Earnings Call
Dynatrace, Inc. (DT)
Earnings Call Transcript - DT Q3 2022
Operator, Operator
Greetings. Welcome to Dynatrace's Fiscal Third Quarter 2022 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. At this time, I will now turn the conference over to Noelle Faris, Vice President, Investor Relations. Noelle, you may now begin.
Noelle Faris, Vice President, Investor Relations
Thanks, operator. Good morning, everyone and thank you for joining Dynatrace's third quarter FY '22 earnings conference call. With me on the call today are Rick McConnell, Chief Executive Officer; and Kevin Burns, Chief Financial Officer. Before we get started, please note that today's comments include forward-looking statements such as statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties, depending on a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. Additional information concerning these uncertainties and risk factors is contained in Dynatrace's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's views on February 2, 2022. 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 with that, let me turn the call over to our Chief Executive Officer, Rick McConnell. Rick?
Rick McConnell, CEO
Thanks, Noelle and good morning, everyone. Thank you for joining us on today's call. I am very excited to be kicking off what I anticipate will be the first of many positive earnings calls as Dynatrace's CEO. First, I'd like to thank John Van Siclen for his contributions in growing Dynatrace as CEO to nearly $1 billion in ARR. He set the stage for a smooth and seamless transition in leadership for which I'm very grateful. I'm going to cover a lot of ground today. So at the highest level, there are three key messages I'm hoping you take away from today's discussion. First, Dynatrace has established a solid foundation and we are continuing to fire on all cylinders. Second, Q3 was a very strong quarter, beating expectations across all key operating metrics and we are raising guidance for FY '22. And third, we're leaning further into our sales and marketing as well as R&D investments with the intention to drive accelerated growth. Before talking about our financial performance and how I think about the future of the business, I thought it would be helpful to share with you my primary reasons for joining Dynatrace. First, the addressable market is enormous, over $50 billion and accelerating across all industries and we've only scratched the surface. Second, Dynatrace's technology is world-class and highly differentiated. Customers and analysts provided me with powerful third-party validation of the strength of Dynatrace and its products and my recent customer conversations since taking the role have further reinforced this perspective. Third, Dynatrace's financial performance is exceptional and positions us in a very elite group of companies with similar results, with growth in excess of 30% and strong profitability, we are in an excellent position to continue investing to deliver ever-increasing value to our customers. I enjoyed building market-leading multibillion-dollar businesses and this is precisely the opportunity we have in front of us at Dynatrace. And finally, I joined Dynatrace because of the expertise and talent of our people. I admire the vibrancy of the Dynatrace culture, celebrating innovation, collaboration and customer orientation. In short, this is a company I'm thrilled to be a part of. And my passion and enthusiasm have only grown since starting in mid-December. I'm fired up and looking forward to this next phase of growth. Moving on to our Q3 performance. Let me start by sharing how extremely pleased I am with the team's execution, once again beating guidance across all our key operating metrics. ARR finished at $930 million, up a very strong 32% year-over-year in constant currency. Subscription revenue was $226 million, up 34% year-over-year in constant currency. People often speak of the Rule of 40 as exemplifying strong performance in a highly successful SaaS business with the combination of ARR growth and free cash flow being greater than 40%. On a trailing 12-month basis, we've been operating at a rule of nearly 60 with 32% ARR growth and 27% unlevered free cash flow margins and this remains the case for our FY '22 guidance. Our foundation for sustainable, long-term ARR growth continues to be the combination of adding new logos to the Dynatrace platform plus the ongoing expansion of existing customers. We continue to see strength in both areas. We have added more than 500 new logos to the Dynatrace platform over the past nine months which at 22% growth is above our historical 15% to 20% goal. During the quarter, we continue to add industry leaders from diverse industries such as Varian Medical Systems, Janus Capital, the State of Arkansas and Wendy's. Of equal importance, we are closing larger initial transactions driven by multi-module sales, a key indicator of the value our customers are deriving from our observability platform. Year-to-date, our new logo ARR is up 37% over last year and 50% of these were three plus module sales. As to existing customers, Secretario General de Administración, Marathon Petroleum and General Motors are a few examples of companies that expanded their Dynatrace investments, contributing to our net expansion rate being above 120% for the 15th consecutive quarter. The consistent execution against the two building blocks of new logo acquisition and net expansion rate has resulted in a sustained 30%-plus ARR growth business over the past couple of years which is a tremendous accomplishment. At the same time, we continue to see healthy bottom line performance in Q3 with 25% non-GAAP operating margins and non-GAAP EPS of $0.18 per diluted share, reflecting our commitment to running a balanced business even as we invest for future growth. With the strength of our Q3 results and positive outlook ahead we are increasing our guidance for FY '22, as I mentioned which Kevin will provide more detail on shortly. Now I'd like to shift to how I think about our business moving forward. It would come as no surprise to any of you that digital transformation is at the heart of many global businesses today with IDC forecasting global spending in this area to exceed $10 trillion over a five-year period. The result, if executed well, is an organization that is better suited to meet its customers' needs, can compete more effectively in an online world and is equipped to do so more efficiently at lower cost. Digital transformation has become ubiquitous in driving corporate strategy from customer relationships to supply chain, to internal processes and beyond. To execute digital transformation initiatives, organizations are often leveraging modern, ever-changing multi-cloud environments to deliver efficiency and flexibility but these environments also bring a scale and complexity that's well beyond that of the data center world. Teams need assistance in simplifying the overwhelming volume and complexity of data. To innovate quickly, organizations need what we think of at Dynatrace as answer-driven automation, not just data but rather answers from the data that drive automated action. They want to optimize all aspects of their business at every moment in time, anywhere around the globe. And if there is an issue, they need to know it in real time before their customers or partners do. They need to be able to pinpoint the origin of the problem to enable rapid or even automatic resolution and they want to go further to gain insights and user experiences and use the wealth of information flowing through their systems to understand customer behavior and drive better business results such as increased conversions, higher revenue and profit optimization. This is the power of Dynatrace. Instead of requiring multiple disparate and disconnected tools and providing petabytes upon petabytes of data, Dynatrace provides a software intelligence platform that makes sense of it all, even in the most complex hybrid and multi-cloud environments. These modern environments demand more than serving up data on dashboards from manual analysis and action. Rather, we provide deep situational awareness to keep businesses operating and to radically improve innovation, efficiency and responsiveness. Powered by our unique AIOps engine, unified with a deep and broad observability provided by the Dynatrace platform, we deliver the answers companies need to run their businesses most effectively and the automation to do it efficiently. In so doing, we have gone well beyond the capabilities of other in-house or competitive tools to become an indispensable part of our customers' cloud ecosystems. Let me share a couple of examples of how the power of our platform translated into several strategic customer wins for Dynatrace during Q3. One of the largest insurance providers in the U.S. has a goal to digitally transform the insurance industry and make it easier for customers to buy their distribution teams to sell and their employees to work. In the midst of their transformation, they found the previous siloed multi-tool approach required far too much manual work and did not provide the answers to allow them to innovate at the speed and quality the business demanded. With Dynatrace, they moved to a single source of truth and AI-driven answers. This freed time for innovation, accelerated their digital transformation and enabled them to optimize every step of their biggest client-facing application to ensure that their software performed precisely as internal and external customers expect. Another customer, a Fortune 500 global oil and gas company based in Asia is reshaping its operations to ensure a sustainable future. Their previous monitoring tools and approaches were not designed for modern environments. The scale, speed of change and complexity of the multi-cloud architecture that is powering their transformation have surpassed these tools' ability to keep up. The customer came to Dynatrace to tame cloud complexity and provide end-to-end visibility and root cause analysis to reduce manual work. By delivering intelligence and automation at enormous scale, we eliminated thousands of alerts in innumerable war rooms resulting in greater simplification, faster innovation and more efficient collaboration. As a result, Dynatrace has now become the blueprint for observability across the organization. These are just a couple of customer examples. I learn of more each day and with each successful engagement, it reinforces my enthusiasm for Dynatrace and the value we bring to our customers. Near term, our focus will be on continued execution, leveraging what we're doing well and then finding ways to grow even faster. Consequently, we believe there is an opportunity to modestly increase investment in both sales and marketing as well as R&D to accelerate growth while maintaining healthy profitability which Kevin will say more about shortly. We've already made great strides in these areas with quota-carrying reps growing over 30% year-over-year, partners now influencing more than 50% of our transactions and brand awareness increasing. The level of interest generated for our Perform conference next week is a great indicator of these efforts with more than 32,000 registered attendees expected, representing over 8,500 organizations, more than half new to Dynatrace. You can also expect that we'll continue to fuel our innovation engine with existing module expansion, new module creation and platform innovation to enable even more comprehensive views of our customer ecosystems. Our cloud application security module is a great example of our focus on continued innovation to produce substantial customer value as a fundamental element of our software intelligence platform. We're seeing positive early signs of traction and our differentiated approach is worth highlighting. Back in December, as the world raced to protect systems from the Log4j vulnerability, our application security module was able to detect it within minutes of being published. Not only did we detect all instances of vulnerability across highly distributed multi-cloud environments but through our AI engine as well as our associated understanding of the topology and transaction patterns, we helped our customers prioritize application updates and mitigation strategies. Customers using alternative tools had to go through the painful and largely manual process of upgrading their agents and restarting their applications to mitigate Log4Shell. One customer said, "Other tools tell us we have a vulnerability but Dynatrace AppSec tells us everything about what, where and how to fix it." Another customer told us, "It's mind-blowing how Dynatrace Application Security found the Log4j vulnerability before any of our other numerous security products." And yet another said, "We've spent hundreds of hours trying to understand our exposure. And once Dynatrace AppSec was enabled, we immediately understood it." With this level of clear value-add to customers, it's no surprise that we saw an over 10x jump in POCs during this time. While we don't hope for more vulnerabilities, they have become an unfortunate and common reality. It is still early in Dynatrace's AppSec journey but I was delighted with the performance of the module as well as our customers' engagement and response. It offers a strong proof point of our unique offering and leads to our plan to drive ARR growth in this area in FY '23 and beyond. It is worth also noting my personal enthusiasm for our opportunity in this area, given my background in application security over the past decade. Before I turn it over to Kevin, I am very pleased to welcome Ambika Kapur to the Dynatrace Board. Ambika has extensive product marketing knowledge and experience from her work at VMware, Bracket Computing and Cisco and her expertise in this area represents a valuable addition to the already strong breadth of knowledge and experience across this group. In summary, I am delighted with our continued strong performance in Q3 and for the first three quarters of this fiscal year. We are putting our growth, profitability and cash generation to good use in our investments in innovation, go-to-market and the world-class talent needed to fuel future growth. I couldn't be more delighted to be part of Dynatrace and I look forward to meeting many of you in the future. Now, I'll turn the call over to Kevin for more on our Q3 financials and our outlook for the fourth quarter.
Kevin Burns, CFO
Thank you, Rick and good morning, everyone. As Rick mentioned, we delivered another outstanding quarter on both the top and bottom line, setting us up for a solid finish to fiscal '22 with the building blocks in place for sustained ARR growth of 30% plus. Our investments in sales and commercial expansion continued to result in strong top line performance with ARR, revenue and subscription revenue exceeding our guidance and resulting in another increase in our annual guidance. ARR for the third quarter was $930 million. That's an increase of $66 million sequentially or $208 million year-over-year, representing 29% year-over-year growth. Sequentially, this includes a $15 million FX headwind. On a year-over-year basis, this is a $21 million FX headwind of roughly 300 basis points. Given the fact that we focus on the needs of global enterprises, approximately half of our business is conducted in currencies other than the U.S. dollar. This means that our ARR and financial results are subject to foreign currency fluctuations. Given the strengthening of the U.S. dollar, this is creating an ongoing headwind to our reported growth. As a result, we believe investors should focus on our constant currency growth rates as these reflect the true strength of the business. On a constant currency basis, total ARR was $951 million, an increase of $229 million, representing 32% growth over the last year. Backing up the $34 million of perpetual license headwind to ARR which negatively impacted year-over-year growth rate by about 450 basis points, our constant currency adjusted ARR growth rate was 36% year-over-year. This represents the fourth quarter in a row with sustained growth rates above 35% and is reflective of the increased investments we have been making in our commercial organization. As we wind down the perpetual license revenue included in ARR, we believe the constant currency adjusted ARR growth reflects a sustained and durable growth rate of the business. Expanding on this further, when looking at ARR, excluding the impacts of the perpetual license headwind, we added $263 million of new ARR over the last 12 months compared to $176 million for the prior 12 months, an increase of nearly 50%. We included a quarterly historical chart of new ARR expansion, normalized for currency and perpetual runoff in our investor deck and data trends table that are available on our website. As Rick mentioned, the building blocks for sustained ARR growth remain the same. The addition of new logos, combined with the ability to expand existing customer relationships as measured by our net expansion rate. New logo growth continues to be healthy. We added 206 new logos in the quarter, an increase of 9% over last year and year-to-date, we added 501 new logos, up 22% compared to the same period last year. Given the changes in seasonality of our business last year, where we had a much stronger back half due to the COVID headwinds in the first half, we believe a year-to-date view is the best way to look at new logo additions as it normalizes for these quarterly fluctuations. As observability becomes a primary driver for new sales, we continue to see positive momentum with a higher percentage of customers landing with three or more modules. On a year-to-date basis, the number of new logos landing with three or more modules was 44% compared to 33% for the same period last year. In addition, over the last year, new logos have continued to land at a very healthy level with initial ARR lands of $116,000 on a trailing 12-month basis. Given the observability landing zone, we're starting to see a healthy increase in our average land size. At this point, nearly half of our customers are now using three or more modules, demonstrating that Dynatrace's open and unified platform is an indispensable part of their ecosystem. With over 3,200 customers on the platform, that's an increase of more than 450 customers from a year ago, when about one-third of our customers used three or more modules. Average ARR for three plus module customers has increased to nearly $500,000, almost twice the size of the average ARR per Dynatrace customer at $287,000. Underlying this healthy average ARR for three plus module customers is the ARR contribution from our infrastructure module which increased over 75% from Q3 of last year. Moving on to revenue. Total revenue for the third quarter was $241 million, up 33% year-over-year in constant currency and exceeding the high end of our guidance range by $6 million. Subscription revenue for the third quarter was $226 million, up 34% in constant currency, a $5 million beat versus the high end of our guidance. As I move forward in prepared remarks, I will be using non-GAAP measures unless otherwise noted. With respect to margins, gross margin for the third quarter was 85%, in line with last quarter and Q3 of last year. As we have said before, a very healthy margin reflecting the value and efficiency of the Dynatrace platform. Overall, we are extremely pleased with the strength of both our ARR growth and associated revenue performance. We believe that this further validates our strategy to continue to accelerate investments to grow the top line, as Rick discussed. You will continue to see us lean in on both commercial expansion and technology innovation to capture the large and growing market opportunity ahead of us. For the third quarter, we invested $34 million in R&D, up 37% from last year. We continue to successfully attract and retain talent in our R&D organization, consistent with our expectations. On the go-to-market side, we invested $84 million in sales and marketing, up 45% over last year and within our current target investment zone of 34% to 36% of revenue. Our operating income for the third quarter was $61 million, $5 million above the high end of our guidance range, primarily due to the revenue upside that flowed through to the bottom line. This resulted in an operating margin of 25% compared to 29% in the third quarter of last year. Again, keep in mind that we saw significant savings last year related to the COVID shutdown and we began to reaccelerate investments starting in Q3 of last year. On the bottom line, net income was $52 million or $0.18 per share. Turning to the balance sheet. As of December 31, we had $409 million of cash, an increase of $109 million compared to the same period last year. We are pleased with our continued healthy cash generation and believe it puts us in a strong position to consider strategic business investments where there's an opportunity to accelerate growth in selected areas. Year-to-date, our unlevered free cash flow was $152 million, consistent with the same period last year. As a reminder, due to changes in billing patterns, we believe it's best to view unlevered free cash flow over time. On a trailing 12-month basis, our unlevered free cash flow was $238 million or 27% of revenue. The last financial measure that I would like to discuss is our remaining performance obligation, RPO was approximately $1.4 billion at the end of the quarter, an increase of 37% on a constant currency basis over Q3 of last year. The current portion of RPO which we expect to recognize as revenue over the next four quarters, was $804 million, an increase of 35% year-over-year on a constant currency basis. We are very pleased with the growth in RPO. However, we continue to believe ARR is the best metric to understand the business' performance as it removes variability associated with billings and contracting. Moving on to guidance. As a reminder, when we talk about margins and profitability, I will be referring to non-GAAP measures. Since the end of Q3, the U.S. dollar has further strengthened, resulting in a growing Q4 FX headwind. To provide investors better visibility into the fundamental strength of our business, I'll share and recommend that investors focus on constant currency growth rates. Once again, we believe our investments in commercial expansion and product innovation will enable us to maintain a 120% net expansion rate and 15% to 20% new logo growth over the midterm. These are the core building blocks that deliver sustained ARR growth of 30% plus over time. With that in mind, we are once again raising our FY '22 ARR guidance to 30% to 31% growth year-over-year on a constant currency basis, up 100 basis points from our prior guidance. We expect as-reported ARR to be between $990 million and $996 million, up 28% to 29% year-over-year. In addition, our ARR guidance assumes roughly 300 basis points of headwind to ARR growth rates in fiscal '22 due to the associated perpetual license wind down. Therefore, we expect that our constant currency adjusted ARR growth will be 33% to 34%, again, an increase of 100 basis points from prior guidance. We are also raising our constant currency revenue guidance by 100 basis points for the year. We now expect total revenue to be between $922 million to $924 million, representing 31% year-over-year growth or 30% to 31% year-over-year growth on a constant currency basis. Underlying that, we are also raising our subscription revenue guidance for the year by 150 basis points in constant currency. We now expect subscription revenue to be between $866 million and $867.5 million, up 32% year-over-year both as reported and in constant currency. We continue to expect subscription revenue to be 94% of total revenue, driven by the size and strength of ARR and associated subscription revenue growth. Moving down the P&L. We expect full year operating income to be between $228 million and $230 million. As Rick mentioned earlier and consistent with our stated goals over the last year, we plan to lean in on investments to fuel additional ARR expansion and top line growth. However, it will take time to ramp additional investments before we further move the needle on ARR expansion. For the year, we expect sales and marketing to be in a range of 35% to 36% of revenue and R&D to be around 15% of revenue, resulting in an operating margin of nearly 25% of revenue. As we plan beyond fiscal '22 and continue to lean in on our investments, we expect to layer in another 200 to 300 basis points between R&D and sales and marketing throughout fiscal '23. For the full year, we expect EPS of $0.66 to $0.67 per share, up $0.02 on the high end of our previous guidance. Our net income and EPS calculations assume an effective cash tax rate of 12%, consistent with prior guidance. At these investment levels, we are able to continue delivering strong unlevered free cash flow margins. We are raising unlevered free cash flow slightly to be $268 million to $275 million or approximately 29% to 30% of revenue for the year. To summarize, our full year guidance is a continuation of our durable balance of growth and profitability, guiding to a Rule of 60 business when combining ARR growth and unlevered free cash flow margin. Looking at Q4, we expect total revenue to be between $245 million and $247 million, up 25% to 26% year-over-year or 27% to 28% in constant currency. In addition, subscription revenue is expected to be between $230.5 million and $232 million, up 26% to 27% year-over-year or 29% to 30% in constant currency. From a profit standpoint, operating income is expected to be between $51.5 million and $53.5 million, resulting in an operating margin of 21% to 22% of revenue as we continue to execute on our investment strategy combined with the incremental spend related to our Perform conference next week. Finally, we expect EPS to be between $0.15 to $0.16 per share. In summary, we are once again very pleased with the overall momentum of our third quarter performance with strong ARR and top line growth combined with healthy margins. As we have outlined, we have a solid foundation for sustained growth. And with that, we will open the line for questions.
Operator, Operator
Thank you. Our first question is from Matt Hedberg with RBC Capital Markets. Please proceed with your question.
Matt Hedberg, Analyst
Hey guys, good morning. Rick, welcome to Dynatrace. And we certainly look forward to working with you on an ongoing basis. So congrats on that, first and foremost. Guys, it seems like people are focused on the slight constant currency-adjusted ARR deceleration this quarter. But I think your new disclosures on the net new ARR growth was super helpful this quarter. And the way I look at it, if you exclude currency and the perpetual runoff, it looks like on a two-year stack basis, you continue to accelerate ARR growth. Is that the right way to think about this? And I guess, overall, can you characterize the spending patterns for those that worry about maybe a slowdown in digital transformation spending post COVID?
Kevin Burns, CFO
Sure, Matt, it's Kevin. So I think you're absolutely right. I think what we did provide in the top track and also in our supplement that we filed in our 8-K that's on our website is a disclosure about our new ARR expansion bookings. And what this is, is the growth in the business. And this year, on a trailing 12-month basis, we grew our ARR by $263 million which as we highlighted, was up 49% on a year-over-year basis. So that really is the underlying growth of our expansion bookings and we think that's a great indicator of the health of the business. I will also say it's important to look at our growth rate on a constant currency basis over the last four quarters, our ARR, excluding the perpetual license headwind, has been north of 35%. This quarter, it's dropped slightly to 36% but super healthy. Underlying the business, the demand environment remains very robust. The company continues to perform and we're hiring sales reps above plan. And we think the business is continuing to do extremely well. So between the combination of the 36% ARR-adjusted growth and the 49% ARR expansion bookings, we're super excited and pleased with the results in Q3.
Rick McConnell, CEO
And thanks very much for the welcome, Matt. Appreciate it. Look forward to meeting you. Very excited both on the new logo front as well as net expansion rate, both look very strong and feel very good about the future.
Operator, Operator
Our next question is from the line of Sterling Auty with JPMorgan. Please proceed with your question.
Sterling Auty, Analyst
Yes, thanks. Hi everyone, let me echo Matt's comments and welcome Rick to Dynatrace. To build on Matt's questions, we are seeing significant inbound interest from investors. Regarding the ARR side, could you provide any insights into the 2% deceleration quarter-over-quarter? Specifically, what can you share about your market share for the quarter, pricing trends, or any other factors that may have contributed to this slowdown?
Kevin Burns, CFO
No significant changes, Sterling, in market share. We continue to have very healthy win rates across the board. So I think that continues. I'd say there is a slight change in seasonality. If you look at our ARR expansion in the first half of last year and certainly, on a year-to-date basis, it was impacted by COVID in the first half which made a little bit of an easier comp in Q2 of '22 compared to Q3 of '22. So fundamentally, win rates remain very healthy across the board. And as I mentioned earlier, the demand environment remains robust and people are continuing to accelerate their digital transformation initiatives and we think that bodes well for the future.
Rick McConnell, CEO
What I would say, Sterling, is that we continue to see the greatest opportunity in replacing DIY solutions. This represents the largest area for growth. As 15,000 global customers implement digital transformation initiatives, they often find themselves with a mix of tools that they need to replace with a unified software intelligence platform, and that's our primary focus for these companies.
Operator, Operator
Our next question comes from the line of Mike Cikos with Needham & Company. Please proceed with your question.
Mike Cikos, Analyst
Thank you for taking my questions. I wanted to revisit some of the prepared remarks to ensure I understood correctly. You mentioned that you are planning to increase investments in sales and marketing as well as in research and development for fiscal '23. Can you clarify how these investments are expected to be implemented in those areas and how long it typically takes for a new sales representative to become fully productive at Dynatrace?
Rick McConnell, CEO
Sure. Let me take the first part of that. Our expectation and what we're seeing in the market is that there is upside opportunity for growth and that's what we're going to be investing in. So we're looking at a one to two-point increase in R&D to drive innovation and additional product deployment in terms of new modules and module expansion and one to two-point expansion during FY '23 in sales and marketing to drive awareness, new logo generation and overall penetration with partners. So those are the areas that we're going to be focused on driving in order to generate that growth incremental opportunity.
Kevin Burns, CFO
And from a time to productivity, Mike, it's fairly consistent over the last couple of quarters. It's anywhere from four to five quarters for our sales reps to become productive. And we continue, as I mentioned earlier, a very solid, healthy clip of growing our sales reps. As you probably know, last year, we grew our sales organization direct quota capacity 25%. This year, our goal is 30%; we did better than that in Q3 here. And as Rick mentioned, we're going to put some more money into sales and marketing and one of the goals as well is to increase the number of direct sales reps as well across the board.
Operator, Operator
The next question comes from the line of Raimo Lenschow with Barclays. Please proceed with your question.
Raimo Lenschow, Analyst
Yes, thank you. Rick, I wish you all the best too. When considering the investments you're making, if I evaluate the next four to five quarters, it's challenging to gauge how we view growth. My question is fundamentally about how you perceive growth for your company. Kevin mentioned that there is potential for growth in the market. Can you provide a broader perspective on this? You've consistently experienced solid growth in the mid-30s for several quarters. How do you see this evolving in relation to the increasing market opportunities?
Rick McConnell, CEO
Let me take that. Thanks for the question. The starting point here, as we articulated in our prepared remarks, is really around digital transformation. That really is the fundamental and primary market driver that is growing this and especially growing the opportunity in the market in the Global 15,000, because that is creating enormous complexity of everything from on-prem to hybrid cloud, the multi-cloud environments that are untenable. And so that's where we start. And our linkage opportunity into these digital transformation projects is just enormous which is why one of the areas we're leaning into is through partnerships, hyperscalers and others because they're now generating a substantial percentage of new logo opportunity for us; so that's the beginning. And then what we need to do is we need to provide an integrated software intelligence platform that provides situational awareness to allow for the monitoring and the observability of an entire infrastructure, not reactively but proactively to provide essentially answers to the questions that customers are asking about managing those infrastructures going forward and automatic resolution. So these are the kinds of areas in which we're investing to drive our opportunity into the future.
Operator, Operator
The next question comes from the line of Jonathan Ruykhaver with Baird. Please proceed with your question.
Jonathan Ruykhaver, Analyst
Yes. Good morning, everyone. So Rick, I think this is more for you. When you look at the sales motion, I'm curious to hear your view on developer engagement versus being focused on targeting C-level suite, particularly given the success some of your competitors are showing with a more bottoms-up approach.
Rick McConnell, CEO
Great question. We are certainly shifting our focus earlier in the development cycle. This will be a crucial part of our development and marketing efforts as we look toward the future. We are not only implementing features like code validation but also integrating through APIs, which will allow observability metrics to be incorporated directly at the code level. This aligns perfectly with our future direction regarding the shift left strategy in the development process.
Operator, Operator
The next question is from the line of Adam Tindle with Raymond James. Please proceed with your question.
Adam Tindle, Analyst
Okay, thanks and good morning. Rick, I just wanted to double click and take a step back on the increased investment notion. First, could you just maybe just take us through the process that you went through in determining the need for the further investment? I understand you run a very efficient R&D organization but already fairly healthy levels for sales and marketing spend. So the process that you went through in determining that? And secondly, the framework that you thought about for earning a return on those investments. I imagine a lot of it's related to growth, if you could maybe double click on the specific areas of growth that you're thinking about for payoff, that would be helpful.
Rick McConnell, CEO
Great question. Regarding our R&D efforts, we operate a very efficient organization mainly based in Europe, and they deliver exceptional results. We see significant potential for expanding both our current modules and exploring new opportunities. One example is the AppSec module, where we believe we have tapped into a significant need for vulnerability analytics that is just emerging. We are in the early stages of AppSec annual recurring revenue, yet we believe there is substantial opportunity for growth next year. This is one area where we are investing in development, along with logging related to infrastructure, which also requires significant investment in R&D. There will also be necessary investments in sales and marketing to enhance our opportunities in both infrastructure and AppSec, as well as increase brand awareness in the market. We are recognizing this potential through our customers’ spending patterns, particularly with multi-module deployments and the growth in annual recurring revenue per customer. This analysis indicates that now is the right time to invest, and the new modules will enable us to pursue additional market share.
Operator, Operator
Next question comes from the line of Kash Rangan with Goldman Sachs. Please proceed with your question.
Kash Rangan, Analyst
Thank you very much and congratulations on your position. Curious to get at a high level, any changes in the strategic direction for the company? Secondly, on a more tactical level, were you able to discern any changes in product contribution from the different silos? And any update on the competitive environment would also be very useful.
Rick McConnell, CEO
Certainly. In terms of our strategic direction, we believe the company is operating at full capacity. John did an outstanding job building the company to its current state, and I feel fortunate to be part of a well-performing organization with a solid foundation. There are no significant changes to our strategy in my first few weeks. However, we recognize opportunities to expand, particularly with new modules and capabilities in infrastructure and AppSec. These areas will receive focus from both development and sales and marketing teams. Additionally, I want to emphasize the potential of partnerships. To drive acceleration in FY '23, we need a dual approach, enhancing our sales force while also leveraging partners to reach the market more comprehensively. We will explore these opportunities further. While I can't discuss M&A in detail, I have a history of engaging in acquisitions, and we will be strategic buyers, pursuing opportunities where appropriate. Our recent acquisition of SpectX, which enhances our continuous analytics capabilities, is an example of how we can integrate elements to foster growth.
Kash Rangan, Analyst
That's great. And just a quick follow up. If all these initiatives were to bear fruit, are we making too much of the sequential deceleration that everybody is pointing out? And if these initiatives bear fruit, could we see reacceleration in the business because you are definitely investing for growth, as you said, the research development and the partnership and the sales and marketing side?
Kevin Burns, CFO
Kash, it's Kevin. Yes. As Rick said, we are firing on all cylinders. And these incremental investments are all focused on accelerating ARR growth over the midterm and longer term. It will take a few quarters for that to obviously kick into that ARR top line. But the market opportunity is tremendous ahead of us. Our platform is amazing. We have some great modules that we're bringing to market here in the next 12 months as well. And I think all those combined gets us pretty excited about that top line ARR growth number accelerating over the longer term.
Rick McConnell, CEO
Thank you.
Operator, Operator
Our next question is from the line of Kamil Mielczarek with William Blair. Please proceed with your question.
Kamil Mielczarek, Analyst
Good morning, everyone. Thanks for taking my question. So, I just want to follow-up on the comment that I think Rick made on M&A. Can you just maybe talk a little bit more about the framework behind your decision to acquire versus build new products? And given Dynatrace is now in a net cash position and we're seeing digitization drive the secular tailwind for likely multi-years, would you consider something more transformative?
Rick McConnell, CEO
We won't comment on specific acquisitions and opportunities, but I appreciate the question. We are going to be opportunistic and actively scanning the market for mergers and acquisitions across different areas. While I won't commit to any transformational M&A deals, I can say that we will view M&A as a means to accelerate growth. We will evaluate opportunities of all sizes, but our acquisition strategy will be very disciplined.
Kevin Burns, CFO
Yes, it's unfolding as we expected and communicated during our Q4 call. As a reminder, we identified about 200 customers who were single module, non-platform legacy customers that we anticipated would churn over the next four to six quarters. We have already churned about half of them. Over the next three to four quarters, we expect to see the remaining approximately 100 customers churn as well.
Operator, Operator
Our next question is from the line of Fatima Boolani with Citi. Please proceed with your question.
Fatima Boolani, Analyst
Good morning. Thank you for taking my questions. And Rick, welcome to the team. I look forward to working with you. Maybe I'll start with you, you've set a tremendous pedigree in the security arena and you spent a lot of time talking about how big the application security franchise could be for Dynatrace. I'm curious in the reinvestment envelope that you set out for fiscal '23, can you talk to us a little bit about maybe the opportunities and challenges with selling to a much more different buyer in the security realm in sort of how we should think about that manifesting in your sales and marketing expenses and posture? And then I have a quick follow-up for Kevin.
Rick McConnell, CEO
In terms of the buyers, the good news is I believe there is significant leverage with our current buyers. Following the Log4j issue that arose last December, discussions progressed quickly to implement our AppSec module into proofs of concept. This was not a new buying cycle; it involved our existing clients who had an urgent need to address the Log4j issue swiftly. There's considerable overlap in this area. As we delve deeper into AppSec, the profile of the buyer may shift a bit, but we see great potential there. Regarding AppSec as a whole, I believe it represents a substantial growth opportunity for the company. It makes sense for customers to manage their entire ecosystems while ensuring they are protected. The value proposition is exceptional, and it creates a consistent narrative for our customers to expand in this sector.
Kevin Burns, CFO
From an operational expense perspective, we outlined slight increases in both research and development as well as sales and marketing. We plan to gradually make these investments over the next few quarters. This won't be an immediate change, so you'll notice a margin impact over this period in fiscal '23. In terms of free cash flow, we are not providing guidance at this moment, but we anticipate a reduction of a few hundred basis points. Our cash flow has also been affected by the decline in perpetual licenses over the past couple of years, which might mitigate some impact. Therefore, we don't expect the unlevered free cash flow to be impacted as significantly as operating income. Regarding our expectations for fiscal '23, we are targeting a net expansion rate of 120% and a new logo growth of 15% to 20%. When you calculate these figures, a 120% net expansion translates to approximately $200 million in annual recurring revenue next year. If we achieve a 20% growth in new logos with an average deal size of $100,000 to $125,000, that's an additional roughly $80 million in ARR. Altogether, these factors could contribute $280 million to our business growth. While we are not offering guidance today, these represent our baseline expectations. Despite facing some headwinds from perpetual licenses affecting our net expansion rate, we believe it will improve as those challenges diminish. Our current net expansion rate remains healthy, well above the 120% benchmark. I hope this clarifies our fundamental outlook for the business in the coming year, which remains unchanged. Additionally, we are implementing various programs that we believe will further enhance our growth. Thank you.
Operator, Operator
Our last question is coming from the line of Koji Ikeda with Bank of America. Please proceed with your question.
Koji Ikeda, Analyst
Great guys. Thanks for squeezing me in here. So a question for Rick. You've been there for a couple of months now; you saw some big deal expansion. I mean, the business is operating in a big TAM. Business is investing in sales and technology, APM observability is super important for organizations of all sizes out there and then thinking about the legacy runoff, too. The question is, how do you think about the potential with the commentary on NRR? It goes up to 125% plus or maybe even better, up from the 120% plus the company has been delivering so consistently for such a long time now.
Rick McConnell, CEO
Well, NER is a huge metric for us. And the fact that we've delivered it now for 15 straight quarters at north of 120%, I think, is demonstrable of just the power of the platform that our customers see and the fact that they are leaning in aggressively to things like multi-module deployments, increased host units, full stack spend, infrastructure and new modules. All of these elements are driving that NER northward in terms of the installed base of existing customers. And then once we deploy new customers, the other good piece of news is that those new customers are increasingly likely to deploy multiple modules as well. So we're seeing the power of the platform really across the board. It is certainly my expectation as we add more module capabilities in the existing modules plus new modules such as AppSec that we're going to see even further expansion of multi-module deployment and further increases in spend. So I believe that there's an opportunity to have some accretion in NER as we look forward. But still early in that regard. In the meantime, we look to continue to operate the business in north of 120% in NER as we look at it. So all, thanks very much for joining for my first call as CEO. I really appreciate it. The summary message, I guess, I would leave with you coming out of the call is as follows: number one, we are a company firing on all cylinders. To some of the questions and remarks that came through the Q&A session, that's why I'm here and that's why I'm excited about it. I do think that there is an opportunity for accelerating growth which is why we're leaning in here even more aggressively in some of the areas like R&D and sales and marketing. And so those are opportunities for further expansion as we look to the future and that's why we increased the guide for the fiscal year. So we're leaned in. Also super excited about our Perform conference to come next week where we've got over 30,000 expected registrants. And so that's another area where we look forward to seeing some of you on that session as well. So, thank you all very much for participating in our call. And as I said at the outset, I look forward to meeting many of you in the future. Thanks very much.
Operator, Operator
This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.