The famous venture capitalist John Doerr penned a business tome a few years back that explains how to bring quantitative rigor to running a company’s operations, called, Measure What Matters.

Some version of that is playing out at PagerDuty (NYSE:PD), the twelve-year-old firm that makes software to help operations teams keep up with breaking issues in systems management.

Howard Wilson, CFO of PagerDuty, sat down with Capital Market Labs following the company’s successful second-quarter report on September 2nd, as he has in past. One of the themes Wilson talked at length about is how the company has a feedback loop of sorts, to measure how people use the product, to gain insight into what can presumably make the product more heavily used.

“We can see certain signals” in the way the product is used, Wilson told CML. “We can tell, for example, if someone takes our free plan, and they have only a single user, then they’re probably using it in a very limited way.

“But if they add five users, then that’s a signal: there’s a team, there’s a team of five.” And then PagerDuty can start to focus its customer relations on how to nurture that group of five, to expand the sale further.

Think of it as measuring what matters not just inside a company, as Doerr suggested, but measuring, too, what matters with the customer’s use of the product.

What emerges is a picture of a company that is able to increase its usage within a given shop in a somewhat methodical way.

“We are experimenting a bit in terms of both how do we use our products to lead to growth of that customer, and nurture them in a way that it’s not intrusive, and also not expensive.”

That approach of measuring and then using what is measured has a direct business result: it can increase the company’s retention rate, meaning, how much it sells to a given customer relative to historical standards. And it can make the product more sticky.

“There’s more users on the back-end, and with that, then there’s more annual recurring revenue, that helps dollar-based net retention,” said Wilson.

“We have high predictability with roughly a third of our enterprise customers expanding with us each quarter,” he said.

Wilson gave the example of a food service business that during the quarter extended its use of PagerDuty to more individuals within the engineering team.

Said Wilson, “Their expansion with PagerDuty to ensure that every engineer is covered, and extended teams covered, is a good example of how PagerDuty is acting at the center of the nervous system to allow them to deliver their service to the end customers.”

One-on-One with the CEO of PagerDuty (PD)
Capital Market Labs: To start with, as we usually do, Howard, I’ll throw it out to you. What things do you think are most important for investors to take away from the results and outlook?

Howard Wilson (CFO PagerDuty): Yeah, well, Q2 for us was a really strong quarter in terms of both execution with revenue growing at 33% year over year.

We were delighted to see that acceleration in revenue.

The second is that, also, we’re seeing good demand signals, and those demand signals are coming across enterprise and mid-market companies, which are a large part of our focus, but also even in small business, which is typically the startup space for us.

But we saw that SMB space, in fact, returning to levels better than pre-COVID almost. It was just such a strong showing.

I think those were two things. One, we felt that our execution was strong; and two, we felt that there’s good demand in the economy.

We’ve seen increasing recovery in some sectors that were hit quite hard by the pandemic, like travel. One of the customers that we mentioned was TripActions, which obviously has a focus on travel. We saw them expand with us again.

There’s also large North American international airline that also had been impacted, they started spending again. We’ve seen some good signals in areas that had been impacted.

And then a continuing trend in companies that were doing well in the pandemic. Food delivery services, we have one customer that has expanded again this quarter.

For them, the way that they put it is that if they are not able to service the demand for deliveries, that can actually lead to potentially a million or millions of dollars of missed orders, and that represents significant revenue at the end, since they get a commission on that piece.

For them up time is money.

Their expansion with PagerDuty to ensure that every engineer is covered, and extended teams covered, is a good example of how PagerDuty is acting at the center of the nervous system to allow them to deliver their service to the end customers.

A lot of positive signals across the business.

CML: The beat in total customers was 18,000 versus what I think was Street consensus for about 15,500 or so. What led to that dramatic upside in customer count?

HW: Yeah. When we reintroduced our free offering — which we spoke about last time we connected — almost a year ago now, what that free offering does is, it’s made PagerDuty accessible to more companies.

When we speak about that 18,000 number, that includes both companies that are paying customers and also companies that are free customers.

Those free customers represent a really strong funnel for us in terms of future growth.

This was clearly a good decision that we made a few quarters ago, because previously we had this trial motion, which means that customers would come in, you have a relationship with prospects who come in.

We have a relationship with them for a couple of weeks, and then either they would convert or you would lose touch with them.

But now with the free offering, we actually are able to get a better understanding of what those companies need, how they’re developed.

We see good progression in the large customer space and mid-market and enterprise customers converting from free to our paid offering.

In the meantime, we’re creating opportunity for, again, a lot of technology startups to start using PagerDuty while they are still small and young and, hopefully, we’ve got the next Twilio or the next Zoom or next Okta sitting in that mix.

CML: Or the next Confluent, or the next PagerDuty.

HW: Exactly. Any of the above.

CML: I love it. That’s a really good point.

Given that this is a point in time, Howard, when you speak to the Street about customer count and that sales motion of free-to-converted, do you give them a sense of, or do you know even internally, what conversion takes, and what conversion trends are going to happen to the point that you can extrapolate into the future?

HW: Yeah, before we introduced our free plan, we had external consultants work with us around understanding how that could evolve over time. They helped map out for us anticipated conversion rates by cohorts.

Because often when you introduce a free plan, you could end up with accounts staying in their free plan for an extended period of time.

You continue to grow that funnel and you expect to see levels of conversion out of that, both in total and then by cohort.

We’ve seen better-than-expected results in terms of conversion to date.

We think that’s very encouraging. We do still feel, though, that we are early in that cycle.

We are experimenting a bit in terms of both how do we use our products to lead to growth of that customer and nurture them in a way that it’s not intrusive and also not expensive, so that we can do that in a cost-effective way.

Internally our teams are looking at, like, what’s the motion with which we should continue to provide them with additional information, highlight certain features that they could access, connect them, maybe, with someone via chat, connect them with some sort of sales development person.

That’s something that we are continuing to look at quite closely. This is where it’s been quite interesting bringing in Sean Scott as our Chief Product Officer beginning of the year now, who was previously with Amazon.

He comes in with a really keen understanding of what’s almost a consumer-like experience.

When somebody goes online and signs up to use PagerDuty, even the free offerings, it’s more like a consumer experience than it is like an enterprise software experience.

CML: Because they just put down a credit card you mean? Is that what you’re talking about?

HW: Yeah. That’s right. But in the free, you don’t even have to provide your credit card.

But when you convert, you put in your credit card details and away you go.

You can just buy PagerDuty online. He [Scott] brings along some interesting perspectives, together with our head of growth, around how do we make sure that we’re optimizing that particular channel.

What’s interesting about that is, we can see certain signals, and I don’t want to get too technical on this because it may not be of interest to your users.

We can tell, for example, if someone takes our free plan and they have only a single user, then they’re probably using it in a very limited way. But if they add five users, then that’s a signal there’s a team, there’s a team of five.

Then we know that there are certain actions that they can take.

If they are adding a service and the service really represents the way that they’re going to interact with an integration, then they’re doing something real, something solid with it.

If they then create an escalation policy, then it means that they’re using this to ensure that they can hold someone accountable if there’s an issue.

There’s a lot from the way that they use PagerDuty in that free mode that helps us understand how we can best serve them as a free customer but also what could be the point at which they would want to then grow.

There is a natural gating with five users. As their teams grow, they’re going to move to a paid plan.

CML: You couldn’t do this when software was on a diskette!

HW: Exactly, you couldn’t. You had no visibility. It was very analog for a digital offering.

CML: I mean, price per processor, I remember those days, everything was priced per processor because once it’s taken into the data center, it’s all you can eat and there’s no way to be in there.

HW: Yeah, yeah, absolutely.

CML: Dollar-based net expansion rate, or retention rate — I’m sorry, I don’t recall which one of those you use?

HW: We use dollar-based net retention.

CML: Retention.

HW: Yeah.

CML: It was 126%, I think, last quarter. You’re guiding to 118% to 124% for the full-year range. It sounds like there’s a dip in the second half…?

HW: Yeah. Our dollar-based net retention was 126%, which was actually 10 percentage points higher than it was the same period a year ago, and it was five percentage points up sequentially from where it was last quarter.

It went from 121% to 126%. In fact, in the enterprise, it was 130%.

When we guide on dollar-based net retention, we normally provide a fairly broad range which is why we guide to 118% to 124%, both for Q3 and Q4.

It’s not that we’re necessarily anticipating a dip.

It’s just that it’s hard to always anticipate how it’s going to play out, because when you look at dollar-based net retention, you’re looking at a cohort of customers who were customers a year ago and what they’re spending with you at the end of this period.

CML: Right.

HW: Trying to predict exactly which customers would expand when and by how much, whilst we have some fairly good instincts around that because we have high predictability with roughly a third of our enterprise customers expanding with us each quarter, you don’t know quite how much this spend is going to be.

That’s why we give that indication.

Our view is that anything within that range is healthy. In fact, anything above 120% is world-class.

There are very few companies that, at our size, can sustain a dollar-based net retention rate above 120%. But certainly, we would expect to be within that range, and enterprise a little bit higher.

CML: Okay. There’s not some specific event or development that you’re saying, aha!

HW: No, nothing specific there to watch for.

CML: Okay. Customer service is 12% of revenue I think as of the latest quarter. Is that a new use case that we had spoken about in past, it’s just the customer service vertical is it?

HW: Yeah, so, customer service, it’s 12% of our customers are also using us for customer service.

Part of what we were trying to highlight with that is PagerDuty is a horizontal platform.

Although we were built by engineers for engineers, we started being used in IT, but then we started finding other parts of the business have started using PagerDuty as well.

We noticed this a few years ago that when we were strong within a development organization in a company, they would often act as evangelists or advocates for PagerDuty to other parts of the business.

The one area that stood out for us was customer service.

We started making some investments around particularly honing our offering to meet the needs of someone working in a customer service environment.

Typically, this is somebody dealing with inbound calls from customers, call tickets, and they could be using something like Salesforce, ServiceNow, or Zendesk as their primary tool to capture that.

What we did with customer service is we created an offering which allows customers, essentially the integration is more than integration, it’s a workflow app that allows them to connect to PagerDuty and work within their own customer service environment that they fully integrated into PagerDuty.

We’ve enabled that and now we have an increasing number of our customers that we see are using us in some form of customer service application or use as well as in dev.

We don’t land in customer service typically today. We tend to land within development and then we grow into that other part of the business. But it represents an opportunity for us to be able to, with the work that we’ve done around our integrations and making it more fit-for-purpose for customer service, to eventually be in a position to be able to go directly to customer service.

CML: I may have asked you this before, Howard, forgive me. Is there another function or use case that is similarly bubbling up to the same degree?

HW: Yes. In fact, we’ve seen increasing use by security teams, particularly DevSecOps teams who are teams that are typically small teams but very critical to organizations, and they tend to also be focused on incident response.

If you think about an issue that you might have in terms of a security threat, it looks very similar to how you might manage an incident with a customer-facing issue.

Security teams, a lot of the integration work that’s happened around PagerDuty has been around getting threat detection software and things like CrowdStrike response tooling into PagerDuty, so you can manage a security incident response within PagerDuty.

That in fact now we have 20% of our customers are using us in addition to dev also in a security use case.

From a business perspective, every quarter we are always hearing about new use cases.

One example, a large global music streaming service is using PagerDuty, and it turns out that they were using us in their finance environment, for example, to be able to ensure that when there are invoices that are identified as critical that need to be paid on a certain timeline, they’re using PagerDuty to orchestrate the people who need to make that happen.

They’re using us within the HR environment to ensure that if somebody leaves the company, that all the off-boarding processes are completed and that somebody is held accountable to make sure that that happens.

We’re seeing an endless range of ways in which PagerDuty is being used across enterprises.

To us, that’s something that’s so special.

As I said, we were built originally with a particular audience in mind but because it does operate as a platform, we can service multiple use cases.

I guess what’s interesting is that, sure, people can do alerting in terms of sending notifications in email. That’s nothing.

But how do you hold people accountable and how do you ensure that it escalates to the right people, that there’s a team that’s organized, that it initiates something that someone needs to respond to?

That’s where the capability of PagerDuty to orchestrate teams and orchestrate the right people ensures accountability.

Anyone can send off a note to say, go and do this. But what we do is we actually orchestrate the right people at the right time.

CML: I guess to go back to a couple points ago, either by module or scaling up seat license, this will contribute to dollar-based net retention?

HW: It will. Yeah, because this really means that we’re accessing additional teams, which means that there’s more users on the back-end and with that then there’s more annual recurring revenue. That helps dollar-based net retention.

When I look at our dollar-based net retention, going back a few years, it was largely driven just by user expansion or seat expansion.

But now it’s a combination of user expansion and then the fact that we can access new teams in customer service or in security or in the business, and then the next element is really around our product upgrade, so taking our more advanced plans like our digital operations plan or our event intelligence product or landing with our automation product that came with the acquisition of Rundeck.

So how, we have a number of different levers that can contribute to that dollar-based net expansion or net retention.

CML: That’s great. All right, I want to come back to this small business point that you mentioned.

When you mentioned healthy signs, I’m wondering: small business is a trend that we’ve seen from a lot of companies like DigitalOcean and SEMrush, companies that are serve these companies.

In addition to coming back as a cohort from extremely low levels last year, do you think, is small business for you a meaningful driver overall of new customer acquisition and expansion?

HW: Today, small business represents about 20% of our revenue. That’s meaningful, but it’s not the largest part of our business. But it’s certainly meaningful.

We also take small business seriously because we do see that as being the future generation of our growth. Also, we do expect to see increasing levels of acquisition because it’s just a broader population of customers that you can access. Small business is important for us.

We try to ensure that we are providing the right mechanisms to address small business.

I think the piece that’s interesting to me is just having a look at how that was an area that was very heavily affected with COVID.

If I go back to Q2 last year, which was kind of one of the most traumatic quarters of my working career, that was a time when we saw, like, small business being really hard hit.

Because they were also typically the companies that were on month-to-month arrangements with us, they didn’t sign up for annual contracts.

It meant that they just had to dial down their use to the absolute minimum or leave. We felt that impact immediately.

But what’s good to see now is that small business is coming back, and a good portion of our small business is electing to take annual contracts.

We now have 87% of our revenues coming from customers on term contracts, which is good for us as a business because it gives us resilience. It’s more predictable. We only have exposure around 13% to variable customer use.

CML: To close out this theme on use cases, DevSecOps is a really very fruitful area, especially right now, very hot area. Do you think there are other vectors along which PagerDuty can expand that we haven’t addressed in that regard?

HW: Look, I think Jennifer [Tejada], our CEO, used the term infinite state of use cases, because I think there isn’t a particular limit to a particular business function.

If anybody is trying to manage either time-sensitive or time-critical work or work that that becomes time sensitive or time critical based on accountability of individuals, then PagerDuty is a platform to help manage that work.

We’re in a unique position to be able to take that from a signal and ingest any kind of signal because we now have over 600 different integrations, and that number keeps on growing, which we can ingest into our platform.

We use our machine learning to make sense of that.

Now with our automation capabilities, some of the time you can just initiate automation to act in service of the user, not to replace the user, into actually service of the user to go and perform the routine functions that need to be done and maybe close it up so that a human doesn’t have to get involved, but in some cases actually do the work so that when the human does get involved, they’re doing so with rich context and there’s a whole lot of things that have already been done.

We can close that loop from detection to other remediation which has become really critical when you think about just the availability of talent.

You want to make sure that you’ve got your highly-skilled talent working on the most important stuff. PagerDuty actually enables that. It allows your teams to focus on innovation or more important, more valuable work, and we let the machines do as much of the routine work as possible.

CML: I like it. I think Jennifer mentioned, Howard, 30% revenue growth for the foreseeable future. Do I have that correct?

HW: Yes, she did. I always have to keep Jennifer in check, I know, but she did mention we are growing above 30%, our guidance that we’ve given for the next quarter, the midpoint of that guidance is 30%.

We spoke even at our Investor Day that we see ourselves as being a company that can grow fairly consistently and sustainably at 30% or above.

CML: Okay, thank you. One last question for you. Free cash flow, to me, is really a meaningful element. How are you thinking about over the course of the next several years approaching free cash flow?

HW: Yeah, sure. We’ve always been a company that’s been very careful about how we manage capital and being capital-efficient.

We’ve also always felt that we need to sort of balance with that equation between investing in growth and what you expense, so that you don’t end up burning cash unnecessarily. We have a strong track record there.

I think at this period in time we have a few things that we are wanting to, because we’re seeing that growth signal, we’re making additional investments and that, of course, means that there’s slightly higher utilization of cash, but nothing particularly unusual.

But over the longer term, for us, when we model out our growth as a company, we see ourselves getting to sustainable free cash flow in the next few years, because it’s part of our model as we think about growing close to $500 million in revenue and then on to $1 billion.

CML: Great. It sounds to me like you’re on course for maybe like a Salesforce.com kind of thing if I think back to the early days when Salesforce came public.

HW: Yeah, yeah. That’s a good company to be compared with.

CML: Absolutely. Thank you, Howard. Anything else you want to mention in our waning time together?

HW: No. I mean it’s always good to catch up with you and lovely to share with you what we’re doing and appreciate you taking the time.

CML: Thank you for taking time. It’s great. It’s always great talking to you and this is really useful. Till next time, cheers.

HW: Cheers, bye.

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The author has no position in PagerDuty at the time of this writing. 

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