In the ever-evolving landscape of cloud-based applications and infrastructure, one company stands tall in shaping the future of observability use cases – Datadog (NASDAQ:DDOG). Renowned for providing one of the most comprehensive cloud monitoring solutions available, Datadog has woven a compelling success story. Its commitment to innovation and strategic expansion into key monitoring segments like Application Performance Monitoring, log management, and synthetic/real user monitoring has fostered robust growth trends. In this in-depth exploration, we dive into Datadog’s core operations, market expansion efforts, and the driving forces behind its success while illuminating the potential risks and financial standings that shape the company’s future.
Business Analysis
Datadog’s primary focus and revenue generation predominantly lies within observability use cases, where it provides one of the most extensive cloud monitoring solutions available today. True to its origins, infrastructure monitoring remains its top-performing product, contributing $1 billion to the Annual Recurring Revenue in the first quarter of 2023. This offering serves as an attractive entry point for customers who often begin by overseeing a portion of their cloud infrastructure, later broadening their usage to other available modules. This progressive customer adoption pattern has significantly accelerated Datadog’s expansion into other key monitoring segments like Application Performance Monitoring, log management, and synthetic/real user monitoring. We estimate that these observability modules account for over 90% of Datadog’s current ARR, with other market-oriented modules in the early adoption stages among customers.
We anticipate that observability will continue to form the central component of Datadog’s product line and ARR composition, backed by strong growth trends in this market for the foreseeable future. The recent acquisitions of Ozcode in 2021 and CoScreen, Seekret, and Cloudcraft in 2022 present a promising future pipeline of observability stock-keeping units. However, we emphasize that the company has consistently proven its competence in introducing new SKUs through its internal development too, as exemplified by its database monitoring product, which successfully grew to over $10M in ARR just three quarters after its introduction.
TAM Expansion
In 2020, Datadog introduced Cloud SIEM, its inaugural security-centric product, as part of its strategy to penetrate deeper into and dismantle barriers within IT organizations’ components. Since that launch, the company has unveiled seven stock-keeping units extending beyond mere observability. These preliminary modules aim to facilitate the shift left security strategy, empower DevOps teams with enhanced security function insights and control, and stimulate developer productivity and uptake.
It’s worth noting that the possibilities in the security and developer workflow sectors are still in their infancy. Many of the security modules are only one to two years old, representing a burgeoning market opportunity. However, Datadog is already experiencing robust traction with these newer modules. For instance, CI Visibility has already grown to over $10M in annual recurring revenue just six months post-launch, and the security SKUs have onboarded thousands of customers.
Looking ahead, Datadog has identified other sectors, such as business intelligence and IT service management, as potential expansion fields. These areas seem to be logical progressions for the company, given that they often operate alongside the existing product suite, leverage similar backend data, and attract a comparable user base. While we anticipate that observability will persist as Datadog’s primary revenue source, these markets present additional growth catalysts and substantial opportunities in the future.
Analysis of Market Drivers
The dynamics of technological trends are heavily influencing Datadog’s business operations and growth potential. A significant factor is the accelerating transition of workloads from traditional on-premise infrastructures to cloud-based architectures across all types and sizes of organizations. As this shift takes place, conventional tools often struggle to manage the increased complexity and data volume from cloud operations. To address this, Datadog helps businesses pivot towards newer observability tools specifically designed for hybrid and cloud-based environments.
In line with this, the surge in the adoption of microservices and container-based application architectures, replacing monolithic structures, has given rise to complex webs of connectivity. This complexity, combined with the vast amount of telemetry data each microservice produces, creates a challenging environment for error detection and performance evaluation. Recognizing this, Datadog is focusing on offering modern observability software that can centralize and simplify the understanding of these interconnections, thereby aiding users in swiftly identifying and resolving issues.
With the rapid pivot towards online business operations during the pandemic, digital customer experience has taken center stage. This emphasis has endured even as in-person business operations have largely resumed, emphasizing the need for robust digital experience management. In response, Datadog is expanding its offerings to include critical solutions like session replay, synthetic monitoring, and real user monitoring to help businesses optimize their digital interactions with consumers.
Lastly, the growing adoption of DevSecOps culture, which aims to streamline development processes and create more secure code by breaking down barriers between different IT teams, is influencing Datadog’s business strategy. As collaboration needs increase, so does the demand for tools that enable it. In response, Datadog’s observability tools are facilitating the DevSecOps transformation by enhancing developers’ and testers’ understanding of application interactions within the broader environment. By correlating and analyzing application and infrastructure outputs, these tools enable quicker and more accurate problem identification and resolution, thereby driving Datadog’s business success.
Risks
Datadog is heavily reliant on the growth patterns of broader cloud trends. Given the company’s specific concentration on cloud-based applications and infrastructure, its growth potential is inherently linked to the overall expansion of cloud workloads. A significant historical correlation exists between total cloud growth rates and revenue growth. Consequently, any slowdown in cloud expansion could negatively impact Datadog’s growth sustainability.
Innovation remains crucial in the highly competitive and rapidly evolving observability solutions market. If Datadog fails to innovate or swiftly provide solutions for newly emerging technologies consistently, it could potentially jeopardize its competitive standing and growth opportunities. It is noteworthy that the company contends with several well-capitalized public companies and a plethora of private entities in the same industry.
As Datadog seeks to venture into new markets like security, developer workflows, and ITSM, it faces intense competition. These markets, identified as potential growth areas for the company, are extremely competitive. As such, Datadog’s success in penetrating these opportunities may be limited, possibly resulting in future margin shrinkage and growth decay.
Finally, macroeconomic conditions cannot be overlooked. Persistent deterioration in these conditions may force customers to seek cost-reduction measures. These could include opting for open-source competition or trimming IT budgets, which Datadog relies on for its future growth.
Financial & Valuation
Note: All historical data in this section comes from the company’s 10-K filings, and all consensus numbers come from FactSet.
Datadog has been putting up a spirited performance as indicated by its FY Q1 2023 earnings. The impressive figures led to a 14.5% stock jump the day following the earnings release. The company’s revenue growth of 32.7% year-over-year to $482 million, which aligns with consensus estimates, reveals a robust growth trajectory. It’s quite reassuring to see gross margins at an attractive 80.5%, though we observe a dip in operating margin to 17.9% from 23.1% a year ago. Despite the slight pullback in operating margins, the EPS growth of 17% y/y to $0.28, beating consensus by 19.6%, is quite commendable.
We find the financial trends encouraging. A CAGR of 66.5% in revenues over the past three fiscal years is laudable. However, the sell-side consensus forecast of 25.3% and 26.8% revenue growth in the subsequent two fiscal years might seem slightly conservative in comparison. The substantial EBIT margin expansion of 21 percentage points over the past three years from -1.5% to 19.5% demonstrates efficient cost management. Though a forecasted contraction this fiscal year to 16.7% is expected, a rebound is predicted to 17.9% in the following fiscal year.
The rising number of diluted outstanding common shares, with a 40.6% increase over the past three years, is likely linked to the 18.2% of revenue spent on share-based compensation over the same period. Note that when management speaks of EPS, they refer to an adjusted EPS metric that excludes this considerable stock-based compensation expense, a practice we believe can be misleading. It is important to note that the company’s GAAP EPS has been negative and is expected to be negative for at least the remainder of this year.
When considering free cash flow, DDOG shows a significant uptick from a meager $1 million, a 0.3% FCF margin four fiscal years ago, to a projected $412 million, a 19.6% FCF margin this current fiscal year. This, coupled with an average FCF margin of 17.1% over the past four years, showcases the company’s ability to generate cash. Given that the company only spends an average of 2.1% of its revenue on capex, the business can be deemed capital light.
We would like to clarify that stock-based compensation is not a cash expense. Therefore, we believe that using the FCF metric alone may not accurately reflect the company’s actual profitability.
The company does have a strong balance sheet, as shown by its net cash position of $829 million, which should cushion the company from the most conceivable short-term economic shocks.
At the current price of $96.15 per share, giving it a market value of $30.9 billion and an enterprise value of $30.1 billion, DDOG seems to be trading at quite the premium. The stock has lagged behind the S&P 500 over the past year, returning 16 percentage points less. It’s currently trading at a 21.4% premium to its 200-day moving average but still 20% below its 52-week high. It is also significantly above its 52-week low, trading 57% higher. With a moderate short interest of 3.9%, we see no imminent downside risk from a potential short squeeze.
Relative to S&P 500, DDOG is trading at quite a premium in terms of all valuation multiples. Its forward fiscal year multiples are 11.3 for EV/Sales, 63.1 for EV/EBIT, 65.1 for P/E, and 53.5 for FCF. This suggests investors anticipate substantial future growth for the company. A PEG ratio of 2.0, which represents a premium of 38.2% over the S&P 500, further reiterates this expectation.
Conclusion
As we look towards the horizon, Datadog emerges as a potent force in the evolving cloud technology landscape. Leveraging the accelerating transition of workloads from traditional infrastructures to cloud-based systems, the company is strategically positioned to harness growth opportunities. The surge in the adoption of microservices and the increasing importance of digital customer experience have significantly driven Datadog’s business strategy. Coupled with the widespread embrace of a DevSecOps culture, these dynamic market drivers influence Datadog’s business operations and growth potential.
However, as Datadog navigates the opportunities, it is not without potential risks. From dependencies on broader cloud trends to the necessity of constant innovation and competitive pressures in new markets, there are significant factors that may challenge its growth sustainability. Despite these risks, Datadog’s financial performance presents an optimistic outlook, with its recent earnings showing a robust growth trajectory. The company’s ability to generate cash, coupled with a strong balance sheet, safeguards it against conceivable short-term economic shocks. Given the current market valuation and investor anticipation for significant future growth, Datadog is on an exciting technological advancement and market leadership journey.
Despite the promising outlook, we currently maintain a neutral stance on Datadog’s stock. Our position is primarily influenced by the company’s present valuation and the substantial year-to-date rally of 36%. In our view, this rally appears to be driven by a mini tech bubble rather than fundamental improvements in the company’s financial or operational performance. While Datadog undoubtedly presents a compelling story of growth and resilience in the dynamic cloud technology landscape, we believe the timing for investment is crucial. Therefore, we advocate for a cautious approach, opting to wait for a more advantageous buying opportunity, which we anticipate could emerge once the current speculative bubble in the tech sector recedes.
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