The bear market of 2022 has been brutal to software stocks, and some of them are rightfully being punished. Fast growth is good, but profitability matters. And many upstart cloud software companies have been found to be deficient in this department.
That's not the case for Dynatrace (DT 1.06%). The company is dedicated to growing profitably, and the financial results show it. Nevertheless, headed into the fourth quarter of 2022, shares sold off some 45% this year as the stock gets hammered along with the rest of the tech market. Here's why Dynatrace is starting to look like a good deal.
Dynatrace is expanding where it counts most
One reason the market is being clobbered relates to fears of a recession. As economic downturn risk increases, many organizations tighten up their budgets. But the top brass at many cloud companies say they're still growing because "digital transformation" remains a top priority. That makes sense, as investing in digital processes helps a business get more efficient and saves resources in the long run.
That's the story Dynatrace's top team preached this year as well. As giant corporations (Dynatrace's focus) migrate more of their operations to the cloud, they need a new set of tools to ensure these new IT capabilities and cloud-based apps operate properly. That's where cloud observability comes in.
Dynatrace's platform covers everything from application performance monitoring to security to tech infrastructure monitoring. And unlike a lot of legacy software, this toolset doesn't just inform an IT department if something is amiss. It also suggests and helps automate a fix. Data volume and complexity are booming as cloud adoption ramps up, so this kind of automation is mission critical for mega-corporations.
But what if cloud industry growth slows down? At a recent tech conference, CEO Rick McConnell pointed out that the cloud hyper scalers Amazon AWS, Microsoft Azure, and Alphabet's Google Cloud collectively hauled in about $160 billion in revenue in Q2 2022, growing at a 36% year-over-year pace. Even if that rate of increase slows a bit, the cloud universe is doing just fine.
And since Dynatrace generally follows the route of cloud industry expansion, it's doing just fine as well. Its revenue increased 34% year-over-year in its last quarter, even as many of its big customers started reducing spending as recession worries mounted.
Steady growth, great margins, and an improving balance sheet
For its 2023 fiscal year (the 12-month period that will end in March 2023), Dynatrace expects revenue to be up at least 21% (or up at least 26% when excluding foreign currency exchange rates) to about $1.13 billion. Along the way, free cash flow profit margin should be about 28%, a very healthy rate for a growth company.
Granted, this is a slowdown from the recent past. Economic uncertainty and the U.S. dollar's historic run-up are weighing on revenue and profits. McConnell and company also decided earlier this year to invest a little of the company's cash into expanding its salesforce. Over the next year or two, management sees those free cash flow margins edging back up toward 30% as that investment is digested.
And thanks to its steady generation of fresh cash, Dynatrace's balance sheet has also rapidly improved since its IPO in 2019. Once saddled with liabilities, this company is now cash- and short-term-investment positive net of debt.
Data by YCharts.
This debt payoff hasn't hindered Dynatrace's development of more tools, though. McConnell has said the infrastructure monitoring module is pulling in about $100 million a year in sales now, but growing at a much faster rate than revenue overall. The more recently released app security module is well on its way to reaching $100 million in annualized revenue. And a new tool that has been in the works for a few years now, data log management (Splunk's primary software capability), is almost ready to be unveiled. Based on Dynatrace's conversations with customers, log management is expected to also very quickly ramp up to $100 million a year in sales.
After getting dragged down by the market overall, Dynatrace stock now trades for 32 times enterprise value to free cash flow. It's a rare software company that is reporting fast growth and robust free cash flow generation. I think it could be time to nibble here if you are looking for quality cloud computing stocks to hold for the next few years.
