Dynatrace Q3 earnings: Stock sales unfair; Buy Now (NYSE: DT)

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Investment thesis

The day Dynatrace (NYSE: DT) announced its Q3 earnings figures, shares tumbled 18%. I think the market has overreacted to the slight delay in ARR and overlooked the promising medium-term growth prospects. In my opinion, the sale is absolutely unfair and offers a good buying opportunity at current levels. I will provide five good reasons why I see it that way.

1 – Unusually strong FX headwind, increasing perpetual license deposits

After considering FX effects and perpetual license deductions, we can see a significantly better ARR growth profile for Dynatrace. At first glance, if we look at the reported JoJ ARR growth rates, we can see a significant slowdown in Q3 22. For several quarters we were able to observe 35-37% YoY growth which recently slowed to 29%:

Dynatrace Custom ARR

Dynatrace Custom ARR (Dynatrace Q3 Earnings Presentation)

After considering currency effects, we get a completely different picture. In Q3 22, the dollar was significantly stronger year-on-year compared to most foreign currencies. This resulted in an exceptionally large FX headwind, which reduced the total ARR by more than 2%. If we look at constant currency growth rates, we can see that there was no significant slowdown in ARR growth in Q3 22. However, it is true that the small ARR growth acceleration from 32% to 34% seen in Q2 22 came to an end after the company again pushed constant currency growth of 32% JoJ in Q3 22.

If we exclude ongoing license deposits, the revenue growth trend remains the same, but we can see higher ARR growth rates in absolute terms of around 36-38%. Perpetual licenses have remained on the balance sheet of previous, optionally renewable contracts and will expire soon. Based on the company’s Q3 earnings offering on December 31, 2021, only $ 21 million perpetual ARR license remained outstanding. That’s just a little over 2% of the total ARR for the third quarter, so the decline in these perpetual license deductions will soon be negligible.

2 – Harder comparisons

The two quarters after the initial outbreak of the pandemic were marked by somewhat lower revenue growth rates at many SaaS companies. Dynatrace was no exception to this, which can be seen on a very useful slide in the company’s earnings offering that they shared with investors for the first time:

Dynatrace New ARR Growth

New ARR Growth (Dynatrace Q3 Earnings Presentation)

Q1 and Q2 in FY 2021 are those two quarters most affected by the pandemic. We can see that the quarterly new ARR grew by only $ 30 and $ 28 million respectively in these two quarters. It was a fairly significant decline on an annual basis at that time. It was “easy” to grow quarterly new ARR by 63% in Q1 22 and by 92% in Q2 22. Now comparisons for quarterly new ARR in Q3 years have become significantly more difficult again. Although even under these circumstances the company was able to grow the figure by 22% on an annual basis, constant growth in currency ARV (excluding perpetual license deposits) decreased to 36% from 38% in the previous quarter. In light of this changing composition, I think that this small delay in ARR is not enough to draw far-reaching conclusions about revenue trends.

3 – Strong RPO growth

If we look at the trend in remaining performance commitments, we can see that the way has been paved for continued 30% + JoJ ARR growth. Due to the exceptionally strong FX headwind, the company shared the constant currency YoY RPO growth rate for Q3 22 in its earnings call, which was 37%. Based on this number, I calculated the constant currency RPO figure for Q3 22 of $ 1.439 billion, which I then compared with the reported figures of previous quarters. In these quarters, FX tailwinds were typical, so the Q3 22 RPO figure presented below is still a conservative estimate:

Dynatrace Remaining Performance Commitments

Remaining performance obligations (image created by author based on data from company 10-Q filings)

We can see on the chart that RPO, after stagnating for the previous three quarters, has grown significantly again in Q3 22. Although some of this is due to typical seasonality, it is important to see that the YoY growth rate of 37% in the quarter is significantly above the 31% growth rate seen in Q3 21 the year before. It is also higher than the 36% JoJ adjusted ARR growth rate for the most recent quarter. These trends show that ARR growth momentum should remain strong in the coming quarters as the RPO / ARR ratio of Dynatrace is quite high, which means better short-term visibility.

4 – Increased investments in growth

Based on the Q3 earnings call, Dynatrace sees upward opportunity for growth in the market and has a clear intention to accelerate its ARR growth rate in medium term. For this reason, they plan to increase investments in Sales and Marketing and in R&D by an additional 2-3 percentage points of revenue in FY 2023. Dynatrace has already increased its sales organization’s direct quota capacity in FY 21 by 25% on an annual basis, which they plans to increase to 30% in FY 22. It takes about 4-5 quarters for sales reps to become productive, so it may take a few quarters until these additional investments pay off.

At the top of additional investments, Dynatrace plans to make changes to its go-to-market strategy. Based on the earnings call, they want to put more emphasis on the bottom-up sales approach, which means targeting software developers rather than company executives. As Datadog (NASDAQ: DDOG) has already made a huge success in this way, I am optimistic about this strategic shift.

5 – Rule of 60 company for a surprisingly cheap price

With 27% TTM leverage-free cash flow margin and 32% year-on-year constant currency ARR growth rate, Dynatrace is almost a Rule of 60 company and he intends to keep doing so. It is surprising to me that stocks despite this fact only trade at 11.7 times FY 2023 average analyst income estimates.

I think the situation is very similar to that of Smartsheet (NYSE: SMAR), where investors can also buy the shares of a market-leading SaaS company at a big discount, as I described in my previous SA article. Both Dynatrace and Smartsheet mainly serve the larger business segment and have lower revenue growth rates than some of their higher flying counterparts, such as Datadog or Asana (NYSE: ASAN). But even after adjusting for these growth differences, the market seems to be too conservative on the bigger, enterprise-heavy names (I have already covered this topic for Dynatrace and Datadog here). As a result, I think these stocks are now very good investment opportunities, as the market will sooner or later realize that they are worth much more than current valuations would suggest.

Closure

Q3 earnings did not alter Dynatrace’s excellent growth prospects in the observability space. The share price nevertheless fell sharply after earnings due to concerns about slowing ARR growth. After adjusting for one-off effects, ARR growth retardation becomes minimal, even with significantly more difficult year-on-year comparisons. Furthermore, increased investment in sales and strong growth ambitions could lead to ARR growth accelerating again in the coming quarters. In light of this, I think there is currently a huge sale in Dynatrace shares, which will not last long. It is better to take advantage of this opportunity sooner rather than later.



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