“We are raising our free cash flow guidance to $415 million to $420 million, an increase of $19 million at the midpoint, representing a free cash flow margin of 25% of revenue.”

In context

“Jim Benson (Chief Financial Officer): Thank you, Rick, and good morning, everyone. Q3 marked another quarter of consistent execution as we once again surpassed the high end of our top line growth and profitability guidance metrics, showcasing the durability of our balanced business model and ongoing demand for our leading AI-powered observability platform. Now let's review the third quarter results in more detail. Please note, the growth rates referenced will be year-over-year and in constant currency unless otherwise stated. Annual recurring revenue or ARR ended the third quarter at $1.65 billion, up 18% year-over-year. Q3 net new ARR on a constant currency basis was $68 million down modestly from the same period last year and up 5% year-to-date for fiscal 2025. In Q3, we added 193 new logos to the Dynatrace platform. As we have stated in the past, we continue to target landing high quality new logos that have a greater propensity to expand. Our average ARR per new logo was over $140,000 on a trailing 12 month basis and up versus both the prior quarter and prior year. Our value proposition continues to resonate with enterprise customers that are outgrowing their existing DIY or commercial tooling solutions. They are seeking business value from tool consolidation and coming to Dynatrace for the depth, breadth and automation of our unified observability platform. Once customers experience the benefits of the Dynatrace platform, they are often quick to expand their usage. Average ARR per customer continues to grow and surpassed $400,000 for the first time, highlighting the continued adoption of the platform and value we provide to customers. Gross retention rate remained in the mid-90s demonstrating the strategic relevance of the Dynatrace platform as it remains a mission-critical part of our customers' operations. Net retention rate or NRR was 111% in the third quarter. Our DPS licensing model continues to gain traction and adoption. We now have almost 1,500 DPS customers globally representing more than 35% of our customer base and over 55% of our ARR. As Rick mentioned, our expectation when we launched DPS was that customers with full access to the platform would trial more capabilities and adopt Dynatrace more broadly within their IT environment. I'm pleased to say that thesis is proving itself out. What has become clear as DPS has started to mature and scale is that the customer friendly approach to DPS pricing, which does not penalize customers for exceeding commitments, is leading some customers to consume DPS on-demand instead of renewing early. This on-demand consumption is benefiting subscription revenue growth, which outperformed expectations nicely in Q3. However, it's important to note that this revenue is not captured in our ARR or NRR metrics, which only include contractually committed revenue. Let me put some numbers around this to make the impact on our financials clearer. In Q3, we had $7 million of on-demand consumption in our subscription revenue. This contributed to 150 basis points of year-over-year subscription revenue growth. On a year-to-date basis, we had $12 million of on-demand consumption revenue. The fact that DPS makes it easier to consume the platform is positive for Dynatrace. The outcome of customers expanding and broadening their usage of the platform, whether that be contractually committed or on-demand drives continued subscription revenue growth. Going forward, we believe investors should assess the underlying health of the business by taking into consideration both ARR, which will still be the largest growth indicator, and on-demand consumption revenue. Our expectation is that as DPS grows and scales, so too will on-demand consumption with likely variability and seasonality quarter-to-quarter. Moving on to revenue. Total revenue for the third quarter was $436 million, up 20% year-over-year and exceeding the high end of guidance by $8 million. This beat includes absorbing a $3 million FX headwind from the strengthening US dollar. Subscription revenue for the third quarter was $417 million, up 21% year-over-year and exceeding the high end of guidance by $7 million as reported and $10 million in constant currency. With the upside primarily driven by the on-demand consumption dynamic I just mentioned. Shifting to margins, non-GAAP gross margin for the third quarter was 84%, down slightly from the prior quarter and prior year due to increasing cloud hosting costs as we migrate more of our customers to our SaaS solution. Non-GAAP income from operations for the third quarter was $131 million, $11 million above the high end of guidance driven by increased revenues flowing through to the bottom line. This resulted in a non-GAAP operating margin of 30% exceeding the top end of guidance by 200 basis points. Non-GAAP net income was $112 million or $0.37 per diluted share. This was $0.04 above the high end of our guidance. We generated $38 million of free cash flow in the third quarter. Due to seasonality and variability in billings quarter-to-quarter, we believe it is best to view free cash flow over a trailing 12 month period. On a trailing 12 month basis, free cash flow was $406 million or 25% of revenue. As a reminder, this includes a 650 basis point impact related to cash taxes. Pre-tax free cash flow on a trailing 12 month basis was 31% of revenue and up 25% year-over-year. On a related tax note, as part of our ongoing strategic tax planning efforts, we completed an IP related transfer to a Swiss subsidiary resulting in a non-cash $321 million tax benefit to our GAAP net income and EPS. There was no impact on non-GAAP net income or EPS. And while the impact of this IP transfer to fiscal 2025 cash taxes is insignificant, we do expect it will have a more meaningful impact in fiscal 2026 and beyond. More to follow on this in our May earnings call. Finally, a brief update on our $500 million share repurchase program. In Q3, we repurchased 732,000 shares for $40 million at an average price of $54.64. Since the inception of the program in May 2024 through December 31st, we repurchased 2.7 million shares for $130 million at an average price of $48.89. Moving now to guidance. Let me walk through some of the assumptions and insights underpinning our updated guidance. First, based on our learnings from early DPS cohorts, we believe it is likely that on-demand consumption will be an ongoing and growing part of our subscription revenue stream as the DPS contracting model matures. To put a finer point on this, going forward subscription revenue growth will be driven by a combination of upfront ARR growth and on-demand consumption on the tail end of contracts for those customers that choose not to renew early once they've exceeded their upfront commitment. Second, the trend of larger and more strategic deals related to observability platform architecture and tool consolidation initiatives continues to grow. The sales funnel is weighted heavily to these types of deals. While we believe this trend is a net positive for Dynatrace given our highly differentiated AI-powered platform and positions us well to capitalize on these opportunities, it also introduces increased variability in terms of both close timing and deal certainty. Third, we continue to mature the go-to market adjustments we made at the beginning of this fiscal year. As we expected, it takes time for new reps to build relationships and positively impact sales productivity. Fourth, while the demand environment for observability remains healthy, we do not assume a material change in the macro environment as enterprises continue to be cautious in their spending. Finally, with 40% of our business denominated in foreign currency, the strength of the US dollar since our last call creates a sizable headwind. We now expect FX to be a headwind of $38 million to ARR and $17 million to revenue. This represents an incremental headwind of $28 million to ARR and $10 million to revenue. And with that as context, let me outline our updated outlook. We are raising our constant currency full year guidance across all top line growth and profitability metrics. We are increasing our full year ARR growth guidance 75 basis points at the midpoint to $1.705 billion to $1.715 billion. This represents 16% to 16.5% growth year-over-year. We are raising our total revenue growth guidance 150 basis points at the midpoint to $1.686 billion to $1.691 billion, representing 19% growth year-over-year. And with the uptick in on-demand consumption revenue, we are raising our subscription revenue growth guidance 250 basis points at the midpoint to $1.609 billion to $1.614 billion representing 20% growth year-over-year. This growth rate represents a 350 basis point increase from the midpoint of guidance that we provided at the beginning of this fiscal year. Turning to our bottom line. We are raising our full year non-GAAP operating income guidance by $13 million. This translates to non-GAAP operating margin guidance of 28.5% to 28.75%, up 50 basis points at the high end of the range and up roughly 75 basis points from where we landed in fiscal 2024. We are raising non-GAAP EPS guidance to a range of $1.36 to $1.37 per diluted share, representing an increase of $0.05 at the midpoint of the range. This non-GAAP EPS is based on a diluted share count of 303 million to 304 million shares. This EPS and share count guidance excludes the impact of any potential share repurchases in Q4. We are raising our free cash flow guidance to $415 million to $420 million, an increase of $19 million at the midpoint, representing a free cash flow margin of 25% of revenue. Excluding an expected 650 basis point impact from cash taxes, this represents a pretax free cash flow margin of 31.5%, which is up 150 basis points from fiscal 2024. Looking at Q4, we expect total revenue to be between $432 million and $437 million. Subscription revenue is expected to be between $410 million and $415 million. From a profit standpoint, non-GAAP income from operations is expected to be between $104 million to $110 million or 24% to 25% of revenue. Keep in mind, we have some seasonal expenses in the fourth quarter including incremental spending for our Perform Customer Conference and a structural reset of payroll taxes. We believe it is best to look at margins on a full year basis. Lastly, non-GAAP EPS is expected to be $0.29 to $0.31 per diluted share. In summary, we are pleased with our third-quarter fiscal 2025 performance. The observability market is healthy and growing. We have a proven track record of disciplined execution balancing top line growth with expanding profitability and free cash flow. While we continue to maintain a prudent approach to the near-term outlook, we are optimistic about the long-term growth opportunities in front of us and the maturation of our go-to-market evolution to go after it. And with that, we will open the line for questions.”