The cloud monitoring specialist Dynatrace (DT -1.88%) posted better-than-expected fiscal third-quarter earnings results. Yet investors should remain prudent. The company's elevated valuation, with a stock price at its all-time highs, suggests the market expects flawless execution over the long term amid intensifying competition -- a risky proposition. 

Solid performance

Over the last several years, Dynatrace has expanded its core application monitoring capabilities to build an integrated and automated platform that leverages artificial intelligence to deliver infrastructure monitoring, business intelligence, application security, and more.

With solid execution and tailwinds from the secular growth of cloud computing, the company sustained strong revenue growth and increasing profitability. During its fiscal third quarter, which ended on Dec. 31, revenue grew 28% year over year (25% at constant currency) to $182.9 million, compared to 25% in the prior-year quarter.

Person reading charts and graphs on head up display interface screen

Image source: Getty Images.

In particular, the net expansion rate exceeded 120% (for the 11th quarter in a row), which indicates that existing customers spent at least 20% more than last year, as the company upsold solutions beyond its core application monitoring capabilities. As an illustration, CEO John Van Siclen highlighted during the earnings call that more than 33% of customers used at least three modules, up from 24% one year ago. 

In addition, in contrast with many high-growth cloud players, Dynatrace is already profitable on a generally accepted accounting principles (GAAP) basis. During the last quarter, GAAP net income increased to $23.2 million, up from $1.8 million in the prior-year quarter.

And with scale and operating leverage, profits should keep growing. Management anticipates full-year non-GAAP (adjusted) operating income to land in the range of $202 million to $204 million, up from $130 million one year ago.

The company's strategy explains such an enviable bottom line for a growing cloud vendor. Indeed, by focusing on large enterprises, Dynatrace minimizes its sales and marketing expenses, which represented 35.4% of revenue during the last quarter, compared to more than 50% for several competitors such as Splunk, New Relic, and Sumo Logic.

DT Sales and Marketing Expense (% of Quarterly Revenues) Chart

DT Sales and Marketing Expense (% of Quarterly Revenues) data by YCharts

High expectations amid increasing competition

Following such strong performance, Dynatrace's stock price more than doubled since its March lows to all-time highs, at 21 times the midpoint of management's forecast full-year revenue. That suggests the market expects nothing less than phenomenal execution to continue over the next several years. 

Granted, the company addresses large markets that will expand from $50 billion to $68 billion over time, according to management, which leaves plenty of room for growth. But those expanding markets have attracted many competitors.

Indeed, several monitoring specialists adopted the same strategy as Dynatrace: They have been expanding their core products to develop integrated platforms that cover many aspects of the monitoring, analytics, and security areas. 

For instance, the legacy application monitoring specialist New Relic released its New Relic One platform last year to propose an integrated observability solution that includes network monitoring, logging (records of device-generated events), and more. The high-growth cloud-native vendor Datadog has been enhancing its monitoring offerings at a rapid pace to become an observability platform, too, with extra cybersecurity capabilities. 

In addition, some legacy tech giants have been ramping up their efforts in that area. For instance, last week Cisco Systems announced new cybersecurity features for its application monitoring solution AppDynamics. And in October, Oracle revealed its new cloud observability and management platform. 

That intensifying competition doesn't mean Dynatrace won't thrive. But the company will have to sustain high research and development and sales and marketing expenses to keep innovating and remain competitive.

Thus, Dynatrace's elevated stock price doesn't leave much margin of safety should the company deliver less-than-impressive performance in an increasingly challenging environment. So investors looking for exposure to the tech sector should stay on the sidelines and consider other attractive opportunities instead.