Small, high-growth, and profitable software stocks that also don't break the bank are hard to come by. Little-known cloud infrastructure software outfit Dynatrace (DT 0.36%) is a rarity in this department, and its technology is best-in-class. Amid worsening economic conditions, the company topped expectations once again in its latest quarter and is strengthening its balance sheet. Here's why I'm still buying.

A top-ranked company for application performance monitoring

Let's begin the discussion of Dynatrace by acknowledging its spot in tech researcher Gartner's Magic Quadrant for Application Performance Monitoring (APM) and Observability. This critical software for computing infrastructure performance is growing fast right now as large organizations migrate their IT operations to the cloud. Dynatrace was once again named a leader in APM and observability by Gartner, ranking about even alongside better-known stock Datadog. Both were ranked far ahead of peers like New Relic, Splunk, and Elastic in APM software capabilities.  

Unlike other companies in this niche of cloud infrastructure, though, Dynatrace stays focused on designing tools for the world's largest organizations. Many of these complex businesses use their own in-house-developed IT observation software, so Dynatrace's biggest challenge in recent years has been hiring enough people to market itself. Sell-through support from cloud hyperscalers like Amazon AWS and the like has been on the rise of late and it's aiding marketing and distribution efforts, but Dynatrace has overall been a slow and steady grower for years. The first quarter of fiscal 2023 (the three months ended in June) was no exception.  

CEO Rick McConnell said 135 new customers were added last quarter. Among existing customers, the net expansion rate was over 120% for the 17th quarter in a row, implying customers are spending more with Dynatrace every year as their reliance on the cloud grows. The result was a knockout quarter with fast and steady growth and an improving balance sheet.  

Metric

Q1 Fiscal 2023

Q1 Fiscal 2022

Change

Revenue

$267 million

$210 million

27%

Adjusted earnings per share

$0.18

$0.16

13%

Free cash flow

$136 million

$80.5 million

69%

Cash and equivalents

$571 million

$463 million

23%

Long-term debt

$244 million

$274 million

(11%)

Data source: Dynatrace.  

Is this cloud stock a buy?

Of course, not everything is perfect right now. Like everyone else, Dynatrace is feeling the impact of slowing global economic growth this year. It's also getting hit by the U.S. dollar's historic run compared to most other foreign currencies (which lowers the value of international revenue when Dynatrace converts currency back into dollars for reporting in the States). 

As a result, the company slightly lowered guidance for the current fiscal year. Annualized recurring revenue (ARR) is now expected to be about $1.21 billion to $1.23 billion (previously $1.25 billion to $1.27 billion), and free cash flow profit margin guidance was lowered to between 27.5% and 28.5% (previously 29% to 30%).  

Nevertheless, the company is still on track to continue growing its free cash flow per share at a very healthy rate. And given the rising balance of cash net of debt, valuation is also improving. Shares currently trade for 40 times enterprise value to trailing-12-month free cash flow. Expect plenty of volatility ahead given the high price tag, but I continue to add to my current position in small batches on a quarterly basis.

Dynatrace's best-in-class software toolkit is translating into steady and highly profitable expansion. The stock still has a premium price tag, but it's a solid buy for the long term as cloud computing continues its advance as an integral part of the global economy.