DDOG - Datadog: Customer Optimization Shift Is Key

2024-01-09 16:34:29 ET

Summary

• Datadog continues to show strong customer growth, with a 21% increase in customers and 20% increase in high-value customers in Q3.
• The company is seeing signs of stabilization in customer usage optimization, which could lead to more robust usage growth.
• Datadog's valuation is high, and it will need to see revenue growth accelerate for the stock to move higher from here.

Back in October, I said Datadog ( DDOG ) was a great growth company, but that its valuation was high. With the stock up about 35% since then and the company reporting earnings and attending some conferences since then, let’s catch up on the name.

Company Profile

As a reminder, DDOG offers an observability and security platform that provides end-to-end monitoring and analytics. In order to allow for faster problem detection and resolutions, it break down the silos between development and operation teams to provide clients with real-time understandings into software applications.

Its products can be deployed as a unified platform or customers can purchase individual product modules. Among the product modules its offers include infrastructure monitoring, application performance monitoring ('APM'), log management, digital experience monitoring, database monitoring, network performance monitoring, incident management, cloud cost management, observability pipelines, and cloud security management, among others.

New Customer Growth And Customer Optimization

With a usage-based model and offering multiple product modules, the expansion part of its land & expand strategy had long been the key driver for DDOG. However, DDOG has shown a strong ability to add new customers and this has been a big driver for the company more recently, as its usage growth has slowed in recent quarters due to customer optimization.

It ended Q3 with 26,800 customers, up nearly 21% from 22,200 a year ago. Customers with an ARR (annual recurring revenue) of $100,000 of above were 3,130, up 20% from 2,600 a year ago and they represent 86% of its ARR.

The company said for the second quarter in a row that it closed a record number of new deals with more than $100,000. It said it also expects new customers to turn into much larger customers over time.

At the end of Q3, 82% of customers were using two of more products. About 46% were using 4 or more products, while 21% were using 6 or more. These percentages were similar to Q2, with a slight 1% uptick in customer using 4 or more products.

Now the other big part of the equation for DDOG is still customer usage. At a conference last month, the company noted that between 55-80% of its revenue growth typically comes from usage growth. About a year ago, the company saw some customers starting to optimize their usage and in Q2 usage growth for existing customers was relatively weak. For Q3, usage returned back to Q1 levels and started to see some stabilization.

At a Barclays conference last month , CFO David Obstler said:

"The themes are similar to what we've been discussing, which was first optimization. We had said that starting in Q2 of last year [2022], we had the effects of optimization. The most intense was around highly ramped cloud-natives in certain industries. In Q2, we said too early to call, but we had seen sometimes a stabilization in that most affected group. And then in Q3, indeed, the signs were more robust that there had been stabilization. And in fact, that cohort, which was the most affected had, in many cases, committed to longer-term contracts and were growing slightly. We also said on staying on the theme of optimization that even though we still were in a cost-conscious environment that the cohorts other than that had improved somewhat. We used the word generation in the report, less intensity. There are lots of words that we were using. So that was one thing that everybody was very concerned about. What's going to happen next? We said that in October, we had a relatively strong month, [but] that one month does not a quarter make. .. But we said essentially that as of our earnings call, we had seen the continuation of less intense optimization.”

In December, meanwhile, a Stifel survey found that half of customers surveyed were nearing the completion of their cost containment activities compared to only 1 in its last survey. However, the survey did see some customers say they could potentially look to optimize their usage in the future.

“While the optimization data points from our survey are mixed and indicate that optimization is still ongoing, we believe that the overall commentary and results show an incremental improvement vs. our last survey from ~6 months ago,” analyst Brad Reback wrote in a note.

A return to more robust usage growth is really the key for DDOG moving forward. The company has done a great job of adding new customers and taking share. However, customers becoming more cost-conscious and looking to optimize their usage ate into the robust growth that the company had been used to seeing. Revenue growth was still strong in 2023, but it was not the hypergrowth the company had seen in prior years.

October seems to have been a potential turning point with regards to the optimization trends that have hindered the company. Right now, customer optimization still appears to be going on, just to a less extent. If the trend stabilizes and usage begins to grow more robustly again, DDOG could start to see accelerating revenue growth from here. Revenue growth stabilized at 25% in Q3, the same as in Q2.

Valuation

SaaS companies are generally valued based on a sales multiple, given their high gross margins and the companies wanting to pump money back into sales and marketing to grow.

On that front, DDOG is valued at an EV/S ratio of about 14.6x based on the 2024 consensus for revenue of $2.58 billion. Based on the 2025 sales consensus of $3.27 million, it trades at an EV/S multiple of 11.5x.

Revenue is projected to grow 22.5% in 2024 and 26.5% in 2025.

From an EBITDA perspective, it trades at an EV/EBITDA multiple of 75x the 2024 consensus of $501.8 million and 63x the 2025 consensus of $598.0 million.

In the past, the company has often traded at over 50x LTM sales. However, growth is slowing from 60-70% a year to around mid 20% over the next few years.

DDOG is one of the pricier stocks among its peers, as seen in the chart below. Security company CrowdStrike ( CRWD ) trades at a bit higher multiple, but is growing faster.

Previously, I did not place a price target on DDOG. However, I’d value a high margin SaaS company with mid 20% revenue growth at between 10-12x sales. That would place a fair value on DDOG of between $101-$121.

Conclusion

Unless DDOG can ramp up its revenue growth back up to over 30%, I think the stock currently looks pretty fairly value. If customer usage optimization wanes and the company sees more robust usage growth to go along with its strong new customer wins, this can happen. However, right now the company is seeing more signs of stabilization than anything. That’s a start, but not quite enough to convince me that it will grow revenue 30%+ in 2024.

At this point, I still think DDOG is a very good company that should continue to see nice growth over time, but its days of hyper growth now appear to be behind it. As such, I think the stock is towards to higher end of its fair value range. I rate the stock a “Hold.”

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