- Datadog is a leader in IT Observability and serves over 19,800 customers, which include Samsung, Shell, Sony, Deloitte, the Washington Post, and many more.
- The company is poised to ride secular trends across Digital Transformation, Cloud, IT Observability, Big Data, IoT, and Cybersecurity.
- The IT Observability industry alone is forecasted to be worth $53 Billion by 2025.
- Datadog has grown its revenue at a blistering 83% rate and is now undervalued intrinsically after a substantial pullback in share price.
The Digital Transformation of businesses was accelerated by the pandemic. Enterprises are now using an abundance of various software as a service ("SaaS") Apps, IT applications, Databases, Cloud providers, and even IoT (Internet of Things) devices. The issue is observing all the data from different applications can be complex and challenging. Thus, the mission of Datadog, Inc. (DDOG) is to act as a "WatchDog" simplifying the complexity and creating a "Single pane of glass" for IT Observability.
In the words of the company;
"See it all in one place, Your servers, your clouds, your metrics, your apps, your team. Together."
According to one study , 93% of IT leaders say that "Observability" is a foundational part of running a successful modern enterprise. Yet only 19% of repeat processes for Observability have been automated, thus this represents a huge opportunity for Datadog. The company estimates the IT Observability industry will be worth an estimated $53 billion by 2025, up from $38 billion in 2021.
In addition, Datadog is also poised to ride the growth in trends such as Big Data , IoT and even Cybersecurity after they recently announced a new security product.
Datadog was founded in 2010 and IPO'd in 2019. The stock price went on a major bull run in 2021 and increased by 149%. However, since the high inflation numbers were released in November 2021, the stock price has plummeted by 47%, due to interest rate hikes which have compressed the valuation multiples for all "Growth stocks." However, over the same period the stock has generated blistering revenue growth up 83% year over year. In addition, the company's product has a fantastic Net dollar retention rate of over 130% which shows customers are finding the product "sticky" and spending more.
The stock is now undervalued intrinsically, according to my discounted cash flow ("DCF") model and an analyst from Bernstein recently given the stock an "Outperform Rating." Thus, let's dive into the Business Model, Financials and Valuation for the juicy details.
Innovative Business Model
Datadog is a leader IT Observability, its platform brings together data from multiple sources and enables observability, querying, control, and more recently security.
Datadog is the "Top Dog" as a Gartner Magic Quadrant Leader in this IT Observability and Application Performance Monitoring ((APM)), see the top right of the chart below for details.
Datadog's Application Performance Monitoring ((APM)) platform provides an end to end solution for tracking Browsers and mobile devices to backend services such as databases and even individual lines of code.
Datadog's "Watchdog" application ingests all this real time data and uses Artificial Intelligence ((AI)) to identify and alert customers of failures, errors or anomalies which need to be remedied. According to one survey of CIO's, 93% of them believe the use of AI will be "critical" for IT's ability to cope with increasing workloads and deliver maximum value to the business. As you can see from the chart below historically tech applications were developed by software developers "Dev's" and managed by "IT Operations" or "Ops." However, in today's fast paced tech landscape of daily releases, the need for these teams to work closely together has never been greater. This has led to a " DevOps " culture and even Business departments are now having an input. Datadog's mission is to break down these siloed departments and given the teams a "Single Pane of Glass" for viewing all the data.
The Datadog platform also helps with User Experience ((UX)) and Network Monitoring. This enables team members to delve deep into where the bottleneck is for applications and then provide solutions. In addition, Enterprise customers often face "Big Data overload" and thus, Datadog helps to decide which data is most important and should be "indexed" so it can be searched easily in the future and which to just archive.
Founder-Led Management
For those of you which have followed my past writing, you will know a key part of my investment strategy is to invest into founder led companies where management has "Skin in the Game." In this case, Datadog's co-founders are Olivier Pomel and Alexis Lê-Quôc, both of whom own a substantial insider holding each, with ~10% and ~6% stake respectively.
Blistering Financials
Datadog generated strong financials for the first quarter of 2022. Revenue grew by a blistering 83% year-over-year and reaching $363 million. Over the past few years, revenue has grown at a rapid 74% compounded annual growth rate, and that is forecasted to continue for the full year 2022, with $1.6 billion predicted.
This growth has been driven by Datadog's strategy of "moving upmarket" and focusing on larger customers. For example, Customers with Annual Recurring Revenue ((ARR)) of over $100,000 increased to 2,250 in Q122, up from 1,406 in the prior years equivalent period. I believe this is a great strategy moving forward as larger organizations tend to offer more stable recurring revenue.
Another element of Datadog's strategy is to focus on the upsells and multi-product growth. As you can see from the chart below, the percentage of customers using over two products was 81% in the first quarter of 2022, which is fantastic. In addition, over one third of customers use over 4 products and this has also been steadily increasing over time. The company's Application Security Monitoring product was launched in 2022, and this is poised to be a huge growth driver given the Cybersecurity market is forecasted to be worth $376 billion by 2029. The multi-product strategy is similar to Salesforce, which started as a one product offering before becoming a "platform."
Datadog has generated a strong Gross margin of 78%, which is characteristic of a SaaS company. However, it should be noted the company is barely profitable on an operating margin basis with $10 million in operating income reported in Q122 at a 3% margin. The good news is when I delve deeper into the income statement, I see Datadog invested $147 million into R&D in Q122. Thus, they could easily be more "profitable," but would rather invest for product improvement in a more tax efficient manner, which I think is a better strategy.
Datadog generated strong free cash flow of $124 million (levered) in Q122, up a substantial 184% from $43.6 million in Q121. The company has a robust balance sheet with $1.7 billion in cash and $808 million in total debt.
Advanced Valuation
In order to value Datadog, I have plugged the latest financials into my advanced valuation model, which uses the discounted cash flow method of valuation. I have forecasted 55% revenue growth for next year and 52% for the next 2 to 5 years based on my own and analyst estimates.
Datadog Stock Valuation (created by author Ben at Motivation 2 Invest)
As the company reaches great scale and its multi-product strategy starts to develop further, I predict margins to increase. I forecast margins to increase to 23% within the next six years, which is slightly below the 25% average for the software industry. In addition, I have capitalized R&D expenses to improve the valuation accuracy.
Datadog Valuation 1 (created by author Ben at Motivation 2 invest)
Given these factors, I get a fair value of $118/share. The stock is currently trading at $100/share and thus is ~16% undervalued at the time of writing.
As an extra datapoint, Datadog trades at a Price to Sales (Forward) ratio = 19.65, which is lower than historic levels over the past two years. However, it should be noted this is much higher than competitors in IT Observability such as Dynatrace ( DT ) (PS = 9.8) and Splunk ( SPLK ) (PS = 5). Thus, I would put data in the category of Growth at a Reasonable Price (G.A.R.P).
Risks
Competition
Datadog faces a lot of competition in the IT observability market. They are a "Leader" on the Gartner Magic Quadrant, but are also tied with Dynatrace. In addition, a check of Gartner reviews also shows Dynatrace has a slightly higher review score at 4.5 vs 4.4 out of 5 stars for DDOG.
IT Spending Slowdown
Many Analysts are forecasting a "shallow but long" recession which is expected to start in the fourth quarter of 2022. Thus, enterprises may cut back of IT spending within the next year in order to help boost their profit margins.
Final Thoughts
Datadog is a fantastic company and a true leader in the IT Observability industry. They have been growing revenues at a blistering pace and have been executed their multi-product strategy well. The company's new security product opens up the total addressable market and they have a long growth runway ahead. After the major pullback in share price, the stock is now undervalued assuming the company can still grow at over a 50% per year clip over the next 5 years. The macro environment of rising interest rates and a potential recession may cause volatility within the next year, but after-which I see no reason why this stock can't be the top dog.
For further details see:
Datadog: Every Dog Has Its Day