, we'd love to start with a high-level question, just big picture. For those that are new to Dynatrace and those on the webcast, if we could talk a little bit about the background of the company and how the product family has evolved over time. It's sort of a 5-part question, by the way. So what problems the company solves, the total opportunity and the overall vision of the business.

You're going to start with a 5-part question? Oh my gosh. Well, let me start at the beginning. So we are in the observability space. And we are fueled in our market by the immense investments being made in digital transformation overall. Digital transformation is leading to a huge number of cloud deployments. And with those cloud deployments comes enormous complexity and explosion of data. And with the explosion of data and an increase in its complexity, you need much more sophisticated tools, capabilities to manage that environment. And so that's essentially what we do. Our goal is to enable software by enterprise-class companies to work perfectly. And we do so by providing a set of observability capabilities that enable you to oversee the situational awareness environment to achieve that goal. What's different about Dynatrace -- and maybe this addresses at least part of those questions in terms of how to think about Dynatrace vis-à-vis others in our market is that, as we say it, we provide answers and intelligent automation from the data that you pull out of your ecosystem rather than just dashboards, rather than just data to glass. So today, the way that it often works is you have an army of people sitting in a network operation center watching screens, trying to figure out why something went red and then what to do about it. What we do instead is we make sure that we cut directly to what the problem is, isolate that and enable very rapid evolution and triage of that issue. So that's sort of how we've evolved our business.

Fantastic. So it's been a little over a year, if I had my math right, since you joined Dynatrace.

Right.

If you could talk a little bit about the surprises, both positive and negative, since you've been at the company and some of the changes that you've implemented along the way.

Well, I'd say the biggest negative surprise is the economic environment hasn't exactly been our friend broadly, I'd say, in software over the course of the last year as -- there are probably a few better people than you to recognize that, Fred. On the positive side, though, I have not been disappointed in the least in Dynatrace. I joined because we have an incredible portfolio that adds amazing value to customers. Customers across the globe over the past year have told me that we are indispensable to them, that we enable their software ecosystem, their software environment, to work the way they expect it to work. And that's very heartwarming. And customers are very, very loyal to Dynatrace. Their spend with us continues to increase. So that's an enormous positive. The other element is that we have always run a very financially sound and balanced business with very strong growth but also very strong profitability, mid 20s operating margin on good growth numbers. So the good news is solid financials, great portfolio, exceptional customer base, a really good foundation for growth. I would say that, that hasn't surprised me, but it certainly has been a great validation point since my joining.

So you brought up macro first. So I'm going to talk about macro a little bit.

Okay. Sounds good.

And so at Akamai you've been through several business cycles. And so how are -- how is the go-to-market shifting, if at all, at Dynatrace? It's a traditional enterprise selling motion. We talked about weakness a little bit in Europe. Has the weakness spilled over to other regions? And how are you shifting your go-to-market playbook to address macro?

So the macro environment certainly is challenging, but we really are focused on what I've been referring to over the course of the last couple of quarters as winning in the turns. This is, I think, an exceptional environment for organizations broadly to figure out how they win amidst enormous competitive and market pressure. And from my standpoint, we want to do the same thing. We also want to enable them to do it through their cloud deployments and through their successful deployment of Dynatrace. And so that's really what our orientation has been toward customers. What that has evolved into from a go-to-market perspective is an increased focus really around partners and indirect penetration in distribution and selling. And whether it's through hyperscalers, global system integrators or other partners, we believe that that's a substantial opportunity for accelerated growth as we look to the future.

Right. And so with regard to regional weakness you called out Europe specifically. And so what -- is it mostly increasing sales cycles? Is it a longer motion, smaller deal sizes? What are some of the specifics around some of the headwinds?

Not smaller deals, I wouldn't say that. But certainly, in Europe and then with, I'd say, minor bleed to some of the other geos, but principally in Europe, we saw some deferral of deals that typically has amounted from either higher level of approval requirement or just a push out of budget generally, IT budget, that has resulted in companies just deciding, you know what, I can do this for another quarter, what was I doing for, I can do it for another quarter or another two. And I think that's sort of the state that organizations are in. In our space, observability continues to be very greenfield. So a lot of what organizations are doing today is homegrown software, homegrown open-source access integration in your existing application environment. And the result of that is that organizations at very high levels of the companies are typically just saying, you know what, we can just -- we can make it work for one more quarter or we can make it work just a little bit longer. But back to where I started, Fred, at the very outset, it's not changing the dynamic of what's happening in the cloud. Organizations moving to the cloud are going to run into an inability to manage that environment the way that they're doing so today.

You mentioned that the majority or a number of your new logos are greenfield. What percent of the -- what percent is roughly greenfield today?

Well, the new logos we're adding are in the 650 to 700 new logos per year. So that's an expansion in that area. And we've been running with a net expansion rate of greater than 120% for many, many quarters and years past. So that's sort of how we've looked at it. Now the expectation as we look to the future with guidance is that, that net expansion rate at 120% will probably come under a bit of pressure as we look to the second half of this year. But the expectation is that as the macro environment turns around, we should be able to accelerate away from that.

Okay. Let's shift to the fun stuff on the product portfolio. And how would you evaluate your product family, your product portfolio today? Where do you think the key strengths are? And where are some areas for improvement?

So the product portfolio of Dynatrace, as I mentioned earlier, is incredibly strong. I really do believe that fervently based on the feedback from customers, not just my own personal assessment of it. The origin of it really started as application performance monitoring for Dynatrace. That was our bread and butter. But since then, we've expanded in multiple dimensions. Infrastructure is now well in excess of $100 million of ARR for us. We have launched business into application security, in particular vulnerability management, that we have set expectations to be in $100 million sort of range over a 3-year span. So that's that. And then finally, we, last quarter, just launched a new solution called Grail. And Grail really is tantamount to a massively parallel processing data lake house that enables us to really go after aggressively the log management and analytics market, which we believe is very right for disruption.

Can we little bit more about Grail? This is a perfect segue. You mentioned some MPP, data lake house. Can you tell the audience what that is exactly and why you will succeed in logs through this MPP architecture?

The opportunity for Grail is quite dramatic. We started on this effort around 4 years ago or so when we really observed that the explosion of data was going to make data management for us a core requirement of our technology stack, not an ancillary or contextual one. So we really invested with that in mind. Now in log management, and analytics specifically, I would say 2 enormous sets of advantages around what we at Dynatrace can do in this particular area, one is that by delivering Grail using the architecture that we're delivering it, we can enable no rehydration, no reindexing of data. Technical -- sort of a technical comment, but the nontechnical explanation is not doing rehydration enables you to not have to pull logs out of cold storage, enables you to reduce cost. Not reindexing the data enables you to be much more efficient in accessing the data in real time. So we can provide highly complex queries in near real time, which can increase the performance of log analytics by 5 to as much as 100x depending on the query. So you're getting dramatic scale, enormous performance, lower cost with an indefinite ability to retain these logs over time. So that's on log side. One more element that's important to know is that we really don't observe logs as being an independent silo. It doesn't make any sense to us to have logs be off in its own island. We really see logs as a data type that is fundamental to your observability environment altogether. And by bringing log management and analytics into Dynatrace in a more contextual way, we can integrate and access all of the data types using our observability platform.

Got it. And how about a little bit about the pricing strategy of Grail? If a customer is spending $1 with you today, what is the potential uplift from Grail?

Well, certainly, I expect that even the immediate uplift could be in the 30% to 50% or so range in terms of overall spend. Now it's going to take a little while for that to evolve. We just launched it last month. So it will happen over the course of time. But we are already in process with 100-plus POCs to -- on Grail just 1 month in. So we are delighted with the early take-up and substantial early interest.

So I know you're launching on AWS, you're launching Grail on AWS and I'll be at re:Invent this Friday. So I'm hoping to bump into some customers there to get some early feedback. And yes, I'm excited to learn more. Your -- so Grail is a SaaS solution, delivered only in SaaS.

That's correct.

And your business currently has some customers that are on a managed service solution. The -- do you view Grail as an opportunity to move some of those managed services customers into a multi-cloud or into the cloud with AWS?

We absolutely see the SaaS-ification of customers as being important.

SaaS-ification. That's a better way to say it instead of...

It's a simpler way of putting this managed to SaaS conversion, at least that's how we think about it, Fred. But we do see Grail as being a catalyst in moving customers from managed to a SaaS environment. But in some ways, we don't need a catalyst in the sense that many workloads are being moved to the cloud proactively by customers as well. But having said that, it does provide that incremental catalyst.

And so what percent of your customers today are on managed services?

The majority of our customers are SaaS customers today and the vast majority of new workloads and new customers are coming up on SaaS today.

And one of the things I've been trying to understand as well is the economics of a SaaS customer versus the managed services customers. Are there differences in churn? Are there differences in the lifetime value of those customers? How do I think about the variation there?

We haven't seen any difference in churn versus -- of managed versus SaaS. And maybe part of that is because we have such low churn. In anything greater than $100,000 of ARR, the churn from Dynatrace is really so low that it's just not discernible, which is a great position to be in. So that's a good start. But with regard to SaaS, the economics are very similar to managed. We're providing more of the capabilities and so in that regard, by way of infrastructure, in particular. So that does have some implications on the financial model, but it's very similar.

Shifting gears a little bit over to competition. And when you're in a competitive bake-off, who do you see most often, knowing that you're attacking the 15,000 largest companies in the world? And when you win, why do you win? And when customers go a different direction or prospects go a different direction, why do they head in that direction?

You might be surprised of the number of times there are competitive bake-offs. And more often than not, it is a competitive bake-off or just an opportunity greenfield against DIY. So the vast, vast majority of opportunities that we see are really just DIY migration. And then you might imagine the people that when there is a competitive bake-off, the typical cast of other companies that we would run into. And where win is precisely for the reason that I described earlier, which is for global 15,000 companies, we provide a highly differentiable, distinguishable platform capability based upon delivering answers, not just dashboards. And in so doing, those larger organizations with more complex footprints are going to be more inclined to use Dynatrace.

We get a number of inbounds from investors about pricing. It can be very confusing to look at logs ingest, and we tried to deliver a big analysis in our initiation around this. What is your pricing strategy? And do you consider it disruptive? Is it a differentiator? And how are you thinking about the evolution of your pricing over the next few years, especially with the introduction of Grail?

The way we price today is largely on a committed per module basis. And the directional heading -- and that's worked just fine when you had a small number of modules. As the number of modules has expanded, that pricing becomes more complex because now you need to manage against multiple modules. The good news is that our customers are expanding in their number of modules and the deployment of modules quite substantially, which is we love to see. So we now have more than 50% of our customer base on 3 or more modules. And more than 50% of new customers are starting up with 3 or more modules. Moreover, the average ARR for a standard customer, non-multi-module customer, is around $300,000. The average ARR for a multi-module customers is around $500,000. So you can imagine our depiction of wanting to drive an overall platform sale is really quite valuable. So that's really been our focus. The evolution, to get back to your question on the pricing front, is to really move to cross-module pricing. And the format of that would be more of an umbrella commit that enables you to essentially consume that commit really across the portfolio as well.

Now this is a little bit of a multipart question as well, and they're all kind of related to each other. But how many observability tools does your company -- your customers have? On average, how many tools do they use? And so how many different vectors of telemetry are they taking all at the same time? And then -- well, let's start there and then I have a question, a follow-up to that.

We've seen some customers, even some new customers, report to us that they've got 30 to 60 tools doing, in some sense, what we do. In many cases, we're brought in to consolidate that down to 1 or 2 or 3 that have slightly different purposes. But the enormity of the number of existing tools is incredible. And as I said at the outset, that really is a result of homegrown, internal investment dashboard creation using open source capabilities, but it really is oriented to delivering dashboards. And for global 15,000-type companies that is becoming wholly inadequate in managing their environment to achieve the objective we described earlier, which was making software work perfectly. You really do want this ability to cut quickly to the answer and then be able to address that answer.

So the follow-up on that is with 3-plus modules, you have 50% plus of your customer base with 3-plus modules, is there a structural reason why that can't be 100%?

No, I would say no. It's -- we are continuing to evolve our customer base to having more modules, more penetration. We've added application security. Grail adds capabilities around log monitoring analytics. We've got already digital experience monitoring. Infrastructure is a business that became a $100 million business within 8 quarters, so very rapid growth, continues to grow quite dramatically above the average ARR of the company. So infrastructure penetration is enormous with a lot runway left, a lot of white space even just in our installed base. So the combination of all those factors result in us believing that there's a huge amount of white space in multi-module deployment for customers.

That's excellent. And so as we think about your go-to market a little bit, your typical land, your average land, is north of $100,000. What are the benefits of a larger land? Some of your peers have much smaller lands. They talk about starting small and then landing and expanding, et cetera. What are the benefits of a bigger land as it accrues to lifetime value?

The advantage of a larger land from our standpoint is just stickiness, that you see just way lower customer churn than you would -- if you bring on customers at a much lower starting point. The corollary to that question that you may ask next, if I were to let you, is why not higher land? Why it couldn't be $200,000, $300,000 or $400,000 or $500,000? Why couldn't it be higher land? And the answer is sometimes it is. Sometimes they're $1 million or multimillion dollar lands. So they do fluctuate. What we have found is that the $100,000 level is sort of in the right zip code, if you will, for the best land for us. Our differentiator, as I've said a few times, is really delivering sophisticated answers from data, not just data. And if you're only on for a dashboard, we can do that, but that is not our differentiation in Dynatrace. And it tends to be in that higher land area where you really start to see the value of the Dynatrace platform relative to other solutions in the market. So that's where we focus.

So is your sales force incentivized to drive larger lands?

The sales force is incentivized to drive higher lands not in a specific way, only in the sense that, well, a booking dollar is a booking dollar. So if I close more -- if I close a bigger deal than I'm paid more.

But are there accelerators if they're north of a certain level?

Not at land, no. And we do that quite intentionally. And we do it simply because we don't want a salesperson to hold the deal until it's $250,000, if they get closer to $100,000 because, in all likelihood, based on our experience, that $100,000 becomes $250,000 faster than if you waited to close the $250,000 in the first place, in many cases. And so it is sort of that land and expand sort of motion that really is quite relevant to us. It's just that the landing zone is maybe a little bit higher for us because of our target customer base.

Another inbound we've been getting is, how -- because you've been so great at balancing growth and profitability, right, and it's been extremely impressive, is that changing considering the current macro conditions? And how is that evolving over the next couple of years?

I don't see the profitability changing of the company. We set guidance this past quarter in the mid-20s range for operating margin. And while I'm clearly not setting specific guidance for FY '24 at this point, we absolutely do believe that we are a company that can and should and expect to operate in that mid-20% operating margin-type range, high-20s cash flow sort of range.

So how penetrated is Dynatrace with regard to your current installed base? If you were never to add another new logo, what could we see in revenues over time?

I believe the installed base is its own enormous white space. It's maybe 20% penetrated in terms of the overall opportunity, even with our installed base. And we look at it in several dimensions. Number one is we might be deployed for the primary mobile app of a company or the main homepage or the conversion page for an e-commerce company. And as that app requirement expands for the -- on the part of our customer, you're going to need to add licenses, hosting events, and that's going to expand naturally. Secondly, you have the expansion we've talked about, which is multi-module expansion. You may have application performance monitoring, but maybe you want to add digital experience monitoring, maybe you want to add application security log monitoring, et cetera. So that's a sort of horizontal span. Then the third one is the interest in adding applications, more infrastructure to Dynatrace. So you have 3 distinct and equally important dimensions of expansion within the installed base. And if you add all of that up, I still believe that we've only just begun in many ways.

And so zooming out a little bit, how penetrated do you think the industry is from an overall observability perspective?

Well, almost -- it's interesting you ask it that way because we really do see the overall market for observability is around $50 billion, if you include the combination of observability and application security, so it is an enormous space. But the vast, vast majority of that is handled through monitoring, internal monitoring tools. So if you're asking in terms of is there monitoring that's out there that's in that market number? Of course, there's some sort of green, yellow, red dashboard probably running in a network operation center associated with the vast majority of applications that exist because they are important applications. They need to be running. Somebody needs oversight against them, and they look at them accordingly. But in terms of the penetration of what I would call modern observability, Dynatrace-level answers generated from that data, it's a small, small deployment relative to the overall market environment.

I would love to touch on security just for a minute. You talked about how you address mostly vulnerability management at the moment. What's the -- what's your approach to security? Is it a priority today? And is it a customer pull? Or is it more of a push from Dynatrace?

Combination of push and pull, for sure, I would say. And application security for us today is about 250 customers, so -- and growing rapidly. We have set expectations that we believe that application security will be for us about $100 million business in 12 quarters. So 3 years versus the 2 years it took for infrastructure, slightly different buyer, but nonetheless, very rapid growth, very significant opportunity for expansion. The strategy in application security is we don't want to be the be all and end all to everybody in application security because it's a crowded space. Where we are focused are those areas, in particular, where our underlying platform and the knowledge we have derived from that platform is really differentiable and differentiating to the application security environment that you have as well. Vulnerability management is a great example of that. With our capabilities and where we sit in your ecosystem, we really can ascertain much more rapidly where you have a vulnerability in your environment than other vendors in the space. And so that's a great example of where the bridge between application security and vulnerable management, in particular, against observability, is quite intertwined. And that's where we can take advantage of that engagement.

And would you say the security opportunities is as greenfield as your APM and infrastructure opportunity?

In the spaces in which we are focused around application security, I would say, yes, it's as greenfield. Look at vulnerability management. Log4j happened, and when Log4j happened back in December of last year, companies were really struggling to figure out where do I have this vulnerability and they were trying to figure out the tools that they could use to assess where they had it. Meanwhile, we could come in and, in many cases, in 15 minutes, even for complicated, highly deployed customers, we were able to tell them not only all the places they were making Log4j library calls, but what was the stack rank by utilization. And so therefore, they could prioritize their patching on the Log4j libraries according to the overall usage stack, which was, for many of our customers, incredibly valuable.

We probably have time for just one question, if there are any questions in the audience? Well, I guess I'll give the last 20 seconds back to you. Thank you very much for joining us. And thank you, everyone, and have a great rest of the conference.

Fred, thank you very much, and thank you all for coming. Bye.