2023-03-09 16:38:03 ET
Dynatrace, Inc. (DT)
Morgan Stanley Technology, Media and Telecom Conference
March 7, 2023 4:30 PM ET
Company Participants
Rick McConnell – Chief Executive Officer
Jim Benson – Chief Financial Officer
Presentation
Unidentified Analyst
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. I really appreciate you having on to the conference.
Before we get into the conversation, let’s go through the disclosures real quickly. For important disclosures, 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 or their cloud transformations. I was wondering if you can sort of frame it in the context of coming out of pandemic, 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? Where they headed in terms of their cloud transformations?
Rick McConnell
You want me to take it? No real pull forward that we’ve observed, our customers are continuing their migration in the cloud. They’re continuing that at good speed. And the good news 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.
Unidentified Analyst
And in terms of just that mix, like today, what 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?
Rick McConnell
Yes. The way that we talk about it is that already the majority of our ARR is from SaaS monitor. So SaaS monitoring is the majority of workload. The vast majority of new logos, new logo customers that come onto the platform are 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.
Unidentified Analyst
Right. And so that’s why this 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?
Rick McConnell
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 three major hyperscalers reported a quarter in which they were doing $170 billion of annualized revenue.
Unidentified Analyst
Right.
Rick McConnell
That 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 in the cloud, it gets unmanageable by your existing network operations 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.
Unidentified Analyst
Yes. The AIOps engine and Davis has been the thing that 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 yet, you guys are 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 on terms of sales cycles, longer purchasing decisions in the…
Jim Benson
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 were 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’re 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 cycles 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 two or three quarters ago.
So I feel very good about visibility now. And I would also say very good about sales as general understanding of where things are going to land that, you don’t need to have perfect execution. You 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 the environment that maybe you’d do better with your existing customers, where we actually saw the upside was actually in 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, 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 are – have GSI as the 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 seven 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 GSI. 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 in them starting to show and manifest themselves in incremental bookings.
Unidentified Analyst
Yes. Let’s stay on that topic around on GSIs and partners. It sounds like it’s an emerging part of the story. Could you sort of either of you sort of speak to why were the GSIs 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?
Rick McConnell
Well, I actually think the GSIs like the hyperscalers themselves were in the tornado. They are taking orders and advancing workloads in the cloud as quickly as they can. And there’s huge demand for that. We are now in a slightly more mature, I would say, environment. And 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 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 whereas the problem. Well, in an on-prem environment where you are releasing software every six 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 in an inflection point right now in my view because of these factors that we’ve just talked about.
Unidentified Analyst
Yes. Let’s stay on that topic because that is a – I think you had a quote there is that there’s a racing expression. You win races when the turns happen. And we’re in a 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?
Rick McConnell
We have – we’ve absolutely double down in areas like our investment in Grail. Grail is a massively parallel processing data lake house. We’ve been working on it for four years now. We announced it back in October. Its first instantiation is log management and analytics. It does this with a new architecture that uses graphing technology that has no rehydration, no re-indexing, so very, very efficient to do highly performant 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 or 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.
Jim Benson
I 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 all many of the names you cover that, this have been a focus on, we need to work on margin expansion because they were maybe a little bit overweighted on focusing on growth and not an underweighted on profitability.
And so they’re pivoting a bit to, I’ll call it right-sizing 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 Rick’s point about the investments, ours is a tuning, it really is, that’s all it is. It’s – do you want to tune something up a little bit? Do 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 because that’s important. When you’re changing focus in 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.
Unidentified Analyst
Yes. I think implied in your comments, I didn’t write this question down, so apologize for speaking off the cuff. But implied in that is an opportunity for like competitive advantage, as you know, the broader ecosystem has to focus on finding ways to get more efficient, dialing back on the land grab strategy that they’ve – that many players have been pursuing. Does that provide an opportunity for you to expand your voice in the market, take more share within your customers?
Rick McConnell
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, 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. 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 we actually – we can overweight investment in the area pretty quickly if – because the business model allows that.
Unidentified Analyst
Yes. And 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 years ago I said the number of monitoring tools and the enterprise is like double digits, like 14, 15 plus. And so everyone in the category now is really on the theme of tool consolidation, vendor consolidation. And so I guess, the question is like, why is Dynatrace going to be a net consolidator of spend in the category versus your competitors? And specifically because we 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.
Rick McConnell
That is the – that is indeed the seminal question. So let me see if I’m can attack 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 and 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 last year with a deployment by BT. It was 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 incidents by 50%. They reduced MTTR meantime to repair, meantime to respond by 90%. That frees up engineering resources, frees up IT resources, and by the way, they put a projection out that they expected to save over a three year span, £28 million as a result of the deployment of Dynatrace. That solves the problem of the cloud explosion that we talked about.
So number 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 do about it? And not all observability tools will solve that in the same sort of end-to-end observability cross-platform way that we will.
Unidentified Analyst
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, and correct me if I’m wrong that you guys laid out a $100 million run rate target for log management within two years. Can you talk about the technology that underpins, because log management’s a pretty ubiquitous capability that a number of different providers have to market. What’s special about Grail that’s going to be differentiated in the market that is allow you to get to that $100 million run rate target?
Rick McConnell
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 four years of development. During which we realized that we needed a massive, highly performant 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 about in creating Grail. We delivered that back in the October timeframe. 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 to set on top of it. One of which is log management and analytics, which is where we started, which is made much more performant at very high scale based on the fact that it doesn’t do re-indexing, doesn’t do rehydration. So architecturally, it is an extremely efficient architecture to be able to attack that.
Unidentified Analyst
Yes. So the point here is like Grail is like a technology foundation and log – it’s a productization.
Rick McConnell
Exactly. Exactly.
Unidentified Analyst
And there’s probably more to come on that front. And so let’s – and so like kind of the other area that the team’s highlighted is the opportunity around AppSec and DevSecOps has been definitely a thing 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 insecurity?
Rick McConnell
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 runtime, not only could we immediately tell you all the places you call Log4j as a library. But number two, we could tell you the rank order of where you were calling it and where you weren’t to be able to prioritize your patching. 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.
Unidentified Analyst
So getting better at log management, apps, security story evolving, still some runway or still a lot of runway in observability. What does the broader product roadmap 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?
Rick McConnell
I would say, both. We’re going to continue to expand into adjacencies in 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 annualizing the cloud with the three hyperscalers. I don’t know what precisely that wallet share should be in terms of a 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]
Unidentified Analyst
Yes. Makes, makes perfect sense. I want to go out to the audience see if they have any questions, before I reach out to them. Jim, let’s go through the obligatory 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, hey, if things go right, what leverage could drive upside to?
Jim Benson
Yes. So we’ve – obviously, we’ve only provided guidance for our fourth quarter in 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 a 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 2024 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 six – next six to nine 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 an in vivo 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 a guidance that is prudent for our fiscal 2024.
Unidentified Analyst
Yes, no, it makes perfect sense. It sounds like you’re incorporating the – inserting in macro quite well. So let’s reach out to the audience. If you just raise your hands if you had any questions for the team. There’s one in the back right here.
Question-and-Answer Session
Q - Unidentified Analyst
Yes. So you mentioned about $170 billion of cloud spend, and then if you look at observability, there’s Datadog, Dynatrace, [indiscernible] three 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 of people are spending today?
Jim Benson
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 in 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 that grows that aggregate span against the cloud providers.
Unidentified Analyst
Great. Any other questions for the team, the 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 correction in the market is how teams are managing a stock-based compensation and shared dilution. What’s sort of your operating falsely going forward with respect to both?
Jim Benson
Well, I think if you’ve seen for the company, the company’s 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 and 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 sometime 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 three to six 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.
Unidentified Analyst
Great. And with that, we’re out of time. Thank you so much Jim and Rick for giving us the update on Dynatrace. Really enjoy the conversation.
Rick McConnell
Thanks very much. Thanks for coming.
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Dynatrace, Inc. (DT) Morgan Stanley Technology, Media and Telecom Conference Transcript