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Dynatrace: A “stealth” hyper-growth story
Dynatrace (NYSE:DT) shares have moved in a well-trod trajectory over the past couple of years. The shares made a high of almost $79/share in Oct. 2021, fell to $32/share a year later and have since recovered to the mid $50/share range. More recently, the shares were as low as $44 in late October before the furious rally through the end of the year which brought the shares to $56 before the most recent consolidation phase. Over the last two years, the shares are up about 12%, the IGV tech/software ETF is up about 13% while the WCLD ETF has fallen 17%. Overall, the share price on a relative basis has kept up with bench marks but its operational performance has been quite strong. (Share price calculated as of 1/12/24.)
I last reviewed the company on SA back in Feb. 2022. At that point, the huge rerating of tech stocks was perhaps 1/3rd done: there was plenty of downside ahead. Overall, the shares have appreciated by 31% since the last article I wrote; the shares dropped as low as $31 since the publication of the article, and they are currently near a high point. That’s a bit better than the IGV tech/software ETF over the same period (it’s up about 18%) and quite a bit better than a representative cloud ETF-the Wisdom Tree World Cloud-which is down 11% over the same span.
In all that time, the growth of Dynatrace business has been fairly steady. The quarter that ended 2 years ago showed revenue of $241 million, ARR of $930 million and full year free cash flow of about $270 million; that works out to a free cash flow margin of 30%. The quarter that is scheduled to be reported in a few weeks is likely to have seen revenue of $365 million, ARR of about $1.485 billion, with a free cash flow margin for the year of around 23%. Free cash flow margins are very variable quarter to quarter; for the full year the company is continuing to achieve a free cash flow margin of around 30% after adjusting for a significant one-time cash tax payment. I expect the free cash flow margin to be a bit lower in the next 12 months as the industry trend of smaller increases in deferred revenue is likely to influence the short term trajectory of free cash flow margins. Over the last two years dilution, or the cost of SBC, has been less than 3%.
The company is profitable on a GAAP basis. I look at dilution as the actual cost of SBC rather than the metric that is reported; dilution of 3% over 2 years is significantly below comparable figures from other high growth IT companies.
Growth has contracted far less than the percentage revenue growth of many other high growth IT companies; ARR growth was 24% this past quarter compared to 32%, 2 years ago. Two years ago marked the apogee of the boom in IT spending growth; currently, IT spending growth has been constrained by macro headwinds. While the company does not specifically forecast net new ARR, it was $59 million last quarter, above company expectations. In the year earlier period, net new ARR had been about $34 million. While net new ARR is a 2nd order metric, I look at it as one of the principle metrics in evaluating the sales performance of a vendor. The year over year growth of 80% is more than a bit impressive particularly in the current environment.
Much of the growth in net new ARR is being driven by take-off of the company’s Grail offering. While Grail was initially released in October 2022, its real impact is just being seen now, and will continue to be a significant tailwind for Dynatrace ARR over the next few quarters, I believe. Grail, at the moment, is a significant factor in differentiating DT observability from its competitors and is accelerating DT market share gains.
Why recommend Dynatrace shares at this point? A combination of visible market share gains within a strong component of the IT space, rising non-GAAP margins and relative growth that is greater than all but a few IT companies has motivated this author to update his prior purchase recommendation. The shares have not seen the same sharp increase in valuation that has concerned many observers about the need for a consolidation period. Notionally, DT shares are not substantially undervalued on a relative basis. That said, I expect the current 24% ARR growth to be a floor, with a potential reacceleration based on trends in IT spending-which seem to be more favorable than feared as well as the potential impact of generative AI created apps that need to be observed and managed. This article presents a case for growth stock investors to buy Dynatrace shares at this time and at this price.
This morning December’s CPI report was slightly hotter than expectations. Almost all of the upside was driven, as has been the case for a couple of years, by the shelter index, and most particularly owner’s equivalent rent which rose 0.5% last month. Just how accurate that metric might be can readily be questioned, but that is not the purpose of this article. Before running for the exits because of fears of a “sticky” inflation cycle, Friday’s PPI report was considerably cooler than prior expectations.
Why are the CPI and PPI indices relevant in a discussion of Dynatrace shares? Dynatrace shares exist in the market as a whole and in the market for high growth IT equities. This is not an article attempting to handicap inflation, market valuation, interest rates or other economic macros. In the short term, those metrics are going to have a substantial influence on Dynatrace shares, probably greater than that of the company’s operational performance.
Bucking macro headwinds: Why has Dynatrace been able to maintain its growth rate when so many other IT companies have seen growth shrivel?
Dynatrace is one of the leaders in the observability space. Historically there have been 3 pillars of observability; logs, metrics and traces. These data outputs provide different insights into the health and functions of systems in cloud and in microservice environments. I have linked here to a Dynatrace article that attempts to define observability and which highlights how observability has expanded beyond those three pillars. One thing to note: observability is not quite the same as what is called application performance management. APM has been around for a long time. One of the pioneers in the space, New Relic, recently went private. Observability actually has seen its functionality extend to include APM. Another distinction to make: Observability as it is used by enterprises these days, is not monitoring. Monitoring is far more useful in static environments-those built with DIY on-prem applications. Observability is basically a way of monitoring for a very dynamic unknown environment such as is typical for the cloud.
To reiterate, observability these days has moved beyond logs, metrics and traces. In order to get reasonable results that help users to actually optimize network performance so that it supports business objectives and priorities, observability has to include analysis of metadata, user behavior, topology and network mapping with access to code-level detail. Observability is part of what is called AIOps. This is traditional AI-not generative AI. AIOps is a way of automating more processes as part of what is called DevSecOps. Without trying to do a deep dive on DevSecOps, it is the modern gold standard used as a basic tool by many enterprises as the cornerstone of their application development paradigm.
One of the key benefits of observability is that it provides organizations an accurate and timely window into the business impact of digital services. One of the most important use cases for observability is to see how a digital service is performing for end users and what can be done to improve the performance and to reduce bottlenecks. The most vivid examples come from the e-commerce space where some networks are unable to process orders and to check out customers because of system bottlenecks. The use of observability to fix the resource problem and to improve conversions by retail customers when shopping on-line has been a factor in accelerating demand for observability. Observability has continued its upward climb as a spending priority for users and that has enabled Dynatrace to maintain a growth rate near peak levels.
There are two reasons why Dynatrace has been spared the worst of the IT growth slowdown that has engulfed so much of the space. One is that observability has become more of a priority for users. Despite all that has been written about cloud optimization, organizations are still moving workloads to the cloud and are deploying new cloud based applications. Those are durable secular trends and have been responsible for a “rising tide” paradigm. But the other is market share gains. In my view, many investors do not realize just how strong the competitive position of Dynatrace in the observability sector actually has become. And that is what the next segment of this article explores.
I think it is also worth noting that overall IT spending trends, at least as compared to 2023, have turned positive. There are many IT spending intention surveys and there can be a lack of convergence in the spending data presented. I have linked here to the Gartner survey which shows IT spending growth rising from 3% to 8% and I have linked here to another survey that has the same IT spending growth forecast. But there are others which show a smaller growth in IT spending growth percentage. My guess is that 2024 will be a less difficult market than last year, but will certainly not see the IT spending growth that was in evidence in 2021 and early in 2022.
Dynatrace Market Shares Gains-A key factor in evaluating the shares
I think if it were possible to ask a significant cohort of informed investors which company was the high growth champion in the observability space the answer would like to be Datadog (DDOG). Indeed, for some extended period of time, Datadog has been the growth champion of the companies in the space. But the irony or misconception is that Datadog is the growth champion in observability. While Datadog certainly has been a formidable competitor in the observability space, and I expect that to be a durable factor in the market for the foreseeable future, much of Datadog’s erstwhile hyper growth has been a function of a strictly usage based revenue model coupled with its extensive forays outside of observability. And its percentage growth for some quarters now has been constrained because of cloud optimization trends that have impacted usage growth.
Last quarter Datadog reported revenue growth of 25% It is projecting revenue growth of 21% for the current quarter. Because so much of Datadog’s revenue is usage based, ARR is not reported as it would not be particularly relevant. The point is, though, that at this point, Dynatrace is growing about as rapidly as Datadog and projections for revenue growth for the current calendar year are similar.
Indeed, because usage bills got so large for some customers, Datadog has instituted what it calls configurable ingestion controls-sort of similar functionality to preventing children from accessing inappropriate content on TVs and through the web. Because of this, it is unlikely that DDOG’s percentage growth will ever return to the levels seen in 2022 even as cloud optimization trends revert to more normal levels. I don’t want to be seen as bashing Datadog shares-just for the record I own Datadog share and have done so for a long time now, and they have a significant weighting in the Ticker Target high growth portfolio. That said, however, If I were making a fresh money buy at this time it would be shares of DT.
But I think that Dynatrace growth in terms of ARR has been stronger than realized and reflects market share gains-not so much takeaways from Datadog, but takeaways from Splunk (SPLK), New Relic and the other less successful companies in the space. Why is this happening? I have linked here to the Gartner Magic Quadrant analysis published last July. The quadrants show just how far Dynatrace is in the lead. As those thing go, it is a pretty significant lead at this point.
One of the major factors animating the recent success of Dynatrace has to do with its introduction of Grail. Grail was first introduced in October 2022, but it is only recently that it has been the prime factor in the growth of DT. Because it was designed recently, it is simply more efficient than competitive offering in terms of optimizing storage and its analysis of logs, metrics and traces. The advantage of Grail is basically because it is based on what is called data lakehouse technology that has only recently become widely used in developing applications. Grail has only been available as a SaaS offering which these days is the preponderance of customer deployments. At this point, essentially all of Dynatrace AWS (AMZN) users have migrated to Grail and Grail is just now being made available for Microsoft (MSFT) Azure customers.
Dynatrace has an AI based engine called Davis that is designed to analyze dependencies. One of the keys to maximizing the efficacy of observability is to determine dependencies. This analysis allows businesses to understand what resources are critical for specific applications. In turn, this allows organizations to optimize resources to support business objectives. Is Davis a better analytical engine than alternatives? That is what Gartner indicates, and it is a significant component of differentiation that would be difficult for competitors to replicate.
Gartner also calls out the high availability characteristics of the DT offerings. According to Gartner, DT is considered to offer capabilities that are better at scalability and load balancing in order to meet unexpected spikes in demand and traffic. Data storage, in a Dynatrace deployment is redundant. High availability has become a user focus after Datadog’s network went down for over a day last March. It is awfully difficult to say that one observability solution is more reliable than a competitor; on the other hand the perception is that the DT solution is rock-solid with many redundancies and back-ups in order to insure constant availability.
Again, according to Gartner, the principle caution it has with regards to Dynatrace is that its solution is not a good fit for the SMB space. This is congruent with the DT strategy-it wants to sell to larger enterprises and it has a product that is of greatest utility for large enterprises. Smaller businesses probably can’t get the business value or ROI that DT provides to its targeted customers.
I don’t want to suggest that because DT has a solution identified as superior by a leading 3rd party consultant it will necessarily have the highest growth rate in the space. There is, to be sure, a correlation between the ROI of a set of solutions and its relative growth rate in a space, of course, but it is not 100%. That said, the Dynatrace marketing message of “our customers sleep because Dynatrace never does” is seemingly resonating with customers.
While always difficult to assess, the company’s go-to-market strategy of additional relationships with GSIs, increased integration with cloud infrastructure providers, and some stepped up investment in sales capacity seem likely to help Dynatrace exploit its current product leadership position. In the last year, like many other IT companies, DT has chosen to constrain the growth in marketing spend. At this point, because it perceives growing opportunities to gain market share and to upsell existing users, it is planning on some modest ramp in sales and marketing spend.
As is the case in many other IT segments, Dynatrace has been able to grow share with larger enterprises because of its platform approach. Vendor consolidation has been, and is likely to remain a significant factor in the company’s market share gains. While Gartner’s evaluation didn’t call it out, Dynatrace believes it has the most automated solution in the space. That’s mainly a function of the maturity of the AI solutions that have been embedded in the latest versions of the offering and are built on a huge amount of data that DT has collected over the years. My guess, though, is that it is the capability of DT to align business priorities with observability insights that is likely the most significant factor in competitive POC wins. One such, which is fairly typical, was called out in the most recent earnings conference call. A major US car rental company was having performance issues with its network which were impacting revenues. The company added Logs to its deployment and has been able to use instant learning and auto remediation to proactively identify and resolve performance issues to grow their business. Most investors probably do not realize that observability has begun to morph into a business driver for its users, rather than a cost to be borne in order to maintain network performance.
Most recently, the company has begun to offer its users log management use cases that leverage Grail to eliminate the manual correlation process that has been a severe pain point for most current observability solutions. Using logs collected through Grail software is the secret sauce that allows Dynatrace users to figure out how to optimize system resources to enable business priorities. As I mentioned earlier, based on the Gartner analysis, this is a function that is offered by Dynatrace and which is not currently effectively offered by Splunk and others.
Finally, of note, Dynatrace is expanding its security capabilities. It is harder for an outsider to know just how differentiated these new capabilities are compared to what else is actually being offered by competitors. Most observability competitors are talking about security features, and as mentioned earlier the DevSecOps paradigm that is a focus of many other vendors. The use of Grail allows users to improve the security of developer activities. And security analytics that were recently announced allow current users to detect, prioritize and investigate runtime vulnerabilities.
Just how much of a tailwind has all of these recent product announcements created for DT? According to the company its pipeline is at record levels and it is willing to accelerate salesforce hiring, something almost unheard of these days in the enterprise software space. While the company, like most IT companies these days, only increased its guidance for the current quarter marginally, I believe this has set up the company to report another quarter above
In addition to product advantages and a reasonable go-to-market strategy, Dynatrace has the opportunity to replace competitive vendors and to win new enterprise opportunities against a variety of vendors who simply haven’t effectively focused on this space. Of those, the largest is Splunk, soon to be acquired by Cisco (CSCO). Cisco is also a competitor with its own issues in the space. Some years ago, it acquired AppDynamics, at that time a hot company in observability. AppDynamics has simply not kept up with industry trends such as automating observability processes and managing agents. It is now only available through distributors, essentially ceding the large enterprise market to competitors.
The integration between Splunk and Cisco is likely to prove messy and an opportunity for competitors to displace historic incumbents. Splunk, itself, has been a share donor for some time now. Gartner says that Splunk’s offering lacks product support for ingestion and analysis of log data, a pretty telling deficiency for an observability offering. It also is said not to have a well-integrated threat detection or vulnerability identification capability, again, a significant issue given the sensitivity most users have with regards to security capability.
New Relic, one of the pioneers of modern observability, has been through its share of trials. It was recently acquired by private equity. The company has been a share donor in the space for some time and its ownership by private equity has seen the company more focused on cash flow generation than on revenue growth.
Dynatrace: Its generative AI offering is in the wings
In writing about market share expectations these days it would be impossible to do so without commenting about generative AI. The company has announced its generative AI capability as Davis Co-Pilot. Davis Co-Pilot is designed to create queries, dashboards and suggested automation workflows. One of the biggest benefits of Davis Co-Pilot is that it can be used by customers to avoid outages and performance degradations before they start.
Dynatrace calls its new functionality Hypermodal AI which combines predictive AI, the old fashioned AI so to speak, causal AI and generative AI. I have linked here to the Dynatrace blog describing the total capability of Davis Co-Pilot. If it all works as advertised, it will be a gold standard in observability. I should caution, however, that the product is still in beta test and won’t reach general availability until sometime later this year. It usually takes 9-12 months for a new product of the scope and complexity of Davis Co-Pilot to start to see substantial deployments. At this point, the pricing details of the new functionality haven’t been released-I wouldn’t be surprised if they have yet to be finalized by Dynatrace.
Not terribly surprisingly, Datadog has its own set of advanced generative AI functionality and so does Splunk and New Relic. They all sound good in their marketing releases. It is not really feasible at this point to try to handicap winners and losers in the observability space as generative AI offerings become broadly available. In any event, generative AI will not be generating significant revenues this year; if the solution performs as has been advertised, its revenue impact will start to be seen sometime in the calendar 2025 year.
Dynatrace: It has been able to leverage growth and its gross margin is rising as well.
Last quarter non-GAAP operating margins for DT were 30%, 300bps above the company’s guidance for the quarter. Non-GAAP operating margins rose by 400 bps year over year and by 200bps sequentially. For many years, Dynatrace has had more of a focus on margins than many other IT companies, and this is reflected in operating cost ratios that compare favorably to most other high growth IT vendors. Of course it has helped that the company has been able to achieve above plan growth while holding operating expenses at consistent levels for the last couple of quarters.
Last quarter the company’s gross margin reached 85%, up 100 bps sequentially, and up by 200bps year over year. Some of the gross margin improvement has been a function of better pricing the company has received from the cloud hyper-scalers; some of it has been a fairly benign pricing environment in the observability space as competitors deal with numerous issues of their own.
Operating expenses continued to show favorable trends, in part because of limited hiring during the first half of the fiscal year. Overall, non-GAAP opex was 53% of revenues last quarter compared to 57% of revenues in the year earlier quarter. Sequentially, operating expenses actually fell by 2%, while revenues rose by 5.5%. Sales and marketing expense also fell by 2% although it was up by 17% year on year. The CFO talked about increasing sales and marketing spend in the next few quarters to make up for constrained sales and marketing hiring in the first half.
Just how much further the company can increase non-GAAP margins from this point is difficult to handicap. If revenue growth remains in the mid-20% range, then it is likely that margins can continue to increase.
Through the first half of the year, free cash flow fell marginally. The company’s cash tax payments increased noticeably which has constrained the growth in free cash flow. The CFO guided free cash flow margins essentially flat at just below 30% for the full year after adjusting for the onetime cash tax payment.
Wrapping Up-Reviewing the purchase case for DT at current levels.
Dynatrace shares have appreciated by about 30% since their low point before the start of the significant tech stock rally over the last 9 weeks of 2023. I have tried to make the case that the shares still are reasonably valued and have significant upside over the next year.
While it is true that DT shares are within a few pennies of their 52 week high, a factor that will, no doubt deter some readers from considering the shares, I have tried to look at the company’s relative valuation. That produces a very positive result when considering sustained and substantial market share gains that seemingly are flying below a lot of radars..
DT shares, at least on the current conservative numbers embodied in the consensus have a valuation that is only slightly below average based on a combination of the expected revenue CAGR and free cash flow margin. I think expected revenue estimates are likely to be exceeded. Most important in that expectation is the significant impacts of Grail that are starting to show up in results. The company now has noticeable functional differentiation, and it is taking market share from vendors such as Splunk, Cisco and New Relic. It has developed applications that help users monetize the value of their logs to tune their networks to prioritize business objectives. In addition, the recent addition of security analytics to the DT platform seems likely to further differentiate the offering. Grail has just recently become available on Azure, and I expect that this factor alone will be a noticeable revenue growth tailwind.
Dynatrace has continued to develop significant partnerships with global system integrators. It is one of the rare companies in the IT space that is actually accelerating salesforce hiring as its visibility has improved, with stronger pipelines and more top of funnel creation.
The company has a generative AI solution that was announced a few months ago, but which is not yet generally available. That said, Davis Co-pilot is not currently part of the revenue growth expectation for the next 12 months. Realistically, it is more likely to be factor in revenue growth acceleration in the 2nd half of calendar 2025.
In addition to factors specific to Dynatrace, Observability, overall, has become more of a priority for many users. As workloads continue to migrate to the cloud, the need for observability has continued to increase. Observability has seen a paradigm of a rising tide elevating lots of boats, and I expect that to continue.
Finally, I do think the growth in IT spend is likely to be greater in the coming year than the depressed levels of 2023. It has become a bit easier to obtain project approvals, although the return to the conditions of 2021 is not likely for IT spend.
Overall, I expect that the company’s 3 year CAGR can return to the low 30% range that it was achieving before the decline in IT spending growth.
As mentioned, there is a tendency amongst some commentators to shy away from recommending stocks that are at 52 week highs. The thought is that everyone is aware of the positive elements in the outlook. On the other hand, revenue growth expectations which show a consensus forecast of continuing declines in percentage growth seem very unlikely. And the forecast for EPS which is $1.27, up just 15% year on year seems to be at an exceptionally de-risked level.
I have owned DT shares for some time now. Looking at all the market share drivers and new product introductions I am happy to continue to do so. I can’t say that the shares won’t consolidate after this most recent run; over the full year, however, I do expect the shares to deliver positive alpha for their holders.
