Mar 1 2020 - Datadog: Stay Long Or Stay Out

Summary

Datadog has the potential to become the largest player in the DevOps space.

Its strong growth momentum and margins trend suggests a growing owner's earnings in the near term.

At 25x FY'20 revenue, Datadog isn't cheap. Therefore, timing volatility will be tough.

Investors should keep a tab on the proliferation of open source DevOps tools.

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Source: Author (using data from conference call)

The thesis for Datadog (DDOG) to keep acquiring market in the growing DevOps market remains valid. While valuation has mostly priced in future growth, there isn't evidence of substantial near term weakness. Datadog will continue to dominate the APM and DevOps space due to its brilliant products and strong momentum, which is propelling its brand value in its niche. Datadog is a long term hold, and any attempt to predict near term price action will fall short due to the difficulty inherent in timing volatility.

42079636-1582799091882183.pngSource: Author (using data from Conference Call)

The demand for Datadog's products remains strong. Management is guiding for strong revenue and ARR growth in 2020. The case to upsell new products is also strong as this will drive the dollar-based net expansion rate, which came in strong at over 130%. This will positively impact margins and free cash flow, which are nearly breakeven.

Given the strong third party reviews and ratings of its products, which has reflected in its growth numbers, the product retention rate will be the most significant source of near term weakness. Management put the gross retention rate above 90% in its S-1. The retention rate can be impacted by pricing and product value proposition. Given that the product value proposition is solid, the only near term concern I project is pricing. Datadog's business model is riding on the latest cloud service evolution, which has enabled platform providers to add more value to enterprises by charging for cloud deployment on a per-usage basis. The aim of this billing methodology, which largely explains the serverless computing trend, is the affordability and scalability it gives enterprises to consume cloud resources at an optimal rate. However, with the proliferation of cloud resources, enterprises will carry a lot of cloud service inventory. This makes it easy to underestimate the yearly billing that can be accrued when buying DevOps services. On Datadog's pricing page, the level of granularity in pricing helps justify the ROI and meticulousness of its monitoring and log solutions. However, it can lead to a massive enterprise bill, which might be tough to explain to the C-level execs, mostly in the mid-market space.

In periods of economic downturn, up-sell and cross-sell will have to be justified from a TCO and ROI standpoint for Datadog's billings to maintain the 90%+ renewal rate.

From my experience in DevOps, an organization is as smart as its ability to detect the next point of failure or bottleneck while ensuring business continuity. Enterprises will continue to require Datadog’s services as they are increasingly becoming mission-critical for daily business operations.

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Source: Author (using data from Conference Call)

In cases when a company can't afford the enormous bill for monitoring such level of infrastructure granularity, the case to adopt open source technologies becomes compelling. However, most of Datadog’s customers were into open source technologies before opting for Datadog due to performance and scale issues. I assume that there is only so much pricing leverage that can be executed in the long term. In the short term, Datadog has the potential to be the Palo Alto Network (NYSE:PANW) (powering above all competitors) of the DevOps space. Due to its strong brand momentum, I will be unwilling to provide a price target, and I will be upgrading my bearish rating sentiment to a neutral rating.

Valuation

Cartoon of the Day: Mousetrap - 12.31.2019 FOMO trap cartoon

Source: HedgeEye

The rationale for Datadog's valuation is embedded in the nature of platform business models. Like all platforms, Datadog's offerings provide intelligence and resources that scale over the years, making it tough for customers to switch to another platform. This makes its relationship with its customers tough to severe.

One of the toughest problems with companies undergoing digital transformation is data instrumentation. Once the set single point of truth or point of reference is changed due to the adoption of a new platform, internal reporting, measurement, and analytics is reset, and intelligence is lost. Today’s enterprises can’t afford to start their measurement or analytics from scratch as web users obsess of little glitches in web app performance, trust, and brand experience.

As a result, top APM players are guaranteed a steady growth in ARR with the potential to grow margins and cash flow as they monitor more services and cross-sell more products. This is inevitable as enterprise businesses grow their on-prem and cloud assets. This is the thesis that bulls are baking into the current valuation. At 25x FY'20 revenue, Datadog is trading at a premium to most of its peers. Therefore, I am not comfortable acquiring shares at this point as Datadog is still vulnerable to potential volatility from the mass adoption of an improved open-source monitoring tool or ecosystem.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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