Dynatrace (NYSE:DT) was identified by Garner and Forrester as a leader for using artificial intelligence to observe IT performance. Many major players noticed as well, helping the company achieve double-digit revenue growth. I think with enough technological innovation, the company will most likely continue to deliver positive free cash flow growth. Among my DCF models, Dynatrace offers more upside potential than downside risk.
Dynatrace provides a software intelligence platform for multi-cloud environments. With major partners in a variety of industries, the company’s precise answers about the performance and security of customers’ applications seem costly.
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 money on hand to fund more product development and business traction from recent mergers and acquisitions.
Dynatrace reports $303 million in long-term debt, which appears to be less than the total amount of cash. With negative net debt, I wouldn’t expect financial advisors to be concerned. Like other software companies, Dynatrace reports a large amount of deferred income so that it does not need financing from banks. Customers fund the company’s operations.
The base case includes successful user experience improvement 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 provide innovative solutions and understand user behavior. In this case, revenue growth is likely to increase:
User expectations for software performance have grown rapidly and enterprises are focused on advancing brand experiences to maximize revenue, differentiate offerings and maintain competitiveness. Source: 10-k
In line with the previous reasoning, let’s note that, in my opinion, a lot needs to be done regarding the user experience. The number of customers noticing an adverse user experience is significant:
According to a 2018 report by NewVoiceMedia (now known as the Vonage Salesforce Contact Center solution), U.S. businesses lose $75 billion a year due to poor customer experiences, up $13 billion from 2016. Faced with poor customer service, 39% of respondents said they would never use the offending company again. Source: 10-k
I also assumed that organizations will continue to need hybrid environments with access to both clouds and on-premises platforms. Under this type of market, I believe that Dynatrace will find many business opportunities, enabling companies to manage the increasing complexity.
Organizations build and deploy software in hybrid environments with multiple clouds and on-premises platforms. Source: 10-k
Assuming a scenario of revenue growth of approximately 25% and 12% from 2023 to 2030 and an EBITDA margin of 26%, EBITDA for 2030 should be $970 million. With increasing capital expenditures and changes in working capital, free cash flow could also reach nearly $867 million by 2030.
I also assumed a discount of about 8.53% like other analysts and an exit multiple of about 12x EBITDA, which is close to the industry median. My results include an implied price of $47, with an IRR of 3%.
The worst-case scenario would include a decline in revenue growth, leading to a fall in the share price
The company very recently reported a year-over-year revenue growth of more than 89%. I think it will be difficult to maintain the same revenue growth for the foreseeable future. Let’s not forget that the more an organization grows, the less revenue growth increases. In the worst case scenario, certain shareholders may not be satisfied with the growth in net income. They can sell their stake, which would lead to a drop 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 their competitors. Let’s keep in mind that the company works with actors in many industries, so the likelihood of a lack of innovation in one industry is higher. The company may also encounter failures in their systems. In summary, with enough damage to the company’s reputation, I think revenue growth is likely to slow:
Many of our customers operate in industries characterized by evolving technologies and business models, requiring them to develop and manage increasingly complex software applications and IT infrastructure environments. Our eventual future success will be based on our ability to consistently provide our customers with a unified, real-time view of the performance of their software applications and IT infrastructure, perform degradation and failure notification and prioritization, root cause analysis of performance issues, and analyze the quality of their end-user experiences and the resulting impact on their businesses and brands. Source: 10-k
In this scenario, I assumed revenue growth of -35% in 2023, then an uptick in 2024 and 2025. By 2030, revenue growth should be about $2 billion. Also, with an EBITDA margin between 23% and 25%, I achieved a 2030 EBITDA of nearly $515 million. Finally, with a capital investment of $50 million in 2030 and changes in working capital of -$210 million, 2030 FCF is likely to 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. Also assuming an exit multiple of 10x 2030 EBITDA, the implied price should be $23.
With enough development of Dynatrace’s artificial intelligence and more contracts with partners, I reached a target price of $75
I would expect an improvement in the user experience. Dynatrace would successfully develop its artificial intelligence technologies so that customer satisfaction would increase more than expected. Management discussed the benefits of artificial technologies in the latest annual report:
We believe that the accuracy and precision of the responses delivered by our AI engine enable our customers to transition from reactive to proactive recovery, delivering significant benefits in terms of time savings, efficient use of resources, customer satisfaction and business results. Source: 10-k
In this case, I would also expect more and more customers to recognize the need for big data architecture and web scaling environments. As a result, I would expect revenue to grow more than expected:
Dynatrace leverages big data architecture and proven cloud technologies developed for web environments. With role-based access and advanced security functionality, we purposely built Dynatrace for enterprise-wide adoption by the largest organizations in the world. Source: 10-k
Finally, with technological innovations, other partners will try to enter into contracts with Dynatrace. Thus, the company can enjoy economies of scale as the number of customers is likely to increase:
Our strategic partners include leading systems integrators, software vendors, and cloud and technology providers. We plan to continue investing in our partner ecosystem, with a particular focus on expanding our strategic alliances and cloud-focused partnerships. Source: 10-k
I believe we can see 25% revenue growth from 2028 to 2030, and a median EBITDA margin of 28%. I also assumed that Dynatrace may not need to invest the same amount of capital investment, so the free cash flow growth will likely be even greater than in the previous scenarios.
My final results would include free cash flow of $1.37 billion in 2030 and a long-term discount of about 6.5%. Finally, if we also assume a larger exit multiple than in previous scenarios, the implied price should be $75.
Selected by Garner and Forrester and already with many major partners, Dynatrace will most likely drive revenue growth over the next decade. In my opinion, if the company successfully develops its artificial technology, and customers notice, the free cash flow is likely to continue. Under conservative cost of capital and EBITDA margin levels, the fair valuation appears significantly higher than the current share price. Yes, I see some risks of lack of innovation, IT failures and a decline in revenue growth. This means that the downside risk does not appear to be that great.