DT - Dynatrace: Near-Term Prospects And Growth Rates At 38x FCF

2023-09-15 14:24:03 ET

Summary

• Dynatrace, Inc. is valued at around 45 times forward free cash flows, offering a reasonably priced investment opportunity in the software sector.
• While the recent earnings call noted cautious enterprise spending and tighter budgets, Dynatrace's medium-term prospects in observability and application security remain intact.
• Growth rates have stabilized around the mid-20s%, with dollar-based net retention rates showing a decline to the mid-teens as the new normal.

Investment Thesis

Dynatrace, Inc. ( DT ) is a reasonably valued monitoring and analytics platform, with solid free cash flows.

Previously, as we headed into Dynatrace's earnings results, I said ,

[Here I] note some minor blemishes that readers should think about, such as its slowing customer growth rates and the potential compression in its free cash flow margin for the year ahead.

Subsequent to those comments, the share price took a breather, with investors looking to take profits. Understandably, really, given that its earnings call didn't exactly exude optimism, as I presumed it wouldn't. But I get ahead of myself.

Here's the pitch in a nutshell. This stock is priced at approximately 45x forward free cash flows. It would be wrong to say that this is the cheapest software stock going. But it's hardly richly valued either. This is a stock for investors who are able to use this opportunity to buy into a stock with a small dip and remain patient, waiting for a better opportunity in the stock to present itself.

Dynatrace's Near-Term Prospects

Dynatrace focuses on application and infrastructure performance monitoring. It provides real-time insights into the performance of applications to optimize user experiences. It's a favorite amongst DevOps teams (essentially developers) within the IT sector.

Fundamentally, the business is delivering strong results, something we'll soon discuss. But the tone of the earnings call doesn't inspire much confidence. More specifically, Dynatrace notes that enterprises remain cautious in their spending. Going so far as to acknowledge that tighter budget scrutiny and elongated sales cycles could remain in place for a while.

That being said, Dynatrace's medium-term prospects remain intact. As organizations increasingly rely on multi-cloud computing, the need for observability and application security will remain in high demand.

Revenue Growth Rates Still Solid

The graphic above is a reminder that Dynatrace's growth rates are now around the mid-20s% CAGR. Yes, Dynatrace did see its growth rates jump higher during the Covid years as companies were forced to embrace the digital transition, but for the most part, this is a company that can be counted on for 20% CAGR. A no-thrills steady compounder. That's not to say that's a bad investment, in fact, a steady compounder can do what it says on the tin, compound steadily without any heartache. And that of itself is very valuable!

Next, let's discuss some pesky details that detract from the bull case.

What we see above is that Dynatrace's dollar-based net retention rates are down 400 basis points y/y. What's more, during the call, management reaffirmed that for this year as a whole investors should come to terms with mid-teens net retention rates. Meaning that this is now the new normal.

Profitability Profile Remains Strong, With But

In my experience, when a growth company asks investors not to focus on their current quarterly results, but instead, focus on their trailing metrics, this sometimes points to a slowdown.

Case in point, here's a quote from the earnings call,

We continue to 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. On a trailing 12-month basis, free cash flow was $321 million, or 26% of revenue.

To reflect my assertion, consider Dynatrace's free cash flow below.

As you can see above, Dynatrace's free cash flow was down slightly. Not substantially, but nonetheless slightly compressed.

For their part, Dynatrace remains consistent that it's expecting around $310 million of free cash flow this year, which would point to about 45x free cash flow multiple on its stock.

In summary, the stock is far from exuberantly priced. Furthermore, if we were to assume that next year its free cash flows would grow by approximately 15% to 20%, this would see its free cash flows reaching around $370 million, leaving the stock priced at around 38x next year's free cash flows, a multiple that is quite reasonable.

The Bottom Line

Dynatrace presents an intriguing opportunity in the software sector.

At approximately 38x next year's free cash flows, I believe it's appropriately priced for its sector. While the recent earnings call didn't exude optimism, citing cautious enterprise spending and tighter budgets, the company's medium-term prospects remain intact.

Although its dollar-based net retention rates have declined and its CAGR has stabilized around the mid-20s%, it's still a reliable, no-thrills steady compounder.

The profitability profile remains strong, with free cash flow consistently around 26% of revenue on a trailing 12-month basis. Considering its potential for 15% to 20% free cash flow growth in the coming year , Dynatrace offers a reasonably valued investment opportunity for patient investors.

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