Source: Aithority

Dynatrace (DT) is enjoying favorable demand-side tailwinds. It needs to move as fast as competitors to continue to enjoy the extra support from its profitability factor, which will be boosted by cross-selling its new offerings. This will lead to DT deploying more capital to drive its new products. The weakness of the sharing economy also impacts growth. Valuation is in line, and investors should adopt a long-term strategy before initiating a position.

Demand (Rating: Bullish)

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“The APM market is one of the largest sub-segments of the ITOM market, with forecast spending in 2020 of $4.48 billion and an 11.1% CAGR through 2023.”

Dynatrace is maintaining its leadership position in the observability space. Dynatrace’s global reach is benefitting from the growth of mobile apps, the adoption of multi-cloud observability platforms, and the growing work-from-home trend. Demand for its observability platform is benefitting from the need for app reliability tools, ease of integration with other platforms, and data growth.

The growth metrics reported last quarter were solid. ARR grew by 42% (y/y). Reporting ARR puts all investors on an equal footing with regards to growth expectations. Dynatrace is in the final stage of the shift from perpetual licensing to subscription billing. Reporting ARR also helps algos and APIs bake in the right expectations into their models.

Dynatrace expects more customers will expand ACV with time. Most enterprises start with an ACV of $100k. Growing ACV is a logical next step to optimize its cost of capital. Its large enterprise focus will support ACV. ACV will also be supported by its best-of-breed observability platform, which includes capabilities in logging, infrastructure, digital experience, and automation.

Subscription and service revenue grew 37%. While subscription revenue will keep growing, service revenue will decrease. This is attractive because the service segment is a low margin business that isn’t needed with a subscription-based billing model. It was reassuring to know that 80%-85% of DT’s business is from industries less affected by COVID-19. Bearish sentiments were suppressed when Dynatrace highlighted wins in the energy sector.

“For example, we did a sizable expansion deal in Italy in late March. This energy company wanted to assure continuous, high-quality service throughout the country, and if issues arose, proactively addressed them before service was impacted.”

Other attractive metrics include the RPO (remaining performance obligation) growth of 56% and the net retention rate of 120+%. RPO indicates substantial future commitments from its existing customers. It also points to an attractive win rate in an enterprise market where it mostly encounters App Dynamics.

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Going forward, a mix of currency headwinds and lower than expected expansion rate will drive subscription revenue growth guidance of 21% to 23% for the full year. The net expansion rate is expected to dip to 115+%. The net expansion rate impacts near-term ARR and revenue expectations. This also points to a possible revenue collection weakness in addition to the perpetual licensing drawdown, which affects bookings. Dynatrace’s price action since the last earnings call suggests that algos are underestimating the potential cash flow volatility in the coming quarters. The sharp market recovery partly explains the recent price action.

Business/Financials (Rating: Neutral)

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APM: This is DT’s core strength. The demand for its APM solution remains solid. Demand is assisted by integrations and partnerships with top cloud and open-source platforms. Cloud partners drive visibility while open source collaboration enables its platform to ingest more data to drive better insights.

Infrastructure: DT is expanding its Infrastructure capabilities in major software and public cloud platforms. Infrastructure is now at 29% of DT’s customer base.

Logs: DT is bundling its logs solution with Infrastructure to drive value-add to its customers. It is also adding automation and AI to analyze logs efficiently.

Digital Experience & Business Analytics: These modules are attractive because they strengthen DT’s capabilities in the marketing and sales analytics space. If the go-to-market strategy is successful, it could provide a way for DT to expand its TAM (total addressable market) as it partners with more CRMs and marketing analytics platforms.

From the very first day of use, we were able to determine that the precise root cause of a recent drop in scheduled payments was due to a website performance error. Immediate business results like this get folks really excited about what we’re doing and improve the way our business and IT teams collaborate.”

Customers buying three or more modules grew from 15% to 25%. The expected DBNER decline invites a dig into DT’s pricing and bundling strategy. DT highlighted in the last earnings call that it sells APM and Infrastructure differently. APM is bundled with AIOPs, while Infrastructure is also bundled with AIOPS, log monitoring, and network monitoring. Rather than go after granularity, Dynatrace prefers to go after complex business issues. This makes it possible that Dynatrace’s new wins are enterprises that have waited for their observability problems to grow. While it will win needy customers easily, they might push back if they get courted by players who offer cheaper solutions as they expand. Also, it’s not clear if this strategy is best suited for mid-sized enterprises that want to start with a freemium trial. While most midsized enterprises will take a long time to mature, growing with them drives a better retention rate.

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Source: Author (using data from Seeking Alpha)

DT’s gross margin improved to 83%. The subscription business had a higher gross margin of 88%. The conversion to a subscription business is now 92% complete. DT’s operating margin also came in above expectations. Profitability has primarily been boosted by the high margin (cloud) subscription business.

Dynatrace also improved its balance sheet. The debt to equity ratio now stands at an attractive 56%. Going forward, Dynatrace is expected to experience headwinds to free cash flow. The headwinds will subside as the near-term impact to deferred revenue from perpetual licensing bookings and services declines.

Two levers will pull margins: net expansion trend and COGS. On a longer time scale, Dynatrace needs customer upgrades and cross-sell to buffer its operating margin. Investors should expect more product feature updates and possible pricing revision.

The observability market is still underpenetrated. Therefore, Dynatrace will have to come up with a fair compensation structure to sell infrastructure and logging. It also needs to sell them efficiency to reduce the near-term impact to working capital given its little cash position, growing DSO (days sales outstanding) and AR (accounts receivable), and potential pricing pressure from competitors. Further DSO growth, potential deal slips, and weaknesses could catalyze a possible EPS miss next quarter.

Macro/Competitors (Rating: Bullish)

Integrations-Acquisitions-Partnerships-International Expansion

Dynatrace is well-positioned in the observability space. Its platform is integrated with the top cloud and open-source platforms. It boasts capabilities in automation and AI to help drive more compelling insights from its platform. This improves its go-to-market strategy. This is an area where competitors need to catch up. It is regarded as a leader in Gartner’s APM magic quadrant. Like most cloud platforms, it needs to keep exploring new use cases for its platform. This will help widen its TAM. Adding capabilities in security incident and events management, incident management, or vulnerability management will be attractive to its customers. It is reassuring to know that Dynatrace has completed most of the acquisitions it needs to win in the current environment. Its last acquisition was Qumran, which was meant to strengthen its business analytics capabilities.

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Dynatrace has built most of its global cloud locations. It has cloud servers concentrated in North America, Europe, and Australia. It recently released support for more Linux platforms to improve the depth of its partnerships. The resurgence of the US stock market is also boosting its macro positioning.

Investors/Valuation (Rating: Neutral)

Network Effect-Economies Of Scale-Switching Cost-Momentum-Analysts

Source: Author (using data from Seeking Alpha)

DT is trading close to analysts’ average price target of $37. Analysts are bullish on the adoption of observability platforms due to the growing demand-side tailwinds. Shares will be susceptible to the trading volatility induced by secondary offerings from existing investors.

DT’s growth factor needs to be strengthened for the current momentum to be sustained. This means DT will be vulnerable to soft earnings prints in the next quarter if it falls short on closing large deals. These concerns, in addition to the oversubscription to cloud stocks, have caused a growth in short interest.


Source: Author

The biggest risk factor with DT is the market’s oversubscription to tech stocks. This will make it tough for multiple expansion to neutralize the potential EPS dilution from growing share count.

Most tech stocks are in the overbought territory. Investors need to be able to stomach short-term volatility to profit from new positions.

Conclusion (Overall Rating: Hold)

Source: Author

Given the growing competition in the observability space, a bullish position is a bet that Dynatrace will be able to evolve its platform to score new wins and expand usage from existing customers. The growing competition in the observability space suggests customers will have more bargaining power. Regardless, platforms that focus on adding value to customers will win. Dynatrace appears to be positioning itself for this evolving trend. Given that the penetration rate of observability platforms is still on the low side, investors should expect DT’s growth factor to modulate near term volatility. As a result, DT remains an attractive investment.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.