Earnings Call Transcript - DT Q3 2020

Operator, Operator

Good morning, ladies and gentlemen. Thank you for standing by, and welcome to the Dynatrace Third Quarter 2020 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your moderator today, Michael from Investor Relations. Please go ahead.

Michael Bowen, Investor Relations

Thank you, operator. Good morning and thank you for joining us today to review Dynatrace's third quarter fiscal 2020 financial results. With me on the call today are John Van Siclen, Chief Executive Officer; and Kevin Burns, Chief Financial Officer. After prepared remarks, we will open up the call for a question-and-answer session. Before we start, I'd like to draw your attention to the Safe Harbor statement included in today's press release. During this call, we'll make statements related to our business that may be considered forward-looking within the meaning of Section 27A of the Securities Exchange Act of 1933, as amended, and Section 21-E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical fact are forward-looking statements, including statements regarding management's expectations of future financial and operational performance; expected growth and business outlook, including our financial guidance for the fourth fiscal quarter and full year 2020. Forward-looking statements reflect our views only as of today, and except as required by law, we undertake no obligation to update or revise these statements. Please refer to the cautionary language in today's press release and to our latest Form 10-Q, which was filed with the SEC on November 4, 2019; and our other SEC filings for a discussion of the risks and uncertainties that could cause actual results to differ materially from expectations. During the course of today's call, we'll refer to certain non-GAAP financial measures as defined by Regulation G. The GAAP financial measure most directly comparable to each non-GAAP financial measure used or discussed and a reconciliation of the differences between each non-GAAP financial measure and the comparable GAAP financial measure can be found within our third fiscal quarter 2020 earnings press release in the Investor Relations section of our website at dynatrace.com. With that, I'd like to turn the call over to our Chief Executive Officer, John Van Siclen. John?

John Van Siclen, CEO

Thanks, Michael. And I'd like to start by thanking all of you for joining us today. Once again, we are very pleased with the company's quarterly performance, which resulted in third quarter financial results that were better than both our top line and bottom line guidance. I'm especially pleased that ARR once again increased by 44% year-on-year to $534 million, with our new Dynatrace platform now making up 87% of total ARR, up from 61% from a year ago. Fueled by the continued growth in ARR, our subscription plus services revenue, which we see as the best measure of revenue growth on our P&L, increased by 36% year-over-year. As we look ahead, we remain optimistic about the business as our new Dynatrace platform continues to be adopted by a growing number of new enterprise cloud customers, and each quarter we are proving our ability to expand rapidly within this growing customer base. Our optimism is reflected in the increased top line guidance that Kevin will detail in a few minutes. We're also proud that our solid growth is complemented by strong operating margins. We run an efficient business with gross margin at 84% and a non-GAAP operating margin of 26% for the third quarter. We continue to be cash flow positive on an operating basis while investing across the board in growth. As we've said before, we believe in running a balanced business, a powerful combination of growth and profitability at scale. We believe this balance, combined with our focus on investing aggressively in commercial expansion and continuous innovation, provides Dynatrace with attractive durability over the long term. Now let me turn to four major advancements made in our fiscal Q3. New logo expansion; customer net expansion once they are on our new Dynatrace platform; continued progress moving Classic customers to Dynatrace; and finally, innovation highlights around platform expansion and differentiation. I'll take each of these in order, starting with business from new customers. This past quarter, we saw a sizable uptick with new customers on the Dynatrace platform. Three hundred eighty new customers joined the Dynatrace platform family in Q3, bringing our total Dynatrace platform customer account to 2,208, nearly double from a year ago. Q3 was a strong conversion quarter for us with twice as many customers converting as we converted a year ago. And even with this strong conversion uptick, half of the customer growth added to our Dynatrace platform came from customers that are new logos to the franchise. Nearly every new customer win, whether net new or converted, is driven by the realization that their cloud program is disrupting their ability to keep up with the accelerating complexity of the ecosystem supporting their digital transformation. More and more run the business applications are being deployed into their enterprise cloud, while visibility and situational awareness are declining. To regain control and bridge the complexity gap, more and more enterprises are turning to Dynatrace. For example, a large U.S. bank recently became a Dynatrace customer after concluding that its current APM solution could not keep up with the dynamic nature and scale of its microservices-based environment. Prior to Dynatrace, the bank experienced successive service disruptions in applications running in their AWS Cloud, which negatively impacted the bank's business and put their brand loyalty at risk. Like most of our customers, the bank ran a trial Dynatrace to prove ease of use, scalability, and the value of our advanced automation. The bank was immediately impressed by the Davis AI engine at the core of our platform and its ability to automatically map the entire stack topology of the hybrid cloud, and precisely identify problems and the root cause in real time right out of the box. At the conclusion of their trial, the bank became a seven-figure ARR customer with plenty of room for expansion over time. I should also mention that shortly after starting with Dynatrace, the bank began to use our digital business analytics module announced in October to understand and reverse its drop-in conversion rates for bringing new customers to the bank. This is a great example of the power of our all-in-one approach with the intent to observe ability from user experience through infrastructure, putting business context to drive better digital business outcomes. As we said, once customers are on the new Dynatrace platform, we see rapid expansion, which is evidenced by the solid growth in our ARR that I referenced earlier. Once again in Q3, our net expansion rate exceeded 120%. This is the seventh straight quarter we've exceeded this mark. As we are still in the early innings of Dynatrace adoption, most of our expansion is driven by customers deploying our platform into new application stacks. The automatic continuous discovery and instrumentation, the self-adjusting baselines, the automatic problem determination prioritized by business impact, all contribute to rapid rollout and the high value for low-effort economics our customers enjoy. In addition, we are also beginning to see increased adoption of additional platform modules as customers recognize the power of our broader platform capabilities. Let me share an example of one of the many meaningful customer expansions during the quarter. A U.S.-based SaaS company decided to standardize on the Dynatrace platform and within two quarters completely replace their previous Gen 2 supplier who missed the market transition to the enterprise cloud. Earlier this year, the SaaS company was struggling to effectively manage their four different data centers with their previous solution, and foresaw even greater issues with their evolution to hybrid orchestrated cloud. After a successful trial last summer, the company decided to start by switching to Dynatrace in one of their data centers. Based on the rapid deployment of Dynatrace and success they achieved as a result of gaining real-time answers and insights into performance degradations and anomalies, thanks to Davis, they decided to expand their Dynatrace footprint and make Dynatrace the company standard for both the remaining data center migrations as well as their upcoming move to a dynamic web-scale cloud. This expansion came after only two quarters from the initial land deal with Dynatrace. Turning to our continued progress on the conversion front, which is the movement of our Classic APM customer base to the broader Dynatrace software intelligence platform, Classic ARR has now declined to $69 million, that's down $25 million from a quarter ago, and now represents only 13% of total company ARR. As we've discussed, we started this conversion program seven quarters ago with approximately $200 million in ARR to convert. We've been successful in moving our Classic customer base to the new Dynatrace platform because virtually every company has new enterprise cloud initiatives. We're not simply upgrading from one product set to a new version. Our conversions typically involve a shift from legacy stacks to new stack cloud environments. While it takes more time to find new stack buyers, yields are much more valuable customers in the strategic go-forward growth segment of their business, their enterprise cloud. As an example of a converting customer this past quarter, a large U.S.-based airline converted from our Classic tooling to the Dynatrace software intelligence platform. As the airline transformed from legacy systems to a modern multi-cloud architecture, they realized that the disparate monitoring tools, both commercial and open source that they had acquired over the years were costing them precious time, money, and resources. This led to excessive manual configuration, the need to stitch together data from multiple sources, and operating more rooms to get the answers they needed. As part of an initiative to gain observability into their entire environment, including all airport terminal kiosks, the airline began a trial of the all-in-one Dynatrace software intelligence platform. Again, it was advanced automation and full stack observability at scale across a wide array of IaaS, tasks, and container technologies that were the key factors in the successful displacement of competing tools. Our all-in-one platform provides the airline both the modern observability it requires and the real-time precise answers required to address degradations in performance, in business-impacting anomalies. After a successful trial, the airline converted from our Classic tooling to the new Dynatrace platform, leading to an expanded seven-figure ARR contract. We are excited to be well along the way with the conversion process and look forward to wrapping this up over the next few quarters. As I've said before, this is particularly exciting for us for two reasons: First, we've proven our ability to expand rapidly with customers once they are on the broader Dynatrace platform, and second, we believe the completion of this process will further improve the productivity of our sales organization as conversion distraction ends and they focus 100% of their efforts on landing new customers and expanding them across more applications and modules. Let me finish by highlighting several of the innovations we announced recently, which we believe will further improve our ability to win new customers, expand with existing customers, and incentivize remaining Classic customers to convert to Dynatrace. In early December, we announced the extension of our software intelligence platform to support AWS hybrid clouds that provide seamless support across all AWS public regions and outposts. Due to regulatory or data security requirements, many enterprise customers want flexibility with regard to where their observability data resides. With a flexible deployment model, Dynatrace offers a single platform built on cloud native architecture that seamlessly supports any configuration of AWS hybrid cloud environment, including both VMware Cloud on AWS Outposts and the AWS native variant of Outposts. Dynatrace AWS customers benefit from regular, automatic updates and automated administration of the Dynatrace platform, while still meeting the strict governance, security, and latency requirements of on-premises workloads. This reduces the complexity, costs, and risks associated with alternative cloud observability approaches that do not support the flexible deployment modes of AWS and other major IaaS and PaaS providers. During Q3, we also announced Keptn, an open-source pluggable control plane to advance the industry's movement toward autonomous clouds. Keptn is an outcome of the knowledge and expertise gained as Dynatrace adopted a NoOps environment itself internally. In talking with CIOs and CTOs of many of our enterprise customers, it's become clear that advanced levels of automation intelligence are required to bridge the growing gap between limited IT resources and the exponential increase in scale and complexity of dynamic enterprise clouds, and the growing cloud-native workloads now being deployed. We purpose-built our new Dynatrace platform with a powerful explainable AI engine at the core to identify anomalies and degradations with precise root causes to trigger automatic self-healing actions. But what’s been missing has been a simple repeatable way to harness this potential and leverage it for a true NoOps approach. Keptn provides the automation and orchestration of the processes and tools needed for continuous delivery and automated operations for cloud-native environments. We have a growing number of customers now engaged in leveraging Keptn and Dynatrace expertise to advance NoOps within their enterprise cloud environments. Finally, just two to three weeks ago, we announced that we’d been collaborating with Google, Microsoft, and other industry leaders on the open telemetry project to shape the future of open standard-based observability. Having been a leader in distributed transaction tracing at scale for years, Dynatrace is contributing know-how and manpower in this area to the project as OpenTelemetry gains momentum. Open telemetry data will serve as an additional data source that further extends the breadth of our cloud observability, which in turn feeds Davis, our AI-engine, providing our customers with richer insights and automatic actions, across a wider landscape as dynamic multi-cloud continues to evolve in scale. We see this open-source standard as a benefit to the market and another potential accelerant to the adoption and expansion of Dynatrace. In summary, our innovation engine continues to differentiate our solutions and expand our market opportunity. Our Dynatrace customer base continues to increase as dynamic multi-cloud and workloads expand and scale. New logos are being added, and existing customers are converting and expanding on the new platform at a healthy pace. Our execution across our key performance indicators remains strong. With that, let me turn the call over to Kevin Burns for a deeper review of our financials. Kevin?

Kevin Burns, CFO

Thank you, John and good morning everyone. I'll start by providing a more detailed review of our third quarter performance and I will finish with our outlook for the fourth quarter, and our increased full-year guidance. Following my remarks, we will open the call for questions. Our key financial metric focused on business momentum is annual recurring revenue. As John said, ARR was $534.5 million at the end of the third quarter, an increase of 44% or $162 million compared to the year-ago period. Of the 44% growth year-over-year, five percentage points of the annual growth was due to customer expansion at the time our customers converted from our Classic product to Dynatrace, and the balance of 39 percentage points of growth came from new logos and expansion in our customer base on the Dynatrace platform. This compares to 44% growth last quarter on a year-over-year basis of which six percentage points of growth was due to expansion at the time of conversion and 38 percentage points from new logos and Dynatrace platform expansion. The Dynatrace platform continues to increase as a percent of total ARR and was approximately $466 million at the end of December or 87% of our total ARR. The remaining 13% of our ARR relates to our Classic offerings. This compares to a mix of 80% Dynatrace and 20% Classic at the end of the last quarter. We continue to track the plan on conversions and expect to be substantially complete with moving our customers to our new platform over the next three quarters. As you may recall, we started the conversion program with our sales organization seven quarters ago, and to date we have converted nearly two-thirds of the Classic base. We are actively working with the remaining customers on conversion timelines and continue to have a very good line of sight to completion. We are very pleased with the success of the program and the benefits that have been realized by our customers once they are on our new platform. By the end of our fiscal Q4, we expect Classic ARR will be below 10% of total ARR marking a major milestone for the company. Circling back to total ARR. There are two ARR growth drivers in our business. The first is new logo customers, and the second is our Dynatrace net expansion rate. During the quarter, we added 380 net new Dynatrace customers, ending the quarter with a little over 2,200 Dynatrace customers. Consistent with recent quarters, new customers were a healthy balance of adding new logos to the franchise as well as Classic customers moving to the Dynatrace platform. Over the last 12 months, 54% of our Dynatrace customer account growth has been the result of new logos to the company. In addition to a steady flow of net new customers, our Dynatrace net expansion rate remained at or above the 120% threshold for the seventh consecutive quarter. As a reminder, our ARR growth is not a result of our customer base converting from Classic products to the Dynatrace platform as we do not charge a conversion fee. Our ARR expansion is driven primarily by footprint and product expansion in our customer base. We have been very focused on moving our customers to the Dynatrace platform because from there our customers can expand their use cases and footprint in ways that were not possible with our Classic products. As noted earlier, only five percentage points of our 44% ARR growth occurred at the time of conversion, and even those five percentage points are through customer expansion. Our current Dynatrace ARR per customer remains north of $200,000 for the fourth consecutive quarter, and we continue to believe that there's a large opportunity for further expansion in our existing customer base. The majority of our applications that our customers still lack instrumentation, we continue to expand our value proposition and use cases, and our enterprise customers continue to expand their portfolio of cloud-based applications as they digitally transform their business. Let’s now turn to revenue. Total revenue was $143.3 million, $5.3 million above the high end of our guidance and an increase of 25% on a year-over-year basis. Total revenue growth was driven by strong growth in subscription revenue, which was $128.5 million in the third quarter, an increase of 40% year-over-year. For the quarter, Classic license revenue was $3.9 million, down from $12.1 million in the year-ago period. As John indicated from a P&L perspective, we believe the best measure and reflection of our ongoing revenue growth profile is the combination of subscription and services revenue, which was $139.4 million in the quarter, representing 97% of total revenue and an increase of 36% on a year-over-year basis. Before moving to our profitability metrics, I would like to point out that I will be discussing non-GAAP results going forward as outlined in the tables in the earnings press release. Our non-GAAP gross margin was 84% for the third quarter, an increase from 82% in the third quarter of fiscal 2019. We continue to see a healthy increase in our subscription gross margin percentage as we realize the benefits of winding down the Classic product stack, and more importantly, the benefits of the Dynatrace platform, which has one code base in over 90% of our customers on a version released within the last 30 days, an extremely efficient product. Our non-GAAP operating income for the third quarter was $37.5 million, well above the high end of our guidance of $31 million due to a combination of revenue and associated gross margin upside and to a much smaller extent some investments that moved to the fourth quarter. This led to a non-GAAP operating margin of 26%, up from 21% in the third quarter of 2019. We are very pleased with the strong profitability performance for the quarter. However, as discussed before, we remain focused on investing for long-term growth and plan to reinvest some of the upside we realized during the quarter back into the business, which is reflected in our Q4 and full-year guidance. Non-GAAP net income was $26.7 million or $0.10 per share, this surpasses our guidance of $0.6 to $0.07 per share. For the quarter, we had $280.2 million diluted weighted average shares outstanding. Turning to the balance sheet, as of December 31, we had cash and cash equivalents of $189 million and our long-term debt was $549 million after taking into account a $30 million principal payment in Q3. Our leverage ratio was 2.7 times our trailing 12-month-adjusted EBITDA of $139 million, this is down from a leverage ratio of 8.9 times at quarter end prior to our IPO. Keeping in line with our program to consistently reduce debt, we made another debt payment of $30 million in January and our gross debt is now approximately $510 million. While on the debt topic, I would like to let you know that later today we plan to launch a repricing of our debt facility. We anticipate that there will be some modest cost in the fourth quarter and our guidance excludes any potential impact. During fiscal 2021, we expect to realize a modest benefit related to reducing our interest expense. But it is not material to our overall results and we will provide more color on next quarter's call. Moving back for key metrics, unlevered free cash flow for Q3 was $13.3 million, and it was $161.9 million or 32% of revenue on a trailing 12-month basis. As we've discussed, quarterly cash flows can vary due to seasonality combined with the fact that as we convert our customers from Classic to Dynatrace, that can impact the timing of when we invoice our customers. The last financial measure that I would like to discuss is our remaining performance obligation, which at the end of the quarter was $800 million, an increase of 74% over Q3 of last year. The current portion of RPO which we expect to recognize as revenue over the next 12 months was $456 million, an increase of 66% year-over-year. Our healthy RPO expansion has benefited from our move toward subscription business combined with an increase in the duration of our new subscription agreements. We have consistently stated that we do not view calculated billings as a meaningful business metric in the near term, mainly due to variability created by the timing of our customer conversions and our ongoing shift from perpetual license to a subscription offering. We are very pleased with the success that we've had in moving our business to a subscription model. This shift has no impact on ARR and it actually has a positive impact on the long term given it's a renewable source. Keep in mind, however, that the shift to subscription has and will continue to put pressure on our long-term deferred revenue balance as annual invoicing for subscription is lower than the upfront invoicing for perpetual licenses that are recognized over three years. Moreover, the shift to subscription has happened even faster than expected this year which we believe is a great thing for our business. It's for these reasons that we are focused on our ARR from the time of our IPO as we believe it is the most relevant leading indicator of our business momentum and will continue to be the case until we complete our revenue model transition. Now, let me cover our guidance which has increased due to the strength of our third quarter results combined with our continued positive outlook and the momentum of our business. For the fiscal year, we are increasing ARR guidance to a range of $563 to $566 million representing year-over-year growth of 40%, an increase from our prior guidance of $550 to $555 million. Total revenue is now expected to be in a range of $542.2 million to $543.2 million, an increase from our prior guidance of $533 million to $535 million. We expect our non-GAAP operating income to be in the range of $127.5 million to $128.5 million, up from our prior guidance of $119 million to $121 million, representing the non-GAAP operating margin of 24% at the midpoint of the range. Non-GAAP net income per share is now expected to be $0.28 per share, assuming approximately 272 million weighted average diluted shares for the year. For the fourth quarter, we expect total revenue to be in the range of $147 million to $148 million representing year-over-year growth of 27%. It is worth pointing out that we expect the combination of subscription and services to once again grow over 30% in the fourth quarter. We expect fourth-quarter non-GAAP operating income to be in the range of $33.5 million to $34.5 million and non-GAAP EPS of $0.08 per share, assuming $284 million diluted weighted average shares outstanding for the fourth quarter. In summary, we are very pleased with our third-quarter performance and our optimism about the future is reflected in our increased guidance for the year. With a large and growing Total Addressable Market in front of us and a market-leading position, we believe that Dynatrace is well-positioned for the long term. Most importantly for shareholders is that we continued to show a financial profile that we believe is highly unique including meaningful scale, strong growth, healthy profitability, and cash flow. With that, we will open up the call for questions. Operator?

Operator, Operator

Your first question comes from Sterling Auty with JPMorgan. Please go ahead.

Matt Parron, Analyst

Hey, guys. This is Matt on Sterling. Thanks for taking my question. So looking at the significant upside in ARR versus what you did in subscription revenue. Wondering if you could comment on the linearity in bookings during the quarter? Thanks.

Kevin Burns, CFO

Hi, Matt. Thanks for the question. So we obviously track linearity on a monthly basis. What I will say is for our December calendar year-end quarter, we typically see a moderate percentage of our bookings come in that month three. So yes, it is a little bit higher in this quarter, but it’s consistent sort of with the last few years in terms of linearity. So no real outliers in terms of the flow of the bookings.

Matt Parron, Analyst

Great. Thanks, guys.

Operator, Operator

Your next question comes from the line of Matt Hedberg with RBC Capital Markets. Please go ahead.

Matt Hedberg, Analyst

Hey, guys. Thanks for the question. Great quarter. In addition to the 44% ARR growth, new customer additions was really impressive to us. And I think you added 130 more than you did in the year-ago quarter as well as last quarter. Can you talk in a bit more detail about why new customer additions were so strong? Has something changed competitively? Perhaps could there be some acceleration in competitive replacements?

Kevin Burns, CFO

Hey, Matt. So a couple of things. First of all, it was a big conversion quarter. And we've said that we've been stimulating the base now for a while and we're seven quarters into the program. And the end of the year is always a forcing function for many things, and this just happened to be a big quarter for moving the base over to Dynatrace. So that's a big part of it. But even with that, about half of that growth is still net new logos to the franchise. And that's really coming because the market is now moving much more aggressively to multi-cloud and web-scale environments including the modern workloads, microservices-base workloads, and Kubernetes-orchestrated environments and really leaving the Gen 1 and Gen 2 tooling behind. Our reinvention five or six years ago is now really playing well in the market and so there is a competitive tailwind for us as well.

Matt Hedberg, Analyst

That's great. And then maybe when you look at your customer base, John, can you estimate what percentage of say an average customer is monitoring cloud-based apps or infrastructure versus say an on-premise app or infrastructure? And how do you think that differs versus in sort of the broader competitive landscape?

John Van Siclen, CEO

From our perspective, we've done some analysis, and we find that about 70% to 75% of our modern cloud workloads and environments are being monitored by the new platform. Our market approach focuses on identifying those modern cloud teams and stacks. As these teams adapt to how Dynatrace integrates automation and intelligence, they create greater efficiency with their limited IT resources, which allows them to extend its use back into their legacy environments. This demonstrates a significant ratio, especially compared to older tooling. We believe this is a favorable position for us, and over time, we expect that percentage to increase since we are uniquely suited for these environments.

Matt Hedberg, Analyst

Great color. Well done, guys.

John Van Siclen, CEO

Thank you.

Operator, Operator

Your next question comes from the line of Heather Bellini with Goldman Sachs. Please go ahead.

Heather Bellini, Analyst

Thank you very much. It's clear that you are successfully converting your installed base, and I understand you expect to complete this conversion over the next few quarters. You've also seen considerable success in acquiring new customers. Could you provide more insight on your strategy for salespeople? You mentioned that shifting their focus from conversions to new acquisitions will enhance productivity. Will there be any changes to the incentives for the sales team as we approach the next fiscal year, especially since conversions will decrease? Additionally, when targeting new customers, how does the size of those initial deals compare to your initial conversion deals? I realize you don’t charge for conversions, but I'm curious about the revenue uplift from those conversions. I apologize for the complex question, but any insights would be greatly appreciated.

John Van Siclen, CEO

Yes. So, first of all, we haven't set our sales plan for the following year. That's in discussion now. Our approach has been to try to move as much of the base across the line, convert it by the end of this fiscal year, so that we can free up sales and rework the sales incentive plan, so that they focus 100% of their time on new logo opportunities and expansion of the base, especially cross-selling some of the new modules. That’s still our program. We still have to work through some of the details, but those are our thoughts at this time. Relative to a land versus expand the deal, the land deals have been very consistent in the 95K kind of range. I think if you look, we've been talking about 92K to 100K sort of in that or 92K to 97K sort of in that range for the last three quarters. So that's very consistent. And the expansion deals vary a little bit by time of year. Q3 happens to be a very strong expansion quarter and so does Q4. So those times of the year, the expansion deals can be track a little bit larger on an ASP basis and then they come down to a little more of a run rate range in Q1 and Q2 for the fiscal year. Overall, there is not a huge difference between the two. We're a transaction-oriented business. We're not a big deal-oriented business, and I think that helps us manage a more effective business over the long term.

Heather Bellini, Analyst

Great. Thank you.

Operator, Operator

Your next question comes from the line of Walter Pritchard with Citi. Please go ahead.

Walter Pritchard, Analyst

Hi, thanks for the question. For John, I’m interested in the expansion you’ve experienced, particularly in areas like digital experience monitoring and infrastructure monitoring compared to just expanding into new applications. Has there been a noticeable trend regarding product expansion versus overall footprint expansion as you continue to increase that ARR number?

John Van Siclen, CEO

We still feel like we're in the early stages of cross-selling. Most of our expansion comes from adding more applications, largely because our automation for instrumentation is highly effective and automated. We are still focusing on this with most of our customers. However, we are noticing an increase in cross-selling as we put more emphasis on it. We are accustomed to positioning digital experience, which is currently performing well. We're also seeing positive growth in the infrastructure area, driven by the realization that older tools are becoming obsolete in a dynamic enterprise cloud environment. We are optimistic about our ability to scale this as we move into next year, and it's one of our key focuses as we finish conversions and start ramping up cross-selling as we approach our fiscal 2021.

Walter Pritchard, Analyst

Kevin, can you discuss your investment strategy, particularly in Q4, and how that relates to your plans for investing in 2021?

Kevin Burns, CFO

Yes. I believe the situation remains steady. By that, I mean we are continuing to focus on innovation and enhancing our R&D organization to sustain our competitive edge in product offerings. We have successfully maintained that lead over the past couple of years. The second major area of investment will also be ongoing investments in commercial expansion and some marketing initiatives. These are two aspects we have executed effectively over the past few quarters, particularly in the last year, and you can expect to see more of this in Q4 as we aim to continue growing this business at a strong pace.

Operator, Operator

Your next question comes from the line of Bhavan Suri with William Blair & Company. Please go ahead.

David Griffin, Analyst

Hey, good morning. This is David Griffin on for Bhavan. Thanks for taking the questions. Two if I could. First, just so last quarter you called out pretty encouraging early interest in the new digital business analytics module. I was wondering if you could just give us an update on the level of interest that you're seeing from customers there? And maybe just talk a little bit about how the early partnership conversations with the traditional BI vendors are progressing?

John Van Siclen, CEO

It's still early for our sales organization to fully adopt and introduce new capabilities to their accounts. Customers need time to trial and start using these features. I mentioned in my earlier remarks about a customer who quickly embraced it. They faced conversion challenges with some new applications and onboarding new clients at the bank, and our solution came at just the right time for them. This kind of example will help our sales team understand the product better. Over time, I believe business analytics will play a crucial role in our discussions with customers and market opportunities. I'm satisfied with our current progress, but it's just the beginning. Regarding our position among other analytics providers, particularly those targeting digital business teams rather than operations teams, our relationships are opening up new opportunities. We complement existing analytical tools like Adobe Analytics, enhancing visibility across the tech stack in these environments. It's not only about conversion rates and revenue; we help identify reasons for drop-offs and optimization opportunities. This visibility allows teams to collaborate more effectively with their development and operations staff to refine their digital marketing strategies.

David Griffin, Analyst

Got it. That's helpful. And then I want to talk about one other recent announcement. So in December, you announced a new autonomous cloud enablement practice that I guess, the goal is to provide things like best practices, hands-on expertise, and automation services to help customers, kind of make the transition of autonomous cloud operations which certainly sounds interesting in an area of need. Can you talk in a little bit more detail just about the practice kind of how that's different from what you've been doing on the services side previously? And then maybe whether there are any margin implications associated with that?

John Van Siclen, CEO

Sure. The focus of our service organization is always making sure that customers get the most out of our software platform. As customers will tell you and I believe as well, nobody really wants to buy software. They're trying to solve the problem or they're trying to get sort of some kind of a lead in the market. Our services organization has been fantastic in helping customers drive adoption, explore new cases, etc. With this new announcement and this new practice, what we want to do is be sort of a little bit more proactive and help customers do what we've done ourselves, which has moved their sort of reactive IT organizations, reactive to issues knowing to a proactive highly automatic or automated state. This practice is led by a team that's been very close to some of the work we've done with our open-source control plane, Captain, and the thinking behind that. They're now taking that to a number of customers who have been asking us for more and more best practices and expertise in this area. We're building out a program to help them and then help enable them and help do some of the work for them to make sure that they can accelerate their directions and their drive towards cloud, which is really an inevitable place for every customer building webscale clouds. Nobody really wants to have lots of humans running around trying to manage and optimize them. We're just at the front edge of the spear on that one for the marketplace. It’s a great place for us to be and we have a great platform to enable it.

David Griffin, Analyst

Great. That's helpful. Thank you for taking the questions and congrats on a solid quarter.

John Van Siclen, CEO

Thank you.

Operator, Operator

Your next question comes from the line of Richard Davis with Canaccord. Please go ahead.

Unidentified Analyst, Analyst

Hey guys. This is Luke on for Richard. So, we've been talking with a number of interesting vendors in the DevOps space. It seems like they've finally gained some mainstream momentum. Our question for you guys would be, how do you think about the space? And do you envision extending into that ecosystem presumably on the op side of things? Thanks.

John Van Siclen, CEO

Sure. Well, we already are in the DevOps world. We’ve always thought of performance and cloud application optimization as something that needs to go upstream, continuous deployment all the way back into continuous integration. So we already do this. The value we provide in those environments is fairly straightforward. People have lots of capabilities to drive new function, but very few capabilities to make sure that they have their architectures maintained, and the ability to scale is built into continuous integration, continuous deployment models. As we see more and more from a dev standpoint wanting to understand what their new code is doing in production, visibility into sort of the early production releases, whether they're canary releases or A/B testing, we see even a broader opportunity to be able to help those DevOps teams optimize code, drive better quality in those early stages prior to when things get out into production. The last thing I'll say about it is that our autonomous cloud program actually starts with something we call unbreakable pipelines. We start there because it's more straightforward for the devs to put all this together with the open-source pluggable backplan that we built in Captain. We'll be bringing even more focus to the DevOps side of things as we go forward.

Unidentified Analyst, Analyst

That's very helpful. Thanks.

Operator, Operator

Your next question comes from the line of Jennifer Lowe with UBS. Please go ahead.

Jennifer Lowe, Analyst

Great. Good morning. First question for me. So the commentary around the improvement in conversion was I thought particularly interesting. And I wanted to pass through that a little bit more. Can you talk about how much of that was a function of market i.e. as companies move to seize more complex environments, it's just a more pressing issue to modernize their APM and observability practices versus things that maybe you were doing differently from a sales perspective versus anything you're seeing differently from a competitive perspective where maybe your win rates are a bit better in the quarter than they've been. If you could just sort of give a little more granularity that be awesome?

John Van Siclen, CEO

So, I don't think it's anything that we're doing differently. It's just a culmination of a lot of work we've done over the last six, seven quarters. It takes customers a little while to digest something that's new. We're not doing a like-for-like product for that product kind of a thing; we’re taking multiple tools and we're providing a platform. This just happened to be a quarter that culminated into a lot of things happening at once, which is great. I think it's a peak quarter for us. The next three quarters will be strong, but not as large as this past one. But I think it's just a culmination of a number of things that we've been doing well. The enterprise cloud is a growing part of their portfolios and will become the lion share of their IP portfolios here over the next 12 to 24 months.

Jennifer Lowe, Analyst

Okay. And maybe just to follow-up on that. So if we look at pipelines versus conversions, is it reasonable to think that the pipeline trajectory has been more steady and now the delta is really just converting on that pipeline more effectively or you seeing pipelines expand as well?

John Van Siclen, CEO

We're seeing both pipelines expand as well as conversions remaining strong across the board. So that said, both bode well. Plus, as Kevin's pointed out a couple of times, we've been expanding our sales organization as well. So we're on track for that 25% increase in our sales rep capacity this year and look forward to as they ramp in, they're having some impact and they'll have greater impact as they mature.

Jennifer Lowe, Analyst

Great. Thank you.

Operator, Operator

Your next question comes from the line of Keith Bachman with BMO. Please go ahead.

Keith Bachman, Analyst

Hi. Thank you very much. I had two questions as well. The first relates to an earlier question. But as you look out and you see your conversion of legacy being zero or close to zero, does that help, hurt, or neutral to your ARR growth?

John Van Siclen, CEO

It's a great question and you need a perfect crystal ball to answer it. So three quarters from now we'll be able to have that a little bit of hindsight. What we look at is this: It's great that we're shifting a customer base across. But it's taking a fair amount of sales bandwidth to do it because as I said, it's really like a new sale. We think it will be relatively neutral.

Kevin Burns, CFO

One other comment, just to add on that. If you look at our ARR growth over the last twelve months, as we mentioned, it grew 44%, five percentage points of that growth came at the time a customer is converting. Time of conversion they're expanding their footprint. We believe that they will expand in a much more rapid pace once they are on the new platform.

Keith Bachman, Analyst

Okay. Thank you for that. My follow-up question relates to as your expansion capabilities, or I shouldn't say, your expansion, your portfolio within the context of APM continues to improve. So the pipeline as you mentioned is getting richer, your conversion rates are good. But are you seeing any different changes in attach rates to the infrastructure side?

John Van Siclen, CEO

From a standpoint of cross-selling and what we consider expansion. As we've said before we land from a position of strength as you would expect in our swim lane, which is the application performance monitoring focused on the cloud workloads. The expansion is increasing; the attach rate of infrastructure, as well as digital experience is increasing. It’s not something that we disclose at the moment. We'll be looking at when and how we do that. Maybe at the end of our fiscal year beginning of the coming fiscal year.

Keith Bachman, Analyst

Right. Many thanks. That's it for me.

Operator, Operator

Your next question comes from the line of Raimo Lenschow with Barclays. Please go ahead.

Raimo Lenschow, Analyst

Hey. Thanks for taking my question. More on the bigger picture one. Can you talk about OpenTelemetry, as more vendors are doing it, but then some of the Gen 2 guys are not very openly around that? How does that help you in terms of being out in the market with a more modern solution?

John Van Siclen, CEO

OpenTelemetry is a great standard. It's why we've gotten involved in it with Google, Microsoft, and some of the other industry leaders. Gathering data is not really where the differentiation or value is going to come in. This is why when we built, rebuilt our platform, we thought about it with advanced automation and an AI engine at the core, because that's where we see the advancements and the opportunity to drive value. OpenTelemetry allows us to gather data over a much wider sets of environments, serverless environments, mesh environments, and a number of different areas that are just very hard to figure out how you might instrument or self-discover that. It enables a big footprint, which means that you're going to need a highly scalable engine that can process and analyze lots of data to make sense of it. We see it as a great opportunity to shine the light on our automation and intelligence differentiation, and we think it's going to be a great tailwind for us as we go forward in the business.

Raimo Lenschow, Analyst

Thank you. I have a quick question for Kevin. Could you remind us about the debt situation you mentioned in your prepared remarks? What is your long-term target regarding debt leverage?

Kevin Burns, CFO

Yes. As I mentioned on the call, the net leverage trailing 12 is 2.7 times EBITDA. We're managing this by trying to maintain cash around $150 million to $200 million mark; this means we're going to be paying down on a quarterly basis any excess cash or using excess cash to make that payment. In January, we paid down $30 million. Given our cash generating capabilities, we can reduce this $500 million of debt over the next couple of years very nicely.

Raimo Lenschow, Analyst

Thank you.

Operator, Operator

Your next question comes from the line of Brent Thill with Jefferies. Please go ahead.

Unidentified Analyst, Analyst

Hey guys. Thanks. This is Parthiv on for Brent. Just a follow-up on the net new adds this quarter. The half of net adds that were new to the franchise. Anything you'd call it from a vertical or geo perspective relative to past quarters?

John Van Siclen, CEO

So nothing unusual on any of those fronts really. The digital transformation is really across all industries. There's really no shift in industries. It’s more a mass movement of digital transformation and the realization that it's going to be cloud first. The clouds are no longer static or exploratory; they are enterprise class, multi-cloud, dynamic workloads. We’re hitting that sophistication level and scale level that we anticipated five or six years ago, but it's really starting to hit the mainstream enterprise market now which I think again gives us a little bit of tailwind going forward.

Unidentified Analyst, Analyst

Yes. Makes sense. Okay. And as a follow-up, just when you look at the AWS integration that you guys have just done. How would you measure the opportunity for host expansion with that integration over time relative to what you're seeing up in the hybrid cloud versus what you've seen on traditional on-prem environments?

John Van Siclen, CEO

The AWS move to outposts. It's an interesting move, because it was a religion two, three years ago that everything was going to come to public clouds. It's a bit of a realization that hybrid environments can be around for a pretty long time. We built a unique SaaS platform that allows us to run the same software cluster technology whether it's in the cloud or behind people's firewalls. We’re well positioned to take advantage of that, whether it’s AWS variant or the VMware variant.

Unidentified Analyst, Analyst

Got it. That's helpful. Thanks guys and congrats.

John Van Siclen, CEO

Thank you.

Operator, Operator

Your next question comes from the line of Sarah Hindlian with Macquarie. Please go ahead.

Sarah Hindlian, Analyst

Yes. Hi. Congratulations on the great quarter. Just a quick question for you following up actually on a few of my peers. The international opportunity as you discussed, it sounds like there's still plenty of room for you guys to go there. So, my first question is really how are you thinking about expanding in the international especially with the growth in headcount you just mentioned?

John Van Siclen, CEO

We've always had a very strong international presence; our business is 55% to 60% North America and the balance, international. One of the advantages for us is we don't have to build out that sales support, marketing infrastructure on a global basis. When we talk about sales rep expansion, we think about it as pretty much, although there's a little bit more in North America since that's the front end of the enterprise cloud. But in general, you can think about that as when we say 25%, we mean, 25% pretty much in each of the four major geographies we think about. We think about North America; we think about EMEA, which is Europe, Middle East and Africa; we think of Latin America and then we think of Asia-Pac. So from that standpoint think about that as we expand them all sort of relatively similarly. They all have a fantastic opportunity for us, and we're doing well in almost two geographic sectors.

Sarah Hindlian, Analyst

Okay. Thank you very much. That was really helpful. And as a follow-up, I was wondering, if maybe you're seeing a shift, I mean, you're seeing a lot more protection of cloud-native as you're moving along. But is there any way you can help us to kind of think about the magnitude of shifts you're seeing from on-premise to protecting cloud applications of any kind?

John Van Siclen, CEO

We don't really think about it as a shift from on-premise to cloud. We think about it as a shift from monolithic to cloud or cloud-native environments, containerized environments. These hybrid clouds will run with cloud technologies where everything is virtualized. So there’s a gradual migration to public clouds for sure. But there are so many data sources and environments on prem that are required for these applications to work properly. That creates hybrid environments which we're extremely well suited for.

Sarah Hindlian, Analyst

Sure. That makes sense. Thank you. Congratulations on a great quarter.

John Van Siclen, CEO

Thank you very much. I think just in the interest of time, we're probably going to have to cut off the questions. Thank you all for your interest. We're thrilled with our third quarter performance as a public company. I look forward to talking with all of you again in May when we're back with the end of our fiscal year. Thank you very much. Have a good morning and take care. We'll talk soon.

Operator, Operator

This concludes today's conference call. You may now disconnect.