DDOG - Datadog: Despite Recent Strength It's Time To Lock In Gains

2023-12-08 02:03:25 ET

Summary

• Datadog's stock has soared 60% this year, driven by strong earnings and easing interest-rate fears.
• The primary concern is valuation, as the stock is trading at a high ~14x revenue multiple compared to its growth prospects.
• Despite strong growth and applaudable execution in a tough macro environment, the recent rally has limited potential gains.

With interest rates expected to decline next year and with third-quarter earnings mostly coming in ahead of muted expectations, an air of relief has washed over the markets, especially lifting growth stocks. Against this backdrop, shares of Datadog ( DDOG ) have soared.

So far this year, the infrastructure-monitoring software company, a perennial Wall Street favorite, has soared to the tune of 60%. As usual, the company has delivered a string of "beat and raise" quarters with barely any evidence that macro challenges are impacting its growth trajectory.

Downgrading Datadog to Neutral based on valuation

I had been bullish on Datadog all year long. I last wrote a bullish opinion on the stock in early September , when the stock was trading closer to $90 per share and before the combination of strong Q3 earnings (released in November) plus the tailwinds of interest-rate fears easing helped juice the stock into a sharp rally.

Today, however - while still acknowledging tremendously strong performance on Datadog's part - I'm downgrading my viewpoint on the stock to neutral.

The primary concern here is valuation: even in a world of declining interest rates, I think Datadog has stretched itself to the point where gains will be limited at best for 2024. At current share prices near $115, Datadog trades at a market cap of $37.78 billion. After we net off the $2.34 billion of cash and $741.4 million of convertible debt on Datadog's most recent balance sheet, the company's resulting enterprise value is $36.18 billion.

Meanwhile, for next year FY24, Wall Street analysts have a consensus earnings target of $1.82 per share for the company (+19% y/y) on the back of $2.58 billion in revenue, or 22% y/y growth. This puts Datadog's valuation multiples at:

• 14.0x EV/FY24 revenue
• 63x P/E

Datadog's mid-teens revenue multiple stands out as one of the most expensive valuations in the software sector - and it sticks out even more sorely when considering that growth is no longer as rapid as in the COVID era (50%+) and has decelerated to the 20s.

Of course, I still acknowledge the company's fundamental strengths - as a reminder for investors who are newer to Datadog as to what sets this company apart, here is a summary of what I believe to be the core advantages that Datadog enjoys:

• Huge $62 billion market opportunity. Datadog recently sized the observability market as a $62 billion total opportunity by 2026 (its prior sizing was $53 billion by 2025), which means that Datadog is still only single-digit penetrated into this overall market opportunity.
• Mission critical, recurring revenue software. Once installed, Datadog becomes a fixture of a company's IT stack, necessary to maintain performance and security. This gives Datadog a rich, reliable stream of recurring revenue to build on. Its expansion rates and number of customers using multiple products is also quite high.
• Rule of 40 company. Very few companies growing as quickly as Datadog are able to achieve meaningful profitability. Datadog has 20%+ pro forma operating margins. On top of 20%+ revenue growth, this puts Datadog into a stratospheric "Rule of 40" club, which is rare in the current environment.

Still, we have to consider: to what extent is all this strength already priced into a mid-teens revenue multiple? In my view, Datadog's recent rally has taken a lot of potential out of the stock - and the best move is to retreat to the sidelines and wait for a better price before diving back in.

Q3 download

This being said, we'd be remiss not to acknowledge the strength that Datadog has delivered in an otherwise tough macro environment for most of its peers. Take a look at the Q3 earnings summary below:

Datadog's revenue grew 25% y/y to $547.5 million in the quarter, beating Wall Street's much more modest expectations of $525.2 million (+20% y/y) by a five-point margin - note that this isn't out of the ordinary for Datadog, which typically guides quite modestly and exceeds expectations each quarter. More impressively, in my opinion, is the fact that revenue growth accelerated slightly from 24% y/y growth in Q2 - despite the fact that most other software companies have cited macro challenges as the reason behind decelerating trends.

Still, there are some chinks in the armor. Datadog doesn't report exact net revenue retention rates, but prior to Q3, the company had reported ">120%" net revenue retention, or >20% net upsell. In Q3, this metric fell below 120% as shown in the chart below, indicating that customers are pulling back on usage and seat expansion in the wake of budget tightening.

And note that as recently as Q1, net revenue retention had been greater than 130%. Still, net-new customer additions remain strong, with Datadog adding 700 new customers in the quarter (versus 600 in Q2, and 1,000 in the year-ago Q3).

Here is helpful anecdotal commentary on the quarter's go-to-market trends, taken from CEO Olivier Pomel's prepared remarks on the Q3 earnings call:

In Q3, we saw usage growth of existing customers improve compared to Q2. Overall growth in Q3 was relatively consistent throughout the quarter and comparable to levels we've seen in Q1. We are seeing signs that the cloud optimization activity from some of our customers may be moderating. As a reminder, last quarter, we discussed a cohort of customers who began optimizing about a year ago, and we said that they appear to stabilize their usage growth at the end of Q2. That trend has held for the past several months, with that cohort's usage remaining stable throughout Q3.

Overall, we continue to see impact from optimization in our business, but we believe that the intensity and breadth of optimization we've experienced in recent quarters is moderating. Meanwhile, our new logo activity has remained robust. New logo bookings continue to scale and grow year-over-year. And for the second quarter in a row, we closed a record number of new deals with more than $100,000 in annual commitments. With our land and expand model, we expect new logos to turn into much larger customers over time as they lean into the cloud and add up more of our products."

Profitability also continued to shine for the company, with Datadog generating a 24% pro forma operating margin in Q3, up seven points from 17% in the year-ago quarter.

Note as well two additional things: first, on top of 25% revenue growth, Datadog still sits well within the "Rule of 40" category - which has become rarer in today's market as most software peers have seen revenue growth decelerate to the mid-teens or below. Second, Datadog also came in at an essentially breakeven -1% GAAP operating margin - again, a rarity for companies still growing at Datadog's pace.

Key takeaways

It's truly difficult to make a case against Datadog from a fundamental perspective, but I don't feel comfortable continuing to stay long on this stock at such a rich valuation multiple. Back off here and wait for the stock to recede to the sub-$100 level again before diving back in.

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