Dynatrace, Inc. (DT) Earnings Call Transcript

Okay. We are clouding around up here, but we're going to get serious now. It's Keith Bachman, good to see everybody. We're thrilled to have Dynatrace. Dynatrace is an important provider to Bank of Montreal. So we've standardized our observe Parity platform. And I think it's safe to conclude that Dynatrace would not be here if it weren't for that because they actually be here because I asked them otherwise. Okay. So I don't think we'd be here just to be. I don't think you guys need an induction and I'm sort of stalling because we've been -- I know personally, I was running around a little bit, so I think people are migrating in to see us. But let's go ahead and get started. With that said, we're going to start a little bit on market growth. And as I think about include Datadog and yourselves and what have you, as you think about the advances in AI, if you look at calendar year , and I've been trying to focus all my comments and questions on calendar year '27. How do you think it impacts market growth? The advances in AI on the observability in the markets you serve, how does it impact market growth in calendar year '27?

So let me start with that. Jim can add value. Thanks for joining us this afternoon, Much appreciated. The AI first, mechanism that's in the environment today is clearly driving an enormous tailwind for ability without a doubt. And it's doing so in a number of different ways. Number one, it just drives more data, more workloads, more complexity, more data, which results in more logs, more traces, more metrics, more capabilities, so greater consumption of the platform and that greater consumption of the platform results in higher levels of growth opportunity that we see and certainly higher levels of growth in the market space overall. The second area, though, is what I would think of as really an evolution of observability overall, which we believe is entering a brand-new era and it isn't just about resilience anymore, which is what observability has been about for the last years. It is expanding to not only include resilience, namely is your software working to also include AI absorbability, evaluations, LLM observability and other elements, which are more oriented to assessing whether or not the AI workloads are actually delivering accurate answers. And in this environment, it really is about AI reliability. So what used to be only resilience is now resilience, but also reliability. And both of these elements are, in our view, accelerating market growth look as we look at.

And what I'd offer, Keith, I think to provide maybe a financial lens to your point around like what do you think that's going to mean in calendar '27? I think what we're seeing now is you are seeing the tailwinds of that, as you know, we sell into large enterprises. So we're already seeing that we talked in our last earnings call about our cohort of customers that are leveraging us either for an LLM workload, leveraging up for some agenetic workflow. They're consuming their platform at a very rapid rate, actually customers that are not. I think in calendar '27, you're going to see that, that is going to uptick significantly. So I think consumption of the platform will continue to grow and likely accelerate.

Will that show up though? In other words, the console...

I think this is the $100,000, but you'll see consumption growth. And as you know, that the consumption growth and ARR growth, there's a lag. My expectation is we continue to see an acceleration in consumption growth, you will see a translation that ARR growth and consumption growth will converge. As you know, it's for us, there's a lot of mechanism for the timing of when that happens. But I do believe if we do see an uptick as a result of what Rick outlined, it should manifest itself in more consumption of the platform, more consumption on the platform. should yield more expansion activity.

And just to make sure that we're tracking on the numbers, we're in the 20s BCV consumption growth, but around 16% for ARR growth and so that really does become the opportunity for us to accelerate ARR growth toward consumption growth.

Right. Okay. We're going to get deeper into that for sure. But if you think about -- I want to back up a step, and we've had this same question/comment with a number of companies today. Investors are turning the page on calendar year '27. Part of the issue is budget constraints or budget opportunities. Candidly, it's mostly budget constraints. But in other words, there's more demand for dollars than there is availability for dollars. Do you have any early preview on what your sales reps are telling you about budgets in your area for '27?

I would say the conversations we've actually seen, Keith, relative to the sales organization is that I think you know that our #1 sales play, has been a sales play around customers considering consolidating fragmented tools. When you do that, to your budget point, you're basically taking fragmented tools and you're consolidating them on vendor, is an economic benefit. You're actually lowering your software costs. And so -- and then the premise is, you can consolidate so you get lower software costs. And then, oh, by the way, the belief is that you're going to be able to have your software environment run more efficiently. You're going to need less people chasing alerts. And so in a world where budgets are constrained, I actually believe that you're going to see more of that activity more consolidation. So more consolidation of activity because it's a place where you can find budget dollars. You're not incrementing budget dollars? Or you're just kind of share shifting dollars. You're actually with a lower spend -- this is -- and that's notwithstanding what other pressures that might exist or I don't want to spend more money on cyber. I want to spend more money on AI. I think in general, we're in actually a good place because of that trend. And then I think there's also things we're doing on for some new capabilities on the log side. Another thing, we can save customers money by going from the legacy large provider to Dynatrace and get a better outcome. And so I think we -- from a sales perspective, I think they're excited about that. And that's one of the reasons, let's face it. The sales can be coin-operated at times. That's the reason why that sales play has been extremely effective. That's why the log sales play has been extremely effective.

Mean the holy grail, if you will, these days, Keith, is to figure out how you can use observability to drive autonomous operations. And what autonomous operations really delivers is sort of self-healing, auto remediating software ecosystems. And if you can get there, the benefits are substantial. Not only are you going to get an environment that works dramatically better, but you're also going to be able to manage that with dramatically lower cost. And so as I talk to CSOs, around the planet, which is a privilege that we have at Dynatrace to be able to do, the feedback is all the same, which is how do I save people cost and consumption deliver better outcomes from better software or software that works better in my environment. And the way to do that is a tonnage cipration. What you need to be able to do that is you need the absorbability capabilities that are delivering deterministic inputs to give you the answers that then become actionable by agents. And this is the environment that's evolving.

Okay. Well, let's go to -- I think the #1 question I get on Dynatrace is about acceleration? And so my numbers are a little bit different than what you just described. But I think if we took out your M&A on both deals this year, you're about 15%, okay? And we take it out for the whole period until you anniversary but regardless of whether it's 15 or 16, what investors want to understand is how do you begin to drive acceleration. In an acceleration, there's 2 parts. There's your NR and new logos. So open pitch to -- it's dramatically different stock if you're accelerating versus neutral versus decelerating especially with your multiple where it is. So how are you going to potentially accelerate what needs -- what's the construct of that?

So let me start, and then Rick can kind of offer some others that I think to start, we laid the framework for this Keith 2 years ago when we made some pretty substantive go-to-market changes. And we talked about the journey of fiscal '25 being -- these changes would be modestly disruptive and you'd probably have a productivity loss relative to sales. And then we said fiscal '26 would be a period where you could stabilize. And then fiscal '27 would be a period you could accelerate. So our net new ARR growth in fiscal '25, was effectively low single digits. And we accelerated that this is not through acquisitions. We accelerated organically net new ARR growth to 12% in fiscal '26. If you look at our guide, you pull out the acquisitions. The guide at the midpoint suggests that we accelerate to the mid-teens. And so we are demonstrating acceleration. We need more acceleration because, obviously, the point is you can't grow ARR, which is growing 16%. If you don't have net new ARR growing more than 16%. So I admit we're on a net new ARR acceleration journey. The high end of our guidance suggests you're going to grow in the high teens. So you will see ARR acceleration with that. And the underpinnings are kind of what you talked about. One of the things we've done, I'd say particularly well when you look at the building blocks of new logos and expansions, we've done very well, I'd say, with our segmentation around selling large deals for new logos. And again, it goes back to this value proposition that we bring around end-to-end observability. That has been a very successful sales play. So I'd say it's whale hunting, it's stalled hunting and it's actually been successful and it's been purposeful. I think that's going to continue. And if anything, I think that will accelerate. Now obviously, the nature of that is you're not going to have transactions like that close every quarter. So you're going to have large transactions like we had in Q1 and then maybe you're going to have quarters like Q2 where you don't have as many of them. But I think it's going to be a significant source of growth. So call it, 1/3 of our net new ARR is going to come from new logos. And I'd say it's going to be a play on end-to-end observability. It's going to be a play on logs. It's going to be a play with a rise. And then I'd say on expansions, I think you know now, we're going through a very large renewal cohort here in the back half of the year. It is a significant opportunity for an expansion for customers that either aren't buying some of our offerings today, logs is probably the most notable one. Are they using logs? Are they using logs to a significant extent. Is that a source of significant expansion opportunity. And so I think those are the attributes that were not nearly penetrated with the product set with these customers in a fulsome way. And I think there's a significant opportunity for acceleration for the company just through execution -- this is not like we don't need new products. We don't -- this is selling what's on the truck today and executing and penetrating further with your customers, both expansions and new logos.

Okay. So if we look out over the horizon 12 to 18 months, can the NRR, which is call it 10, 10, somewhere in that neighborhood, can that go higher? Just on what's on the deck today?

Yes, I think it can. I think it can I mean, again, I think this is an execution story. This is not a, hey, what's feasible is the market demand there? Do you have the opportunity? I don't think that's the question. The question is, can you go execute against that?

We have a great market, very solid architecture, a great set of products. Gross retention is in the mid-90s, which is very, very strong. What we need to do is we need to be able to deliver those and that's really a core focus.

Okay. I want to come back -- we're going to stay on the theme of NRR for a second, but organic development. And we've had this conversation over the last number of years, where I look at the pace of new product intro by Dynatrace versus Datadog. And Datadog candidly, has been more effective about promoting incremental products. How do you guys think about your organic dev platform as you look out? I tend to think about it, you've gone very deep in logs, great product, rail, great product. but the proliferation from there into new solution sets to have more things that the sales force could sell is a little slower than Datadog. How do you think about the next couple of years?

I'll take that one. We have been innovating at an incredible rate actually. It isn't -- it just isn't as visible as some of our competitors because of DPS, because of our pricing mechanism. I don't think that's a negative of the pricing mechanism because at least in our customer base, especially Global 2000 and even Global 15,000, they want predictability. They want a single committed spend and they don't want to have to think about chunking it out into SKUs have to buy this much of a, this sponsor. They want to give us a commitment for $1 million or $5 million or whatever the number might be, and they want to be able to draw that down through various cement solutions that they're consuming. Logs is a great example of this as a new solution, relatively new solution for us. It was $100 million in consumption 3 quarters ago. It's rapidly approaching $250 million now, 3 quarters later. So when logs was growing north of 100% and it was $20 million in consumption against $2.2 billion in ARR didn't have that much impact. But logs is now approaching $250 million on over $2 billion ARR stream, all of a sudden has a lot more impact. So, bringing these new capabilities like database monitoring, network monitoring, new other capabilities that we're adding the feature flagging, these are innovations that are coming out of DynaTrace that we're delivering to market, but they are getting consumed through DPS.

Okay. Because I'm an analyst, I have to explore all range of scenarios, right? And so a year from now, when you guys are at the same conference, and Jim is lower -- meaningfully lower index or handicap on the Gulf Coast. It's something -- if you didn't reach an NRR of greater than 10%, what's sort of the highest risk that you would think about that could disrupt that natural flow that you see now. I won't be here, but I think I know you try to answer it. I understand your range of outcomes. And one, I don't think that's a probable outcome. So I'll start with that. I don't think that's a probable outcome. But you say what would have to happen? I'd have to say that your traction on expansions, customers were -- would be more tempered in the volume of their expansions that they'll do an expansion, but they're more tempered. You do a 3-year agreement with them and they say, "Well, I'm going to be more modest in my expansion. Maybe I'll consider doing expansion maybe midterm over the next 3 years. So it's like they don't top up to the level that you expect them to and they'll say, I'll get another bite at the apple on that. So could that happen? It could. I think there's enough tailwinds though, Keith, there's enough -- when I look at our segmentation and you say, we have 4,000 customers. We go after the Global 15,000. We're not nearly penetrated in the 4,000 we have. We have a lot more to go after. I don't believe we're -- this is like -- we're not constrained from a market opportunity perspective. I think there's a lot of tailwinds that are going to drive more AI workloads are going to increase more telemetry, more telemetry means more consumption and observability that all of that means more consumption of the platform, which should yield more expansions. I think to me, it's a question if you got to go execute against that. So it's not a given that you can go do that. I think we have the ingredients to be able to do that. So as I said from the outset, I do believe that the opportunity is there. I don't think it's a scenario that we're expecting, but that would probably have to play out for it to be maybe not accelerating beyond the levels you said.

Okay. And I know there were some questions on Q3, Q4 guidance. Maybe you want to step in at this juncture and talk a little bit about the sequential patterns in Q3, Q4. Yes. So One of the things that we provided some color on, just to make sure everyone is all on the same page is we certainly said, hey, Q2 was a little -- were very open, Q2 was a little bit lighter than we expected from the deals that slipped, not a demand-oriented issue, just kind of slipped deals. And I think everything else being equal, people were like, well, if that's the case, I would expect more net new ARR in Q3 and maybe less net new ARR in Q4 and one of the things I wanted to make sure that investors understood is that the large expansion activity that we expect in the back half of the year is weighted -- those renewals are weighted in the fourth quarter. So 70% of our annual renewals are going to happen in the back half. 65% of that back half happens in the fourth quarter, 35% in the third. So there is a -- you can't take the net new where they are and say, okay, well, I'll take 65% in the fourth quarter and 35% in the third. It won't work out like that. But we said we will be modestly more Q4 weighted than we've been seasonally. And so I think our normal seasonality is like 48-52. Now this is excluding, as you know, we're inheriting $25 million worth of ARR from Ari. So put that aside. And then you adjust for foreign exchange, because what I'm talking about is constant currency. And I think that's about $18 million or $19 million, which is going to affect Q3 primarily. You're talking about, okay, maybe it's more like a 50-50.

Yes. So basically, 70% maybe of the second half comes in Q4 65, 70.

May, we'll see. One of the things I'd say, Keith, the optionality for that is that -- some customers do expand early. So some of those Q4 expansions could happen in Q3. I'd say in the way we guided, we thought that we wanted -- we were, I would say, balanced about it. We said we don't want to assume a lot of that happens, but it could happen. So could there be a surprise to the upside in Q3, there could be.

Okay. Yes, I think I mentioned to you one of the biggest questions we get is ACDC acceleration versus deceleration but the second is, I think investors were a little disappointed in Q2, stock reflected that. Is a concern that, that big Q4 ramp, maybe you get some how do you know there aren't pushouts that similar to what happened in Q2 that show up in Q4?

I mean it is a bit of the nature of large enterprise selling that you're having deals that fall in a quarter earlier, fall outside of a quarter. I'd say probably what gives me confidence is, I had a very an analyst that covers us with a company that begins with a B and end the now and said, "Hey, Jim, you're setting yourself up for a long putt. This was a couple of years ago where I was talking about our net new ARR seasonality being more weighted to have to. And that comment that with me, I certainly remembered it, and we did deliver against it Keith and overachieve it, by the way just to -- but -- if you look at what we're --

As a result of that, that he's now return go back to the golf --

But if you look at what we were looking for, Keith, for net new ARR. This is not like I'm waited to have to any more than I've been. We historically have of your net new ARR happens in the first half, 52% happens in the second half. This is not like a -- like I have to do something incremental to what I've historically not aberration. It is -- and oh, by the way, what are the reasons to believe. I've not had periods where 70% of my annual renewals happen in half like this. And so there's a lot of reasons to believe that there is significant opportunity in the second half. And oh, by the way, I've not waited like I need more than that in the guidance that I provided.

So what you told me before to repeat here is you didn't leave a long put, you don't think for the second half?

I don't think we did kind of do not think we did.

Okay. All right. We're going to --