Datadog: Wall Street Grows Impatient Waiting On Generative AI Tailwinds (NASDAQ:DDOG)

Datadog, Inc. (NASDAQ:DDOG) plunged after releasing first quarter earnings results. The company beat guidance on both revenues and profits, and lifted full-year guidance. Wall Street’s poor reception may be more to do with the stock’s valuation heading into the print, as DDOG is often viewed to be a long-term beneficiary of the rise of generative AI.

DDOG continues to show hints of a future acceleration in revenue growth, with current remaining performance obligations growing at a 40% pace in the quarter. These hints have yet to manifest into revenues, and that may have been a problem for the richly priced stock. While the company’s GAAP profitability and net cash balance sheet help to reduce the risk profile, I continue to find the valuation challenging for those looking to beat the market – I reiterate my avoid rating for Datadog, Inc. stock.

DDOG Stock Price

I last covered DDOG in January, where I explained why I viewed the rally to be unsustainable. The stock has since underperformed the market by double-digits.

The underperformance unfortunately is not reason to buy the stock, as valuations remain an issue here.

Datadog Stock Key Metrics

DDOG is an enterprise tech company providing data observability and security capabilities. The company can be considered as having a “platform portfolio” which has allowed it to sustain above-market growth rates for many years, even despite a tough macro environment.

The latest quarter saw the company deliver 27% YoY revenue growth to $611 million, easily surpassing guidance of $587 million to $591 million but falling short of consensus estimates for $619.9 million. The high consensus estimates are a symptom of the rich stock valuation. The company delivered a 27% non-GAAP operating margin, beating guidance for 22%, and delivered $0.44 in non-GAAP EPS, surpassing guidance for $0.35. I note that the company was also profitable on a GAAP basis in terms of both operating income and net income. I expect DDOG to sustain GAAP profitability for the rest of the year and for potential inclusion in the index to be a relevant medium term catalyst.

DDOG ended the quarter with $2.8 billion of cash versus $743 million of debt, representing a bulletproof balance sheet.

Looking ahead, management guided for the second quarter to see 22% YoY revenue growth to $624 million and 22% non-GAAP operating margins. Management lifted full-year revenue expectations from $2.575 billion to $2.61 billion, representing 23% YoY growth. Consensus estimates already called for $2.61 billion in full-year revenues.

On the conference call, management again touted an improving macro environment, noting that customers continue to be “cost-conscious” but they are seeing “optimization activity reduce in intensity.” During the pandemic, many companies aggressively invested in IT spending given the booming economy. Those tailwinds reversed following the pandemic, and DDOG has had to grapple with a more difficult customer base. The rise of generative AI may help to ease these headwinds given the perceived importance of data in training large language models, but these tailwinds have not yet appeared formally in the numbers. DDOG has seen solid growth in remaining performance obligations (“RPOs”), which might imply that revenue growth may inflect upwards (perhaps due to generative AI tailwinds). DDOG reported “low 40s growth” in cRPOs, which has recovered solidly since bottoming in the “high 20s” in the first quarter of 2023. Management noted that it can take “a number of quarters or even years” to move usage from competing platforms, and this can explain the delay between cRPO and revenue growth.

Is DDOG Stock A Buy, Sell, or Hold?

After the selloff, DDOG traded at a market cap of $39.4 billion. That places it at 15x this year’s sales. I must emphasize that just because a stock falls double-digits does not make the stock cheap. Consensus estimates call for an eventual return to 30% top-line growth, with growth staying at the high double-digit level for many years.

Management has guided for 25% long term non-GAAP operating margins, but I expect GAAP net margins to be more in the 30% range.

I view 10x sales to be a reasonable estimate for where long-term multiples could be in a bullish scenario, as that would imply a 33x earnings multiple based on the above margin assumption. At current prices, if DDOG can meet consensus estimates, then the stock might deliver around 14% annual returns over the next 9.5 years.

The follow-up questions are thus – is this projected return acceptable, and how achievable are consensus estimates? The past several quarters have seen many tech companies, including DDOG, show stronger financial results as they fully digested the changing macro environment.

At this point, I find it reasonable to assume that future upside surprises should prove more moderate than aggressive. The company’s solid cRPO numbers help to justify a return to 30% revenue growth, but that is already reflected in consensus estimates. I find it difficult to believe that DDOG will be able to sustain 20% revenue growth for as long as implied above, as my hunch is that between the law of large numbers and ongoing operational cost discipline from its customer base, DDOG may face significant headwinds that offset generative AI tailwinds. I note that other data-oriented firms like Snowflake (SNOW) have also struggled to show a material acceleration in top-line growth, which further validates these views.

At best, I find consensus estimates to look aggressive, making the 14% projected annual return potential look insufficient given the uncertainty in the underlying assumptions. The company’s GAAP profitability and net cash balance sheet go a long way in lowering return hurdles, but the stock simply trades above and beyond what I am comfortable with, especially given the lack of visibility in the timeline for accelerated top-line growth. I must reiterate my avoid rating for Datadog, Inc. stock unless we see a material acceleration in top-line growth that is sufficient to justify the rich valuation.