Dynatrace Inc

NYSE:DT

Earnings Call Transcript 2021-Q3

[Operator]

Greetings and welcome to the Dynatrace Fiscal Third Quarter 2021 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It’s now my pleasure to turn the call over to Noelle Faris, Vice President of Investor Relations. Please go ahead.

[Noelle Faris, Vice President, Investor Relations]

Great. Thank you, operator and good morning everyone. With me on the call today are John Van Siclen, Chief Executive Officer and Kevin Burns, Chief Financial Officer.

Before we get started, please note that today’s comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. Additional information concerning these factors is contained in Dynatrace’s filings with the SEC, including our Annual Report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company’s views on October 28, 2020. Dynatrace disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial measures during today’s call. A detailed reconciliation of GAAP and non-GAAP measures can be found on the Investor Relations section of our website.

And with that, let me turn the call over to our Chief Executive Officer, John Van Siclen. John?

[John Van Siclen, Chief Executive Officer]

Thanks, Noelle. Good morning, everyone and thank you for joining us on our Q3 fiscal 2021 earnings call. I am pleased to report that we had another strong quarter across all of our key operating metrics. ARR was $722 million, up 35% year-over-year. Subscription revenue was $170 million, up 33% year-over-year and un-levered free cash flow was $74 million bringing year-to-date un-levered free cash flow to $151 million or 30% of revenue. These strong results were driven by a solid combination of new logo additions to the Dynatrace platform, the continued expansion of existing customers in an inherently efficient business model.

Based on the strength of our Q3 results, we are raising our guidance across the Board for fiscal 2021, which Kevin will provide more details on shortly. There are three main factors driving our success in the market and ultimately resulting in our strong financial performance. The first is strong long-term market trends. Second, the investments we are making in go-to-market and commercial expansion are paying off. Third, our commitment to continuous innovation is solving a wider range of problems for our customers and keeping us well ahead of competition.

I will walk you through each of these factors and share why we believe they position us for sustained growth well into the future. First, long-term market trends continue to be in our favor. Companies around the globe and in every industry are undergoing digital transformations at an accelerated pace. And these transformations are happening in dynamic multi-clouds, which leverage continuously changing container and micro-service architectures. We saw many examples of this during last quarter, such as the large energy provider in the U.S. digitally transforming to a Tanzu hybrid cloud platform to stop coal use and reduce CO2 emissions by 70% over the next 10 years, all while delivering smart home energy services to their millions of consumers. Our large brick-and-mortar retailer rapidly transforming to an OpenShift Kubernetes platform to drive omni-channel engagement new curbside services and new revenue streams like accepting and processing Amazon returns in state governments and pharmacy chains using DevOps and cloud native application platforms to rapidly rollout online vaccine information scheduling and tracking services. All these and more are powered by Dynatrace to enable greater speed, agility and efficiency sought by CIOs and CTOs today as modern cloud complexity and scale stretches beyond their team’s ability to keep pace. Automation and intelligence contained this complexity free up resources and speed transformation, are becoming requirements.

One of our banking customers recently told me that Dynatrace has been “killer app” behind their digital transformation adding value and automation across a wide variety of bank services, applications and IT used cases. We heard from a new healthcare customer who had been struggling to get a Gen2 observability solution deployed that Dynatrace has been “a knockout” deployed over a weekend, providing value across their cloud environment immediately. And a large government customer recently integrated us with ServiceNow and has reported dramatically reduced incident response times with several recurring issues cutting them from hours to seconds. We invested early in automation and intelligence capabilities to allow digital transformers to do more with less to gain time for innovation and business advantage and those investments continue to give us a well differentiated advantage as market trends move in our favor.

Having a well differentiated solution in a rapidly growing market brings me to the second factor driving our success in strong financial performance. And that is our step up in strategic go-to-market and commercial expansion investments. We are doubling down in several key areas to take advantage of the market momentum and opportunity. We have talked about growing our sales organization at 20% to 25% this year and Q3 results showed that these investments are paying off. We added 189 new logos this past quarter back above pre-pandemic levels. New logo wins were across a diverse set of industries, geographies and government agencies, including Hyundai, Edward Jones & Company, the Texas Department of Health, EchoStar and Denmark Radio. The value advantages enabled by the advanced automation and intelligence of our platform are resonating with customers, whether they are replacing APM solutions, transitioning to observability platforms, or challenged with a tool fatigue of do-it-yourself approaches, we are winning new logos in all scenarios.

In addition, we maintained a net expansion rate above 120% for the 11th consecutive quarter. Expansion deals were equally diverse, including enterprises such as Santander Bank, Publix Super Markets, 3M, and the Department of Works and Pension in the UK. Upselling our market leading APM module to support more applications and workloads continues to fuel the majority of our expansions. At the same time, cross-selling continues to gain strength with 33% of our customers now using three plus modules, up from 24% a year ago and nearly 40% are now using our infrastructure module for non full-stack workloads that support their cloud operations, such as directories, firewalls, load balancers and more. We are seeing a steady rise in customers leveraging the value of our platform for new and expanded use cases and automations as they digitally transform.

Given the solid execution of our sales team and momentum in the market, we are now planning to accelerate the growth rate, our primary quota-carrying reps into the 25% to 30% range. We have kept our foot on the gas throughout the pandemic and are now scaling up commercial expansion to capture greater share and drive continued strong growth. And while our direct sales force is responsible for a majority of our business today, we know there is an opportunity to grow faster by expanding our leverage and reach through cloud partners. Over the past couple of quarters, we have been focused on expanding our tech alliances with the three major hyper scalars, AWS, Microsoft and Google. As you know, we have had a longstanding and close relationship with AWS as a premier partner and continue to scale this out.

And I am pleased with the progress we made to advance our Google Cloud platform and Microsoft as your relationships. First, with Google Cloud platform, we have expanded our strategic partnership to include go-to-market collaboration with joint marketing efforts and a unified go-to-market motion, with sales incentives for both teams. In addition, we have streamlined contracts and procurement processes by allowing Dynatrace purchases to flow through the GCP marketplace and be applied against GCP pre-committed spend. Second, we have enhanced our partnership with Microsoft Azure as well. Similar to our longstanding relationship with AWS and in line with our expanded relationship with Google, we have expanded our collective go-to-market motion and co-selling arrangements and we are actively enhancing our frictionless buying experience through Microsoft Azure’s console integration.

We are very pleased with these strengthened strategic cloud partnerships. And today, we believe we are the only observability platform whose customers can use their committed spend through private offers in all three marketplaces. Private offerings in the marketplaces are the preferred cloud buying mechanism for many enterprises. And this allows our customers the flexibility to choose where to deploy Dynatrace and do it easily and efficiently. Before I leave go-to-market investments, let me add a comment on our annual user conference, Perform, which is coming up next week. This year, we are expecting over 20,000 registered attendees, that’s 10x more than we had for the physical event last year. Certainly, the shift to a virtual event is driving attendance up, but so is the awareness of Dynatrace in the market and the unique benefits of our platform. We are excited to be reaching such a broad global audience, many of whom are prospective customers within our target global 15,000 enterprise accounts.

Now, to the third factor driving our success and strong financial performance and that is our continuous innovation. Our highly talented product team listens intently to our customers and turns these insights into a continuous stream of innovation to advance our differentiation and increase our value advantage. Last quarter, we released the fourth generation of our patented PurePath distributed tracing technology. PurePath 4 now provides the deepest, most complete and fully automatic distributed tracing for modern cloud environments, including those extended with open telemetry and open trace. As modern cloud applications become more dynamic, the increase in scale and exploding complexity advanced levels of distributed tracing are required for precise understanding and immediate actionability for troubleshooting, optimization and proactive remediation use cases.

In December, we announced our entry into the cloud application security market. As we did with cloud observability, we are leveraging the disruptive forces of modern dynamic clouds to enter this market, targeting where the puck is going as modern cloud DevOps processes accelerate innovation and change and cloud native applications sprawl across multi-clouds. There is a growing friction between the speed of innovation and traditional security approaches. Leveraging the power and intelligence of our platform, our new offering solves this challenge to advance DevSecOps for Kubernetes orchestrated cloud native applications. As we said when announced, it will take time for customers to test and validate this new offering. So, the ARR impact will be slow at first, but we believe this new offering has the potential to expand our TAM by $18 billion over time, bringing our total addressable market opportunity to over $50 billion. Both PurePath 4 and cloud applications security are exciting advances for us. And with our annual Perform conference around the corner, you can expect more innovation announcements to come.

Before I summarize, I would like to take a minute to touch on the maturing of Dynatrace as an independent public company. As we look forward to our next phase of growth, we continued to enhance our board and board leadership. I am very pleased to announce that Jill Ward has been appointed Chair of the Dynatrace board. Jill has been a strong voice of leadership on our board since 2019 and brings extensive knowledge and experience from her work at a number of remarkable companies. For more details, please refer to the press release we issued earlier today.

Now, let me summarize as I’ve covered a lot this morning. As I said at the outset, we are very pleased with our performance this quarter and it sets us up to finish fiscal 2021 quite strong. I want to thank our global team of almost 2,700 employees for all their hard work and contributions in helping us achieve the success. We continue to prove that we are well-positioned in the growth market and that our innovation engine can consistently differentiate our solutions and expand our market opportunity. Likewise, we continue to see returns on our investments in go-to-market and commercial expansion, which are driving pipeline momentum and growth. Sales execution is strong. Our partner engine is revving up and we are investing. Add to this the growing awareness of and interest in Dynatrace with a reputation for world class product and expertise for modern cloud based digital transformations and we believe we have the ingredients for strong and sustained growth.

With that, let me turn the call over to Kevin for a deeper review of our financials. Kevin?

[Kevin Burns, Chief Financial Officer]

Thank you, John. Good morning, everyone and thank you for joining us on our Q3 earnings call. As John mentioned, we delivered a great quarter across the board driven by strong ARR performance, which was well above our internal expectations. We believe ARR is the key performance indicator of the overall strength and health of the business. ARR in the third quarter was $722 million, that’s up $188 million representing 35% year-over-year growth or 32% in constant currency. We are extremely pleased with the rate and pace of our ARR growth and it is even more impressive when you take into account the headwinds related to the perpetual license roll-off and COVID-related impacts. With respect to the perpetual license headwind and as a reminder, when we sold a Dynatrace perpetual license, we would recognize the license revenue ratably over 3 years. About 2 years ago, we removed perpetual license agreements from our price book and they were sold on an exception basis only.

As a result, we had begun to see the wind down of these perpetual license agreements, which negatively impacted ARR by roughly $8 million in the third quarter, representing a little more than 1.5 percentage points of headwind to the ARR growth rate in the quarter. So, excluding the perp license headwind, our adjusted ARR grew 37% on an as reported basis and 33% on a constant currency basis. Additionally, roughly 20% of our ARR is with enterprise customers we consider to be an industry that are facing headwinds due to the COVID crisis, such as travel, hospitality and automotive. And while we haven’t seen these customers churn from the platform, their net expansion rates are below the average net expansion rate for the business as a whole. We are starting to see the net expansion rates for this cohort tick back up in the third quarter with expansion deals in retail, automotive and oil and gas verticals. This is a promising time resulting in an ARR headwind that was roughly half to 300 to 400 basis point headwind that we experienced last quarter.

As we have discussed, the building blocks for ARR growth are new logos and net expansion rate. As John mentioned, we continue to see an acceleration in new customers, adding 189 new logos in Q3, which is 9 percentage points higher than the 174 new logos we added in Q3 of last year. We expect that growth rate to accelerate further in Q4, putting us on track to overachieve our previously shared plans of roughly 530 new logos by the end of the fiscal year. As a reminder, we had 145 new logos in Q4 of last year. We exited the third quarter with 2,794 Dynatrace customers. Our net expansion rate was above 120% for the 11th consecutive quarter and our ARR per Dynatrace customer increased approximately 20% year-over-year to $251,000. Our average ARR per customer with three or more modules continues to increase as well. As John mentioned, this cohort represented 33% of our customers in the third quarter, up from 24% last year, with an average ARR of more than $400,000. As more and more customers adopt the platform approach, we continue to believe the average ARR per enterprise customer could be north of $1 million.

Moving on to revenue, total revenue for the third quarter was $183 million, $10 million above the high end of our guidance and representing an increase of 28% on a year-over-year basis or 25% in constant currency. The strength in total revenue growth is being driven by 33% growth in subscription revenue or 30% in constant currency. Overall, revenue came in well above our guidance due to some FX tailwinds, but more importantly, we saw strength in all areas, including new bookings, strong linearity and solid retention rates that drove revenue and ARR outperformance.

With respect to margins, total non-GAAP gross margin for the third quarter was 85%, in line with last quarter and up over 1 percentage points from Q3 of last year. Our non-GAAP operating income for the third quarter was $53 million, $8 million above the high-end of our guidance to do the revenue and associated gross margin upside. This led to a non-GAAP operating margin of 29%, up 3 percentage points from the third quarter of last year. We are very pleased with this performance as it shows the operating leverage potential inherent in our business. However, we have shared that we believe in a balanced approach to operating the business, one that delivers strong and durable performance on both the top line and bottom line.

Last quarter, I mentioned our strategy to accelerate investments in targeted areas to support the long-term growth of the business. Many of these initiatives were in place in Q3 resulting in a sequential increase of $12 million in non-GAAP operating expense, with R&D increasing 5% and sales and marketing increasing 16% sequentially. Looking forward, we expect another step up in investments in the fourth quarter and this is reflected in the guidance that I will cover in a moment. From a profit standpoint, non-GAAP net income was $48 million or $0.17 per share.

Turning to the balance sheet as of December 31, we had $300 million of cash, an increase of $111 million compared to the same period last year. Our ability to generate cash while investing in the business remains strong. Our long-term debt was $451 million at the end of Q3, that’s down $89 million over the third quarter of last year and $30 million sequentially due to a principal repayment that we made early in the quarter. As we have shared in the past, we are committed to reducing our outstanding debt and improving our leverage ratio. At the end of the third quarter, our leverage ratio was well below 1x trailing 12-month adjusted EBITDA. We made an additional repayment of $16 million during the month of January, further reducing our debt balance to approximately $391 million. Through January of ‘21, our principal repayments have totaled $120 million in the current fiscal year. Our unlevered free cash flow for Q3 was very healthy at $74 million. On a trailing 12-month basis, our unlevered free cash flow was $215 million or 33% of the trailing 12-month revenue. This margin level is above our previous annual guidance of 29% to 30% due to a combination of the health of the top line, COVID related cost savings, and a tax refund that was more favorable than our original estimates.

Turning to our guidance, ARR is expected to be between $756 million and $760 million, up 32% to 33% year-over-year or 29% in constant currency. Our ARR guidance assumes approximately $16 million in perpetual license roll-off while roughly 3 percentage points of headwind to growth. Excluding the perpetual license headwinds, our adjusted ARR growth rate is expected to be roughly 32% year-over-year on a constant currency basis. For the fourth quarter, we expect total revenue to be between $190 million to $192 million, up 26% to 28% year-over-year or 23% to 24% in constant currency. Subscription revenue is expected to be between $178 million and $180 million, up 32% to 33% year-over-year, or 28% to 29% in constant currency.

From a profit standpoint, non-GAAP operating income is expected to be between $44 million and $46 million, 23% to 24% of revenue and non-GAAP EPS of $0.13 to $0.14 per share. This EPS guidance assumes cash taxes paid of $3 million in the fourth quarter, resulting in an annual effective cash tax rate of approximately 7% for the fiscal year in line with previous guidance. Total revenue for the full year is expected to be $697 million to $699 million, up 28% year-over-year, 27% in constant currency. Underlying that, subscription revenue is expected to be between $650 million and $652 million, up 33% to 34% year-over-year or 32% in constant currency.

Moving down the P&L, we expect full year non-GAAP operating income to be between $202 million and $204 million and non-GAAP EPS of $0.61 to $0.62 per share. We are raising our unlevered free cash flow margin guidance to approximately 32% of fiscal ‘21 revenue. That’s 2 percentage points above the high-end of our previous guidance due to the top line strength of the business combined with COVID-related cost savings as well as a favorable tax refund of approximately $10 million first our original guidance. This full year guidance assumes operating margin leverage of roughly 5 points compared to last year due to a strong business performance and COVID-related cost savings.

As I mentioned at our Investor Day and since then we are committed to investing for the long-term. We expect to increase our sales and marketing and R&D spend as a percent of revenue. As a result of these strategic investments coupled with a return to a more normal level of employee spend, we expect the operating margins will return to pre-pandemic levels over the next year.

In summary, we are very pleased with our third quarter performance with strong ARR and top line growth, healthy profitability and a proven ability to generate strong cash margins. We believe our unique platform approach will continue to drive new customers to the Dynatrace platform and our innovation engine will continue to power our net expansion rate. These building blocks provide us with the confidence for sustained growth as we move forward.

And with that, John and I would be happy to take your questions. Operator?

[Operator]

Thank you. [Operator Instructions] Our first question today is coming from Matt Hedberg from RBC Capital Markets. Your line is now live.

[Matt Hedberg, RBC Capital Markets]

Great. Thanks for taking my questions and really strong third quarter here. John, I wanted to ask you about the expanded GCP partnership. Obviously, you guys had a press release a little bit ago. But I am sort of curious can you talk about lessons learned from AWS? Obviously, they were sort of a bigger partner earlier? How did that partnership progress? I am just sort of trying to get a sense for how it might impact ARR? And then could you talk about the importance of really being the only observability platform with a private offering in all three public cloud marketplaces?

[John Van Siclen, Chief Executive Officer]

Sure, Matt. Appreciate your comments. So, the GCP partnership is in the past, we have been focused on sort of the technical relationships making sure our products are automatic and simple to deploy in each of the various cloud environments. But we have seen over the last year, we are growing opportunity to enhance the go-to-market side with the hyperscalars as they start to draw more enterprise spend toward them with these pre-commits and that’s provided an opportunity for us to be more aggressive in this area and we see the GCP opportunity as a great one for us and number of our customers are either moving from another cloud to GCP or adding GCP as yet another cloud in their portfolio that they want to leverage for various workloads. So as we have seen that and as the Google Cloud platform folks are continuing to get more and more aggressive in the market, we saw an opportunity to jump ahead of competition and put this go-to-market relationship together in a meaningful way. And so with that, we have had a great relationship with AWS of course and then as well with Microsoft, the GCP addition really does allow our customers now the flexibility to deploy anywhere, run anywhere and do it easily, smoothly and efficiently as well as leveraging pre-commit spends to do so. So we are excited about the combination for sure.

[Matt Hedberg, RBC Capital Markets]

That’s super helpful. And then Kevin, I really do appreciate you calling out $8 million perpetual loan of headwind in Q3 and the $16 million expectation for Q4. I am sort of curious obviously this will continue on into next year and you haven’t guided full year next year. But can you talk about sort of the cadence of that run-off as we progress through fiscal ‘22?

[Kevin Burns, Chief Financial Officer]

Sure. So for the last couple of quarters, meaning Q3, Q2, it was about 0.5 a little bit more than the 0.5 of headwind to ARR growth rate. And then in Q4, our guidance was about 2.7 points of headwind growth. And I think we will see that trend continue for the course of fiscal ‘22 or move up a little bit more on top of where we guided for Q4. So, I think a little bit over 3 points and then there is a pretty big cliff at the end of fiscal ‘22. So, we – there is not going to be a large percent of ARR remaining as perpetual license and it will be de minimis from fiscal ‘23. So, the headwind will diminish as we go out through the course of fiscal ‘22.

[Matt Hedberg, RBC Capital Markets]

Super helpful. Thanks a lot guys.

[Operator]

Thank you. Your next question today is coming from Jennifer Lowe from UBS. Your line is now live.

[Jennifer Lowe, UBS]

Great. Thank you. Maybe just to continue on that last question, if I look at the guidance for Q4 and there are a lot of puts and takes there around currency and the headwinds, but if I – from the model runoff, but if I back those out, it seems like the guidance implies very little deceleration in ARR growth on a constant currency adjusted basis relative to what we saw in Q3. So, if I put that in context, should we assume that sort of reflects easier comparisons versus the impact of COVID kicking in March of last year or are you sort of getting more optimistic about the growth in the business outside of those impacted industries, just any more context there would be helpful?

[Kevin Burns, Chief Financial Officer]

Sure. I will start Jennifer and then John wants to add in if he can. And I think you are right, if you look at the numbers, the guidance implies 32% constant currency growth, excluding the perpetual license headwind, which is fairly consistent actually with Q3 where we ended 33%. And I think there is a lot of different factors that have given us optimism as we move forward in the business. If you look at the sales organization we have been talking about during that 20%, 25%. We are going to be setting that up. We are seeing some step-ups in productivity as people – as we have talked about in the last year, so wind down that conversion activity and focus on new logos and expansion. And we are seeing a nice maturity in sales organization as well. And when you lay on top of that investments we are making in marketing lead gen go-to-market there combined with the innovation, the comments we have made through the course of the year, all those different factors stepped up in the quarter that resulted in really healthy new logo numbers and healthy net expansion rate and we think those trends can continue as we move forward.

[John Van Siclen, Chief Executive Officer]

Yes, I think that’s well said, Kevin. And the only thing I might add to that is we do continue to see at the enterprise level the $1 billion plus company level that the market is moving toward us. And we are seeing more and more evidence that the difference that we bring to the market with advanced automation and intelligence becoming requirements for the highly complex and high scale environments that these large companies have is really starting to resonate and payoff. And so that’s another factor that I would add, but – and I would say, yes, we are feeling optimistic about the business strong Q3 sets us up well for going forward.

[Jennifer Lowe, UBS]

Great. And maybe just one more for me, you commented that 40% of customers were using the infrastructure only module. And I am curious when you get in the door with that offering, how broad do customers typically go on the infrastructure side? Are they – I mean, in theory, you could cover 100% of the enterprise on infrastructure, are you seeing those sort of wall-to-wall deployments yet or is it still sort of more contained around work environments or related to where they are using APM? Could you just add some more context on how broad that can go at this point?

[John Van Siclen, Chief Executive Officer]

Sure. Yes. So first, just to clarify, all of the sort of APM module customers, which is still the majority that includes the infrastructure capabilities, but there are extensions that don’t require those kind of application workloads as I pointed out in the prepared remarks. We are seeing customers go wall-to-wall. It’s not a high percentage yet. So, the vast majority of plenty more infrastructure expansion they can do, but we are getting better at and customers are understanding the value of having sort of a single source of truth across a much wider footprint and the automation and intelligence leverage that gives their digital teams. So again, not only are more customers using that capability and exploring that capability, but they are also rolling it out in a broader way as we go, which is evidenced in our net expansion rate continuing to stay above 120%.

[Jennifer Lowe, UBS]

Great. Thanks, guys.

[John Van Siclen, Chief Executive Officer]

Thanks, Jen.

[Operator]

Thank you. Our next question today is coming from Sterling Auty from JPMorgan. Your line is now live.

[Sterling Auty, JPMorgan]

Yes. Thanks, guys. Just one question from my side, just back on the partnerships, I think from the outsider’s view from the investors’ view, it’s kind of hard to delineate and differentiate some of the announcements that we have seen coming out of Datadog and yourselves. Is there a way to differentiate the partnerships that you have established within these public cloud providers and perhaps, what kind of impact you expect to see from them revenue vis-à-vis where else you have seen announced in the market?

[John Van Siclen, Chief Executive Officer]

That’s – it can be a little bit difficult to parse of course. Each of these hyperscalars are going to play a little bit of Switzerland. So, that the advantages anyone appears to have is relatively fleeting, I would say. But I think the important thing to take away is this that Dynatrace has deep relationships with all three. We are a premium partner with all three. We have not only early access to technology to enable customers to benefit from tighter and tighter integrations with the marketplaces and various offerings, but also that the go-to-market which is becoming as I said earlier a bigger and bigger piece of these relationships as these hyperscalars aggregate enterprise spend. These are things that Dynatrace is at the front of and our customers expect us to be and the value that they received from them is greater efficiency and confidence that we are there with the most advanced services that these hyperscalars offer at the time they offer them. And I think that’s really the key takeaway is that we have the same relationships are better than anybody else in this marketplace.

[Sterling Auty, JPMorgan]

Thank you.

[Operator]

Thank you. Your next question today is coming from Bhavan Suri from William Blair. Your line is now live.

[Bhavan Suri, William Blair]

Hey, guys. Thanks for taking my question. Let me echo my congrats on the solid results and hope the snow isn’t too much of a disruption for you guys out there. We already had our share in Chicago. So, I guess let me just follow-up on Sterling’s question around partnerships, but not the webscale partnerships, but you have got a lot of other partnerships on service now. You have got system integrator partnerships, things like that. I guess John maybe help us think through the strategy of doubling down on sales vis-à-vis using the leverage or leveraging the partnerships to drive growth into new existing accounts or new accounts. How should we think about those investments? And is it still early that you are just going to double down on everything across the board? At some point, do we see a leverage of the partnerships play out where we don’t need to add sales headcount to do that? How have you guys thought about that?

[John Van Siclen, Chief Executive Officer]

Great question. At the enterprise level, it’s a little bit different than maybe in the mid-market. At the enterprise level, especially when you have a platform, that’s quite different in its characteristics, like the Dynatrace platform is, it’s not just in observability, it includes the automation and AI to provide understandability, predictability and actionability all in one. We believe that a sales organization is required to do that. But at the same time, we definitely pickup acceleration in ramp time and acceleration to full productivity by having these kind of partnerships and that’s what’s giving us sort of the combination of grabbing up the partnership, seeing the return there at the same time, we are seeing the productivity improvements in sales has given us the confidence that we ought to continue to tap the gas on that sales front and step it up from the 20% to 25%, where we have been to the 25% to 30%, which is where we are headed right now. So, we are excited about the combination. We think it is that combination that at the enterprise level sets us apart and will help accelerate, as Kevin and I have talked about our ARR growth and continued momentum in the business.

[Bhavan Suri, William Blair]

Got it, got it, got it. Helpful. And then – and just staying on the sales question for a second, any particular regions or verticals that you are adding on? Are you seeing increased adoption and I think you have talked about sort of retail coming back and hospitality coming back a little bit – sorry oil and gas coming back a little bit sort of post where as we get we see the light at the end of the tunnel for COVID. But as you think about adding the sales headcount, are there specific areas whether it’s like maybe crypto providers, I don’t know that you are seeing greater demand in for understanding and monitoring observability etcetera?

[John Van Siclen, Chief Executive Officer]

It’s really not any specific area, Bhavan. It really is across the board, it’s just that digital transformation around the globe continues to accelerate. Everybody is turning into a software company. Everybody needs to make sure they manage that software extremely well flawlessly if they can and we just happen to have a phenomenal platform for those large more complex environments as you know. So, it really isn’t anything on that front. On the – let me add maybe a couple of thoughts as well and that is that we are getting to the size of the business where we are starting to verticalize in certain areas, which I think also has a little bit of opportunity to accelerate in it, certain geographies, certain verticals. And the second thing is we are seeing an uptick, especially in North America, in state and federal government business as we spend more time and invest more heavily in those areas as well, which we talked about earlier this year.

[Bhavan Suri, William Blair]

Got it. Got it. Super helpful. Thanks, guys. Appreciate it for taking the questions.

[Operator]

Thank you. Your next question is coming from [indiscernible] from Barclays. Your line is now live.

[Unidentified Analyst]

Hey, guys. Thanks for taking my question and I will add my congrats on the really solid quarter as well. So, my first question, John, so I was just wondering if you can help us understand the drivers for – maybe the relative proportion of sort of like what will drive the ARR per customer from a $0.25 million right now to $1 million that you have mentioned, right? Obviously, that’s the long-term, but as you go on the trajectory, do you think that the – it’s going to be more about obviously your penetration will maybe and so you have talked about application monitoring coverage doubling, you expect it to double over the next few years at the end at this day last year, right? Is that going to be a bigger driver you are looking for, do you think that you are interested in monitoring your cloud application security module, like they are going to mature enough and be a driver of [indiscernible] as much that, that will be a bigger contributor of that ARR per customer growth? So just wondering if you can help us give more color there?

[John Van Siclen, Chief Executive Officer]

Sure, I’d love to. So first of all, it’s important to know that the 3-plus module, ASP or average ARR per customer is it’s substantially higher than the average. Average is around 250,000 and the 3-plus module cohort is well over 400,000. So, that’s the first thing make sure that you cross-sell. The second thing is that none of our customers are fully saturated on the application side, not even our very, very largest ones. So either the applications continue to grow or they continue to add to them. All of that is consumption based where you have a consumption based model and that means expansion on that, that application front alone is massive. And then you add to it entering new markets, I mean, we are super early in the cloud app security space, but I don’t think anybody questions how valuable that is and how much it’s being disrupted by the cloud. We are pretty good at getting the right, listening to customers that you are in and out as we go into a market. We have proven it multiple times now. And I think you are going to see it again in the cloud app security space. So you put those three together of continued up-sell opportunity with applications, great cross-sell opportunity with existing modules and then adding new capabilities, new modules to the platform and gives us a lot of confidence and running room to continue to drive solid sustainable growth for the long-term.

[Unidentified Analyst]

Great. Thanks for the color. My follow-up question is for Kevin, so great to see that you guys are feeling confident enough to raise the expectations around how much the sales capacity is going to grow. But Kevin, if I go back to your sort of the mid to long-term ARR growth sort of like of what you gave us light of 25%, I am wondering if you can talk qualitatively as to if that moves as well given that the sales capacity is sort of like a higher sales capacity on most companies not to talk about that they would like to see sales efficiency and leverage in the model still. So, if 20%, 25% sales capacity has gone higher, they do our use of like baking in some expectations around the ARR growth in the mid to long-term? That’s it for my side guys. Thank you.

[Kevin Burns, Chief Financial Officer]

Yes. No, if you think about the business and the building blocks of the business over time, obviously, sort of the inputs to that the first is productivity. I think under some of those are not just the 25% to 30% sales capacity growth that John talked about. But it’s also the fact that we do believe over time we can get higher productivity out of our sales organization as they mature and as they are no longer working on the conversions. So those are sort of underlying that. And then we talked about the building blocks to ARR growth, right? And those are two. It’s pretty straightforward, right. The first is the number of new logos that we can add to the franchise. Q3 we grew that 10% year-over-year, Q4, we said that skin back growth rate will accelerate and we have also talked about a 15% to 20% new logo growth as we move the business forward. We couple that with a 120% net expansion rate, you do the math and that ARR numbers is above that 25% long-term target that we talked about. So we are very optimistic about the business. A lot of things moved a lot across the board in the right direction this quarter, everything sort of stepped up. We are optimistic that that can continue as we move forward in the fourth quarter. I am not – we are not going to come off of our long-term numbers at this point that we look forward to updating you after our Q4 numbers and talk about the trajectory of the business coming to them.

[Unidentified Analyst]

Thanks, guys.

[Operator]

Thank you. Your next question is coming from Andrew Nowinski from D.A. Davidson. Your line is now live.

[Andrew Nowinski, D.A. Davidson]

Great. Thank you for taking the question and the nice quarter. I want to ask about the cloud application security solution, if you could just give us maybe any color around what you see as the competitive landscape in that market? And also, is that a different buyer that might be buying that solution when you go into an enterprise to cross-sell it?

[John Van Siclen, Chief Executive Officer]

Great, great questions. So, what we found when we were doing our sort of due diligence before we even brought our product to market is just playing out as we talk to more and more customers now and additional proof-of-concepts that are underway. There is a first of all the folks with the pain are the same cloud application folks that we talked to today. They are the ones that are being throttled by the security teams and probably rightly so because the security teams need to make sure everything is locked down secure that runs and sprawls across these clouds. And the common way of doing this is to try to do code scan after code scan. The pre-production, of course, before things are deployed and then periodic, not continuous, but periodic, in production. And what the results are, are long lists of false positives. Only a few like very small number of actual vulnerabilities, but these development teams have to go to everything and triple check them. So, that slows innovation. And it’s not really what the development teams want to do, they want to innovate. And so we sort of – we saw that friction between the security requirements and the speed of DevOps by providing not only preproduction scanning, but continuous production scanning for vulnerabilities. And we have the intelligence in our platform that eliminates the false positives, I mean reduces the noise dramatically making the development teams much more efficient and obviously the speed of innovation and deployment much greater. So, that’s what’s playing out. We think it’s – we have a great opportunity. The feedback has been super positive. But like anything that’s enterprise grade, especially if it’s going to go through the security gauntlet, it’s going to take a little bit of time to validate and verify, but we are optimistic and excited about the first 90 days here or 60 days and we will be talking more about it, of course, as we go in the future.

[Andrew Nowinski, D.A. Davidson]

That’s great. Thank you. And then maybe just a follow-up to that as well, you had an integration with I believe SNCs, along the same DevOps line, which SNC just caught a very high valuation on their last round. So I am curious as to your views on where you think that partnership can go and how that helps you in that DevOps market?

[John Van Siclen, Chief Executive Officer]

Yes, with SNC in a in the DevOps space?

[Andrew Nowinski, D.A. Davidson]

Yes.

[John Van Siclen, Chief Executive Officer]

Yes. Well, they have a phenomenal vulnerability database. They also happen to have very good information for developers as to exactly how to remediate an issue. So, the combination of our continuous intelligent sort of vulnerability detection, combined with their database, which is what we leverage as well as their information for developers, is like a perfect combination for DevSecOps acceleration. So, they have been a great partner to work with. We are excited to have our systems sort of integrated together. We give them runtime sort of view and value and they give us some fantastic behind the scenes data to leverage.

[Andrew Nowinski, D.A. Davidson]

Thank you.

[Operator]

Thank you. Your next question today is coming from David Hynes from Canaccord. Your line is now live.

[David Hynes, Canaccord]

Hey, thanks guys and congrats on the results. Maybe I want to follow-up on the last question on the security front a little bit. Look, I realized how early it is and I am sure there is a bit of price discovery happening in the market now. But if you think like looking forward, how much of an uplift to spend, could the adoption of security be right? I mean, if you have the average customer spending 250 grand with you, is it a 10% uplift 20% like more like any frame of reference there would be helpful as we think about the opportunity?

[John Van Siclen, Chief Executive Officer]

So, our plans include multiple different kind of capabilities in the – for this module, this first capability, the vulnerability detection we think is a 10% to 20% uplift. But there is no reason that based on the plans we have and what we think we can bring to market that our app security module can’t be dollar to dollar with the APM module. I mean, the value is significant obviously and it’s the kind of solution that gets rolled out in a very broad way, not in a piecemeal way once it’s proven. So anyway, that’s – those are some of the thoughts behind why invest in this versus something else? Not only is it great disruptive moment, but it’s also something we think we can continue to build on and really have a significant ARR impact over time.

[David Hynes, Canaccord]

Yes, yes. Makes sense. And then maybe just a higher level question that kind of gets at the triggers for expansion, I think looking backwards right over the last couple of years like the migration of the new platform was a great opportunity for you guys to get in there and get bigger right. Now that we are past that like what’s typically the catalyst for expansion in the base, right? Is it just the digital transformation initiatives that you are seeing? Is it new products trigger conversation? Is it just happened at renewals like help us like what’s the process and speak to that maybe in the context of sustainability of that 120 plus net dollar expansion?

[John Van Siclen, Chief Executive Officer]

Sure. Well, so, really is the couple of different motions, the first one land and expand motion. The landing zone hasn’t changed much. But what’s happening is more and more companies are hitting what we call the microservices ball where the dynamic complexity at the application level gets so great and that blind spots are vast and sort of massive gaps in observability when it comes to sort of multi-app portfolios and large scale environments. And there is nothing like Dynatrace in those environments and more and more companies are finding that there are alternative solutions whether they were a Gen-2 APM solution, whether they thought they could do it with an infrastructure approach and maybe that would be enough or whether they are trying to throw a bag of tools at it, open source tools at it, I mean all of those are falling short at the enterprise level. So that’s helping us land new logos faster as well as bring new reps up to speed more quickly.

On the expansion front, like I said, everybody is putting more workloads on these clouds as fast as they can rewrite the old apps or add new apps, everyone is doing it. DevOps is a fantastic thing, because companies can move faster at the same time, lots of new workloads and services going out in production that need to be observed, observed, understood, troubleshot, optimized etcetera. And then the cross-sell is just natural for our customers once they get the hang of how a platform works. That’s earlier days as we have talked about, but it’s catching on, people are getting the hang of see if I have automation and intelligence, why wouldn’t I want more of it across the broader footprint of my infrastructure and services. So, I think it’s really the combination of all three of those that are driving the momentum and that’s why we are stepping things up whether it’s on the partner front or the sales front.

[David Hynes, Canaccord]

That makes sense. Thanks and congrats.

[John Van Siclen, Chief Executive Officer]

Thank you.

[Operator]

Thank you. Your final question today is coming from Walter Pritchard from Citi. Your line is now live.

[Walter Pritchard, Citi]

Hi, thanks. Just a follow-up on last – on a couple of questions here. Around the sales organization, you are taking on more partners, you have got the security, go-to-market which is a little bit of a different buyer and then you continue to rapidly expand the size of the sales force stepping up that hiring rate as you talked about. Can you help us understand as we move into fiscal ‘22 any structural changes or any sort of evolutions you are making to the sales force to enable you to sort of keep up this pace of growth and these new initiatives that you have articulated?

[John Van Siclen, Chief Executive Officer]

Yes, no great question, Walter. We plan our sales superstructure pretty well ahead. So, I think on the direct sales front, we are in pretty good shape, nothing too dramatic. I mentioned a little bit around some vertical focuses. We are doubling down in state and federal in North America, couple of things like that, that are obvious and smart expansions I think. We are expanding our partner team both on the tech alliance side and on the cloud system integrators. So, that continues under the hood. We talked about that a little bit before. And then, we have really stepped up our marketing efforts. We don’t talk about that quite as much, but the entire organizational structure there and sort of program and program management there toward digital as opposed to physical has been a big shift for us over the last 12 months. So, all those pieces are in place and we are really just stepping up on what’s in place and expanding across a number of areas, but nothing sort of dramatic that we have to do – that we have to prove out, it’s just more of step on the gas and build on what we have going right now. It’s a lot easier.

[Walter Pritchard, Citi]

And then just in terms of where you are getting sales people as you look towards that acceleration, is there any sort of bend you are making in types of people you are hiring as you look at the future versus the last couple of years?

[John Van Siclen, Chief Executive Officer]

Not a lot of changes. I think if anything, we are spending more time sort of going to adjacent infrastructure spaces as opposed to try to find people with performance or performance or infrastructure monitoring kinds of backgrounds, we find there is some bad habits there. So, we like to train folks new and we are doing a really good job now I think of finding better talent, people not looking for work, but having a reputation for being a fantastic company to work for especially on the sales front. And I think that’s helping us with talent, acquisition, reducing turnover. And as Kevin said, it’s a little bit of sort of the secret sauce under the hood with sales right now is that the maturity is increasing quickly with a lot more reps having been here for 2 plus years and they really get the hang of how Dynatrace is different, who to find and how to articulate our value advantage.

[Walter Pritchard, Citi]

Got it. Great. Thanks. Thanks for that compare.

[John Van Siclen, Chief Executive Officer]

Thanks, Walter. Maybe I can just add real quickly, I know people are going to have to hop a quick thank you for joining us. You could tell Q3 was a great quarter for us, sets us up for a great finish in 2021 we think. And we are pleased with how the market is moving, how our go-to-market is paying off innovation engine alive and well. And we are looking forward to giving you guys an update in May as to Q4 results and the year as well as FY ‘22 guidance. So with that, we are back to execution. Thank you very much and have a great day. Cheers.

[Operator]

Thank you. That does conclude today’s teleconference and webinar. You may disconnect your line at this time and have a wonderful day. We thank you for your participation today.