Summary
- Datadog, Inc. reported strong Q4 numbers recently and announced its guidance for the upcoming year.
- The strong correlation between AWS and Datadog revenue growth rates indicates that Datadog's guidance for 2023 is substantially de-risked.
- If taking the differentials in revenue growth and cash generation ability into account, Datadog shares are finally valued fairly within the observability space.
- Long-term growth prospects are compelling, especially with the expansion into IT security.
- Datadog replaces Dynatrace as my #1 pick in the observability space.
Intro
Since its IPO back in September 2019, Datadog, Inc. ( DDOG ) has been regarded as the best-of-breed company in the observability space whose shares trade at a significant valuation premium compared to its peers. This premium has been so extreme in my opinion that I wrote the following article at the beginning of 2022: " Dynatrace Is A Better Investment Than Datadog ," comparing the two best end-to-end observability platforms in my view. I have expressed that although the fundamental momentum of Datadog was superior compared to Dynatrace, Inc. ( DT ), the valuation gap between the two was unjustifiably wide and that should have made Dynatrace shares a better investment compared to Datadog. Although a few days after publication Dynatrace delivered somewhat softer earnings than expected, while Datadog did the opposite, giving my thesis a hard start. When we compare the share price performances of the two since then, we can see the following:
Although both companies decreased in value, Dynatrace weathered the "great valuation reset of 2022" significantly better than Datadog, with its share price falling "only" 13% compared to 37% of Datadog. I didn't write this down to glorify myself (just a bit:)), rather I wanted to show my way of thinking when analyzing companies. I usually take the long-term perspective and make a deep dive into fundamentals by researching the target market, analyzing revenue and profitability trends, and making a rigorous check on valuation. Regardless of what direction the share price goes, I stick to my thesis, as I focus 100% on fundamentals, which I believe pays off over the long run. I believe the piece I mentioned above represents this well. If you like this kind of analysis, I'm glad if you follow me here on Seeking Alpha, and share your opinion in the comment section providing readers an even more comprehensive picture on the company in question.
Turning back to Datadog: during the end of 2022 and the beginning of 2023, I have happily observed that the exaggerated valuation premium has diminished, making shares of the company more investable. However, there was one last hurdle to jump: announcing a guidance for FY 2023 after releasing 2022 Q4 earnings that pleases investors who got used to superior topline growth rates in the past. I believed this is something Datadog could fail, which led me to write my quick take on the upcoming Q4 earnings release: " Datadog Earnings Preview: Too Many Red Flags To Ignore ."
With the release of Q4 earnings last Thursday, it turned out that Datadog couldn't fight gravity indeed, the significant growth slowdown the hyperscalers experienced throughout December and January made management strike a cautious note for FY 2023. Although this has sent shares lower in the aftermath, it has finally cleared the way from a fundamental perspective to say a strong Yes! for investing in the company's shares.
In the following analysis, I will explain why I think that the shares of Datadog are finally valued fairly and why I believe that the guidance for FY 2023 is properly de-risked now. Finally, I will elaborate on the company's long-term growth prospects in the light of its rapidly evolving product range.
Growth momentum has lost steam at the end of Q4
Datadog reported strong numbers for the 2022 Q4 quarter as the company managed to beat top line growth expectations by the typical ~5% even in an uncertain macroeconomic environment. Revenues came in at $469 million growing 44% yoy, which is quite impressive for a company with an annualized revenue run rate of almost $2 billion. However, only a few quarters ago this growth rate was significantly higher, showing that the recent economic slowdown takes its toll on Datadog's fundamentals as well:
Created by author based on company filings
Based on management comments on the Q4 earnings call , the main reason behind the slowdown was that larger existing customers began to optimize their IT budgets, which affected their observability spending at Datadog as well. Furthermore, companies in the consumer discretionary sector where observability is a core pillar of the business (e.g., e-commerce or food delivery) continued to slow their growth in observability spend as their businesses struggle with the economic downturn.
The main question is how far this slowdown could go? Based on general trends at hyperscalers and management's guidance for 2023, I believe it has more room to go. In the following, I will analyze to what extent this could continue and whether management has been conservative enough with its 2023 guide.
There is an interesting relationship between the growth rate of AWS and Datadog revenues, which held up quite well during 2022. The revenue growth rate of Datadog has been exactly 2.2 times the growth rate of AWS from Q2-Q4 in 2022:
Created by author based on company filings
Although there is no great thing to wonder as the revenues of Datadog obviously correlate with the growing number of workloads handled in the cloud, the correlation seems still very strong between the two. What we already know from the Q4 earnings call of Amazon is that AWS revenue growth has slowed further to the mid-teens in January. If we assume that this holds for the entire Q1 quarter, AWS revenue could grow ~15% yoy (represented in orange on the chart). If we multiply this growth rate by 2.2, it results in 33%, which would be a fair estimate for Datadog revenue growth rate in Q1 in my opinion. However, management provided a more conservative guidance for the quarter, with 29% yoy revenue growth at the midpoint (represented in purple on the chart), "only" 1.9 times AWS revenues if they grow 15% yoy indeed. Based on this, I believe the Q1 guidance of Datadog management has been conservative enough, clearing the way for another ~5% beat.
The main risk factor would be that AWS revenue growth (and cloud revenue growth of hyperscalers in general) continues to decelerate further throughout February and March jeopardizing Datadog's Q1 ambitions. Although the jury is still out on this one, I believe sooner or later we should reach the point where the chance of positive surprises emerges again as everyone tried to be very cautious regarding their guidance for 2023.
Based on the Q4 earnings call I think Datadog management did exactly the same:
"But what we see in early 2023 so far is consistent with what we see in in Q4 or in the second half of 2022 in general. So, it's too early really to pass judgment, but it really factors into our guidance, which is that we don't believe that the optimization has stopped. We assume it's going to continue. We don't know yet when going to stop. We know it's going to happen at some point, but we're not planning it for this year in our guidance." - Olivier Pommel on Q4 earnings call.
In numbers, this equals a guidance of $2.08 billion in revenues for 2023, representing a yoy growth rate of ~24%. After growing 63% in 2022, I believe this sounds quite conservative indeed. Going back to our previous correlation example, this would mean that AWS would grow revenues by 11% in 2023 yoy (11% x 2.2 = 24%) if the relationship still holds. Based on the fact that most 3rd party research firms expect a ~15% CAGR for the cloud computing market this decade, I believe this 11% for 2023 should be a bar easy to jump. And even if there is more pain to come on the short run, this will correct itself on the long run.
With this, I believe Datadog managed to de-risk its 2023 guidance properly providing room for a potential significant upside if the economy begins to normalize during the year. Although this had some negative effect on the share price, I believe this will more than pay off over the medium-term.
Finally, a quick look at margins before going on to valuation. Datadog has been characterized by strong free cash flow generation for many years. This hasn't changed amid the current global economic slowdown, as the company exited 2022 with an excellent non-GAAP operating margin and a free cash flow (( FCF )) margin as well:
Created by author based on company filings
The fact that revenue growth has slowed significantly during the year, but margins stayed at elevated levels signals conscious cost control in my opinion. Both for Q1 and for 2023 as a whole management guided for a non-GAAP operating margin of 15% at the midpoint signaling that the efforts of keeping a healthy margin profile should continue. In general, FCF margin used to be a few percentage points higher than non-GAAP operating margin, which should be the case for 2023 as well.
My concluding remarks for this paragraph are the following: 2023 revenue expectations for Datadog have been reset conservatively after Q4 earnings release providing comfortable room for upside surprises during 2023 if economic conditions didn't deteriorate meaningfully further. Meanwhile FCF generation remained strong keeping the company one of the most promising SaaS investments from a fundamental perspective in my opinion.
Although I think this has been true for Datadog since its IPO back in 2019 there have been few such periods when this was accompanied by a rather reasonable valuation. In the following, I want to show why I believe that now we are in such a period.
Valuation: Datadog is worth its price
The recent conservative guidance for 2023 from management had two important implications on Datadog's valuation. On the one hand, shares sold off after the earnings release, falling approximately 7% on the day of the release, significantly more than the shares of competitors on the same day. On the other hand, revenue expectations for 2023 came down in the light of conservative management guidance. The first effect made Datadog's valuation cheaper compared to competitors, however the second one resulted in the increase of sales-based valuation multiples like P/S or EV/S as the denominator in these multiples decreased.
After this small reset in Datadog's multiples the current relative valuation framework for public observability companies looks as follows:
Created by author based on company data
On the "x" axis companies are depicted according to their Rule of 40 metric in order to capture their cash generation ability on the top of their sales growth rate. Revenue growth rates are forward looking numbers based on analyst's estimates, while FCF margins refer to the trailing twelve months as companies and analysts rarely provide forward looking guidance for this metric. Based on these assumptions Datadog is currently a "forward" Rule of 49 company.
On the "y" axis readers can see the price investors pay currently for revenues for the upcoming 12 months on a per share basis adjusted for cash and long-term debt, i.e., the forward EV/Sales ratio. Datadog shares trade currently at a forward EV/Sales of 12.
I believe this chart puts it straight that Datadog shares are finally valued fairly within the observability space as its relatively higher forward EV/Sales multiple is explained by its superior growth and cash generation ability. Based on the correlation equation if Datadog manages to increase its Rule of 40 metric by 5%-points compared to its competitors in 2023 its current forward EV/Sales valuation multiple of 12 would exactly fit on the regression line. This means that company shares are valued currently very close to direct competitors when taking differences in sales growth and FCF margins into account.
I believe that with its recent conservative guidance for 2023 Datadog has the most chance to surprise investors to the upside like it has been the case for the past several years. I think this is a further argument in favor that from this point on Datadog shares should outperform its peers on the medium/long run.
Based on this and the company's strong fundamentals I rate Datadog as a Strong Buy, being my #1 pick in the observability sector going forward, replacing Dynatrace.
Compelling long-term growth prospects
Datadog started as a cloud Infrastructure monitoring company in 2010 and perfected its solution in the upcoming years. In 2017 they expanded their product portfolio with Application Performance Management ((APM)), in 2018 with Log Management building out two strong pillars besides their core Infrastructure monitoring service. Although the company also offers solutions for on-prem environments they are best known for their cloud-native technology. Looking at the expected growth rate of these core markets over the upcoming 5-7 years we can see the following:
Created by author based on 3rd party data
Sources: Infrastructure monitoring ( 1 , 2 ), APM ( 1 , 2 ), Log management ( 1 , 2 , 3 ).
Based on this, the total market for Datadog's core services is expected to experience a CAGR of somewhere between 13-14% over the current decade in my opinion. And let's not forget that Datadog is specialized in cloud solutions, so if we would narrow or focus only to cloud environments these growth rates would be definitely higher. A good example for this is the cloud monitoring market that is expected to grow at a CAGR of 22 - 23 %, several percentage points higher than the 15-16% CAGR of the Infrastructure monitoring market in general. Based on this an expected CAGR of ~20% for Datadog's core services until 2030 is a realistic assumption in my opinion, which doesn't seem too aggressive compared to the 15% expected CAGR for the cloud computing market in general.
On the top of these core businesses, Datadog has expanded its product portfolio quite aggressively in the past several years, having currently 17 distinct products for customers to offer. IT security, especially for cloud environments is one of the leading areas of expansion, where the company builds on its long-standing experience from its core services:
Datadog 2022 Q3 earnings presentation
When we look at the expected CAGRs of these markets, we can see that they can be also strong drivers of long-term growth over this decade:
Created by author based on 3rd party data
Sources: Cloud security management ( 1 , 2 ), Application security management ( 1 ), SIEM ( 1 , 2 ).
Another great example for Datadog's innovative nature is their recently introduced Cloud Cost Management service that fits perfectly in the current uncertain macroeconomic environment, where everyone tries to optimize their spend. This is a great tool for identifying potential cost savings on IT infrastructure and for conducting efficient FinOps. Management called out on the Q4 earnings call that since the October launch a handful of customers opted for this product and some of them with quite large initial commitments.
Finally, if we look at the product penetration of Datadog customers based on the supplemental information the company offers to its earnings release, we can see that their Datadog journey is usually only in the early innings:
Datadog Q4 earnings supplemental information
We can see that the majority of Datadog's customers have already at least 2 products, supposedly made up of the core services. However, if move up a few steps the ladder we can see that only 42% use 4 or more products, while only 18% 6 or more products. What is especially encouraging that the last two categories show a clearly increasing tendency from quarter to quarter proving the efficiency of the company's land and expand model.
To sum it up, the core observability market for Datadog seems to provide a strong base for future growth. The company is working hard to expand this already compelling growth opportunity by significantly expanding its TAM. The customer base for these new products is already there and growing, waiting to be penetrated with these new services. I believe these make Datadog shares an excellent long-term investment.
Main risk factors
In the short run, continuing IT cost optimization efforts are biggest threat to Datadog revenues in my opinion, which could possibly get worse if the economic downturn gets more prolonged. I believe this is the first real slowdown in the cloud space that is driven by a classic downturn in the economic cycle (unlike Covid), which could bring important lessons for the future. I think that the flexibility of cloud solutions leads to declining revenues in the space only on the short run but will prove as an important growth driver on the longer run.
Competition is always an issue, and the observability market is not an exception to this. The big 3 cloud providers each offer their own solutions in the space that could be an important threat on the longer run. Furthermore, there are many other smaller competitors as well, typically in specific segments of the observability market. However, there are only a few companies who offer a complete, end-to-end observability solution combined with best-of-breed technology. I believe these players are currently Datadog and Dynatrace, regularly the most highly ranked companies in different 3rd party reviews . As the observability market moves closer to saturation over time these companies should be the winners in my opinion. On the top of that, Datadog is opening to new markets (e.g., IT security) as well, which could provide important cushion from a growth slowdown.
Conclusion
The publication of Q4 earnings and the accompanying conservative guidance from Datadog management removed important risk factors from investing in the company's shares. On the top of that, valuation has decreased to reasonable levels recently, which wasn't characteristic for the stock for a long time. These factors make the shares an excellent investment opportunity in my opinion, especially in the light of strong long-term growth prospects. Hence, I believe Datadog, Inc. is currently the top stock pick in the observability space, in of the most important areas of cloud.
For further details see:
Datadog: Rule Of 50 For 12x EV/Sales, Finally Valued Fairly