Summary
- After two guidance cuts in a row, Dynatrace, Inc. finally surprised investors (not the ones who read my previous analysis on the company) in a positive way.
- The company's enterprise focus, its end-to-end observability platform, and its profitable business model provide a strong shield in current challenging times.
- Valuation seems still compelling after the post-earnings rally.
Previously on Dynatrace
Dynatrace, Inc. ( DT ) is one of the leading companies in the IT observability space, focusing on enterprise customers in both hybrid and cloud only environments. Their end-to-end AI-assisted observability platform has been recognized by the most renowned 3 rd party research firms.
For those who are looking for a deeper dive into the observability market in general or the position of Dynatrace within the market, I suggest reading my previous article on the company: “Dynatrace: Deserving A Richer Valuation As A Profitable Growth Stock.” For those, who are already familiar with the Dynatrace story, but want to catch up what happened with the company in the previous quarters, I suggest reading my most recent article on the company: “Dynatrace: What To Make Of 2 Guidance Cuts In A Row.”
In a nutshell: the need for efficient IT observability solutions has drastically increased as a result of the transition to the cloud. Interrelations between different systems and applications are becoming increasingly complex, while the data generated by these grow at an unprecedented pace. All of this has to be monitored carefully.
Dynatrace is riding this wave very well and is mentioned generally as the top service provider in the observability space beside Datadog, Inc. ( DDOG ). The continuous migration of enterprises to the cloud provides a stable revenue stream for the observability players (Dynatrace has strong ties to the large cloud players). On top of that, based on CEO comments, there are still many greenfield opportunities in the space, which could provide an additional layer of revenue growth.
Looking at recent financial trends, Dynatrace saw some softening in business conditions in the previous two quarters (especially in Europe). It decided to trim its FY23 Annual Recurring Revenue ((ARR)) guidance both after the release of Q1 and Q2 FY23 results. In my previous article on the company, I argued that with this, the bar seems to be set very low and there is a good chance for Dynatrace to finally positively surprise investors. Looking now at Q3 FY23 results, it seems this has been the case indeed.
Fiscal Q3 earnings walkthrough
Due to their future-oriented nature, the single most useful metric for gauging the top line performance of Software as a Service ("SaaS") companies is Annual Recurring Revenue ("ARR"). Dynatrace calculates this number by multiplying the daily revenue on the last day of the quarter from all revenue-generating contracts by 365 (excluding month-to-month contracts), effectively showing what revenue the company in the next 12 months would generate if there was no change in these contracts and also no new contracts.
As the ARR metric is significantly distorted by FX movements (40% of Dynatrace revenues are generated outside of North America) and by so-called perpetual license roll-offs (almost immaterial but see more on this topic in my previous articles), Dynatrace, Inc. provides an adjusted ARR metric, where these effects are filtered out. The comparison between the reported and the adjusted ARR growth rate can be seen below:
The company reported $1.163 billion total ARR for the end of Q3, which was a 25% increase YoY. However, if adjusted for the factors mentioned above, the growth rate stands at 29% YoY. Although this is a slowdown compared to previous quarters, it is better than the 27% YoY growth that management suggested based on their net new ARR forecast on the previous earnings call . This called for flat ~$60-60 million net new ARR for Q3 and Q4 FY23, while Dynatrace achieved $81 million in the current quarter already:
The main reason for the beat (besides management’s conservative guidance) was that new logo acquisitions came in better than expected. Based on flat year-over-year ("yoy") numbers in the previous two quarters management guided for a yoy decline, while at the end the company managed to add 215 new customers, a 4% increase yoy:
This partly resulted from shorter than expected sales cycles and better than feared performance in Europe. In my opinion, this a good sign for the upcoming quarters, especially in the light of the fact that the average ARR for these new logo lands stayed consistent with Q2 at ~$120,000.
As Dynatrace, Inc. management warned previously, the company’s net expansion rate has dipped just slightly below 120% after 18 straight quarters of 120%+ growth. This was mainly the result of elongated sales cycles, which management expects to persist for the upcoming quarters as well.
If we look at the contribution of these two components (new logo adds + net expansion) to adjusted ARR growth, we see the following:
The approximately 1/3 contribution of new logos and 2/3 contribution of net expansion to adjusted ARR growth has prevailed, and management expects this to be the typical lineup for FY24 as well. In my opinion, in the long run this should pave the way for ~30% ARR growth with net expansion at ~120% after the problem of elongated sales cycles cools off. This would be consistent with previous management comments that Dynatrace aims to reaccelerate its top line growth.
Guidance remains conservative for Q4, but beware of FY24 guidance next quarter
Based on the company’s adjusted ARR growth guidance of 26% yoy for the end of fiscal 2023, it seems that management stuck to the $60 million net new adjusted ARR guide for Q4 FY23 despite the current ~$20 million beat. The calculation for this looks as follows:
Based on this, the bar is set quite low again for the fiscal Q4 quarter, as the usual seasonal pattern shows only a slight decline in this metric from Q3 to Q4, while management projects a more significant one this time:
This could pave the way for a similar beat of ~2%-points for the headline-adjusted yoy growth rate next quarter, which could fall closer to 28% rather than the 26% guidance of management. This is especially true in the light of the fact that management didn’t see material worsening of business conditions over December. This is a slight relief in my opinion after Microsoft Corporation ( MSFT ) commented on further slowing Azure growth over this period. A possible explanation for this could be the enterprise focus of Dynatrace, as typically small and midsized businesses ("SMBs") are those companies who tend to cut back most on IT spending in the current fragile economic environment. Because of this, I am curious about Datadog earnings two weeks from now, as they are more exposed to the SMB clientele.
Although the current conservative guidance of Dynatrace provides a good set-up going into fiscal Q4 earnings, there is still an important risk factor to consider regarding the company’s upcoming guidance. Management will provide FY24 guidance numbers when releasing Q4 results. These numbers could turn out to be quite conservative based on management’s current stance:
Relative to fiscal ‘24, I certainly don’t want to get ahead of ourselves and start providing guidance on fiscal ‘24 on this call. But I will tell you that we will build a similar level of prudence into our fiscal ‘24 guide when we talk to you guys about it in May. And I think we will have – obviously, we will have the benefit of another three months of seeing what the macro environment is doing. It’s pretty dynamic. As Rick said, we don’t expect any significant improvement in the environment. And we are actually managing the business with that in mind. – Jim Benson, CFO – Q3 FY23 earnings call .
Based on this, the next earnings release could be a tale of two stories: comfortable beat on adjusted ARR top line growth, coupled with a conservative outlook for FY24.
Finally, the most important question in my opinion regarding the future of Dynatrace is whether the company will be able to maintain the ~30% top line growth on the long run. It’s worth to look out for hints from management on this topic on the next earnings call.
Profitability remains strong
Taking a quick look at the bottom line, we can see the usual stability we got used to from the company:
Non-GAAP operating margin stabilized at 25% this year after falling 4%-points in FY22 when the beneficial effects of the Covid lockdown faded. Free cash flow ("FCF") margin is tracking approximately at same rate making Dynatrace a Rule of 50-55 company, if adding adjusted ARR growth and FCF margin. With this balance between growth and profitability I think Dynatrace occupies a special space among SaaS companies, which is still not sufficiently appreciated by investors, in my opinion. This brings me to the closing topic of my analysis: an update on valuation.
Valuation update: shares still cheap after recent rally compared to the technology sector
After the post-earnings rally, the market cap of Dynatrace reached $13.4 billion with a forward 12-month revenue estimate of $1.3 billion. This makes up for a forward P/S ratio of ~10.3. I think it’s fair (or even conservative) to assume that the company will be able to reach a net margin of at least 20% when it reaches a more mature phase when stock-based compensation ("SBC") declines proportionally, and operating margin grows further from current ~25% levels. With a 20% net margin the forward P/S ratio of 10.3 would translate into a P/E ratio of 51.5. Dividing this number by the most recent adjusted ARR growth rate of 29% results in a PEG ratio of 1.78. This is still ~15% lower than the current average for the IT sector:
This makes me conclude that there is still further room for Dynatrace, Inc. shares to relatively catch up to the IT sector in general.
Conclusion
The profitable growth story of Dynatrace, Inc. remains still intact, which makes the company a good investment opportunity in the current volatile economic environment in my opinion. On top of that, Dynatrace, Inc.’s enterprise exposure seems to provide further stability in the current changing environment. Dynatrace, Inc. valuation suggests there is still much upside potential from current levels despite the post-earnings rally.
For further details see:
Dynatrace Fiscal Q3 Earnings: Strong Enterprise Focus Provides Resilience