Dynatrace (NYSE:DT) was identified as a leader by Garner and Forrester for the use of artificial intelligence to observe IT performance. Many large players also noticed, which helped the company deliver double digit sales growth. In my view, with sufficient technological innovation, the company will most likely continue delivering positive free cash flow growth. Under my DCF models, Dynatrace offers more upside potential than downside risk.
Dynatrace offers a software intelligence platform for multi-cloud environments. With large partners in different industries, the company’s precise answers about the performance and security of client’s applications seem precious.
Gartner, Forrester, and other experts noted that the company is a leader in artificial intelligence for IT operations, cloud-native observability, and AI-powered observability.
Balance Sheet: Tons Of Cash And A Lot Of Goodwill
As of December 31, 2021, management reported $408 million in cash and $1.2 billion in total liabilities. So, in my view, management has cash in hand to finance more product development as well as business traction from recent M&A.
Dynatrace reports $303 million in long-term debt, which appears lower than the total amount of cash. With negative net debt, I wouldn’t expect financial advisors to be worried. Like other software companies, Dynatrace reports a large amount of deferred revenue, so it does not need financing from banks. Clients are financing the company’s operations.
Base Case Scenario Would Include Successful Enhancement Of User Experience And More Hybrid Environments
Under normal circumstances, management will continue to invest in user experience. The fact that many large organizations already use Dynatrace’s software means that software engineers really know how to offer innovative solutions and understand users’ behavior. Under this case, revenue growth will likely increase:
User expectations for software performance have rapidly increased, and enterprises are focused on advancing branded experiences to maximize revenue, differentiate offerings, and retain competitive positions. Source: 10-k
In line with the previous rationale, let’s note that in my view, there is a lot to be done with respect to user experience. The amount of customers noting detrimental user experience is significant:
According to a 2018 report by NewVoiceMedia (now known as the Vonage Salesforce Contact Center solution), U.S. companies lose $75 billion per year due to poor customer experiences, a $13 billion increase from 2016. Faced with poor customer service, 39% of respondents indicated they would never use the offending company again. Source: 10-k
I also assumed that organizations will continue to require hybrid environments with access to both clouds and on-premises platforms. Under this type of market, I believe that Dynatrace will find a lot of business opportunities, helping companies manage growing complexity.
Organizations are building and deploying software across hybrid environments with multiple clouds and on-premises platforms. Source: 10-k
If we assume a case scenario with sales growth around 25% and 12% from 2023 to 2030, and an EBITDA margin of 26%, 2030 EBITDA should stand at $970 million. Also, with growing capital expenditures and changes in working capital, the free cash flow in 2030 could reach almost $867 million.
I also assumed a discount around 8.53% like other analysts and an exit multiple around 12x EBITDA, which is close to the median in the industry. My results included an implied price of $47, with an IRR of 3%.
Worst-Case Scenario Would Include A Decrease In The Revenue Growth, Which Would Lead To A Decline In The Stock Price
The company reported revenue growth of more than 89% y/y very recently. In my view, maintaining the same revenue growth in the near future will be difficult. Let’s remember that the more an organization grows, the less the revenue growth increases. In the worst-case scenario, certain shareholders may not be satisfied with the net revenue growth. They may sell their stakes, which would lead to a decline in the share price:
From the year ended March 31, 2020, to the year ended March 31, 2021, subscription revenue as a percentage of total revenue grew from 89% to 93% respectively. This subscription revenue growth may not be indicative of our future subscription revenue growth and we may not be able to sustain revenue growth consistent with recent history, or at all. Source: 10-k
Competitors may offer more innovation than some of its competitors. Let’s note that the company operates with actors in many industries, so the likelihood of lack of innovation in one industry is elevated. The company may also encounter failures in their systems. In sum, with sufficient damage to the company’s reputation, I believe that sales growth will likely decline:
Many of our customers operate in industries characterized by changing technologies and business models, which require them to develop and manage increasingly complex software application and IT infrastructure environments. Our future success, if any, will be based on our ability to consistently provide our customers with a unified, real-time view into the performance of their software applications and IT infrastructure, provide notification and prioritization of degradations and failures, perform root cause analysis of performance issues, and analyze the quality of their end users’ experiences and the resulting impact on their businesses and brands. Source: 10-k
Under this case scenario, I assumed sales growth of -35% in 2023, and then some rebound from 2024 and 2025. In 2030, sales growth should stand at approximately $2 billion. Also, with an EBITDA margin between 23% and 25%, I obtained 2030 EBITDA of almost $515 million. Finally, with 2030 capex of $50 million and changes in working capital of -$210 million, 2030 FCF will likely be around $565 million.
I assumed that the cost of equity would increase, so that the weighted average cost of capital would be 15% in 2023 and 2024. If we also assume an exit multiple of 10x 2030 EBITDA, the implied price should be $23.
With Sufficient Development Of Dynatrace’s Artificial Intelligence And More Contracts With Partners, I Obtained A Target Price Of $75
I would expect enhancement in the user experience. Dynatrace would successfully develop its artificial intelligence technologies so that customer satisfaction increases more than expected. Management discussed the benefits of artificial technologies in the last annual report:
We believe the accuracy and precision of the answers delivered by our AI engine enable our customers to shift from reactive to proactive remediation, providing a substantial advantage in time savings, resource efficiency, customer satisfaction, and business outcomes. Source: 10-k
Under this case scenario, I would also expect that more and more clients will likely recognize the need for big data architecture and web-scale environments. As a result, I would be expecting revenue to grow more than expected:
Dynatrace utilizes big data architecture and enterprise-proven cloud technologies that are engineered for web-scale environments. With role-based access and advanced security functionality, we built Dynatrace purposefully for enterprise-wide adoption by the largest organizations in the world. Source: 10-k
Finally, with technological innovations, other partners will try to sign contracts with Dynatrace. Hence, the company may enjoy economies of scale as the number of customers will likely increase:
Our strategic partners include industry-leading system integrators, software vendors, and cloud and technology providers. We intend to continue to invest in our partner ecosystem, with a particular emphasis on expanding our strategic alliances and cloud-focused partnerships. Source: 10-k
I believe that we could see sales growth of 25% from 2028 to 2030, and a median EBITDA margin of 28%. I also assumed that Dynatrace may not have to invest the same amount of dollars in capital expenditures, so that the free cash flow growth will likely be even larger than that in the previous case scenarios.
My final results would include 2030 free cash flow of $1.37 billion and a long-term discount around 6.5%. Finally, If we also assume a larger exit multiple than that in previous case scenarios, the implied price should be $75.
Selected by Garner and Forrester and already with many large partners, Dynatrace will most likely deliver revenue growth in the next decade. In my view, if the company successfully develops its artificial technology, and customers notice, free cash flow will likely continue. Under conservative cost of capital and EBITDA margin levels, the fair valuation appears significantly higher than the current stock price. Yes, I see some risks from lack of innovation, IT failures, and a decline in sales growth. With that, the downside risk does not seem that large.