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

Good afternoon, everyone. Hopefully, you got your coffee. We got a whole round of sessions going out to the rest of the afternoon. We're super pleased to have the Dynatrace management team, CEO, Rick McConnell; and CFO, Jim Benson. Thank you so much for joining us both. We really appreciate you having at this conference. Before we get into the conversation, let's go through the disclosures real quickly [indiscernible] please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. With that, Rick, I wanted to start the conversation around where the Dynatrace customer base is today in terms of their cloud journey and their cloud transformations. I was wondering if you can sort of frame it in the context of coming out of pandemic, what are your customers, what your customers were focused on? Was there any element of pull-forward in terms of their cloud journeys? And as we look to 2023 and beyond, how do you access the Dynatrace customer base, where are they and where they are headed in terms of their cloud transformations?

I'm going to take it no real pull-forward that we've observed. Our customers are continuing their migration to the cloud. They're continuing that at good speed. And the good case about it is you can use Dynatrace SaaS to monitor workloads, whether they are in the cloud or on-prem. So one of the great advantages of Dynatrace is the ability to really monitor and observe workloads wherever they are physically located.

And in terms of just that mix like today, where does that sort of stand in terms of the mix of monitoring sort of on-premise applications via the SaaS platform versus something that's more cloud-native?

Yes. The way that we talk about it is that already the majority of our ARR is from SaaS monitoring. So SaaS monitoring is the majority of workload. The vast majority of new logos -- new logo customers that come on to the platform, our SaaS as well. And something on the order of 85% of our customers have at least one if not more workloads that are modern cloud workloads in the cloud.

Right. And so that's just like goes into the next question around observability and the importance of observability as a category within the IT budget. Is there a way to think about your customers spend on Dynatrace as a percentage of their overall cloud spend or their overall IT budget, where has that been in the past? And is there a thesis there about where that could go in the future?

Well, this is unbiased. But having said that, we're doing just over $1 billion in ARR at this point in Dynatrace's history. And last quarter, the 3 major hyperscalers reported a quarter in which they were doing $170 billion of annualized revenue. That doesn't sound to me like the right ratio or mix of observability because as we often say at Dynatrace, we really believe that we can deliver, in some sense, cloud done right. It is this notion of delivering a set of cloud workloads that really add incredible value to your overall IT ecosystem. And it is by enabling you to be much more efficient in your cloud deployments. And this is where we get back to things like cloud optimization, for example. But the problem with cloud deployments is that they deliver an enormous amount of data with ridiculous amounts of complexity. And as you deploy more and more and more applications in the cloud, more infrastructure to the cloud, it gets unmanageable by your existing network operation center and the number of IT resources. You need, as we say, answers, not just data. And that's what we do at Dynatrace. We deliver very sophisticated answers and intelligent automation from data, not just dashboards, not just data. And we do that using our AIOps engine that provides that layer of automation to really make that cloud environment work better.

Yes. The AIOps engine and Davis has been the thing that's certainly been leading the market in terms of on the capabilities to get faster to the answer, right, which is I guess, the importance of this category. I wanted to bring Jim into the conversation and sort of revisit a little bit the Q3 results. Very solid quarter to beat the high end of guidance across all key operating metrics. What I thought was impressive is that the environment out there is still kind of tough and you guys have still executed quite well. Can you highlight for us what are the things that are allowing the company to get deals over the line, execute within the customer base? And to what extent do you see more cautiousness in terms of sales cycles, longer purchasing decisions?

Yes. I mean kind of to reiterate your point, we had a very strong third quarter, kind of it surpassed our expectations and obviously, the guidance that we shared on the high end across the board. I think what's occurred to be frank, is that we've lived through several quarters now of kind of, I'll call it, the new normal of macro uncertainty. And so you got to think about a sales organization. Our sales organization prior to the macro headwinds that we're currently seeing, we're not in an environment of seeing those headwinds. And so pipeline and pipeline coverage in the past was very predictable for them around where they thought you'd land. Well, when you're in macro headwinds, you need more pipeline, you need better pipeline coverage. I think it took a few quarters for the sales organization to become better at that. So I think they are much more accustomed to be able to know that you need more pipe, you need more coverage to be able to cover that. So I think for the third quarter, what you're starting to see with the sales organization is more understanding that, yes, deal cycles are elongated. Deal sizes from the beginning of a sales cycle to the end of the sales cycle might actually reduce a little bit. And they're able to call the ball a little bit better than they did, say, 2 or 3 quarters ago. So I feel very good about visibility now. And I would also say very good about sales as a general understanding of where things are going to land that you don't need to have perfect execution. You've got to expect that there will be some deals that are going to push out of a quarter. You might be able to have a deal that gets pulled in and you need to be able to ensure you manage it that way. So I think that's what we saw in the third quarter. And then I'd say a highlight that I would mention on the third quarter, which is not intuitive for a lot of investors, which is we did really well on new logos. And you would expect that and in an environment that maybe you do better with your existing customers where we actually saw the upside was actually new logos. And I think it happened for a few reasons. One, we made some sales coverage, model changes for the company to get a little bit more focus on new logos at the beginning of our fiscal year. It takes a little while because obviously, deal cycles take a while that we started to see the benefit of those coverage changes manifest themselves in new logo generation in the third quarter. And I'd say secondarily, we're very early in the journey, which I'm sure we'll talk about maybe here in a few minutes on -- with GSIs. And I would not suggest that we [indiscernible] flywheel, but it's actually now an extension of a new channel for us to bring in business. We actually mentioned in our third quarter that we actually closed a 7-figure deal in Latin America for us through a GSI. This is a deal that a year ago, we wouldn't have seen because we were not embedded with the GSIs. We're starting to have these conversations with GSIs. It's starting to produce, I would say, a trickle effect of business for us. And so between some coverage model changes, where we're getting some leverage from and an enhancement through some of the areas, GSIs being one, we feel pretty good about some of the coverage changes that we've made and them starting to show and manifest themselves in incremental bookings.

Let's just stay on that topic around GSIs and partners. It sounds like it's an emerging part of the story. Could you sort of either you sort of speak to why were the GSI is not really focused on observability as a category? What sort of change? And how does that fit into their broader digital transformation, cloud transformation, selling message to their clients?

Well, I actually think the GSIs, like the hyperscalers themselves were [indiscernible] they are taking orders and advancing workloads in the cloud as quickly as they can, and there's a huge demand for that. We are now in a slightly more mature, I would say, environment, in that mature environment is, my god, I've got an unmanageable ecosystem that's coming out of the cloud with the resources that I have based upon the number of applications, the amount of infrastructure, number of end users, et cetera. And I've got to figure out how to manage this more effectively. And that's where observability comes in. Now remember, there's always been monitoring. There's always been observability. Everybody for every application has a dashboard somewhere. It might have been constructed internally, might have been through open source. They've got red, yellow, green indicators. They just don't know what to do when an indicator turns red, where is the problem. Well, in an on-prem environment where you are releasing software every 6 months, not as hard as it is today, when it's going through a cloud ecosystem through multiple steps in the journey using microservices, Kubernetes containers, all of these other factors, and you just don't know where the issue might have occurred. So triaging that takes much, much longer. And if you expand that based upon the number of cloud workloads, it becomes untenable. I believe that the observability space is at an inflection point right now. And it is at an inflection point right now, in my view, because of these factors that we just talked about.

Yes. Let's stay on that topic because that is a -- I think you had a quote there that there's a racing expression, you win races when the turns happen. And we're in an uncertain macro environment. But where is Dynatrace doubling down on investment? And what are the competitive advantages Dynatrace hope to gain coming out of this particular market environment?

We've absolutely doubled down in areas like our investment in Grail. Grail is a massively parallel processing data lakehouse. We've been working on it for 4 years now. We announced it back in October. Its first [indiscernible] is log management and analytics. It does this with a new architecture that uses graphing technology that has no rehydration, no reindexing. So very, very efficient to do highly performing analytics at enormous scale. This is an example of investments that we've made over the past and continue to make. Application security, another area of significant investment for the company. So we absolutely are investing, as you said, sort of through the macro environment to make sure that we're well positioned really as the platform of choice for observability. And that's how I would describe Dynatrace. We have an end-to-end platform that's holistically integrated to include all data types, logs, metrics, traces, routes, real user data, metadata, behavioral analytics, all combined in a single data store in context. And that contextual data enables you to do analytics on that data in context that provide inherently better results. We then apply that to different use cases, application performance monitoring, infrastructure, application security, digital experience monitoring, which is real user monitoring. If you take all of that and apply it in multiple settings, you really do get a holistic answer as to how your IT ecosystem is operating at all times. And that's what customers want.

I'll just add one thing to that, which is Dynatrace has always had a history of balancing growth and profitability. And so what you're seeing now in the broader IT ecosystem from many of the names you cover that this has been a focus on, oh, we need to work on margin expansion because they were maybe a little bit overweighted on focusing on growth and not and underweighted on profitability. And so they're pivoting a bit to, I'll call it, rightsizing in their organizations. We haven't had to do that. We've been on this journey, and it's always been a journey of balance. And so to Rick's point about the investments. Ours is a tuning. It really is -- that's all it is. If you want to tune something up a little bit, you want to tune something down a little bit. So we're in a good place. It's not a change in direction for the company. That's important. When you're changing focus on a company from, say, growth to maybe something that's underweighted, say, profitability, you're changing the focus of a company. I'd say we're benefiting from the fact that we've made these investments, and we'll -- we're starting to see some traction with them, and it's a matter of tweaking the model than us doing something wholesale.

Yes. I think it implied in your comments on -- I didn't write this question down, so I apologize for speaking off the cuff. But implying that is an opportunity for competitive advantage as the broader ecosystem focus on finding ways to get more efficient, dialing back on the land-grabbing strategy that many places have been pursuing. Does that provide an opportunity for you to expand your voice in the market, take more share within your customers?

Yes. I mean I would say that the answer is yes, but there's a -- we are dealing to your earlier point, we are dealing with an uncertain macro environment. So we're also being prudent that -- but we have the benefit of -- we can dial things up pretty quickly. So we're looking at signals like the demand environment, pipeline, things of that nature. We think we're in a good place relative to our go-to-market coverage. If we start to see the demand environment show some uptick, yes, we can take advantage of that because we can move on it quickly. We're not in an area where we're trying to prioritize one over another. We're in an area where actually we can overweight investment in the area pretty quickly if -- because the business model allows that.

Yes. So on a similar theme, when I look at the key players in this space, I think there's a famous Gartner report a couple of years ago, I said a number of monitoring tools in the middle enterprise is like double digits, like 14, 15, right? And so everyone in the category now is really on the theme of tool consolidation, vendor consolidation. And so I guess the question is, is like -- why is Dynatrace going to be a net consolidator of spend in the category versus your competitors? And specifically, you could frame it from whether it's a product perspective or go-to-market perspective, what's going to be the forcing function for customers to, say, Dynatrace is the one I should be betting on versus some of the other tools that may be in my environment?

That is indeed [indiscernible] question. So let me see if I'm going to tack it this way. The investment thesis, I think, around Dynatrace is twofold. The first aspect of it is what's happening in the market. And I've tried to lay that out for all of you. In terms of the criticality of observability, generally to modern cloud deployments. I think it's essential. The second piece gets to your question, which is why Dynatrace? Why does Dynatrace win. And this is where I would suggest that not all tools are created equal. What we do is we deliver answers in intelligent automation from data, not dashboards, not data to glass. And the result of that is that we, in our view, uniquely solve the problem that is being created by the explosion of cloud monitoring requirements. And that is simply tantamount to us being able to address this explosion of data, explosion of complexity and when something goes wrong, the ability to triage that immediately. We had a great example that I sometimes talk about that occurred over the last year with the deployment [indiscernible]. It is a very large deployment. It's a public case study that they published actually a press release on it. They had a large deployment. They reduced as a result of Dynatrace, they reduced incidence by 50%. They reduced MTTR mean time to repair, mean time to respond by 90%. And that brings up engineering resources, frees up IT resources. And by the way, they put a projection out that they expected to save over a 3-year span, 28 million pounds as a result of the deployment of Dynatrace. That solves the problem of the cloud explosion that we talked about. So one, there's a huge problem that is growing with cloud deployments and being able to manage these software environments. Number two, what are you going to do about it and not all observability tools, we'll solve that in the same sort of end-to-end observability cross-platform way that we will.

Yes. Let's talk a little bit about product. And you sort of hinted, Rick, in the answer to some of the previous questions around Grail and log analytics I think you guys -- correct me if I'm wrong, that you guys laid out a $100 million run rate target for log management within 2 years. Can you talk about the technology that underpins because Log Management is a pretty ubiquitous capability that a number of different providers half to market. What's special about Grail that's going to be differentiated in the market that allow you to get to that $100 million run rate target?

So just to make sure that everybody is aligned on what Grail is, we announced Grail back in October, it was, in many ways, the beginning of the next stage of the journey, but really completion of 4 years of development, during which we realized that we needed a massive, highly performing data store for contextual data of all sorts, logs, metrics, routes, traces, et cetera. That had to be kept together in a single store to provide the degree of context needed for an AIOps engine to be able to process that effectively. That's what we said [indiscernible]. We delivered that back in the October time frame. We've since evolved it to include some of the other data types. It will continue to evolve. Grail isn't something we sell. It is a core technology that is part of our platform overall that enables a number of use cases as set on top of it, one of which is log management and analytics, which is where we started, which has made much more performance at very high scale based on the fact that it doesn't do reindexing, doesn't do rehydration. So architecturally, it is an extremely efficient architecture to be able to attack that.

Yes. So the point here is like Grail is like a technology foundation and log analytics is a productization and there's probably more to come on that front. And so like kind of the other area that the team has highlighted is the opportunity around AppSec and DevSecOps has been definitely, I think that investors have been focusing on as an opportunity for this category. Can you walk us through broadly your strategy in security and sort of the similar question like what gives you license to win in security?

Well, there are lots and lots of security vendors, many here at the conference, obviously, that are a lot bigger in security than we are. The areas that we are going to be focused on in security are those where frankly, our observability, knowledge and information have net incremental value because those areas in which we do believe that we have a right to win and we can add a tremendous amount of value. We do see the convergence of observability and application security happening, no doubt. And in many application security use cases, the existence of the observability data is an extreme net value add. One example is vulnerability management as we do today. Log4j hit in December of 2021. And when that hit, companies immediately wanted to know. My gosh, where am I exposed? Because we sit at the code level and at run time, not only could we immediately tell you all the places you call Log4j, a library. But number two, we can tell you the rank order of where you were calling it and where you weren't to be able to prioritize your [indiscernible]. A great example of marrying together the advantage of having both AppSec and observability data. Those are the kinds of areas in which we would invest going forward.

So getting better at log management, apps security story evolving, still some runway or still a lot of runway in observability. What is the broader product for that look like? Do you -- I mean do you have enough opportunity in front of you to reach your growth and margin targets? Or do you feel like there's other adjacent product markets do you want to go out and try and expand into?

I would say both. We're going to continue to expand into adjacencies and AppSec and logs seem as an interesting use case that we will do differently based on our data stores and so forth. But at the end of the day, look, back to my comments on $1 billion plus of ARR relative to $170 billion of spend annualized in the cloud with the 3 hyperscalers. I don't know what precisely that wallet share should be in terms of portion of spend, but it should be a lot higher than that ratio because we enable that spend to be most effectively optimized and utilized. And so that's what we want to deliver against as we look at. So there is a huge amount of runway with even the offerings we have today long before you needed to expand [indiscernible].

Yes, makes perfect sense. I want to go out to the audience if they have any questions. Before I reach out to them, Jim, let's go [indiscernible] outlook question. What are some of the key assumptions that underpin your forward outlook? And if you sort of assess where you're being more conservative? And if things go right, what levers could drive upside?

Yes. So we've obviously -- we've only provided guidance for our fourth quarter at the end of our fiscal year. And the general premise of the guidance that we provided was an assumption that the current macro uncertainty continues. So I would say we use the term prudence, which is we tried to build prudence into our guidance around where we thought ARR growth would be. I think what you can expect going forward, we will provide guidance for our fiscal '24 in May. I'm not going to do that here. But I think the general color is we don't expect in the near term that the macro environment shows any level of improvement or worsening from where it is. So we expect it's going to continue at least for the next, call it, foreseeable next 6 to 9 months. I can tell you that because, as I mentioned earlier, we've had this balance of growth and profitability that -- you should expect that we're going to continue to operate kind of roughly at the levels we are now around scale around the margin front. We'll provide more specifics on what that might look like. I think we're in an enviable position being in kind of the mid-20s operating margins growing at the rates that we are. So I think we're going to be looking at things around pipeline, pipeline coverage, things of that nature that will help hopefully provide a signal when we provide our guidance for next year of something that we believe we can execute against, to be frank, because we're going to probably provide guidance that is prudent for our fiscal '24.

Yes. It makes perfect sense. It sounds like you're incorporating the uncertainty in macro quite well. So let's reach out to the audience. If you can just raise your hands, if you have any questions for the team, there's one in the back for you here.

Yes. So you mentioned about $170 billion of cloud spend. And then if you look at observability, there's [indiscernible] 3 big vendors, maybe like $4 billion to $5 billion between all of them. So what's the stimulus to grow that $5 billion to a meaningful amount of the cloud spend because cloud spend is cloud spending but people are spending today?

It is precisely in many ways, the answer I tried to address earlier, which is that there is an explosion of data, huge amount of increased complexity and at that rate of growth of the cloud, simply unmanageable by customers to keep their software operational. And as a result, I believe that whether it is us or our competitors, the observability market as a whole is gaining much more notoriety and much more traction in terms of its criticality to rendering software working better than it does today. And assuming that that's true, you're going to get a market tailwind that grows that aggregate spend against the cloud providers.

Great. Any other questions for the team, Dynatrace team. All right. Let me go back to more Jim-related questions. So big topic in software over the -- since we've seen a traction in the market is how teams are managing stock-based compensation and share dilution. What's sort of your operating [indiscernible] going forward with respect to both?

Well, I think as you've seen from the company, the company has been quite prudent in its management of stock-based compensation. So you look at us relative to broader peers, we stack up quite well. So we'll make sure that our stock-based compensation from an employee perspective is competitive. But the expectation that we have is we're going to kind of operate roughly at the current levels that we have for kind of stock-based comp as a percent of revenue in current dilution rates. One of the things we haven't talked about is kind of use of cash. So the question is, at some period of time -- right now, I'd say our use of cash is going to primarily be looking at maybe technology tuck-in M&A. But there may be some time, we may want to revisit whether or not some of that could be used for some level of share buyback program. I would say that's not kind of a near-term thing in the next 3 to 6 months, but it's something that we'll be looking at. So relative to your broader question about stock-based compensation, there's multiple ways to manage that one. You want to make -- we're very mindful of dilution for shareholders, we're very mindful of the amount of spend we have in there that it is -- it's shareholder money, we want to make sure we manage it prudently.

Great. And with that, we're all out of time. Thank you so much, Jim and Rick for giving us the update on Dynatrace. Really enjoyed the conversation.

Thanks very much.

Thank you for coming.