June 1 2020 - Datadog: The One That Got Away

Summary

Datadog is innovating faster than competitors.

It is also gaining market share at a faster pace.

While achieving these feats, it is improving its margins to drive free cash flow.

The market has priced in a huge portion of future growth.

Regardless, investors with a huge risk appetite will find Datadog's story compelling.

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Source: Revelry Labs

Datadog (DDOG) is one of the rare cloud stocks doing all the right things. It is growing in an expanding market, improving its margins and cash flow while also making acquisitions to expand its capabilities. These factors have assembled to uphold its momentum. Investors with the risk appetite should consider this investment and hold for the long term.

Demand (Rating: Bullish)

Globalization-DBNRR-ARR-ACV-SaaS

Datadog continues to report attractive metrics that will boost its growth factor. Its global reach and cloud-based subscription model mean anyone can use its solutions. Revenue increased by 87% (y/y) when it reported last quarter. Dollar-based net retention rate (DBNRR) was above 130%. This is impressive because, unlike the dollar-based net expansion rate, DBNRR includes the effect of churn. Billings, which grew 55% y/y, was a bit down. Investors shouldn’t focus too much on billings because COVID-19 will force enterprises to scale down some projects. To achieve maximum cost savings on future projects that will be halted, it’s logical for Datadog's customers to switch from annual billings to semi-annual or quarterly billings. RPO (remaining performance obligation) grew by 82%. Massive RPO growth means more customers are convinced that Datadog will be their future partner. These commitments mostly come after a careful review of competitors. This is a strong signal that Datadog is offering competitive products.

Other impressive metrics include multi-product adoption. Datadog reported that 63% of customers are now using two or more products. This is up from 32% last year. 75% of new logos land with two or more products. This means it is succeeding in convincing customers to adopt new use cases for its platform. This is a promising signal that shouldn’t be overlooked because it means it is opening up a new market for itself. Lastly, customers with ARR of 0k or more grew 89% y/y.

Going forward, DDOG is guiding for 62% revenue growth this quarter and 54% revenue growth for the full year. The growth rate means its valuation will continue to defy all traditional valuation metrics.

Business/Financials (Rating: Bullish)

Platform-Land & Expand-Margins-FCF-Liquidity

While the present is DevOps, the future will revolve around use cases for its solutions to drive average revenue per customer. This will ensure DDOG’s success with system integrators and global system partners. Future success will be initiated with integrations with third-party platforms to kickstart the network effect. This success will be extended by improving product usability and total cost of ownership. This success is inevitable given the rapid adoption of its new products (network performance monitoring and real user monitoring), and its move into the security space.

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Source: Author (using data from Seeking Alpha)

Datadog's gross margin improved to 80% last quarter. This isn't surprising given the capital-light nature of its SaaS business model. Cost savings and pricing typically drive gross margin from cloud platforms.

Two levers typically pull opex — cost savings from economies of scale and investments in product evolution. Last quarter, opex was impacted by cost savings related to COVID-19. Going forward, management’s focus on growth means operating margin will fluctuate in the short term. On a long timeline, economies of scale from renewals and expansion will make margins a bigger contributor to operating cash flow. This will boost earnings per share.

Cash flow is mostly driven by earnings contribution to OCF (operating cash flow), stock-based compensation, and deferred revenue from billings growth. It is reassuring to know that DDOG's operating cash flow is improving. It’s not surprising that Datadog is achieving profitability faster than competitors. This mostly happens to usage-based products that drive productivity for large enterprises.

"By 2025, 50% of new cloud-native application monitoring will use open-source instrumentation instead of vendor-specific agents for improved interoperability up from 5% in 2019. This will simplify the process of monitoring, enable interoperability between monitoring solutions and disrupt the pricing model to be more about customer value (as opposed to today’s model which is essentially about counting agents)."

Going forward, enterprises will need to onboard talents that will manage the consumption of DevOps solutions. In the meantime, Datadog will continue to enjoy the gains from the extra value add to customers as its ability to observe IP-enabled services becomes more granular.

Macro/Competitors (Rating: Bullish)

Integrations-Acquisitions-Partnerships-International Expansion

"Additionally, we recently crossed 400 out of the box integrations. And among a number of new and improved, I'd like to call out Tenable, Nessus and VMware Carbon Black, which support our new security use cases."

The competitive landscape favors rapid innovators and players who can integrate with other platforms. Datadog’s recent partnership with security players in the vulnerability assessment space is promising.

"Demand for SIEM technology remains strong. The SIEM market grew from .319 billion in 2017 to .597 billion in 2018... We continue to see organizations of all sizes that are reevaluating SIEM vendors to replace SIEM technology associated with incomplete, marginal or failed deployments."

The SIEM space is still up for grabs. Elastic (ESTC) plays in this space by extending the capabilities of its search technology. DevOps players can equally play in this space by extending the capabilities of their monitoring and observability platform. The future favors fast innovators who are lucky to make the right acquisition. It also favors players who can generate insights that lead to lots of cost savings for enterprises. Datadog is pulling all the right strings compared to its competitors. Dynatrace (DT) is the closest pure-play DevOps vendor innovating as fast as Datadog. It fields capabilities in AIOps and automation. This is a potential area for Datadog to plow its next investment.

Success is a complex outcome that involves a bit of luck. Investors should note that Datadog's success means it has been able to access funding and top talents at the right time. This is a tough feat to achieve.

Macro

While COVID-19 has affected SMBs, weak economies, and players in the hospitality space, Datadog's willingness to give and raise full-year guidance is reassuring. Given its huge growth, investors will be willing to stomach slight billings and cash flow volatility.

Investors/Valuation (Rating: Neutral)

Network Effect-Economies Of Scale-Switching Cost

Players that can demonstrate sustainable growth will command a lofty valuation multiple. Datadog is growing revenue at 50%+ y/y. A 40% revenue CAGR projection over the next ten years applies until revenue growth dips into the 30s range.

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Source: Author (using data from Seeking Alpha)

In the base case, investors need to be willing to stomach near-term volatility as Datadog captures more market share to reflect its true worth. Compared to competitors in the DevOps space, there’s no doubt Datadog will achieve its full potential.

Risks

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Overvaluation remains the most significant risk factor with Datadog. Most cloud stocks are oversubscribed, and the potential for occasional corrections shouldn’t be underestimated.

Conclusion (Overall Rating: Hold)

With the right risk appetite, Datadog is a stock to hold for the long term. I will be willing to capitalize on occasional corrections to acquire some position. The future is promising, and Datadog has invested in staying ahead of competitors.

If you enjoyed this article and wish to receive updates on our latest research, click "Follow" next to my name at the top of this article.

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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