Dynatrace Stock: 5 Reasons Why Tumble After Earnings Is Unjustified

Feb. 06, 2022 7:46 AM ETDynatrace, Inc. (DT)7 Comments7 Likes

Summary

  • Dynatrace stock sold off sharply after Q3 earnings on concerns of slowing ARR growth.
  • In my opinion the market overreacted to short term swings in fundamentals and ignored positive medium term developments.
  • This provides a good opportunity to exploit a short term disconnection between the share price and fundamentals, which I think won’t last long.

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Investment thesis

The day Dynatrace (NYSE:DT) released its Q3 earnings figures shares tumbled 18%. I think the market overreacted to the slight deceleration in ARR and overlooked the promising medium term growth prospects. According to my view the sell-off is absolutely unjustified and provides a good buying opportunity at current levels. I'll provide five good reasons why I see it this way.

1 - Unusually strong FX headwind, increasing perpetual license roll-offs

After taking FX effects and perpetual license rolloffs into consideration we can see a significantly better ARR growth profile for Dynatrace. For the first sight if we look at the reported YoY ARR growth rates we can see a significant slowdown in Q3 22. For several quarters we could have observed 35-37% YoY growth that slowed to 29% recently:

Dynatrace adjusted ARR

Dynatrace adjusted ARR (Dynatrace Q3 earnings presentation)

After taking currency effects into consideration we get an entirely different picture. In Q3 22 the dollar was significantly stronger YoY compared to most foreign currencies. This led to an unusually large FX headwind, decreasing 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 reacceleration from 32% to 34% seen in Q2 22 came to an end, after the company printed 32% YoY constant currency growth in Q3 22 again.

If we exclude perpetual license rolloffs the revenue growth trend stays the same, but we can see higher ARR growth rates in absolute terms of around 36-38%. Perpetual licenses remained on the balance sheet from previous, optionally renewable contracts and are set to expire soon. Based on the company's Q3 earnings presentation as of December 31, 2021 only $21 million perpetual ARR license remained outstanding. This is only little more than 2% of Q3 total ARR, so the drag from these perpetual license rolloffs will soon be negligible.

2 - Tougher comparisons

The two quarters following the initial outbreak of the pandemic have been characterized by somewhat lower revenue growth rates at many SaaS companies. Dynatrace was not an exception to this, which can be seen on a very helpful slide in the company's earnings presentation 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 have been those two quarters mostly impacted by the pandemic. We can see that quarterly new ARR grew only $30 and $28 million in these two quarters, respectively. This was a rather significant YoY decrease that time. It was "easy" to grow quarterly new ARR by 63% in Q1 22 and by 92% in Q2 22. Now in Q3 YoY comparisons for quarterly new ARR became significantly tougher again. Although the company could grow the figure by 22% YoY even under these circumstances, constant currency ARR growth (excluding perpetual license rolloffs) decreased to 36% from 38% in the previous quarter. In the light of these changing comps I think this small deceleration in ARR is not enough to draw far-reaching conclusions on revenue trends.

3 - Strong RPO growth

Looking at the trend in remaining performance obligations we can see that the way towards continued 30%+ YoY ARR growth is paved. Due to the unusually 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 have calculated the constant currency RPO figure for Q3 22 of $1.439 billion, which I then compared to the reported figures of the 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 Obligations

Remaining Performance Obligations (Image created by author based on data from company 10-Q filings)

We can see on the chart that after stagnating for the previous three quarters RPO grew again significantly in Q3 22. Although part of it 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's also above the 36% YoY adjusted ARR growth rate for the most recent quarter. These trends show that ARR growth momentum should stay strong in the upcoming quarters as the RPO/ARR ratio of Dynatrace is quite high, meaning better short-term visibility.

4 - Increased investments in growth

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

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

5 - Rule of 60 company for a surprisingly cheap price

With 27% TTM unlevered free cash flow margin and 32% YoY constant currency ARR growth rate Dynatrace is almost a Rule of 60 company and it intends to keep doing so. It is surprising to me that despite this fact shares trade only at 11.7 times FY 2023 average analyst revenue estimates.

I think the situation is very similar to that of Smartsheet (SMAR), where investors are also able to buy the shares of a market leading SaaS company with a huge discount, like I've described in my previous SA article. Both Dynatrace and Smartsheet are predominantly serving the larger enterprise segment, and have lower revenue growth rates than some of their higher flying peers, like Datadog or Asana (ASAN). But even after adjusting for these growth differences the market seems to be too conservative on the larger, enterprise heavy names (I've already covered this topic for Dynatrace and Datadog here). Because of this, I think these stocks are very good investment opportunities now, as the market will realize sooner or later that they are worth much more than current valuations would suggest.

Conclusion

Q3 earnings didn't alter the excellent growth prospects of Dynatrace in the observability space. Nonetheless, the share price fell sharply after earnings due to concerns of slowing ARR growth. After adjusting for one-time effects ARR growth slowdown becomes minimal, even with significantly tougher YoY comparisons. Furthermore increased investment in sales and strong growth ambitions could lead to reaccelerating ARR growth in the upcoming quarters again. In the light of these I think there is a huge sale in Dynatrace shares currently, which won't last long. It's better to take advantage of this opportunity rather sooner than later.

This article was written by

My guiding principle in writing: Quality over Quantity. My main goal is to add value with my analysis by focusing on relevant information.About me: I’m a Senior Manager of a Private Wealth segment at one of the leading banks in Eastern Europe. Before that, I’ve been an Equity Analyst for about four years. Writing about the stock market is still my passion. I tend to focus on disruptive companies with large long term upside potential, but I also like to balance my portfolio with some more mature companies enjoying a cyclical uptrend in fundamentals.I have an attention to detail, I especially like to cover topics which previous articles didn’t elaborate on. Feel free to share your opinion, constructive critique is more than welcome!
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Disclosure: I/we have a beneficial long position in the shares of DT either through stock ownership, options, or other derivatives. 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.

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