Datadog: Business Inflecting As Worst Is Likely Over (NASDAQ:DDOG)

Datadog (NASDAQ:DDOG) reported their 4Q23 earnings results, where both top and bottom line beat expectations.

I also found management commentary and tone positive, while the company continued to execute well on the R&D front with many new features and capabilities launched in the year, along with strong execution on the sales and marketing front with momentum in the go-to-market continuing in the quarter.

That said, management did release guidance for 2024 that was weaker than expected, especially after the strong results that came out for 4Q23.

I do think that there is a chance that the team is being conservative in its 2024 guidance given what we have seen.

I have written extensively about Datadog on Seeking Alpha, and in my last article, I had a Buy rating on the company given the more appealing valuation after the earnings plunge. I continue to give Datadog a Buy rating, as I have explained briefly above, and more details in the sections to come.

A strong 4Q23

There’s no denying this.

Datadog’s 4Q23 were ahead of expectations on multiple fronts.

Revenue came in at $589.6 million, up 26% from the prior year. This was ahead of consensus expectations by about 4 percentage points.

Operating income came in at $166.6 million or 28.3% operating margins. This was ahead of consensus by 26%.

Interestingly, Datadog has exceeded the guidance by a larger margin in 4Q23 than in the first half of 2023, similar to what we saw in 3Q23.

For reference, Datadog exceeded the guidance by 2.9% in 1Q23, 2.0% in 2Q23, 4.8% in 3Q23 and 4.3% in 4Q23.

Total RPO grew 26.9% sequentially to $1,840 million, which was the strongest sequential growth we saw in the past two years.

Clearly, we are seeing an inflection point in the making.

Datadog shared that they are seeing continued usage growth from existing customers contribute to the strong performance in 4Q23, which was what they saw in 3Q23 as well.

Also, management also noted a positive trend on optimization as they noticed that the intensity of optimization seen in the last six quarters seem to have declined and in fact, they are starting to see large optimizers begin to grow again.

The cohort of customers that Datadog has discussed about in the last few quarters that have been optimizing actually saw their usage grow at a faster pace than the broader customer base.

It does seem like the optimization headwind is starting to dissipate, which is a clear positive for the Datadog business.

Guidance lighter than expected

While the 4Q23 results were strong, the guidance for FY2024 was lighter than what was expected.

Revenue guidance for FY2024 was $2,565 million, up 20.5% from the prior year, but was 1% below consensus.

Operating income guidance for FY2024 was $545 million, or 21.2% operating margins, 4% below consensus.

You would expect that guidance should come in stronger after the positive commentary highlighted earlier and growing momentum in the business.

It does appear to me that the guidance looks conservative considering 4Q23 and the management commentary.

According to management, however, their guidance philosophy remains unchanged and is based on the trends that they have seen in the last few months along with some conservatism applied to those numbers.

In addition, it is important to note that Datadog intends to invest for future growth in 2024, and expects to accelerate hiring in R&D and S&M in the year ahead to capture long-term opportunities and global customers.

The expectation here is thus for operating expense to grow in the mid-20-percent range, ramping throughout 2024.

The question here is really whether management was being conservative in the FY2024 guide. It does seem that the set up looks positive given that we are seeing improving fundamentals as optimizations seem to have slowed, management commentary turning more positive and the revenue and bookings for 4Q23 came in better than expected.

Continued R&D in 2023

Datadog spent 43% of revenues on R&D. Clearly, the company has a strong focus on innovation and launching new products, which in my view will maintain its market leadership in the long-term.

In 2023, Datadog launched more than 400 new features and capabilities.

In the observability segment, management highlighted that Datadog now has more than 700 integrations to allow customers to benefit from the newest AWS, Azure and Google Cloud capabilities, along with the newly emerging AI stack. Management shared that they are seeing growing engagement in its generative AI integrations, which have grown 75% sequentially in 4Q23.

In the generative AI space, Datadog continues to bring new capabilities to Bits AI, which is its natural language incident management copilot. In addition, Datadog is progressing towards large language models observability so that customers can deploy and manage their models safely.

Datadog shared that 3% of its ARR comes from generative AI customers today, compared to 2.5% in the 3Q23 quarter, but I think the key is management commentary here, as they “believe the opportunity is far larger in the future as customers of every industry and every size start deploying AI functionality in production”.

In the Application Performance Monitoring (“APM”) space, Data Streams Monitoring was launched to help customers monitor queuing, streaming and event-driven pipelines. Datadog also launched single-step APM onboarding, which allows just one engineer to enable APM across complex applications in a matter of minutes.

Datadog’s Cloud Security business is growing well in my opinion. There are now more than 6,000 customers using at least one of Datadog’s Security products. Among some of the new features and capabilities this quarter include the launching of software composition analysis, which helps its customers to be able to detect, and then address vulnerabilities in the code before it gets to production. In addition, Datadog also announced Cloud Infrastructure Entitlement Management, which serves to help customers prevent identity and access management security issues. Datadog also shipped its cloud SIEM Investigator, which enables its customers to conduct deep security investigation using logs over long periods of time. Datadog also expanded its data security capabilities with Sensitive Data Scanner now , which helps customers discover, classify and redact sensitive data both at scale and in real-time.

Lastly, Datadog extended Cloud Cost Management, to be now GA for AWS and Azure, and Google Cloud will be the next on the list, to help customers have a comprehensive view of costs across their cloud footprint. Datadog also shared that it intends to achieve FedRAMP High and Impact Level 5 authorizations.

Operating metrics improve

Datadog has been successful in getting customers to use more of its products over time.

Today, 83% of its customers use at least 2 products, up from 81% one year ago.

Today, 47% of its customers use at least 4 products, up from 42% one year ago.

Today, 22% of its customers use at least 6 products, up from 18% one year ago.

Today, 9% of its customers use at least 8 products, up from 6% one year ago.

It is worth noting that this strong adoption is across platforms and products. Datadog’s newer products, which excludes its infrastructure monitoring, APM suite, and log management products, grew 75% from the prior year.

With the growing adoption of the number of Datadog products by customers, we are naturally seeing more and more customers spending more on the Datadog platform.

The number of customers with more than $1 million in ARR grew 25% from 317 in 2022 to 396 in 2023.

In turn, the number of customers with more than $100k in ARR grew 15% from 2,780 in 2022 to 3,190 in 2023.

Also the customers with more than $100k in ARR are also the ones that are contributing disproportionately to ARR, making up 86% of total ARR.

The total customer count grew 18% from 23,200 in 2022 to 27,300 in 2023.

I think this highlights the potential growth in ARR from the continued strong growth in customer count as these new customers that are added today can be expected to spend more in the coming years given the strong land-and-expand strategy of the team.

Management highlighted that its land-and-expand strategy continues to have a very strong potential. At the end of 2023, 42% of Fortune 500 companies are customers of Datadog, but the median Datadog ARR for these Fortune 500 customers is actually less than $0.5 million.

This does imply these large enterprises are still early in their migration to the cloud journey and there is a huge opportunity for Datadog to grow with these customers.

Lastly, churn has stayed low as Datadog’s dollar-based gross retention rate is stable in the mid-to-high 90s, and the dollar-based net retention rate is in the mid 100s.

Customer wins

I think that we are seeing that Datadog is not just gaining traction amongst customers, but we are also seeing its customers consolidating with Datadog or that Datadog is successfully displacing competitors.

Datadog achieved its first ever nine-figure deal with a major global fintech company, which is a three-year expansion agreement. This customer is expected to use 15 Datadog products and consolidate 10 legacy tools.

Secondly, Datadog signed a seven-figure expansion with one of the largest restaurant chains globally. This customer chose Datadog because it believed that Datadog was the only platform that can bring about a consistent experience across the four cloud providers it is using, namely AWS, Azure, Google Cloud, and Oracle Cloud. This expansion agreement will mean that the customer will use 10 Datadog products and deploy Datadog for Cloud Service Management use cases.

There was an eight-figure multi-year expansion with a leading European financial services company that is going through a large scale migration to Azure. This customer is starting with 14 Datadog products and has consolidated more than 10 legacy cloud monitoring tools. After the migration to Azure, this customer expects the number of teams that use Datadog each month to grow from 400 to more than 1,000.

Datadog signed a seven-figure win with one of the largest food and consumer good company in the world, which includes 17 Datadog products and the customer expects to consolidate at least six commercial observability tools. Datadog will be the observability foundation of its AIOps strategy using Datadog’s Watchdog and incident management capabilities.

Datadog also landed a six-figure deal with one of the largest US utilities. Datadog was found to be the only platform that could easily integrate end-to-end with their existing sales, customer experience and data workflows. This customer is looking to start using six Datadog products and displace two commercial observability tools.

Datadog also recently hired a new Chief Marketing Officer Sara Varni. Sara has more than 15 years of marketing experience and was most recently Chief Marketing Officer at Attentive. Before her time at Attentive, she was Chief Marketing Officer at Twilio (TWLO) where she helped the company scale revenue and grow the marketing function. Lastly, before she joined Twilio, she was at Salesforce (CRM) in senior marketing roles.

Valuation

If you recall in the previous article, Datadog was trading at 50x 2024 P/E.

Today, it trades at 85x 2024 P/E.

The first thing to realize is that while Datadog may seem expensive today, that is a function of the market pricing in the very strong cocktail of above average growth and above average profitability or margin profile.

Another thing to note is the positive commentary about continued usage growth and positive trend for optimization is also supporting the narrative for an inflection in 2024, which justifies a higher valuation.

As a result, I revised my 5-year financial forecasts for Datadog upwards, as reflected below, where there is a 21% revenue CAGR and 25% EPS CAGR.

Datadog shared that they are seeing continued usage growth from existing customers contribute to the strong performance in 4Q23, which was what they saw in 3Q23 as well.

Also, management also noted a positive trend on optimization as they noticed that the intensity of optimization seen in the last six quarters seem to have declined and in fact, they are starting to see large optimizers begin to grow again. 2024 margins also reflect the decision of Datadog to invest in its business in 2024.

The intrinsic value for Datadog is based on a discounted cash flow model, assuming 50x 2028 terminal multiple and 12% discount rate.

As a result, I derive an intrinsic value of $121 for Datadog.

My 1-year and 3-year price targets for Datadog are based on 80x 2024 P/E and 60x 2026 P/E. While both are certainly achievable P/E multiples for Datadog to attain, I would emphasize that these price targets do not offer much conservatism.

Conclusion

I think Datadog continues to execute well on its innovation plans, with many features and capabilities launched in 2023. The company remains in investment mode and will likely continue to hire key R&D people to continue this innovation.

The company has been proactive in generative AI and I think could be one of the beneficiaries to the trend of increasing spend in generative AI.

In addition, the sales and marketing team has also done a good job in landing large deals.

The positive trend of declining optimizations and increasing customer usage is driving an inflection in the company’s results and points towards a positive start to 2024, and highlights that the worst is likely over for the company.