DT - Dynatrace: Performing Just As Expected And Valuation Re-rating Upwards

2023-11-28 22:13:18 ET

Summary

• I expect continued growth momentum and the market to continue recognizing DT business potential.
• The company reported strong 2Q24 results, with revenue growth of 26% and improved EBIT margin.
• The adoption of Dynatrace Platform Subscription and the rollout of new solutions are driving growth and improving the company's competitive position.

Overview

My recommendation for Dynatrace, Inc. ( DT ) is a buy rating, as I expect growth momentum to continue, supported by the adoption of DPS and the upselling of other products. As DT continues to deliver, I am expecting the market to continue recognizing DT's business potential and rerate the stock multiple times. Note that I previously rated the buy rating for DT as I was pleased with the 1Q24 results. DT was also seeing strong traction with its Dynatrace Platform Subscription [DPS], which I thought was going to continue driving growth ahead.

Recent results & updates

DT reported 2Q24 revenue growth of 26% y/y to a total of $351.7 million. Driving the growth was 28% growth in subscription revenue, offset by soft professional services revenue (down 5%). In the quarter, pro-forma [PF] EBIT margin expanded to 30.3%, beating consensus estimates by a huge margin (30.3% vs. 26.6%), driven by strong revenue performance and improved gross margin. At the bottom line, DT reported PF EPS of 31c and an FCF margin of 10%. The strong performance led me to continue believing that DT growth momentum is still strong. While annual recurring revenue [ARR] growth decelerated by close 170 bps to 24.1% vs. 1Q24, after adjusting for FX tailwinds and perpetual license churn, the notable thing is that growth came mainly from new-logo performance, which I believe indicates continuous strong performance in the coming quarters. The new logo additions, in particular, are seeing higher ASP, which speaks really well about the quality of the new logos that DT is capturing. Hence, while the number of new logo additions is the same as in 2Q23, the dollar value is higher. Although we do not know the exact dollar value, based on management disclosure that there were several notable 7-figure competitive wins in the quarter and now expects the new logo ARR mix to be 40% (used to be 30%) of the net-new ARR for the year, we can infer that the incremental ASP is a lot higher.

In addition, DT now has 250 DPS customers in total, thanks to the 100 customers it has closed worldwide since general availability in April of this year, demonstrating the continued strong adoption. I believe the growing adoption of DPS will drive improvements in net retention rates and ARR growth. A key reason is that DPS makes it easier for customers to adopt other DT’s solutions, which should reduce the adoption friction (as evident by the fact that the percentage of new logos adopting >3 modules has increased to 64% from 55% last year). This is important as it sets the stage for easier adoption of new solutions, like the Davis CoPilot (DT’s generative AI), that is going to be available in early 2024. Aside from DPS, other qualitative commentary provided by management also pointed to a strong underlying demand for other DT’s solutions. With 300 clients paying for logs on Grail, DT is still seeing strong momentum with Grail. Additionally, for another quarter, Grail POCs have grown 20% sequentially. Stringed together, I believe the rollout of more solutions (which are seeing good traction) and the DPS have improved DT’s competitive position as it has more weapons (solutions) in its arsenal to meet customers’ demands and also the flexibility (due to DPS) to price its product more effectively (customers have flexibility over duration and how much to consume).

Hence, I believe DT can achieve its revised guidance. With a 50bps increase in FY24 revenue guidance and a 100bps increase in total and subscription revenue growth on a currency-neutral basis, management now expects total revenue to grow 21% to 22% year over year and subscription revenue to grow 22% to 23% in CC. The guidance already includes incremental marketing investments for 2H24, which is an important thing to note. This significantly reduces the risk of DT missing guidance, as management has made it clear they will step up on marketing investments. From a growth standpoint, it's encouraging to see that Dynatrace is investing in marketing. These investments are meant to boost top-of-funnel pipeline and incremental sales capacity, which shows that Dynatrace is confident in its competitive position and plans to speed up growth once demand normalises.

Valuation and risk

According to my updated model, my price target for DT is $66.40 in FY24, representing a 27% increase. My thesis is playing out nicely, and with the 2Q24 performance, I believe DT can achieve low 20s% growth ahead, especially with DSP adoption and the continuous rollout of new products. Importantly, the market is recognizing DT business potential, as evident by the increase in valuation multiple from 8x forward revenue to the current 9.3x. I have increased my valuation multiple assumption by 1x to 11x, as I expect the market to continue to re-rate DT back to its historical forward revenue multiple of 12.6x.

One emerging risk that might impact DT’s stock sentiment is that its net-retention rate (114%) is tracking below DT’s guide for mid-teen retention rate (~115%). Moreover, management now expects the net-retention rate to be in the 112–113% range for the rest of the year. If this figure continues to decelerate, it might point to existing customers churning away from the platform at an alarming rate (remember that deal sizes are larger).

Summary

After reviewing 2Q24, I still think DT is an attractive investment target, hence, I am reiterating my buy rating. The recent 2Q24 results showcased a robust 26% revenue growth, predominantly driven by subscription revenue. Despite a slight deceleration in ARR growth, new logo additions are coming at higher ASPs. More importantly, DT continues to see growing adoption for its DPS, which bodes well for future net retention rates improvements and ARR expansion.

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