Earnings Call Transcript - DT Q2 2021

Operator, Operator

Ladies and gentlemen, thank you for standing by. And welcome to the Dynatrace Fiscal Second Quarter 2021 Earnings Conference Call. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Noelle Faris.

Noelle Faris, Speaker

Great. Thank you, Operator, and good morning, everyone. With me on the call today are John Van Siclen, Chief Executive Officer; and Kevin Burns, Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties, and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. Additional information concerning these factors is contained in Dynatrace’s filings with the SEC, including our annual report on Form 10-K and quarterly report on Form 10-Q. The forward-looking statements included in this call represent the company’s view on October 28, 2020. Dynatrace disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial measures during today’s call. A detailed reconciliation of GAAP and non-GAAP measures can be found on the Investor Relations section of our website. And lastly, references to growth rates will be in constant currency unless otherwise noted. And with that, let me turn the call over to our Chief Executive Officer, John Van Siclen. John?

John Van Siclen, CEO

Thanks, Noelle. Good morning, everyone. And thank you for joining us on our Q2 fiscal 2021 earnings call. First, let me start by sharing how extremely pleased I am with the team’s ability to continue to navigate the prolonged remote work environment. Productivity and attitude remained strong and we continue to add talent to the team at an accelerating rate. We had another strong quarter of balanced growth and profitability driven by a combination of new logo additions to the Dynatrace platform and the continued expansion of existing customers. ARR for the quarter was up 33% year-on-year and subscription revenue was up 35%, resulting in a non-GAAP earnings of $0.18 per share. Based on the strength of our Q2 results and visibility into the back half of our fiscal year, we are raising our top and bottom-line guidance for fiscal 2021, which Kevin will provide more details on shortly. As discussed at our Investor Day last month, there are two macro trends driving our business. The first is the acceleration of digital transformation, and the second is the dynamic multiclouds are the platform of choice for these digital transformations, especially in the global 15,000 account base we target and serve. Digital transformation is taking place around the globe and across every industry. We recently commissioned a study of 700 CIOs primarily from $1 billion plus enterprise companies and almost 90% of them agreed digital transformation has accelerated in the last 12 months and nearly 60% felt it will continue to accelerate into the future. These are not just the well-known technology brand names you would typically consider when talking about digital transformation; these are retailers, financial service providers, manufacturing companies, public sector agencies, and others who realize digital transformation is essential to the success of their businesses moving forward. As digital transformation accelerates, so does the scale and complexity of dynamic multiclouds underpinning these programs. In the same study, 86% of CIOs said they are using modern architectures, which include cloud-native technologies and platforms such as Kubernetes, microservices, and containers. As the use of these technologies grows rapidly, customers are seeing massive increases in complexity, dynamism, and frequency of change. The volume, velocity, and variety of data produced by these environments is growing exponentially, and the importance of these cloud ecosystems and the applications that run on them functioning flawlessly has never been greater. Interestingly, of the CIOs surveyed, 63% now say that the complexity of their clouds has surpassed a human’s ability to manage them and 70% said their team is forced to spend too much time doing manual tasks that could be automated. These trends are rapidly expanding the size of our market. As I shared at our Investor Day, our bottoms-up TAM for our targeted global 15,000 market segment has grown from $20 billion to $32 billion in just the past 18 months, and we see no reason why TAM expansion should not continue in the markets and use cases we support. With this rapidly expanding market, fueled by long-term macro trends as a backdrop, I’d like to make three points this morning that I believe will help illustrate the sustainable growth opportunity we see ahead. First is that our platform approach to modern cloud observability is uniquely positioned for the customer segment we target and serve; the second is our ongoing investment and advances in go-to-market and commercial expansion; and third is the pace, scale, and effectiveness of our continuous innovation engine. Let me start with our simple yet powerful all-in-one platform approach. As many now know, as modern clouds get more dynamic and complex, the old approaches to monitoring fail. This realization has led to the rise of observability as a new approach to a modern cloud world. Though we are in the early days of this movement, we are seeing three approaches to the observability opportunity. The first is what we call do-it-yourself. We see this in a growing number of engagements. Companies realize their old tooling will not work. They begin to cobble together multiple so-called modern tools, get an open-source database and software, and throw their best engineers on it to figure out how to regain visibility and control. This seems easy at first, but for larger companies with diverse infrastructure needs, the growing number of cloud-native applications, and an increasing number of DevOps teams innovating more and more frequently, scale and complexity quickly prove this manual do-it-yourself approach to be unsustainable. Second is a suite approach from a single vendor. Separate observability tools to gather metrics, logs, and traces, each with their own silo data structure, loosely integrated, often with not much more than a dashboard UI and a query language to unify them. The fact that all the tools come from a single vendor checks the boxes of tool and vendor consolidation, but it holds little advantage over the do-it-yourself approach. Customers still manually configure, script, baseline, analyze, troubleshoot, and so on—all very time-consuming, resource-intensive, and unproductive in advancing digital transformations. The third approach is the one Dynatrace subscribes to, a unified platform approach in which all data, metrics, logs, traces, and, in our case, much more are unified in a common data model with proper context of dependencies and relationships. We do all this automatically and we do it at massive scale. What’s most important to note is data gathering and dashboarding are just a start for us. Through advanced analytics continuously applied in real-time, we add understanding, predictability, and actionability on top. It’s here where customers regain time and leap ahead in efficiency, speed, innovation, and lower cost. It’s here where they transform how they work. We believe we are currently unique in a unified platform approach with sustainable advantages in automation and intelligence to make digital transformation easier and faster for our growing customer base. In fact, last quarter, we added 133 new logos to the platform, including Quest Diagnostics, Coles, Pfizer, Universal Music, and Vail Resorts. And we continue to see nearly a third of our new land deals with three or more modules—this is a reason our landing ARR for customers is climbing. This brings us to nearly 2,600 customers on the Dynatrace platform and we are confident we can add 300 or more new customers in the second half of our fiscal year. Along with healthy new logo growth, we expanded hundreds of customers as well. Application workloads are expanding in the majority of our customers' clouds; many applications are scaling further than ever before, mobile user experience has been exploding for a growing number of customers, and the cross-sell of our infrastructure module continues to gain momentum. Not only was our net expansion rate above 120% for the 10th consecutive quarter, our ARR per customer climbed to $234,000, up 14% from a year ago. Our platform strategy in which adding a new module leverages the power of automation, advanced analytics, and AI built into the core of our platform is gaining traction within our customer base and with our growing cloud partner network. This brings me to the second topic I’d like to discuss, our commercial expansion, including the expanding role of cloud partners and technical alliances. We have talked about growing our sales organization at 20% to 25% this year, and I am pleased to say we are on track. We continue to believe that our free trial-led direct sales approach is extremely well-suited for a modern, highly differentiated offering targeted at the global 15,000 largest companies around the world. That said, we also believe there is a growing place for regional and global cloud system integrators to provide leverage and reach. As digital transformation accelerates and more companies move from early simple cloud infrastructure to dynamic multicloud environments, cloud-savvy system integrators are playing a larger role across a much wider set of companies in advising them through their digital transformation journeys. As we continue to grow in both our customer base and market awareness, cloud system integrators are embracing Dynatrace as a strategic piece in their go-to-market solutions. This is a big reason why we have launched our Cloud Partner Competency program to assure the expertise of our partners and the success of mutual customers. In addition to cloud system integrators, we continue to lean into our cloud technology alliances with the three major hyperscalers, AWS, Azure, and Google Cloud Platform, as well as other key platform players such as IBM Red Hat, VMware Tanzu, and ServiceNow. Our tight and broad technical integrations with these platforms and co-selling relationships broaden our market access by making it easier for customers to find Dynatrace and by aligning our joint sales teams to co-sell to enterprise clients. In addition, AWS, Azure, and IBM customers can draw down their committed cloud spend to purchase Dynatrace, removing sales friction and accelerating close cycles. A great example of our deepening relationship with these cloud alliance partners is our recently announced relationship with ServiceNow. With hundreds of customers and a growing set of cloud system integrators in common, such as Experian, Delta, and DXC, we have seen an increasing opportunity to connect our platforms for expanded customer value. For over a year, we have worked closely with ServiceNow to coordinate our cloud entity mapping, the Dynatrace Smartscape, with the ServiceNow platform CMDB through a Dynatrace ServiceGraph Connector. This allows for both smarter ServiceNow workflows and change-aware AI from Dynatrace. We both see the opportunity to lead in the industry push to autonomous clouds, and together, we plan to bring our joint customers and partners to an entirely new level of intelligent automation to save time, increase efficiency, reduce risk, and accelerate transformational value. We believe this combination of an expanded free trial-led direct sales organization, combined with increasing leverage from a growing number of cloud partners is powerful and will drive solid new logo growth and ARR per customer expansion well into the future. This brings me to the third topic I’d like to cover this morning, the strength of our innovation engine. As many of you know, we do the vast majority of our engineering work in Europe, Austria, Poland, and Spain. As a preferred employer, we are able to attract and retain fantastic talent and we combine this talent with an advanced DevOps, NoOps development process, delivering 25 major releases and hundreds of minor releases a year. The combination is a steady stream of innovation across all modules and platform components continuously. With a hybrid SaaS platform tethered into all our customers, where their data is maintained in the cloud or behind the customer’s firewall, our customers adopt this steady stream of innovations and compatibility releases rapidly. Over 90% of customers run on a release no more than 30 days old. With the pace of change in modern cloud environments, this rapid ongoing innovation model is an important advantage for us. As we have discussed before, one of our bigger focuses this year has been the maturing of our infrastructure module. This past quarter alone we added over 150 new services across AWS, Azure, and a growing number of GCP services. We now have the widest hyperscaler service coverage in the market, and they are all instrumented and gathered automatically—no targeting, no configuration, no scripting, truly automatic. This best-in-class coverage is a big reason for the expansion momentum this module is gaining in our portfolio. In addition, we continue to invest and strengthen our leading digital experience monitoring module. This past quarter, we advanced Davis AI to help digital teams automatically detect and understand the source of mobile application errors to speed remediation and enable continuous optimization. This is especially important as we have seen a 300% increase in mobile traffic over the past year, which has heightened since the pandemic. Our real user monitoring that visually completes and session replay extensions is not only allowing digital teams to better understand end-user experiences and proactively handle customer care use cases, but is expanding into DevOps feature adoption and user behavior use cases as well. With over 70% of our customers using our DIMM module, we see continued steady expansion of this module well into the future as well. Further, I am pleased that our ongoing innovation continues to garner analyst recognition. This past quarter, Dynatrace earned the top spot in ISG’s cloud-native observability quadrant and we also earned Gartner’s peer inside customers’ choice for application performance monitoring. We are proud of this, of course, but what was even more important to me is that I consistently hear from our customers that our technology leadership in modern cloud markets is strong, advancing, and provides significant value at a critical time in their transformation journeys. Having covered a lot here, let me summarize. We have a leadership position in a massive fast-growing market, given the shift from early cloud environments to dynamic multiclouds; we believe the market is moving toward us. Our lead in unified platform automation and intelligence sets us apart in observability today and will be a sustainable advantage for us as companies continue to modernize and advance their cloud platforms. To take advantage of this technology and value lead, we continue to invest aggressively in commercial expansion, including the cloud partner leverage opportunity we see emerging. We continue to advance our differentiation and add to our portfolio through a highly talented, highly efficient innovation engine that’s growing rapidly. We like our organic approach as it enables a tighter, more unified platform, with quicker time to value, lower cost of ownership, and easier collaboration than any alternative. We have multiple pillars driving sustainable advantage, and we are investing aggressively across the board to drive growth and leadership in this exciting market category. With that, let me turn it over to Kevin for a deeper look into our financial results and guidance. Kevin?

Kevin Burns, CFO

Thank you, John, and good morning, everyone. Today, I plan to review our strong Q2 results and then I will review our increased full-year guidance and our outlook for the third quarter. As John mentioned, we delivered a great quarter on both the top and bottom line, delivering what we believe is a best-in-class combination of growth and profitability at scale. This is consistent with our goal to continue to deliver against the Rule of 50. Annual recurring revenue was $638 million at the end of the quarter. That’s up 33% year-over-year, an increase of $158 million or $167 million on an as-reported basis. The two drivers of ARR growth are new logo customers and our net expansion rate. As we expected, we accelerated new logo additions this quarter, adding 133 new logo customers in Q2 to finish the second quarter with 2,594 Dynatrace customers. This puts us on track to achieve our previously shared plan of about 530 new logos by the end of this fiscal year. We continue to invest aggressively in expanding the functionality of our platform, broadening the use cases covered by our existing modules and expanding beyond the modules we offer today. This has led to a consistent net expansion rate, which remained over 120% for the 10th consecutive quarter. ARR per Dynatrace customer also increased to $234,000, up 14% year-over-year. Moving on to revenue, total revenue for the second quarter was $168.6 million, $7.6 million above the high end of our guidance and representing an increase of 30% on a year-over-year basis. The strength in total revenue growth is being driven by 35% growth in subscription revenue, partially offset by the expected decline in Classic license revenue. From a topline growth perspective, we are focused on driving subscription revenue, which makes up 94% of total revenue, and is reflective of our ARR growth. As I mentioned during our Investor Day, we believe subscription revenue will increase as a percent of total revenue due to the compounding nature of the model, combined with the fact that we anticipate more services work to be done through our cloud partners. As a result, we continue to view subscription revenue growth as the most important revenue metric. With respect to margins, we continue to see an expansion in our gross margins as the subscription revenue mix increases combined with the way we manage our platform, as well as some cost savings related to the macro environment. Total non-GAAP gross margin for the second quarter was 85%, in line with last quarter and up approximately 2 percentage points from Q2 of last year. Our non-GAAP operating income for the second quarter was $53.3 million, well above the high end of our guidance of $45 million due to the revenue upside, gross margin expansion, and our overall focus on operating an efficient business. This led to non-GAAP operating margin of 32%, up 9 percentage points from the second quarter of last year. We are very pleased with this performance, as it shows the operating leverage potential inherent in our business. However, we have consistently shared that we believe in a more balanced approach to operating the business, one that delivers strong performance on both the top line and bottom line. Last quarter, I mentioned that we would begin to put programs in place to ramp our current level spend in targeted areas to support the long-term growth of the business. Many of these initiatives were in place by September, but given the timing of the investments within the quarter, the incremental increase in spend will be more prominent in Q3 with an additional step-up in Q4. This is reflected in the guidance that I will cover in a minute. Non-GAAP net income was $52.6 million or $0.18 per share. As you will see in our press release, there was a tax adjustment of $7.5 million in the second quarter associated with the spend and reorganization; excluding this one-time item, non-GAAP net income would have been $45.1 million or $0.16 per share, $0.06 above the high end of our guidance. Turning to the balance sheet, as of September 30th, we had $248 million of cash. As I mentioned during our Investor Day, we expect to grow our cash position over the short- to mid-term, appropriate to support the scale of the business we are building, while we continue to reduce our debt and deleverage the business. Our long-term debt was $481 million at the end of Q2. That’s down $30 million sequentially due to the principal repayment that we made early in the quarter. Following our commitment to reduce our outstanding debt, we made a principal repayment of $30 million during October, reducing our debt to about $451 million. On a trailing 12-month basis, our unlevered free cash flow was $154 million. As we had mentioned before, our cash flow is subject to seasonal variability tied to the timing of our bookings and renewals, with our strongest cash generation occurring in the last quarter of our fiscal year. We continue to expect to deliver full-year unlevered free cash flow margins of 29% to 30%. Before I move the guidance, I’d like to call out that all references to growth rates will be in constant currency unless otherwise noted. Also, please note that with our global presence and European R&D footprint, we view our business as generally hedged from a P&L perspective. Over the last 12 months, we have seen a two-point negative impact from currency on the top line. We expect the mix of the business to drive an FX tailwind in the second half, which will essentially neutralize currency impact and revenue for the year. Our guidance continues to reflect these changes and should pose minimal risk to our outlook. I’d also like to give a brief update on how COVID-19 is impacting our business. The highly affected industries we outlined in previous quarters, which represent about 20% of our business, and include areas such as transportation, hospitality, retail, and energy, continue to hold up well in Q2, as renewals of existing customers remain strong. Now more than ever, customers in all industries recognize the importance of digital transformation and the automation and intelligence that Dynatrace can deliver. One of the great things about our business model is that it is resilient and predictable. With these attributes and our visibility into the pipeline, we feel confident about executing our plans. As a result, we are raising guidance for fiscal '21. We are raising our ARR guidance to $721 million to $727 million, representing 25% to 26% growth. We are raising our total revenue to $668 million to $675 million, representing year-over-year growth of 22% to 24%. And we are raising our subscription revenue to $624 million to $630 million, representing year-over-year growth of 28% to 29%. For the full year, we expect non-GAAP operating income to be in a range of $186 million to $191 million and our non-GAAP EPS of $0.55 to $0.57 per share. As discussed on prior calls and at our Investor Day, we are a growth company with a lot of runway ahead of us. We believe we are well-positioned to deliver against our goal of building a multi-billion dollar category leader. As such, we plan to continue to accelerate investments to support ongoing platform innovation and commercial expansion efforts. Operating margins are expected to be very healthy in the second half of the fiscal year, but lower than Q2, which ran well ahead of our expectations primarily due to the strength of our revenue. I would also note that we anticipate tax expense to be in the range of $6 million to $8 million in the back half. Our full-year guidance includes an annual effective cash tax rate of approximately 8%, compared to our previous guidance of 11%. To reiterate, we continue to expect unlevered free cash flow margins to be approximately 29% to 30%, resulting in $192 million to $200 million of unlevered free cash flow. Turning to the third quarter, we expect total revenue to be in a range of $171 million to $173 million, representing year-over-year growth of 18% to 20%. We expect Q3 subscription revenue to be in a range of $160.5 million to $162 million, representing year-over-year growth of 24% to 25%. From a profit standpoint in Q3, we expect non-GAAP operating income to be in the range of $43 million to $45 million, 25% to 26% of revenue, and non-GAAP EPS of $0.12 per share to $0.13 per share. In summary, we are very pleased with our second quarter performance and are committed to operating the business as a Rule of 50 company. We believe Dynatrace’s financial profile is highly unique, including meaningful scale, strong growth, healthy profitability, and cash flow. With a large TAM in front of us and a market leading position, we believe the company continues to be very well-positioned to achieve our goal of becoming a multi-billion dollar category leader.

Operator, Operator

Thank you. Your first question comes from Bhavan Suri with William Blair.

Bhavan Suri, Analyst

Thank you for answering my questions and congratulations on the impressive results. I wanted to briefly discuss two points. First, regarding the Total Addressable Market, John mentioned it at the Analyst Day. Considering the challenges all companies face during digital transformation, particularly midsized companies, why not consider targeting below the Fortune 15,000? Instead of focusing only on small businesses, what about expanding our reach to midsized companies that utilize services and have more than just a website, possibly with multiple applications and products? How can we approach the idea of moving downmarket to further increase the market we serve?

John Van Siclen, CEO

Bhavan, I appreciate the question. So our focus has been and will remain for some time that Global 15,000. We believe we build products extremely well for that enterprise customer base; it’s a more complex environment; digital transformation matters to their business survival and it’s also where the profitability is as well. So we are pretty happy with a $32 billion TAM at this point. I should also say that nothing precludes us from going down market. There is no product issue. There is no pricing issue. There is nothing in that range. It’s more of a focus of the business. And usually when you focus, you accelerate faster in my experience. And that’s what I think you are seeing in our numbers.

Bhavan Suri, Analyst

Understood.

Bahavan Suri, Analyst

I want to discuss something you mentioned a few times. Regarding the digital experience, you noted that 7% of customers are engaged with it, and you highlighted strength in the log segment. As these new customers begin to come on board, are they adopting multiple products? What is the attach rate? Is there a trend in the attach rate for the newer products among these new customers? Thank you.

John Van Siclen, CEO

Another good question. And yes, we are seeing the attach rate of multiple modules with new customers increasing. So I think at our Analyst Day, we talked about 30% of new logo customers landing with three or more modules. I think what we are seeing and it’s starting to come through in our sales cycles and sales data is that we are starting to see a gradual shift now. It’s still early days. It’s still small. But a gradual shift from sort of being an APM landing zone we have talked about for the past year to an observability landing zone. That observability landing zone is almost by definition a platform kind of thinking, where the customers are looking for a wider footprint of value day one. We are very well positioned for it. We have been anticipating it, and we are starting to see it happen. Again, like I said, it’s early days, but it’s beginning.

Bhavan Suri, Analyst

No. That’s great. Thanks for the color and thanks, John, for answering my question.

Operator, Operator

And your next question comes from the line of Raimo Lenschow with Barclays.

Raimo Lenschow, Analyst

Hey. Congrats from me as well. John, can you talk a little bit about, you mentioned about the increasing uptake for the infrastructure module. In terms of, like, where do you see customer understanding in terms of that module being kind of crucial and being a potential starting point for you going forward? And I had a follow-up for Kevin.

John Van Siclen, CEO

Yes. Sure. The infrastructure module, as you know, we have been working on it for the last 18 months to really mature it, and it’s come into its own now. That’s allowed us to be much more aggressive in the expansion side of it, as well as landing with that module alongside the APM module and the DIMM module. From a wide infrastructure module and log analytics from Dynatrace versus someone else, usually there is some kind of an incumbent in place, a series of tools in place to cover that, what that module covers. But when you start to consider that all of the data gathering across all those infrastructure services is automatic, it’s all given context into our topology map, SmartScape, which maintains that map continually in real-time. Then an AI engine that applies knowledge and algorithms across it to understand where anomalies are happening that impact the business and immediately surface those to folks to take immediate action to proactively handle things before users are impacted. You realize that the value of that platform, that inherent automation and AI assistance is hugely valuable as you consider most of these enterprise IT teams are pretty much resource-strapped these days in time and giving them back time, giving them back resource for more meaningful things like innovation and driving better business outcomes is huge. So that’s what’s driving sort of that expansion of that infrastructure module, and we are still early in it. I would say from a driving ARR standpoint, but the adoption is increasing rapidly within our customer base.

Raimo Lenschow, Analyst

Okay. Perfect. Okay. Thank you. That’s pretty clear. And Kevin, for you, if you think about the investments you guys are doing and John talked about the increase in sales capacity. How do you think about this going forward, because in a way, you are kind of moving from like a 20% grower into a 30% grower? So in theory, there should be like an increase in needed hiring, as well as to drive that further growth, but then also you have obviously productivity gains coming out of that. So, you mentioned already like a little bit of the investments, but how do you think about that in the medium-term to long-term here? Thank you.

Kevin Burns, CFO

Sure. If you take a look at our business model historically and go back to fiscal '20, really what we are trying to work on in the next two quarters is to get back to those types of margins and investment levels. So if you look at our operating levels, our operating income was in the sort of low 20% range, 23%, 24% area, and we had a step-up in Q1 and Q2 as a result of COVID and some pauses in investments, travel, and things like that. But what I will say is in September, we made significant progress in terms of hiring, both from an innovation standpoint and in the R&D area, as well as in the sales organization as well, which we never took our foot off the gas. So we are going to get margins down to that level. We have talked about that at Analyst Day. When we think about over the longer term, what we are trying to do is maintain, as we communicated at Analyst Day, ARR growth north of 25% and continue to grow that top line. We want to balance that with investment, so as we said. So we are going to step on the gas a little bit here in Q3 and Q4, because we think the market is there and the products are there and there’s a lot of opportunity.

Raimo Lenschow, Analyst

Okay. Perfect. Thank you. Congratulations.

John Van Siclen, CEO

Thank you.

Operator, Operator

And your next question comes from the line of Matt Hedberg with RBC Capital Markets.

Matt Hedberg, Analyst

Hey, guys. Good morning and I will offer my congrats again. This is certainly not an easy environment. You guys are doing well. John, on the call you noted cloud system integrators are becoming more important, which is really good to hear and similar to what we have picked up in our checks. Can you remind us what percentage of deals are either partner-influenced or maybe even partner-led, and perhaps where that mix might go in several years?

John Van Siclen, CEO

Sure. Yeah. Partner influence is still the lion’s share, which means your direct sales organization is doing sort of the finding and the development, and then run into the partners that help us move deals along or — and that sort of thing. What we are working on is more partner-source opportunities, which are starting to happen. We have had a partner program, as we said at Analyst Day, for years, but this move from boutique resellers of APM over to cloud system integrators you think of a wider platform that really sort of drives these digital transformations for customers; that is sort of the new opportunity for us. We are still in the range of about 10% for opportunities that are sourced through partners. But we see that capability of growing considerably. We see it up year-on-year consistently right now. When it becomes a sort of a big push, as it is for some other billion-plus companies, we’ll start sharing more percentages and sort of what the pace is of that. What I wanted to share today is that we are starting to see the movement. We are leaning into it. We are getting more aggressive with it, and it will become a more meaningful sort of adjunct to our go-to-market.

Matt Hedberg, Analyst

That’s great. I wanted to follow up on your plans to enter the application security market. This seems very logical, particularly in light of SmartScape and your Davis technology. Could you provide more details about this opportunity? Customers are requesting it, and could you also remind us about the timing of the launch?

John Van Siclen, CEO

Sure, Matt. I figure I’d probably ought to stick with the modules that we have today rather than sort of pre-announce anything. But as we did talk about on Investor Day, we have spent the last 18 to 24 months looking at that security market. We know we have a phenomenal data platform for that environment, especially for the dynamic multicloud environments that are out there; security, where you can’t ring-fence it. You have to build it into the applications themselves. As we get ready to add that capability, that module into our portfolio, we will make sure that we keep everybody abreast as we go. It’s not far away, but it’s not ready to be announced.

Matt Hedberg, Analyst

Got it. Thanks, guys.

Operator, Operator

And your next question comes from the line of Jennifer Lowe with UBS. Please state your company name.

Jennifer Lowe, Analyst

Okay. Thank you. This is Jen Lowe from UBS. Great. So I wanted to ask a little bit about the demand environment, and in particular, John, at the outset you talked about this growing consensus that digital transformation is necessary and only more so in the current environment. But sometimes in our fieldwork we pick up that companies are conceptually on board, but maybe a little reluctant to commit to very big transformational projects in an uncertain time. So it’s on their roadmap, but maybe not actually happening today; it’s more next year. I am just curious in that commentary what nuances you are hearing in terms of those projects starting today versus being on the roadmap but maybe more 2021 business for when things get a little clearer on the macro outlook?

John Van Siclen, CEO

Sure, Jen. Well, from our standpoint, we are not what I would consider a massive digital transformation project. Someone’s already committed to the digital transformation and they are trying to figure out how can I speed it up, how can I reduce risk in the project and how can I create greater efficiency and lower costs while I am doing it. It’s that combination of gaining speed, reducing risk, and driving efficiency that makes this a very practical kind of choice and pay for itself within a 12-month window. So these aren’t projects over three years, four years, and maybe I will get my payback over 10 years. They are much more practical than that. I think that’s a secret to our success, actually. That return on — that rapid return on investment is quite clear, and a number of customers experienced said they talk about it with their peers.

Jennifer Lowe, Analyst

Okay. Maybe one more for me. We have seen some of the other players around the observability space adjust their pricing or announce new pricing plans or focus on plans that are really designed to make it easier to bring in data at a low price point and get away from kind of a host-based model. I am curious if that’s something that you are hearing from customers that they are asking for; anything you think might be on your roadmap at some point?

John Van Siclen, CEO

No. What we hear is customers want? At the enterprise level, they want predictability, and they want transparency. They don’t want surprises from consumption-based models, where they are getting hit with overages month after month after month. They don’t like the idea of, hey, come in chief, and then all of a sudden they would be surprised. So our pricing model is built around use cases—the modules—you get pretty much everything you need within those modules, and the value that they look at is not just in collecting data; they are actually with Dynatrace getting the understanding of the data. They are getting the predictability of where bottlenecks and issues are arising so they can take action, and they are getting a system with precision enough for them to actually build auto-remediations off them. So it’s a different kind of value proposition than the, hey, I am just gathering data kind of value propositions, and I think that our pricing model, which we adjust all the time by the way, as the market moves here and moves there, is working extremely well for our enterprise customers, and I don’t see really any reason to sort of change it at this point in time.

Operator, Operator

And your next question comes from the line of Sterling Auty with JPMorgan.

Sterling Auty, Analyst

Yeah. Thanks. Hi guys. John, in your prepared remarks, you kind of touched upon automation, the most advanced capabilities, which brings to mind AIOps at least from my thought. I am just kind of curious what is the penetration of those advanced automation AIOps capabilities at the moment inside the customer base and what kind of revenue run rate or spending uplift you get when customers go to that level?

John Van Siclen, CEO

It’s a good question, Sterling. Built into the platform is the AIOps capability. So every Dynatrace customer enjoys it at some level. But how many actually take that from the Dynatrace platform and extend it beyond it, is probably, I think, as we have been looking at sort of different environments, we were somewhere in the 10% to 20% range of customers extending beyond. Some of them are pretty obvious ones, like connecting with a ServiceNow environment, other ones are sort of broader, where they work on dozens and dozens of additional data sources pulled into the Davis AI for a much wider AIOps footprint. The way we monetize that is we charge for ingestion of third-party data, data that doesn’t automatically come in via the one agent. It’s not a large amount of our revenue stream, but it’s becoming more meaningful over time. But I think as we go, you will see us do more and more work in a broader AIOps footprint. You saw that we were the number one choice in the ISG observability quadrant that was recently put together, and you are going to see a few other things come up where it’s focused specifically on AIOps, where you will see us ranked quite high and anticipate some of the moves we are going to make going forward here to be more aggressive in that growing market segment.

Operator, Operator

And your next question comes from the line of Keith Bachman with Bank of Montreal.

Keith Bachman, Analyst

Hi. Thank you. I wanted to try to ask two. First, I want to talk about or ask about the competitive landscape. And the small and medium business category in observability has been disrupted over the last probably two years, in particular New Relic with Datadog providing some disruption. I think one of the larger overhangs for your staff is concern around disruption. And so my question is if the SMB category within observability has been or faced increased competition, what can you say to investors about your spaces though I think the rock-solid leader in enterprise? Why won’t that get disrupted over the next couple of years? And then I have a follow-up.

John Van Siclen, CEO

It’s already being disrupted. It’s just that we are the disrupter in that space. We are the ones that have been bringing modern observability to that enterprise segment for the last four years. We are the ones with the full-stack platform. We thought about it thoroughly that it was more than just the data; it was the understanding of the data, the predictive analytics, the ability to take action immediately, quickly, precisely. We are the disrupter in that space. What works in the SMB space, which is sort of a simpler, fewer application, less change kind of environment, gets very complicated when you get to the enterprise. So, that’s my feeling there, and that as folks try to move from SMB up to enterprise, it’s a pretty different world and we are already there.

Keith Bachman, Analyst

Yeah. Okay. Okay. The second question I had is on ARR growth. So you are guiding a growth in constant currency for the year of 25% to 26%, which is up from your previous guide and increased, and I should say, from your previous guidance. Your longer-term guidance is, as you say, north of 25%; normally you see a de-sell over time, but what you are suggesting is, as you reach a level at the end of this year, it holds that. But why it’s just unusual to not see a de-sell, so to speak. So if you could just speak to or address why you think you hold at those levels rather than see some perhaps tailing off below 25% longer term?

Kevin Burns, CFO

Sure. A couple of things there. The first thing I would say is, as we discussed again at Investor Day, we will be facing and we are currently facing some headwinds on our ARR growth due to the perpetual run-off of licenses, and those, as we discussed, over the next four quarters to six quarters will be a headwind to ARR growth. So that’s sort of on the negative side, and as we come out of fiscal '22, those headwinds to ARR growth will disappear. However, if you think about the investments that we are making today, that’s what makes us very optimistic about the future ARR and sustainable growth. Our goal this year is to grow sales and sales capacity by 25%. We are on track to do that. Things are going very well from a sales standpoint there. We are also seeing a nice shift in our sales rep organization as well. We have a lot more mature reps than we did 12 months, 24 months ago, so that should provide a tailwind as well. And I’d say the third thing is, we talked about before is, we are no longer working on converting our base from classic to the Dynatrace platform. So that frees up additional capacity. We talked about that probably around the 20% of free capacity. That over time should help productivity. So you think about those three things combined: sustainable growing sales capacity and maturing of the sales organization, as well as no longer working on conversion programs. Those should all be a tailwind to ARR growth over time.

Keith Bachman, Analyst

Perfect. Many thanks.

Operator, Operator

And your next question comes from the line of Walter Pritchard with Citi.

Walter Pritchard, Analyst

Hi. Thanks. Can you hear me?

John Van Siclen, CEO

Hi, Walter.

Walter Pritchard, Analyst

Hey. So just starting out, just on the 133 customers you added in the pipeline your building for the second half. Can you talk about the trial activity? How much of those are coming in through free trial or most coming in through the traditional sales motion where trials are not a big part of it?

John Van Siclen, CEO

Almost everything involves a free trial, whether we stimulate the customer and suggest that they investigate that way or whether they have already investigated and done their homework and come in that way from their own investigation before we even touch them. The free trial accelerates the sales cycle, no matter which way the customer comes in or the prospect comes in. In fact, they also accelerate the expansion because it’s an easy way for customers to pass on to their colleagues in other departments or other applications, saying, here’s something you ought to look at and it accelerates that early investigation stage. So that’s why we call it sort of a frictionless enterprise kind of program, because that free trial is involved in almost every engagement.

Walter Pritchard, Analyst

Got it. And then if we think about the 300 that you talked about for the second half. Can you help us understand you talked in the past I think last quarter and two quarters ago about, there be some headwind from the macro and so forth. How much headwinds do you think you still face in adding somewhat around 300 customers? And do you think you have already converted or converted all your sales capacity to be able to add new customers? Do you think that 300 is still kind of work in progress, and you would like to see improvements as you look into next year?

John Van Siclen, CEO

Yeah. So, a couple of things. So there is no question that trying to build relationships with enterprise customers where it’s a more complex sale and usually multiple people involved in making decisions is harder over Zoom than it is face-to-face. At the same time, we are getting better at it, and customers are getting used to it. They know they have to advance so they have to figure out a way to make that work, and having a free trial and then being able to do proof-of-concepts remotely, 100% remotely, is a big advantage for us. The number of our competitors still can’t do that. So, we have learned a lot. Customers have learned a lot, and we are starting to see the sales cycles move back to a normal cycle range. That’s what gives us confidence in the second half of the year. As we go into the future and things sort of normalize back again, I believe our muscle in driving new opportunity, we will continue to increase our productivity. We will increase per sales rep, if you want to think about it that way. Then we should continue to see increases year-over-year and keep a steady sort of percent of ARR as we go in that new account and new logo segment.

Walter Pritchard, Analyst

Got it. Thanks. That’s good to hear, John.

Operator, Operator

Thank you. And our last question comes from the line of T.J. Hynes with Canaccord.

Unidentified Analyst, Analyst

Hey. Thanks, guys. Congrats on the results. John, just one from me. So one of the questions I get from investors is they try and make sense of the competitive landscape, is whether it’s easier to expand from APM to infrastructure or from infrastructure to APM, right? And given your model, I know how you will answer the question. But maybe you could just talk about why you think that’s the case?

John Van Siclen, CEO

Well, first of all, we continue to believe that the application layer is the strategic layer of value. It’s where IT meets the business. A CEO doesn’t want to talk about infrastructure; they want to talk about business outcomes that are driven by business applications. So that’s sort of the first thing. The second thing is that very few people have figured out how to do automatic application observability at scale. In the cloud environment, that means you have to actually observe everything at once because it’s all virtualized software. That’s a very difficult challenge. There are hundreds and hundreds of compatibility idiosyncrasies with all the frameworks, all the layers, all the languages, etc. So that’s always been sort of that difficult barrier. Otherwise, everybody would be doing it and you would see dozens of people in the upper right quadrant of the Gartner APM Magic Quadrant. So, that said, our view is, infrastructure has its own peculiarities and uniqueness, and it’s taken us, as I said, 18 months, and then we still have more work to do to get our infrastructure module to a mature level in that segment. No segment is easy. But we view the infrastructure segment as a logical extension that we are fully capable of addressing and one that goes hand in glove with the application layer when you reach enterprise observability and its use cases and extensions thereof.

Unidentified Analyst, Analyst

Yeah. Yeah. Okay. That’s helpful color. Thanks guys.

John Van Siclen, CEO

Thank you. I think we are sort of out of time. That was the last question. So let me just say thank you. We believe we have a fantastic opportunity in front of us with a massive market and a well-differentiated product. We have a great balanced business that you can see. We are going to continue to invest, as Kevin said, in commercial expansion and continuous innovation, which has served us well, and we look forward to catching up again in late January, early February to cover our Q3 results. Thank you again. Enjoy your morning.

Operator, Operator

And thank you. Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation. You may now disconnect.