After a not-so-happy couple of years of a bear market, cloud computing stocks are so back in 2024. As artificial intelligence (AI) hype ratchets up, tech has been fast on the rise in the first two months of the year.
But in reality, cloud software never really went anywhere. Throughout the last couple of years of heightened investor worry, global spending on cloud computing actually kept rising. And according to researcher Gartner, end-user spending on cloud services is expected to home in on $680 billion in 2024, up from an estimated $411 billion in 2021.
While generative AI has captured the spotlight for over a year now, “traditional” cloud services are actually still increasing, too. And with all of these new use cases, the need to monitor and secure all those IT processes is growing alongside them. That’s why chip design companies like Broadcom just completed its mega-merger with the big cloud software management business VMware, and why networking hardware giant Cisco Systems has submitted a bid to purchase Splunk to bet on cloud and network monitoring services.
This wave of cloud spending is benefiting smaller software companies, especially in the security and analytics field. And one of them has been steadily cranking out profitable growth since its initial public offering in 2019.
Cloud observation on the rise
Enter cloud observability and application performance monitoring (APM) stock Dynatrace (NYSE: DT). Dynatrace sells its cloud observability and security software to the world’s largest organizations. That compares to another upstart in this market, Datadog (NASDAQ: DDOG), which started from the other end of the go-to-market strategy offering cloud-based data analytics for smaller and midsize companies. Splunk, the old legacy player, started in the non-cloud era, and only in the last five years started really pushing to modernize its software stack.
The core Dynatrace service is observability and APM, which finds bottlenecks, trouble spots, and security holes in a computing system. Dynatrace’s software (long powered by the AI assistant “Davis”) can recommend and automate fixes.
Dynatrace also just made a small acquisition of an AI start-up called Runecast. Runecast helps customers with security and compliance of their hybrid cloud systems (using more than one public cloud service or a hybrid of public cloud and private data centers). It’s a small purchase, but management is starting to flex its financial muscle.
In this new era of AI, many large organizations need to keep their data and proprietary apps built using data held privately in their own data center. That puts Dynatrace’s flexible software suite at an advantage. It excels in all IT environments, cloud or otherwise — especially catering to those big and complicated customers.
This explains why Dynatrace’s revenue has been (overall) slower but steadier than some of its peers’, hovering around 20% plus or minus a few percentage points in any given quarter the last few years. Big customers take more time to make a move, and Dynatrace also has to work at uprooting in-house home-grown IT software solutions that many of its would-be customers have made themselves.
Dynatrace is a profitable AI stock
In the last quarter (the three months ended in December 2023), revenue grew 23% year over year to $365 million. It was a nice acceleration from the last year and a half or so during the bear market. Dynatrace’s guidance three months ago was for growth of as much as 21%.
The fourth-quarter outlook is for 18% to 20% year-over-year growth, but management often underpromises and overdelivers in true cloud software company fashion. The real advantage, though, is that Dynatrace has excelled at profitable growth by all metrics the last few years. Datadog is still working on that.
In the last quarter, Dynatrace generated net income based on a generally accepted accounting principles (GAAP) basis of $42.7 million (a net income margin of 11.7%) and free cash flow (FCF) of $67.4 million (an FCF margin of 18%). Full-year FCF margin targets also hover around 20%, and a 23% FCF margin is the guide for this fiscal year.
Shares now trade for nearly 80 times trailing-12-month earnings per share (EPS), and about 45 times trailing-12-month FCF. It’s a high premium, so the market has still latched on to this notion that cloud observability and APM will be a high-growth software market that follows the general trend of global cloud spending overall.
One positive helping to justify the premium: The company had total cash and short-term investments on balance of $783 million (up from $555 million at the end of fiscal 2023 last March), and zero debt.
But to balance this promising growth business with the high premium price (which is sure to lead to ample stock volatility), I still view a dollar-cost-averaging plan as appropriate for Dynatrace — at least as far as my portfolio goes. The company keeps executing well on its growth strategy, and I’m happy to be along for the ride.
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Nick Rossolillo and his clients have positions in Broadcom and Dynatrace. The Motley Fool has positions in and recommends Cisco Systems, Datadog, and Splunk. The Motley Fool recommends Broadcom and Gartner. The Motley Fool has a disclosure policy.
1 Little-Known AI Stock to Watch Closely in 2024 was originally published by The Motley Fool