Why I Just Purchased Shares of AI Cloud Observability Company Dynatrace

The COVID-19 pandemic is creating rapid change among organizations around the globe. Technology projects to update operations -- especially in cloud computing -- can no longer be delayed, but rather are critical to the long-term health of many businesses.

As a result, cloud observability software outfit Dynatrace (DT -0.30%) says its total addressable market has surged in the last 18 months from $20 billion a year to $32 billion a year. I was intrigued, and after catching up with CEO John Van Siclen to learn more about the company, I decided to start a position.  

Cloud computing ushers in a new digital era

I've been a happy Splunk (SPLK) shareholder for years. The longtime leader in digital data parsing and analytics has had a bumpy ride as of late as it makes its transition to a cloud-first operation, but it's clearly pulling off its transformation and benefiting from a growing market as demand for its software continues to rise.

Image source: Getty Images.

Nevertheless, Splunk's core competencies (as well as those of peer New Relic (NEWR) and others) spring from an era that pre-dates the cloud, and the door has been left open for upstarts like Datadog (DDOG -1.43%) and Elastic (ESTC 1.04%) to make some headway in this high-growth industry. 

Enter Dynatrace, which had its IPO over the summer of 2019 and has seen its stock price rise about 50% since then. What separates Dynatrace from the rest of the pack?

For one, it got an early start reshuffling its business to focus on automated cloud observability after being acquired (as part of Compuware) by private equity firm Thoma Bravo in 2014. Its system enables automated orchestration of applications across an organization's operations; runs real-time AI analytics across the data and predicts failures or underperformance; and provides actionable insights to help customers remediate problems with their workflows. This is a proficiency Splunk has recognized too with its recent "Observability Suite" announcement. 

Van Siclen thinks Dynatrace's purpose-built platform for the massive and complex scale of modern cloud-based operations sets it apart from its competitors. During the company's last earnings call, he highlighted how organizations have moved beyond the need to simply gather up data from various software tools into a user interface, but rather are in need of a more complex "observability" platform that can also automate remediation when an app isn't performing as intended.

When reorganizing itself prior to going public, this future need was the company's vision. It's paying off as IT departments around the globe are strapped for time and resources and are realizing the various tools they've cobbled together in-house (or the legacy software suites they've been relying on in the past) aren't getting the job done anymore.  

A quick look at the numbers

The new Dynatrace derives nearly all of its income from recurring subscription revenue, so no cloud transformation needed here. And even though many of its customers (Dynatrace targets the world's largest 15,000 global enterprises, versus peer Datadog which has carved out a niche among mostly small- and mid-sized companies) have been deeply affected by the pandemic, it is making good headway. Total annual recurring revenue (ARR) grew 35% during the last quarter to $638 million, and the dollar-based net expansion rate was over 120% for the 10th quarter in a row during the company's fiscal second quarter (implying existing customers spent over 20% more with Dynatrace than a year ago).

Pp = percentage point. Data source: Dynatrace.  

A new market landscape 

Also of note is that Dynatrace is profitable by all metrics. It's certainly refreshing to find a software firm that is able to balance rapid growth and positive bottom-line return. However, it should be pointed out that Dynatrace's biggest challenge right now is hiring enough sales force to go after its large and growing market. Van Siclen told me they've been in touch with about only half of its targeted potential customers, but has a more than 70% deal win rate with those enterprises they do initiate a conversation with. That explains the stated goal to grow the sales team by 20% to 25% this year.  

But with a myriad of names competing in the space, it may appear the data analytics software industry is a crowded one. But Van Siclen points out that combining the revenue from all its peers still represents a small percentage of the tens of billions being spent each year on data analytics and log management software -- and spending is increasing by some 30% at the moment. This is a large and growing pie, and there's plenty of room for multiple players.

Data by YCharts.

For now, it's all about carving up the available market share, but my attention is on the future of this industry when these various firms start to rub shoulders more frequently. What will it look like? According to Van Siclen, a "full-closed loop" of cloud observability that also senses real-time changes in operations. The cloud is huge, it can't be fully mapped out. But AI is essential to keep it running smoothly. Van Siclen told me:

The world will wake up in a year to two years and realize that observability data gathering is a commodity. It's all about the analytics. And the talk track will start to change from observability to understandability, predictability, actionability.

If that's the way the digital economy is headed -- and I think it is -- Dynatrace could be ahead of the curve and poised to benefit with its fully unified platform enhanced with real-time automation. And at 16 times trailing 12-month sales and generating ample bottom-line return to fund its growth, shares look reasonably priced given the opportunity. I therefore am adding Dynatrace to my cloud software portfolio.