Title

Presentation

Dynatrace, Inc. misses on earnings expectations. Reported EPS is $0.07 EPS, expectations were $0.22.

Operator: Hello and welcome to Dynatrace Fourth Quarter Fiscal 2023 Earnings Call and Webcast. [Operator Instructions] A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It’s now my pleasure to turn the call over to Noelle Faris, Vice President of Investor Relations. Please go ahead, Noelle.

Noelle Faris: Good morning and thank you for joining Dynatrace’s fourth quarter and fiscal 2023 earnings conference call. Joining me today are Rick McConnell, Chief Executive Officer and Jim Benson, Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements such as statements regarding revenue and earnings guidance and economic conditions. Actual results may differ materially from our expectations due to a number of risks and uncertainties discussed in Dynatrace’s SEC filings, including our most recent quarterly report on Form 10-Q and our upcoming annual report on Form 10-K that we plan to file later this month. The forward-looking statements included in this call represent the company’s views on May 17, 2023.

We assume no obligation to update these statements as a result of new information, future events or circumstances. Unless otherwise noted, the growth rates we discussed today are non-GAAP reflecting constant currency growth rates and per share amounts are on a diluted basis. We will also discuss other non-GAAP financial measures on today’s call. We provide reconciliations between non-GAAP and GAAP measures in today’s earnings press release and in the financial presentation slides posted in the Events section of our website. And with that, let me turn the call over to our Chief Executive Officer, Rick McConnell. Rick?

Rick McConnell: Thanks, Noelle and good morning, everyone. Thank you for joining us for today’s call. Dynatrace delivered an exceptional finished FY 2023 with fourth quarter results that exceeded expectations across the board. For the full-year, adjusted ARR growth, constant currency subscription revenue growth, and free cash flow margin were all 29%. I’d like to thank the nearly 4,200 Dynatracers globally for their incredible commitment to excellence and tremendous execution this past year. These results continue to demonstrate our ability to run a balanced business that has been delivering high growth coupled with strong bottom line performance. They are a testament to the strength of our market, the significant customer value of our unified observability and security platform, our people and partners and the ongoing durability of our business model.

Jim will share more details about our Q4 performance and fiscal 2024 guidance in a moment. In the meantime, I’d like to share my view of the broader market dynamics, primary use cases that are driving customer buying behavior and significant investment areas for FY ‘24 and beyond. Let’s start with our market opportunity. We believe the estimated $50 billion market for observability and application security is at an inflection point. The complexity of modern technology ecosystems is forcing companies to move from in-house or open source dashboards to much more sophisticated observability solutions that deliver vastly improved insights and automation. Additionally, we expect that AI technologies such as generative AI and predictive analytics will contribute to this inflection point.

In particular, we believe AI technology advancements will increase the volume and complexity of software delivery. Further strengthening the need for observability and security with automation and AI at its core. We are fully equipped already today in our platform, help customers navigate AI initiatives and are in early stages of actively collaborating with the hyperscalers to create secure enterprise ready offerings that bring the power of generative AI and predictive analytics to market. This past quarter, AWS, Azure and GCP reported over $175 billion in combined annualized revenue. Yet Andy Jassy, Amazon’s CEO estimated that 90% of global IT spend is still on premises and poised to move to the cloud. For these and other reasons, we believe the market opportunity for observability and security of cloud-based workloads is enormous.

Without question, the cloud yields undeniable benefits, including accelerated product development, increased supply chain efficiencies, improved customer satisfaction and more. At the same time though, the cloud has also brought some notable challenges. In particular, the scale and dynamic nature of modern cloud ecosystems have made them too complex to manage through legacy monitoring approaches and manual troubleshooting. Effective operations require more than dashboards and alerts. As such, we believe automated observability is rapidly moving from optional commandatory. Dynatrace makes order out of this chaos, we leverage sophisticated causal AI capabilities, and a comprehensive understanding of an organization’s hybrid and multi-cloud ecosystem to deliver rapid insights in real time along with actionable remediation.

We enabled delivery of more reliable infrastructure and applications, improved application security, and more successful digital transformation initiatives. And we believe we are uniquely positioned to lead this market evolution by providing the only fully unified end-to-end platform for observability and application security with analytics and automation at its core. I’d now like to offer several specific use cases that have become key drivers of our customers’ purchasing behavior. First, companies are looking to deliver highly performing cloud native infrastructure and applications. We as end users expect applications to work perfectly. Many organizations underestimate the complexity of the microservice processes required to manage their cloud workloads effectively.

In Q4, one of the top 10 global financial services companies broadly expanded their deployment with a mid-seven figure Dynatrace Platform Subscription or DPS deal to ensure their growing footprint of infrastructure and applications continues to run smoothly. Beginning of DPS, we made it available to our entire customer base last month. With DPS, we are now making our solution set broadly and easily accessible through a simplified cross platform licensing model. This model allows customers to trial and deploy any aspect of our solution such as logs or AppSec, while leveraging a single commit. We expect DPS will drive net expansion and become an accelerant to ARR in future periods. Second, companies want to increase productivity and accelerate software delivery through cloud native technologies and processes.

We believe the adoption of agile development, continuous deployment and DevOps will drive accelerated demand for automated observability solutions to ensure development teams deliver secure high quality releases faster. In Q4, a Fortune 50 technology company embraced a shift left approach and delivered self-service observability and security to their development teams, resulting in increased innovation through automation. Third, organizations are seeking cost effective and more insightful log management at scale. They tell us that they are spending too much time and money on slow and limited analytics and forensics that add few insights to their businesses without substantial manual engagement. Companies are capturing logs, but a log without context of other data types fails to enable rapid reaction to changing business conditions.

We now have a major retailer spending seven figures with us to take advantage of the insights their log management solution provides with rail. Fourth, companies are spending substantial sums to ensure delivery of secure cloud applications. Global data compliance requirements, an increase in software vulnerabilities, end user data breach concerns, and brand impact are among the many contributors to this trend. We closed our largest application security deal to-date, a seven-figure expansion with the same Fortune 50 company I mentioned earlier they help secure their cloud applications from vulnerabilities. We now have nearly 400 AppSec customers and remain on track toward our goal of reaching $100 million in security ARR by the end of fiscal 2025.

Fifth, companies are increasingly coming to Dynatrace for us to provide a fully unified observability solution at scale. This especially applies to the vast array of organizations often using dozens of disparate tools in an effort to manage their software ecosystem. They struggle with a fragmented set of capabilities that lack a single source of truth, making it difficult to develop meaningful insights. This need for unified observability at scale, including a consolidation of other third-party solutions is what Brazil’s Financial Ecosystem App PicPay in addition to a leading French SaaS marketing company to displace and consolidate their existing monitoring tools and sign seven-figure deals with Dynatrace in Q4. And finally, we discussed cloud optimization last quarter as a tailwind for Dynatrace being a headwind for the cloud providers.

One part of cloud optimization is about cost optimization, reducing or eliminating ancillary workloads. Critical workloads, however, generally cannot be eliminated. Organizations need these workloads to be optimized, to run more efficiently and with less manual oversight to ensure maximum return from their cloud environments. These are the areas in which cloud optimization plays directly into our mantra of cloud done right. And this is precisely the value that Dynatrace provides through process automation, faster deployment of software and dramatically improved analytics. Given that we are at the beginning of a new fiscal year and following directly on the pain points that are driving purchasing decisions I’d like to wrap up with some of our primary investment areas as we look to the future.

Keep in mind, our approach to investments remains unchanged. We take a targeted and prudent approach and we plan to balance our investments to grow the top line, while also delivering modest margin expansion in fiscal ‘24. First, we plan to leverage both in our R&D, as well as go to market efforts, the demand shift from point products and observability to a unified analytics and automation platform. As I noted, customers are looking for a single solution that cohesively solves a variety of use cases. Our platform processes all data types, logs, metrics, traces, open telemetry, real user data, behavioral analytics and more in a single contextual data store with near real time analytics. We believe our core technologies of Davis, Grail, OneAgent, PurePath and Smartscape combined to deliver a radically different approach to solve the observability challenge and provide enormous platform differentiation relative to the more siloed approach of our competitors.

Second, we continue to invest in security expansion. We see an ongoing convergence of observability and application security in large part, because the insights derived from observability enable a much more comprehensive and time critical security response. We recently conducted an independent global survey of 1,300 CIOs in large organizations. The research revealed that 68% of CIOs found it increasingly difficult to keep their software secure given the growing complexity of their hybrid and multi-cloud environments. We are expanding our efforts from vulnerability management where we participate today to adjacent areas in both agent-driven and data-driven security. Third, we are accelerating investment in developer observability. Development teams are increasingly expected to incorporate observability capabilities into their solutions or shift left, as well as assume greater ownership for availability and operational management or shift right.

BizDevSecOps will become more crucial in this environment. At minimum, we expect development teams to have growing influence over the observability, application security and automation environments. And thus, we intend to expand both our R&D, as well as our go to market initiatives to deliver best-in-class observability to this audience. Fourth, we are executing against a broad-based set of initiatives around optimizing and expanding our go to market. We remain focused on the global 15,000, where complexity and the value of automation and analytics at scale are greatest. In addition to our planned salesforce expansion during FY ‘24, we increasingly expect to leverage partners to drive a flywheel of opportunity. Partners today already influence nearly two-thirds of our new ARR, but they account for a much smaller percentage of deal origination.

Hyperscalers play an important role in the frictionless onboarding of customers. In fact, new ARR transacted through our largest hyperscaler partner grew by more than 80% in FY ‘23 versus the prior year. We also saw strong traction from the investments we made in growing our relationships with global system integrators, driven both by direct overlap in our customer basis, as well as the highly synergistic value they can deliver to clients in digital transformation projects. We ended the fiscal year with 10 strategic GSI partners and a few including Deloitte and DXC have built Dynatrace into their reference architectures. A final area of investment is in customer success. Fiscal ‘23 was a year of incredible innovation with the delivery of critical new functionality enabling improved log management, enhance infrastructure monitoring and application security, improve user experience and access to insights, faster application development and broader automation tools.

We are driving fiscal ‘24 as a year of customer adoption and value realization. We want our customers to derive maximum value from our solution set and enable them to solve not one, but several of the use cases I described earlier. We expect this will also drive net expansion and contribute to future ARR growth. In closing, we are proud to have delivered a tremendous finish to FY ‘23. Despite ongoing macro headwinds, that continue to create market uncertainty. We drove record levels of ARR and revenue with excellent operating margins and cash flow generation. Additionally, we are innovating at a very rapid pace with groundbreaking new customer solutions and platform enhancements. Our products uniquely address the challenges that our customers face with a high degree of differentiation around data-driven automation and analytics.

We are building upon and evolving our go to market initiatives, including increased leverage with formidable partners who are expanding their digital transformation practices to include observability. And we remain passionate about delivering ever more value to our customers. With that, let me turn the call over to Jim.

Jim Benson: Thank you, Rick, and good morning, everyone. As Rick mentioned, Q4 was another quarter of great execution by the Dynatrace team. In a dynamic macroeconomic environment, we delivered strong results beating the high-end of our guidance across all of our key operating metrics. ARR, total revenue, subscription revenue, operating margin, free cash flow, and EPS. These continued strong results were driven by the combination of solid new logo lands to the Dynatrace platform. The ongoing expansion of existing customers and an inherently efficient business model, allowing us to deliver a sustained balance of growth and profitability. Our ability to successfully navigate through a tight budgetary environment is a testament to the resilience of our value proposition our commitment to customer success and our incredible team.

Now let’s dive into the fourth quarter results in more detail. Please note that the growth rates mentioned will be on a year-over-year basis and in constant currency unless otherwise stated. As we have shared in the past, ARR is a key performance metric of the overall strength and health of the business, and we delivered 29% adjusted ARR growth exceeding the high-end of our guidance range by 300 basis points. Please keep in mind, adjusted ARR growth normalizes for currency and the wind down of perpetual license ARR, a reconciliation of which can be found on our IR website. We saw broad-based strength across most geographies and verticals with notable strength in North America and Latin America and within the government, insurance, banking and financial services verticals, despite the current volatility in the banking sector.

Total ARR for the fourth quarter ended at $1.25 billion, an increase of $252 million year-over-year. Foreign exchange was a $29 million headwind year-over-year. Excluding the impact of currency and the perpetual license roll off, we added $84 million of net new ARR in the fourth quarter, that’s $26 million above the high-end of our guidance, driven by some notable seven-figure competitive wins, and consistent expansion across the customer base, including $13 million of expansions associated with early renewals scheduled to close in the first quarter of ‘24. This is the first time in our history as a public company where we saw a sequential increase over our seasonally strongest third quarter. We ended the year with more than 3,600 Dynatrace customers representing an increase of 9% over last year.

Our gross retention rates continue to be best-in-class in the mid-90s and contributed to a strong dollar based net retention rate of 119% in the fourth quarter. We added 179 new logos in the fourth quarter, for a total of nearly 700 new logos this fiscal year. ARR per new logo was particularly strong highlighting the market trend away from point solutions toward platform adoption. In the fourth quarter, 65% of our new logos landed with three or more modules, up from approximately 50% a year ago, driving our average new logo land up to more than $130,000 on a 12-month trailing basis. We were pleased with the uptick in the average sizes of the new logo lands, including several large competitive takeouts. This aligns well with our focus on the quality of lands that have a greater propensity to expand.

As we’ve mentioned in the past, we believe that the average ARR for enterprise customer could be $1 million or more given the significant cross-sell and expansion opportunities in our customer base. Over 60% of our customers are using three or more modules with an average ARR of over $500,000. And customers with four or more modules have an average ARR of nearly $700,000. Moving on to revenue, total revenue the fourth quarter was $314 million, $7 million above the high-end of our guidance. Total revenue grew 27%, compared to the fourth quarter last year. Subscription revenue for the fourth quarter was $293 million, $6 million above the high-end of our guidance. Subscription revenue grew 28%, compared to the fourth quarter last year. With respect to margins, total non-GAAP gross margin for the fourth quarter was 84% consistent with both last year and Q3 levels.

Our non-GAAP operating income for the fourth quarter was $78 million, $4 million above the high-end of our guidance range, due to the revenue upside in the quarter. This resulted in a non-GAAP operating margin of 25% exceeding our guidance by roughly 100 basis points. Non-GAAP net income was $92 million or $0.31 per share, this is $0.08 above the high-end of our guidance range, primarily driven by some strategic tax planning opportunities and favorable revenue performance. On a GAAP basis, our net income was $80 million or $0.27 per share. We highlight this GAAP financial metric, because following several years of profitability, we determined that we are now able to realize a substantial portion of our deferred tax assets in the U.S. The release of the valuation allowance against these assets resulted in a $40 million GAAP P&L benefit in FY ‘23.

Turning to a quick summary of the financial results for the full-year. Total revenue was $1.16 billion and subscription revenue was $1.08 billion both of which grew 29% year-over-year. Before we move on to operating income, I wanted to provide a quick update on our methodology for allocating certain operating expenses across R&D, sales and marketing and G&A. In the past, depreciation expense was primarily allocated to G&A, as the company scales and invests across functions, we believe a better presentation is to have the cost aligned with the related use of the assets. In the fourth quarter, we made the decision to revise our methodology to allocate depreciation expenses, which are mostly facilities related across R&D, sales and marketing and G&A.

We also recast Q1 through Q3 accordingly. There is no impact to total operating expense, but you will see approximately 100 basis points of reduction in G&A and a corresponding total increase in sales and marketing and R&D to align to this new methodology. Non-GAAP operating income for the year was $292 million, resulting in a non-GAAP operating margin of 25%. Non-GAAP net income for the year was $282 million or $0.97 per share. Our non-GAAP EPS includes an effective cash tax rate of 4.5%. Below the 11% we guided, as we were able to take advantage of a couple one-time strategic cash tax planning opportunities in the quarter. As we’ve mentioned in the past, we believe in a balanced approach to operating the business, one that delivers strong and durable performance on both the top and bottom line.

This approach approves to be even more important as we navigate the rapidly evolving macro backdrop where the resiliency and predictability of our business model shines through. Turning to the balance sheet. As of March 31, we had $555 million of cash and zero debt. Our free cash flow was $115 million in the fourth quarter and $333 million for the full-year or 29% of revenue, exceeding the high-end of our guidance by $12 million. As a reminder, our full-year free cash flow was positively impacted by a one-time tax refund of approximately $35 million in the first quarter. Excluding the tax refund, normalized free cash flow would have been approximately 26%. The last financial measure that I would like to discuss is our remaining performance obligation RPO.

RPO was just under $2 billion at the end of the quarter, an increase of 28% over Q4 of last year. The current portion of RPO, which we expect to recognize as revenue over the four quarters was approximately $1.1 billion, an increase of 27% year-over-year. It is important to remember that seasonality associated with bookings and contract upselling will cause variability in the RPO growth rates. And as such, we believe ARR is the best metric to understand the health and durability of the business as it removes noise associated with the timing of billings. Now let me turn to guidance. We are confident in the long-term growth opportunity for Dynatrace. We believe the addressable market is large and growing, the observability ecosystem is expanding.

The demand environment remains healthy. Our product has proven to be highly differentiated and our financial model is balanced and durable. Near-term, we are mindful of the current macro uncertainty. And while we’ve seen signs of resiliency in the observability market, we believe it’s prudent to continue to factor the dynamic macro landscape into our guidance. Enterprises continue to be cautious in their spending and our approach to guidance assumes the tighter budget scrutiny and elongation of sales cycles we experienced in the back half of last fiscal year will persist through fiscal 2024. There are a few things to keep in mind with respect to our guidance. First, new logos and net retention rate continue to be the building blocks for future growth in the business.

We believe we have the right foundation in place to grow new logos in the low-single-digits and maintain a dollar-based net retention rate in the mid-teens for fiscal 2024. As I mentioned last quarter, we expect roughly one-third of net new ARR for the full-year to come from new logos and two-thirds is going to come from expansion. Second, with more than 40% of our business denominated in foreign currency, continued weakening of the U.S. dollar creates a modest tailwind on ARR and revenue. Based on foreign exchange rates as of April 30, 2023, we expect the FX tailwind to ARR and revenue to be roughly $10 million and $13 million respectively for fiscal 2024. And with respect to Q1, we anticipate the tailwind to be roughly $7 million to ARR and an immaterial impact on revenue.

Third, as we mentioned in the past, the headwind associated with the wind down of perpetual license is now less than 100 basis point impact. To simplify our ARR reporting moving forward, we will no longer be referring to adjusted ARR growth in our prepared remarks. ARR guidance will be provided on an as reported dollar basis and growth rates will be in constant currency. For comparison purposes, we will continue to provide the perpetual headwind detail in our quarterly presentation and in the financial data trends file available on our website. And the final point I’d like to highlight relates to expected increases in cash income taxes and the impact on our fiscal 2024 free cash flow. Given the increasing strength of our profitability, we have fully utilized our NOLs and tax credit carry forwards and we will be a full cash taxpayer.

As such, we expect a significant increase in our effective cash tax rate and related cash taxes in fiscal 2024. And with that as an opener, let’s start with our guidance for the full-year with growth rates in constant currency. We expect ARR to be between $1.475 billion and $1.490 billion, representing an ARR growth of 18% to 19%. And as I mentioned earlier, this growth rate no longer excludes the headwind associated with perpetual license wind down. At the high-end of guidance, this assumes net new ARR $243 million on an as reported basis. And while we don’t guide to ARR on a quarterly basis, we did want to provide you with some color in terms of how we expect net new ARR to come in throughout the year. As I mentioned earlier, we had an exceptional close to Q4 of fiscal 2023, which included roughly $13 million of expansions from early renewals expected in the first quarter.

As such, the seasonality of net new ARR will be a bit more back-end loaded this year, compared to prior years with roughly 35% landing in the first-half of fiscal 2024 and 65% in the back half. Turning now to revenue, we expect total revenue for the full-year to be $1.388 billion to $1.406 billion, up 19% to 20% year-over-year. Underlying that, subscription revenue is expected to be $1.311 billion and $1.327 billion, up 20% to 21% year-over-year. We expect non-GAAP operating income to be between $348 million and $358 million, resulting in a non-GAAP operating margin of 25% to 25.5% for the year. At the high-end, this represents a 25 basis point margin improvement over fiscal ‘23. We expect non-GAAP EPS of $0.98 to $1.02 per share based on roughly 300 million to 301 million shares outstanding.

Our non-GAAP net income and non-GAAP EPS calculations assume a non-GAAP effective cash tax rate of 19%, due to the notable uptick in cash taxes that I mentioned earlier. We expect free cash flow to be between $303 million to $312 million or approximately 22% of revenue. This is roughly 400 basis points below our normalized fiscal 2023 levels exclusively, driven by the projected increase in our tax rate from 4.5% to 19% in fiscal 2024. The anticipated free cash flow impact from the tax rate increase is approximately $60 million. Free tax free cash flow is expected to grow during fiscal 2024. As a reminder, due to seasonality and variability in billings, we expect higher free cash flow in the first and fourth quarters and significantly lower free cash flow in the second and third quarters.

Looking now at Q1, we expect total revenue to be between $325 million and $328 million or 22% to 23% growth. Subscription revenue is expected to be between $306 million and $309 million, up 23% to 24% year-over-year. From a profit standpoint, non-GAAP operating income is expected to be between $76.5 million and $78.5 million or 23.5% to 24% of revenue. From a seasonality perspective, we tend to see a dip in Q1 and Q4 operating margins, due to our annual sales kick off payroll tax resets, and our perform customer conference. Lastly, non-GAAP EPS is expected to be approximately $0.22 per share. Based on a share count of approximately 296 million to 297 million shares. In summary, we are very pleased with our fourth quarter and fiscal 2023 performance.

We have a strong track record of consistent execution. And as we have continued to demonstrate, we are committed to maintaining a disciplined and balanced approach to optimizing costs and improving efficiency and profitability, while continuing to invest in future growth opportunities that we expect will drive long-term value. And with that, we will open the line for questions. Operator?

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Operator: Thank you. We’ll now be conducting a question-and-answer session. [Operator Instructions] Our first question today is coming from Mike Cikos from Needham & Company. Your line is now live.

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Operator: Thank you. That does conclude today’s teleconference and webcast. You may disconnect your line at this time, and have a wonderful day. We thank you for your participation today.