Dynatrace, Inc. (NYSE:DT) Q3 2023 Earnings Call Transcript

Dynatrace, Inc. (NYSE:DT) Q3 2023 Earnings Call Transcript February 1, 2023

Operator: Greetings. Welcome to Dynatrace’s Fiscal Third Quarter 2023 Earnings Call. Please note this conference is being recorded. At this time, I will now turn the conference over to Noelle Faris, Vice President of Investor Relations. Noelle, you may now begin.

Noelle Faris: Good morning and thank you for joining Dynatrace’s third quarter fiscal 2023 earnings conference call. Joining me on today’s call are Rick McConnell, Chief Executive Officer and Jim Benson, Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements such as statements regarding revenue and earnings guidance and economic conditions. These forward-looking statements are subject to risks and uncertainties depending on a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. Additional information concerning these uncertainties and risk factors is contained in Dynatrace’s filing with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q.

The forward-looking statements included in this call represent the company’s view on February 1, 2023. Dynatrace disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial measures during today’s call. A detailed reconciliation of GAAP and non-GAAP measures can be found on the Investor Relations section of our website. Unless otherwise noted, the growth rates we discuss today are non-GAAP, reflecting constant currency growth. To see the reconciliation between these non-GAAP and GAAP measures, please refer to today’s earnings press release and financial presentation under the Events section of our website. And with that, let me turn the call over to our Chief Executive Officer, Rick McConnell.

Rick?

Rick McConnell: Thanks, Noelle and good morning everyone. Thank you for joining us on today’s call. I am very pleased with the team’s execution this past quarter amidst a difficult macro backdrop. Dynatrace’s strong third quarter results solidly beat expectations on the top and bottom line. Adjusted ARR growth and constant currency subscription revenue growth were both 29% year-over-year. Non-GAAP operating margin in the third quarter was 27% and free cash flow margin on a trailing 12-month basis was also 27% of revenue. These results continue to demonstrate our ability to run a balanced business that delivers high growth, coupled with strong bottom line performance. They are a testament to the strength of our market, the significant customer value of our platform and the ongoing durability of our business model.

Jim will share more details about our Q3 performance and guidance in a moment. In the meantime, I’d like to share my view of the current market environment, our platform leadership and differentiation and our investment priorities to support future growth. To start, our market opportunity has never been stronger. We recently conducted an independent global survey of 1,300 CIOs and senior DevOps managers, 90% of whom indicated the digital transformation within their organization has accelerated in the past 12 months. They also said that their DevOps teams spend on average over 30% of their time on manual tasks involving code quality issues and security vulnerabilities, which reduces the time spent on innovation. These research findings support our perspective that observability is increasingly moving from optional to mandatory.

Digital transformation and in particular, cloud modernization initiatives, continue to grow rapidly. Consequently, the volume of data is exploding as is its complexity, making manual troubleshooting and analytics based on dashboards nearly impossible. Organizations need answers and intelligent automation from data to streamline their processes and maximize employee productivity. They expect Dynatrace to provide deep situational awareness to keep their businesses operating while radically improving their innovation, efficiency and responsiveness. As a result, our solutions are becoming an indispensable part of our customers’ cloud ecosystems. It is worth noting that the hyperscalers, AWS, Google Cloud and Microsoft have started to speak more broadly about an increased focus from customers on cloud optimization as an element of their digital transformation initiatives.

This is a trend that directly benefits Dynatrace. Cloud optimization is about ensuring that cloud deployments deliver a compelling ROI. It’s about effectively managing the exploding number of cloud workloads to ensure high availability and resource efficiency. Dynatrace facilitates such optimizations by providing trusted insights based on causal AI-powered analytics and automation to enable substantially higher software liability. This is reflected in our mantra of cloud done right and it is consistent with company’s efforts to work smarter in the cloud. Our ability to provide insight and visibility drive efficiencies and optimize spending across our customers’ IT ecosystems is unique. Industry analysts consistently agree. As we previously shared, we were selected as a leader in the Gartner Magic Quadrant for APN and Observability as well as the ISG provider lens for cloud-native observability and security.

Then in December, Dynatrace received the highest score overall in the Forrester 2022 Wave or AIOps report, topping all other solution providers reviewed. The author later published a blog saying, €œthe vendor best able to demonstrate a strong and differentiating offering across all 35 capabilities was Dynatrace.€ And we continue to invest in our innovation engine to further differentiate ourselves and enhance our leadership position. So turning to our roadmap for R&D innovation, I’d like to talk next about three focal areas. The first is increased automation, including AIOps, DevOps, DevSecOps and the concept of shift-left. Our customers aspire to deliver a software environment that works perfectly and one with an exceptional user experience.

We already enable customers to move away from manual monitoring and dashboarding to automated answers. The next step is to increasingly integrate the Dynatrace platform directly into code to allow proactive automated remediation of issues before they become visible to end users. The second is real-time data management and analytics with Grail. AIOps and automation are the foundation to manage, process, store and analyze data in real-time. Keeping all data including traces, metrics, logs, real user data, open telemetry, etcetera in context, is mission-critical. This requires us to store and manage petabytes of customer data and it mandates highly efficient analytics against that data in near real-time. With our October launch of rail, our massively parallel processing data lakehouse purpose-built for observability and AppSec use cases, we now have the core technology in place to deliver against this sizeable challenge.

It’s still early yet we are now engaged in over 160 active POCs and a growing community of paying customers for our first use case of log management and analytics. This remains a market that we believe is ripe for disruption through improved performance and scale as well as the deep inclusion of logs with other observability data types in AIOps analyses. We closed several 6-figure deals in the quarter and we only just started. That leads me to our third R&D focal area, application security. Observability and AppSec are inextricably converging driven by the growing need for organizations to better understand threat and vulnerability activity inside their environments. Customers are looking to operationalize the observability data being generated to understand and assess these threats in real-time in their infrastructure and apps.

We added 85 new AppSec customers in the quarter, again, including several 6-figure deals. Our application security offering and Grail are excellent examples of our product team’s ability to anticipate where the market is going and develop solutions that meet customer needs. Later this month in Las Vegas, we are looking forward to hosting Perform, our first in-person global customer conference since 2020. We plan to share our most comprehensive set of technology and platform announcements to-date, which will set the tone for the year ahead. Investors are invited to attend in-person or tune-in virtually to our main stage presentations. And members of our leadership team will be on hand for a moderated investor Q&A breakout session. In addition to our relentless commitment to innovation, we also continue to advance our go-to-market efforts.

In particular, we have grown our direct sales force by nearly 20% year-over-year, while at the same time, gaining leverage and scale by dramatically increasing our focus and investment in partners, most notably with hyperscalers and global system integrators or GSIs. In addition to the formal alliance agreement between Deloitte and Dynatrace we announced last May, we have expanded our relationship with DXC as well as 8 other strategic GSIs that are striving to help customers digitally transform their businesses and reduce cloud complexity. Our objective is to participate in digital transformation projects earlier in the purchasing cycle and in so doing enable customers to establish more resilient cloud deployments from the start. Strong partnerships are consequently a critical element for us to construct a flywheel momentum in new logo growth as well as expansion in our installed base.

As I mentioned previously, we also continue to enhance our pricing and packaging structure, which we believe will help unlock the full potential of the Dynatrace platform and accelerate expansion. Our installed base has significant growth potential amidst a rapidly growing solution portfolio and we believe a more extensible and simplified licensing model will help us capture that opportunity. Our Dynatrace platform subscription or DPS model is already used by roughly 100 of our largest customers and enables an ARR accretive, frictionless licensing experience through a committed spend with flexible usage across the Dynatrace solution set. To emphasize the power of these investment priorities and delivering customer value, I’d like to share some recent wins to highlight why organizations choose Dynatrace.

We partnered with AWS to land a 7-figure, 3-year deal with a major airline. They are leveraging 6 of our modules, including logs on Grail, having discovered that their existing dashboard tool provided little value on Cyber Monday due to blind spots and unpredictable cloud resource spikes. Now, the customer has insights with root cause analysis across their workloads and can more effectively and proactively solve problems with AI and automation. We also landed an 8-figure multiyear deal with a large U.S. insurance company that is transitioning to SaaS and leveraging AWS. This company had been dealing with a recurring SevOne issue, impacting tens of thousands of insurance agents. In the past, the company’s application would cease to work multiple times a year for hours at a time, affecting agents, policyholders, IT resources and future customers.

The company estimated that the cost for downtime was millions of dollars per year. With Dynatrace, they quickly found the root cause of the highly complex problem, eliminating application downtime, saving teams from additional waste of time and helping increase customer satisfaction. Another customer, a major bank, expanded its existing 7-figure commitment with us, bringing its total annual recurring revenue up to an 8-figure relationship due to Dynatrace’s ability to scale and drive efficiency across its entire technology ecosystem. And finally, one of the largest European producers of premium and luxury automobiles in charge of multiple car and truck brands signed a 7-figure land deal using DPS licensing, placing Dynatrace as the number one solution for observability within their internal marketplace.

With this agreement in place, all their brands can simply sign on or observability with a pre-negotiated rate card without the time consuming negotiations and approval chain. This is a great example of the frictionless expansion opportunity that the DPS model can create for us. In closing, I am grateful to our customers for their feedback on significant value that we provide in achieving their business objectives, not to mention the positive relationships they have with our team. We have proven our ability to deliver growth in a challenging environment while consistently managing the business top to bottom line in a balanced way. We remain highly motivated by our market opportunity as well as our platform leadership and we continue to innovate to meet our customers’ evolving needs to further differentiate ourselves in the market.

And finally, we remain focused on solid execution, even through turbulent economic conditions to be in an even stronger position when the macro environment improves. With that, let me turn the call over to Jim. Jim, it is great to have you on board for your first Dynatrace earnings call.

Jim Benson: Thank you, Rick and good morning everyone. I couldn’t be more thrilled to be at Dynatrace. As Rick said, Q3 was a quarter of solid execution across the Dynatrace team. In a dynamic macroeconomic environment, we delivered strong results, meeting the high-end of our guidance across all of our operating metrics: ARR, revenue, subscription revenue, operating margins and EPS. Overall, the value of the Dynatrace platform, the resiliency and predictability of our subscription model, the strength of our enterprise customer base and the disciplined execution across the business drove our performance. We have continued to demonstrate a durable and attractive business model and we expect to continue to deliver a balance of strong growth, profitability and cash flow.

Now, let’s dive into the third quarter results in more detail. Please note that the growth rates mentioned will be on a year-over-year basis and in constant currency, unless otherwise stated. As we have shared in the past, ARR is a key performance metric of the overall strength and health of the business and we delivered 29% adjusted ARR growth in the third quarter. Please keep in mind, adjusted ARR growth normalizes for currency and the wind down of perpetual license ARR, a reconciliation of which can be found on our IR website. Total ARR for the third quarter was $1.16 billion, an increase of $233 million year-over-year and $98 million sequentially. Foreign exchange was a $29 million headwind year-over-year and a $19 million tailwind sequentially.

Excluding the impact of currency and perpetual license roll-off, the net new ARR added in the quarter was $81 million, roughly $20 million higher than the expectations we shared in our last call, driven by strong new logo additions. Moving on to the building blocks of ARR growth for the business, we added 250 new logos in the third quarter, up 4% year-over-year and exceeding our expectations. The average ARR for new logo lands was around $120,000 on a trailing 12-month basis, consistent with second quarter. In the third quarter, over 60% of our new logos landed with three or more modules supporting the shift towards a platform approach for observability. The value of the Dynatrace platform continues to resonate with prospects as they look to deliver rapid operational efficiencies in a tight budget environment.

Dynatrace’s ability to quickly drive greater automation and efficiency that deliver strong ROI positions us well among strategic IT investment initiatives. Our net expansion rate for the third quarter was just shy of 120%, driven by ongoing budget scrutiny and elongation of sales cycles. To be clear, the demand environment remains healthy. It just takes a bit longer to close deals. Gross retention rates remained strong in the mid-90s for the business, a testament to the value of the enterprise customers see in the Dynatrace platform. From an existing customer standpoint, we continue to see strength in multi-module adoption, with nearly 60% of our total customers now using 3 plus modules at an average ARR of nearly $500,000 per customer. And we continue to believe that as more and more customers adopt new modules and expand coverage over time, the average ARR per enterprise customer can grow to be north of $1 million.

Moving on to revenue, total revenue for the third quarter was $297 million and subscription revenue for the third quarter was $279 million, both up 29% year-over-year and exceeding the high-end of our guidance by $11 million, of which FX was $4 million. With respect to margins, which I will discuss on a non-GAAP basis, we have a very healthy margin profile, reflecting the value and efficiency of the Dynatrace platform. Gross margin for the third quarter was 84%, up 1 point from last quarter due to the growing scale of our subscription business and improved services gross margins. As Rick indicated, investments in innovation and targeted go-to-market initiatives remain high priorities for us. For the third quarter, we invested $42 million in R&D or 14% of revenue.

As many of you know, the vast majority of our engineering organization resides outside the U.S., providing us with much greater cost efficiency when compared to our competitors. On the go-to-market side, we invested $98 million in sales and marketing this quarter or 33% of revenue, down 200 basis points year-over-year and up 50 basis points sequentially as we ramp seasonal marketing program spend and continue to prioritize targeted investments in expanding our partner programs. Our operating income for the third quarter was $81 million, resulting in an operating margin of 27%, exceeding the top end of the guidance range by over 150 basis points driven primarily by revenue upside and disciplined spend management. On the bottom line, non-GAAP net income was $73 million or $0.25 per share, $0.03 above the high end of our guidance range.

Turning now to the balance sheet, in December, we announced a new $400 million committed revolving credit facility that replaced the prior $60 million facility that was due to mature this August. We were very pleased with the execution of financing and used cash on hand to repay the remaining $221 million loan balance, rendering us debt-free. As of December 31, we had $422 million of cash, an increase of $14 million compared to the same period last year, and that’s after we paid off $311 million of debt over the last four quarters. Our free cash flow was $58 million in the third quarter and $301 million on a trailing 12-month basis or 27% of revenue. We believe it is best to view free cash flow over a trailing 12-month period due to seasonality and variability in billings quarter-to-quarter.

We are extremely pleased with our continued healthy cash generation and believe it puts us in a strong position to make the appropriate investments to accelerate our growth in select areas. The last measure that I would like to discuss is our remaining performance obligation. RPO was approximately $1.7 billion at the end of the quarter, an increase of 24% over Q3 of last year. The current portion of RPO, which we expect to recognize as revenue over the next four quarters, was $983 million, an increase of 25% year-over-year. It is important to remember that seasonality associated with bookings and contract upselling will cause variability in the RPO growth rates. As such, we continue to believe ARR is the best metric to understand the health and durability of the business as it removes noise associated with timing of billings.

Before I move to guidance, I want to give a brief update on the macro environment. Our ability to outperform in Q3 is a testament to the strong execution of the Dynatrace team. The demand environment remains healthy, the market opportunity is still growing, the observability ecosystem is still expanding, and deals are getting done, but with more budget scrutiny, and therefore, at a slower rate and pace. We are confident in the health of our pipeline and the team’s ability to execute in this environment even as macro headwinds persist. At the same time, we are closely monitoring our investments to continue delivering attractive levels of profitability while investing in targeted areas for growth. We will operate with the same rigor in Q4 and are confident that we’re factoring in the appropriate macro trends into our guidance.

Let’s start our guidance for the full fiscal year, again, with growth rates in constant currency. With more than 40% of our business denominated in foreign currency, the weakening of the U.S. dollar is creating less of a headwind than we had projected last quarter. We now expect the full year FX headwind to as-reported ARR to be approximately $30 million and approximately $45 million on revenue. This is compared to the nearly $60 million currency headwind to ARR and revenue guidance we expected last quarter. With that in mind, we now expect ARR to be between $1.216 billion and $1.221 billion, representing an adjusted ARR growth of 26%. This represents a $51 million increase at the midpoint on an as-reported basis. From a constant currency standpoint, this represents $21 million or a 200 basis point increase from prior guidance.

Consistent with prior guidance, the perpetual license wind down for fiscal 2023 is expected to be approximately $8 million or 80 basis points. Underpinning our ARR guidance, we now expect new logo growth to be roughly flat compared to last year, where we added 706 new logos. This is an increase compared to the previous quarter’s expectation of a 5% decline for the full year. We expect net expansion rate to be in the high teens, reflective of the tighter budget scrutiny and elongation of sales cycles. We are also raising our revenue guidance at the midpoint by $27 million for the year on an as-reported basis or 150 basis points in constant currency. We expect total revenue to be between $1.148 billion and $1.151 billion and subscription revenue to be between $1.075 billion and $1.077 billion, both of which result in 28% to 28.5% year-over-year growth.

From a profit standpoint, we remain committed to offsetting incremental macro headwinds with operational efficiencies and appropriate investment management. With that in mind, we are raising our non-GAAP operating margin guidance for fiscal 2023 to 25%, representing a 50 basis point increase compared to our prior guidance. We believe this will still enable us to make the appropriate investments in both R&D and sales and marketing. We are raising non-GAAP EPS guidance to $0.87 to $0.88 per share, representing an increase of $0.06 on the low end and $0.05 on the high end. This non-GAAP EPS is based on a diluted share count of 292 million to 293 million shares and a non-GAAP effective cash tax rate of 11%. And finally, we expect free cash flow to be between $315 million and $321 million, representing a free cash flow margin of 27.5% to 28% of revenue, down 25 basis points at the midpoint as we firmed up cash tax expectations, which are slightly higher than prior guidance.

As a reminder, our full year free cash flow was positively impacted by a one-time tax refund of approximately $35 million in the first quarter. As we think about free cash flow beyond fiscal 2023, we generally expect to see non-GAAP operating margin and free cash flow margins to align on a tax-neutral basis. Therefore, we expect free cash flow margins on an as-reported basis to be slightly lower than op margins, given expected increase in cash tax rates as we fully utilize our tax loss and credit carryovers and generate increased levels of profitability. Looking to Q4, we expect total revenue to be between $304 million and $307 million or 24% to 25% growth. Subscription revenue is expected to be between $285 million and $287 million, up 24% to 25% year-over-year.

From a profit standpoint, non-GAAP operating income is expected to be between $71.5 million and $73.5 million, 24% of revenue and non-GAAP EPS of $0.22 to $0.23 per share. Keep in mind that we have some seasonal expenses taking place in the fourth quarter, including incremental spend related to our Perform conference as well as a structural reset of payroll taxes. In summary, we are pleased with our third quarter fiscal 2023 performance where we saw solid ARR and top line growth, combined with healthy cash margins amidst a dynamic environment. We have a proven track record of consistent execution. And as we have consistently demonstrated, we are committed to maintaining a disciplined and balanced approach to optimizing costs and improving efficiency and profitability while continuing to invest in future growth opportunities that we expect will drive long-term value.

And with that, we will open the line for questions. Operator?

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Q&A Session

Operator: Thank you. Our first question comes from the line of Matt Hedberg with RBC Capital Markets. Please proceed with your question.

Matt Hedberg: Great. Thanks, guys for taking my questions. Congrats on the execution in a tough environment. Rick, for you. Your comment that Dynatrace directly benefits from cloud optimization, I found that to be a really fascinating comment. Obviously, many investors that we talk to are concerned that cloud optimization could actually hurt observability vendors. Could you talk a little bit more about that dynamic?

Rick McConnell: Sure. Thanks very much, Matt. In many ways, I think the cloud optimization is precisely what Dynatrace was built to do. Digital transformation is obviously alive and well, and it’s driving a huge number of workloads, as we all know, to the cloud in terms of cloud migration and cloud deployment. But companies increasingly want to make sure they’re getting an ROI. They want to make sure that they are delivering software that works perfectly. They want to make sure that they’re delivering exceptional customer satisfaction and user satisfaction. And this is really all about cloud optimization. And in fact, that’s what Dynatrace does. We bring €“ we like to think we bring order to the chaos of the cloud. And in many ways, I think cloud optimization is precisely what is going to drive Dynatrace from being optional to mandatory in cloud deployments as we look ahead.

Matt Hedberg: Got it. Thank you. And then maybe one for Jim, obviously, you didn’t guide to fiscal €˜24 yet. It may be a bit early, but wondering if you have any just high-level building blocks, things like sales capacity expectations, new logos, etcetera, as we sort of fine-tune our growth and profitability estimates for next year?

Jim Benson: Yes. You’re right. We’re going to provide a lot more color on fiscal €˜24 in our May call. I will say, obviously, I’ve been here a couple of months now, a fantastic quarter for the company. And as I mentioned in my prepared remarks, relative to building blocks that we actually did a little bit better on new customer logos in the third quarter. And so, I think as we’ve talked about building blocks in the past, call it, roughly third is going to come from new logos and call it two-third is going to come from expansion. And you can expect those, call it, approximate ranges going into fiscal €˜24.

Matt Hedberg: Got it. Thank you.

Operator: Thank you. Our next question comes from the line of Sterling Auty with SVB. Please proceed with your questions.

Sterling Auty: Yes, thanks. Hi, guys. And Jim, welcome back to your first Dynatrace earnings call. I’m just going to ask one question, so you can fit as many in as possible. I think one of the questions that I get a lot is when Microsoft reported, they talked about weakening at the end of the quarter, in particular, in terms of Azure growth. Can you just talk about what you saw at the end of the quarter dynamics and how this quarter kind of started?