With the U.S. Federal Reserve aggressively hiking interest rates to cool inflation, it's looking increasingly likely the global economy could be headed for some sort of recession in 2023. Businesses around the world are tapping the brakes on new spending and looking to cut costs in preparation.
In light of this, cloud-computing infrastructure software company Dynatrace (DT 2.00%) lowered its forecast for growth for the rest of 2022 and into early 2023. However, the company simultaneously raised its outlook for profitability. In this market environment hyperfocused on valuation, this was a fantastic quarterly report for Dynatrace. If you're looking for a small cloud stock with the ability to effectively balance growth with real profitability, Dynatrace could be the investment for you.
A great quarter, but a darkening outlook
First, the numbers from Dynatrace's second-quarter fiscal 2023 (the three months ending Sept. 30, 2022): Revenue increased 23% year over year to $279 million as the company added 164 new customers. Dollar-based net expansion grew more than 120% from a year ago, implying existing customers spent an average of at least 20% more with Dynatrace than in 2021. In total, annualized recurring revenue (ARR) grew 23% to $1.065 billion.
But not all was perfect. Though outside of Dynatrace's control, the record run-up in the U.S. dollar (a nasty side effect of the Fed's record-setting interest rate hikes) dragged down results. Both revenue and ARR would have been up 30% year over year (versus the reported 23%) when excluding the effect of currency exchange rates. A strengthening dollar lowers the value of international revenue, so with over 40% of business coming from overseas (especially Europe), Dynatrace took the dollar's punch right on the chin.
Moreover, Dynatrace downgraded its outlook for the rest of fiscal 2023 (the year-long period that will end in March 2023) as well. CEO Rick McConnell and his management team now expect total revenue to grow 20% to 21% (down from 21% to 22% before) thanks to the strong dollar. Backing out expected effects of currency exchange rates, the growth forecast would otherwise be 27%. In addition to the dollar's tyrannical reign, tough economic conditions in Europe are also lengthening the time it takes for Dynatrace to close deals with customers.
Growth is slowing, but profitability is...expanding?
Negativity aside, something really interesting is happening at Dynatrace: The profit outlook for fiscal 2023 was increased simultaneously with the revenue growth cut. How?
Note that a bunch of growing cloud software companies have for years promised they could aggressively cut costs and turn a profit when they need to. Now would be that time. However, many of these companies have either proved incapable of doing so or have been taking their time about it despite signs of worsening economic conditions. Not Dynatrace.
The company is already profitable on all fronts (earnings, adjusted earnings, free cash flow). And though the company only provides an outlook for adjusted earnings and free cash flow (which exclude stock-based compensation -- more on that in a moment), the expectations are nonetheless impressive. McConnell and his corporate team now expect the adjusted operating margin to be 24.5% in fiscal 2023, up from the previous guide for 22.5% to 23%. The free-cash-flow profit margin outlook remained unchanged and is expected to be in a range of 27.5% to 28.5%.
Managing operating expenses and ratcheting down its spend on investments, research and development have been the key here. Of course, one could argue that cutting costs right now could affect a tech company's ability to grow in the future. Nevertheless, with its customer base in Europe in particular reeling from an energy crisis and war in Ukraine, Dynatrace's prudence seems appropriate. Besides, the company just released its disruptive new cloud-infrastructure tool Grail.
Innovation is still going strong here, teeing up plenty of growth in the coming years. There will be opportunity for Dynatrace to ratchet up its pace of investments later on (perhaps next year) once some of the storm clouds dissipate.
The company also slightly reduced its outlook for total shares outstanding on the year to 292 million to 293 million (up to 294 million before). That compares to total diluted shares outstanding of nearly 291 million at the end of September. Stock-based compensation to employees, which dilutes shareholders' ownership, is still occurring at Dynatrace. But it certainly isn't an out-of-control problem like it is at many other cloud businesses (my primary beef with Dynatrace peer Datadog (DDOG 4.18%), an otherwise impressive leader in the same corner of the cloud industry). Dynatrace is using stock-based comp the right way, rewarding employees without torching its other stakeholders.
Oh, and one other point: Dynatrace used more of its free cash flow last quarter to pay off another $60 million in debt. It ended September with over $563 million in cash and equivalents (compared to $463 million at the start of this fiscal year) and debt of $215 million ($274 million at the start of the fiscal year). With interest rates going up, offloading debt is a fantastic use of cash. Bravo, Dynatrace, for bolstering your balance sheet in preparation for tougher times ahead. Business models matter, and this cloud company is proving it has a highly effective one.
As of this writing, Dynatrace now trades for about 30 times expected free cash flow. I remain a buyer of this cloud stock after the imperfect, but nevertheless impressive, quarterly earnings update.
