Datadog’s High Potential Upside And Risks: Why The Stock Is A Hold Now (NASDAQ:DDOG)

Datadog (NASDAQ:DDOG) is one of the biggest beneficiaries of digital transformation and companies moving to the cloud. Additionally, the proliferation of the Internet of Things (“IoT”) and edge computing is driving a massive increase in machine-generated data, a secular trend that could potentially drive significant future revenue growth for the company’s observability platform. The company displayed its upside potential last year when, despite heavy cloud optimization trends in 2023, it released a third-quarter earnings report crushing analysts’ earnings estimates for the quarter and included a full-year 2023 guidance raise. JPMorgan upgraded the stock to overweight. The stock rose 28.50%, helping it outperform many Software-as-a-Service (“SaaS”) companies over the last year, as shown in the chart below.

However, this company has several risks that some worried about even before last year’s third-quarter earnings. Those risks never really disappeared and made some investors think twice after Datadog reported fourth quarter 2023 earnings before the bell on February 13, 2024. The company forecasted revenue of between $2.555 billion and $2.575 billion for the full year 2024, below analysts’ estimates of $2.586 billion.

Management also issued the first quarter of 2024 adjusted net income per share between $0.33 and $0.35, well below analysts’ estimates of $0.39. The company’s guidance for the full year 2024 adjusted net income per share was $1.38 and $1.44, again missing consensus analyst estimates of $1.78. By failing to meet or exceed analysts’ forecasts, with the risks factored in, the market began to question Datadog’s valuation. Consequently, as of March 22, 2024, the stock is down 7% since the company reported fourth quarter 2023 earnings.

This article will discuss Datadog’s business and its high potential upside. It will also briefly discuss its fourth-quarter earnings, a few risks, the stock’s valuation, and why, despite the company’s potential upside, I think the stock is a Hold at current prices.

Why the company’s platform has high potential upside

Over a decade ago, Marc Andreessen, co-founder of venture capital firm Andreessen-Horowitz, gained fame for stating that “software is eating the world.” What he meant by that is that software is increasingly creating most of the value in businesses in all sectors of the economy. Suppose what Andreessen stated is true; whichever company is the first to produce the most effective and efficient software applications can potentially create competitive advantages in their industry.

Organizations are starting to flock towards cloud computing because it enables development teams to collaborate with Information Technology (“IT”) operation teams to speed up software development, create better software, and manage applications more efficiently. The chart below from its 2024 investor presentation shows that cloud spending and cloud spending as a percentage of global IT spending are rising rapidly.

Datadog defines itself in its 2023 10-K as “the observability and security platform for cloud applications,” services that are vital as cloud computing can vastly increase the complexity for IT operation professionals within companies using cloud computing and other digital transformation technologies to compete.

Consequently, as cloud computing grows, demand for Datadog’s services grows. Cloud computing and other digital technologies can become so complex that it has become vastly more challenging and would require hiring more people to resolve issues with software applications without the company’s observability platform.

The company’s platform can significantly reduce the size of the team of developers needed to build an application and the size of an IT team responding to incidents. During the company’s 2024 Investor Day, Vice President of Product Yrieix Garnier explained how its platform helped a telecom company save time and money responding to major incidents.

The image above shows that Datadog decreased that company’s major incidents by 33% annually. FTEs mean the average number of people engaged per incident. So, the platform cuts in half the number of people that need to respond to a major incident and reduces the time it takes to resolve an incident by 45%. The result is reducing the company’s annual person-hours it devotes to incidents by 82%, allowing personnel to engage in other tasks.

This ability to save organizations time and money is a factor in their ability to retain and upsell most of their customer base despite the cloud optimization trends over the last year. The company’s fourth quarter 2023 gross retention ratio (“GRR”) is in the mid-90s, a good number for a SaaS company, meaning it has successfully retained over 90% of its existing customer’s revenue. Additionally, its net retention ratio (“NRR”) came in above 110%, another decent number for a SaaS company, indicating it is retaining existing customers and upselling those customers by 10% over the previous period.

While software may be eating the world, NVIDIA’s (NVDA) Chief Executive Officer (“CEO”) Jensen Huang predicted in 2017 that “AI eats software.” The proliferation of generative AI is rapidly making Jensen’s prediction come true, and the expansion of this new AI technology has only increased the complexity that organizations need to deal with.

Datadog uses generative AI in two ways. It improves many distinct aspects of its platform with the technology, and the company has created a generative AI chatbot called Bits AI for customers.

Since cloud computing and generative AI are in the early stages, Datadog has a long potential revenue growth runway. Let’s examine how demand for Datadog’s observability, security, and other functionality the company has on its platform translates to revenue growth, profits, and free cash flow (“FCF”).

An excellent fourth quarter 2023 earnings report

The good news is that cloud optimization trends that have held many cloud service providers back over the last year are beginning to decline. Chief Financial Officer (“CFO”) David Obstler said during the company’s fourth-quarter earnings call (Emphasis added):

Last quarter, we mentioned that the larger and more intense optimizers had begun to show signs of stabilization. In Q4, we saw those trends continue and the large optimizers begin to grow again. While we may still be in a cost-conscious environment overall, we believe that the higher intensity of optimization has dissipated and clients are continuing to invest in new digital applications.

Source: Datadog Fourth Quarter 2023 Earnings Call

If that statement is true, it could lead to increased cloud spending for Datadog’s services over the next several quarters. In that case, management’s guidance may prove conservative, and the company may even exceed analysts’ estimates. The table below from Datadog’s fourth quarter 2023 investor relations financial statement package shows several vital metrics investors should monitor to determine whether the company is indeed bouncing back from slowing cloud spending.

Although Datadog produced mid-110% NRR in the fourth quarter, this number is down significantly from approximately 130% in the fourth quarter of 2022. NRR rising to 120% or higher might indicate that cloud spending by customers has resumed. A rising NRR might also raise investor confidence that revenue growth could rise higher in the future.

Alternatively, if NRR starts trending down to 100 or below, investors may become worried about the company losing customers or having difficulty upselling customers to new products. If that happens, Wall Street may become disenchanted about Datadog’s future revenue growth potential.

Total customers rose 15% year over year to 3,190. More customers increase the scale and efficiency of Datadog’s SaaS business, which is essential for expanding the company’s margins.

Customers with equal or greater than $1 million Annual Recurring Revenue (“ARR”) grew 25% year over year to 396. Customers with an ARR of $100,000 or more rose 15% year over year to 3,190. ARR represents the sales expansion to the existing customer base over one year. Datadog defines ARR in its 2023 10-K: “The annual run-rate revenue of subscription agreements from all customers at a point in time.“

A rise in these numbers shows the company is successfully upgrading and cross-selling products to its existing large enterprise customers, resulting in the customer’s lifetime value (“LTV”) rising and customer acquisition costs (“CAC”) declining. When a company raises its LTV and lowers its CAC, investors often become more confident that it can improve its profitability. These are important numbers for investors to follow because investors’ confidence in future revenue growth and profitability could rise or fall depending on what they show. Improved profitability often translates to higher FCF if a company can keep its capital expenses (“CapEx”) down. An increasing FCF is usually attractive to investors for many reasons.

Not shown in the above table, but an extremely important metric, remaining performance obligations (“RPO”), rose 74% over the previous year’s quarter to $1.84 billion. When a company’s RPO grows faster than revenue growth, it indicates a solid sales pipeline and the potential for faster revenue growth. The company grew fourth-quarter revenue by 25.66% and 7.69% sequentially to $589.64 million, above analyst estimates of $568.23 and management’s guidance of $566 million. As you can see on the chart below, revenue growth has taken a substantial dive over the last two years.

Meanwhile, the cost of goods sold (COGS) only grew 8.34% during the fourth quarter, which has the effect of increasing GAAP (Generally Accepted Accounting Principles) gross profits faster than revenue growth, which the chart below shows. Additionally, it helped GAAP gross margins grow 281 basis points (“bps”) year-over-year to 82.2%.

CFO David Obstler said about the gross margin improvement on the fourth quarter 2023 earnings call, “We continue to experience efficiencies in cloud costs reflected in our cost of goods sold as our engineering teams pursue cost savings and efficiency products — projects.“

Similarly, Datadog’s GAAP operating expenses (OpEx) only grew 12.23%, boosting GAAP operating income from a $34.62 million loss in the previous year’s comparable quarter to a gain of $27.74 million in the fourth quarter of 2023. GAAP operating margin was a positive 4.70%.

The reduction in OpEx and the increase in operating margin and operating income resulted from optimization and cost management efforts. However, investors should not expect the same substantial improvements moving forward. David Obstler indicated that the company was more cautious about investing in 2023 due to worries about the global economy and plans to ramp up investment in 2024. Investors should expect that the operating margin will recede moving forward. The company emphasizes non-GAAP numbers in its operating margin guidance. It forecasts a first-quarter 2024 non-GAAP operating margin of 22%, compared to a 28% operating margin reported in the fourth quarter of 2023.

Among the reasons that the stock price has stalled is because management is telling the market that they are going to increase investment, which will lower profitability. Still, management failed to forecast the increased revenue growth analysts had expected for the first quarter and the year. While Datadog’s increased investments may rejuvenate revenue growth in the long term, investors might not see the bang for the investment buck in the near term. An alternative explanation is that management has intentionally made conservative revenue forecasts that they internally believe they can beat. In either case, the market may be unwilling to push the stock much higher than it is until it sees the company’s increasing revenue growth.

Let’s move down the income statement to the bottom line. Datadog generated a diluted GAAP net income-per-share of $0.16, up from a loss of $0.09 in the previous year’s quarter. The non-GAAP net income-per-share of $0.44 aligned with analysts’ consensus earnings but beat the company’s guidance of $0.41.

Datadog spends relatively little on CapEx as a cloud company: $18.94 million, which is only 3.21% of its revenue. Suppose the company keeps the CapEx-to-revenue ratio at the current low level while growing net income more rapidly; this would bode well for increasing FCF growth. The company generated a fourth-quarter FCF of $201.29 million and a trailing 12-month FCF of $597.55.

Datadog ended 2023 with $2.58 billion in cash and short-term investments against $742.24 million in convertible debt due in 2025. The company’s cash and debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio of 3.09 indicates that it has plenty of money to pay down its long-term debt. At the end of the fourth quarter, its quick ratio was 1.24. A number above 1.0 means the company has enough assets to pay its short-term obligations.

Let’s take a look at a few risks.

Risks

One risk that investors should be keenly aware of is intensifying competition. One of the reasons competition is intensifying is that Datadog is expanding into adjacent markets from its original business and encroaching on the turf of more and more potential competitors. The first image shows Datadog’s original area of focus, observability.

During its 2024 Investor Day, management explained how the company first moved into security, where some of its solutions, like cloud Security Information and Event Management (SIEM), compete with CrowdStrike’s (CRWD) Falcon SIEM, SolarWinds’ (SWI) SIEM tool, and Splunk’s SIEM solutions. As a reminder, Cisco Systems (CSCO) recently acquired Splunk. Datadog later created products addressing needs to the right and the left of its core observability product to help development and operations teams collaborate across its new Cloud Service Management platform. This expansion in capabilities could put it into more direct competition with cloud heavyweights such as Amazon’s (AMZN) AWS, Alphabet’s (GOOGL) (GOOG) GCP, and Microsoft’s (MSFT) Azure for cloud monitoring services.

Datadog also has competitors like New Relic (private) and Dynatrace (DT) in its original observability business. In addition, other businesses like CrowdStrike are expanding into adjacent areas that compete against Datadog’s core products. For instance, CrowdStrike bought a company called Humio in 2021, which owned an observability platform that competes with Datadog. People who decide to invest in Datadog must monitor the ever-shifting competitive landscape for acquisitions, new technology, and new entrants to all areas where the company competes. The company’s 2023 10-K states:

With the introduction of new technologies and market entrants, we expect that the competitive environment will remain intense going forward. Some of our actual and potential competitors have been acquired by other larger enterprises and have made or may make acquisitions or may enter into partnerships or other strategic relationships that may provide more comprehensive offerings than they individually had offered or achieve greater economies of scale than us. In addition, new entrants not currently considered to be competitors may enter the market through acquisitions, partnerships or strategic relationships.

Source: Datadog 2023 10-K

Next, investors should monitor Datadog’s share dilution. Its fourth quarter 2023 diluted weighted average shares were up 11.2% year-over-year to 352,907; the stock has a relatively high stock-based compensation (“SBC”) at 21.7% of revenue. As long as a company outperforms, the market has been forgiving of stocks with high SBC. However, if a company with high SBC underperforms analysts’ and investors’ expectations, the stock could accelerate to the downside. Up until now, SBC has yet to be an issue for Datadog. Still, if Datadog continually misses future revenue or earnings expectations, the market may start finding issues with its high SBC.

If you decide to invest in Datadog, be aware that the company’s non-GAAP numbers contain SBC. Although using non-GAAP numbers to illuminate a company’s core profitability is convenient, investors should always examine them alongside GAAP numbers, as SBC can hurt shareholders by diluting their ownership. SBC is also a non-cash charge that can distort FCF. If you are an investor who uses FCF to value a stock, SBC could potentially throw off your valuation.

Lastly, although the company’s convertible notes are not an immediate risk, the debt could create unforeseen problems if, for any reason, Datadog is unable to produce enough cash flow to pay off the principal and interest, which may force the company to raise capital or restructure debt on unfavorable terms. Potential reasons that could reduce cash flow include a poor macro economy, unexpected business developments, or the competitive environment. Management highlighted an additional risk from its convertible notes in its 2023 10-K:

In the event the conditional conversion feature of the 2025 Notes is triggered, as it was during the quarter ended March 31, 2022, holders of the 2025 Notes are entitled to convert the notes at any time during specified periods at their option. If one or more holders elect to convert their 2025 Notes, unless we elect to satisfy our conversion obligation by delivering solely shares of our Class A common stock (other than paying cash in lieu of delivering any fractional share), we would be required to settle a portion or all of our conversion obligation through the payment of cash, which could adversely affect our liquidity. In addition, even if holders do not elect to convert their 2025 Notes when these conversion triggers are satisfied, we could be required under applicable accounting rules to reclassify all or a portion of the outstanding principal of the 2025 Notes as a current rather than long-term liability, which would result in a material reduction of our net working capital.

Source: Datadog 2023 10-K.

If you decide to invest in Datadog, monitoring the company’s convertible debt situation may be in your best interest. Although the probability of something going wrong may be low, the potential negative impact on the company’s finances is significant.

Valuation

By most traditional valuation metrics, Datadog’s stock looks overvalued. Seeking Alpha’s quant rates the stock’s valuation an F. The company hasn’t produced GAAP profits long enough to give a valid conclusion based on a GAAP price-to-earnings (P/E) ratio. Still, the company’s non-GAAP P/E ratio of 80.41 is well above the sector median of 23.17, signaling that the market may overvalue the stock.

The following chart compares Datadog’s price-to-sales (P/S) ratio to that of several other companies that provide an observability product. Interestingly, ServiceNow and Datadog have the same year-over-year quarterly growth rates, yet the market values Datadog higher on a P/S ratio basis.

The following reverse DCF shows the implied FCF growth rates over the next ten years for Datadog’s closing price of $123.45 on March 26, 2024.

Reverse DCF

Click to enlarge

Datadog’s ability to achieve an FCF of 23.9% may be a tall order. According to one analyst estimate, its revenue growth should have a compound annual growth rate of 20.78% over the next ten years, which could make it challenging for the company to grow FCF as fast as the assumptions that go into the above reverse DCF suggest.

However, since Datadog has yet to fully scale its business, the FCF margin will likely continue to expand. How much can it grow? Two comparable cloud SaaS companies, CrowdStrike and ServiceNow, have FCF margins of 30%. If Datadog can expand its FCF margins to 30%, it would only need to achieve an FCF growth rate of 22.9%, which is still a tough ask.

One reason the market may be sensitive to Datadog’s latest fourth-quarter 2023 revenue and earnings miss is that, at the current price, the market assumes a lot of top-line and profitability expansion. Unless the company can grow its revenue by 25% to 26% or expand its FCF margin to 34% over the next ten years, the current stock price may be a stretch. Although the company may be fully capable of doing so, with the amount of competition that Datadog has in its marketplace, I would like to see more evidence that the company’s downward trend in revenue since the beginning of 2022 has hit bottom and whether it can continue expanding margins over the longer term against rising competition.

Why I consider Datadog a hold

The market may have gotten a little ahead of itself in driving Datadog up to the current valuation. If you are a value investor, you may want to steer clear of Datadog for now. Even growth investors should remain wary of this company at its current valuation. However, suppose you are a long-term investor who already owns the stock. In that case, you may want to continue to hold as the company still has a high potential upside from cloud adoption, digital transformation, and generative AI over the next five to ten years. I rate Datadog a Hold.