2022 was a long and painful year for the cloud software industry. The bear market brought valuations down in dramatic fashion as early pandemic euphoria over the strength of the digital economy burned off.
Many investors are still worried about 2023, though. A recession is possible, and although the cloud market is still in high-growth mode, customers are taking longer to sign new deals as they look for ways to cut costs. But it's not all doom and gloom, and some cloud stocks are actually faring far better than what was feared. Dynatrace (DT -0.11%) is one of those companies.
Dynatrace starts 2023 off on the right foot
I love it when companies consistently under promise and over deliver. That's exactly what Dynatrace just did. In its third quarter of fiscal 2023 (for Dynatrace, the three months ended December 2022), it handily beat its own guidance provided a few months ago. Annualized recurring revenue (ARR, an important metric for software subscription companies) was $1.16 billion, up 25% year over year. When backing out the effects of currency exchange (a result of a strong U.S. dollar, which has been wiping out growth for all sorts of multinational companies), ARR was up 28% year over year.
CEO Rick McConnell and the top team had forecast fiscal 2023 ARR to be as much as 18% before, or up as much as 24%, excluding currency exchange headwinds. With Q3 a knockout success, full-year guidance was due for a sizable upward revision. 2023 ARR growth is now expected to be up at least 22%, or up 25%, excluding currency exchange.
Not just growth, but profitable growth
Even better than Dynatrace's top-line performance was its profitable growth. Unlike a lot of other hypergrowth cloud companies, Dynatrace has been focused on balancing expansion with profitability -- long before the bear market of 2022 forced many of its peers to follow suit. No matter how you slice it, Dynatrace is profitable. Net income was $15 million last quarter, or $73 million on an adjusted basis (the discrepancy coming from non-cash employee stock-based compensation and amortization of intangible assets). Meanwhile, free cash flow was $58 million in the last quarter.
For the full fiscal year 2023, Dynatrace now expects free cash flow to be in the range of $315 million to $321 million, which is a healthy free cash flow profit margin of 28% at the high end of guidance. Shares trade for just shy of 43 times the expected free cash flow for the current fiscal year.
The AI explosion is good news for this cloud business
Thanks to ChatGPT and Microsoft's investment in the artificial intelligence (AI) tool's parent company OpenAI, AI is all the rage again right now. Beyond the buzzy news, though, AI has been becoming a top priority for large organizations for the better part of a year now.
With multicloud IT infrastructure creating an explosion in data, organizations are looking for ways to more efficiently manage all of this next-gen technology. That plays into the hands of Dynatrace, which provides a growing toolbox for large enterprises to monitor and automatically fix issues (basically, a type of AI) with their IT infrastructure. Layering in new AI software like ChatGPT serves to illustrate how big and complicated these cloud environments are going to get -- and how important it will be for public cloud providers like Microsoft and peers Amazon AWS and Alphabet's Google Cloud to make those services simple and efficient to use.
McConnell explained on the last earnings call:
[T]he hyperscalers, AWS, Google Cloud, and Microsoft, have started to speak more broadly about an increased focus from customers on cloud optimization as an element of their digital transformation initiatives. This is a trend that directly benefits Dynatrace. Cloud optimization is about ensuring that cloud deployments deliver a compelling ... [return on investment]. It's about effectively managing the exploding number of cloud workloads to ensure high availability and resource efficiency.
Basically, if you're bullish on AI, Dynatrace's cloud observability platform geared toward mega-organizations is worth a look.
Of course, 2023 could still be a rough year, especially if a recession strikes and customers continue to slow their spending on new projects. However, Dynatrace seems to be bucking the trend and increasing its confidence that it can continue growing. Shares aren't cheap, but they're that way for a reason. This company is highly profitable, has a stellar balance sheet ($422 million in cash, and, as of this last quarter, no debt), and is steadily expanding in this AI era. I remain a buyer for the long term.
