The digital transformation of an enterprise's IT stack from on-premise to the cloud has resulted in many companies having their IT assets split across multiple areas. Many enterprises are even still operating with a “hybrid” IT environment with some facilities on site and others in the cloud.
The main issue with this is it can be challenging to track and observe everything that is happening across the network. Datadog (DDOG, Financial) solves this platform by offering a “single pane of glass” to view all “clouds, servers and metrics” in one place.
The digital transformation is forecasted to reach a staggering $1.2 trillion in value by 2026, growing at a blistering 19.1% compounded annual growth rate (CAGR). More specifically, the IT observability industry that Datadog operates in is forecasted to increase from $38 billion in 2021 to $53 billion by 2025.
Datadog had its IPO in 2019. It was one of the stocks that benefitted (and then suffered) from the pandemic bubble. However, since mid June, the stock price has risen by ~27%. With a strong industry outlook and an encouraging second-quarter earnings report, could Datadog represent value now?
Business model
Datadog is a leading platform which focuses on IT observability. The term “leader” often gets overused, but in this case I believe it fits perfectly. The Gartner Magic Quadrant for Application Performance Monitoring and Observability labels Datadog as a category leader along with Dynatrace (DT, Financial).
Datadog uses advanced technology such as Artificial Intelligence (AI) to ingest real time data, monitor common patterns and then alert customers of failures or errors which need to be fixed.
Its Application Performance Monitoring monitors every application no matter where or how it’s run. This includes hardware, cloud, IoT (Internet of Things) devices, databases and even web browsers.
Strong second quarter
Datadog generated strong earnings for the second quarter of 2022. Revenue grew by a blistering 74% year over year to $406 million, which beat analyst expectations by $24 million. This was driven by strong growth in the number of larger customers the company has, as they move “upmarket” with their strategy. Datadog had 2,420 “larger customers,” which means those with greater than $100,000 in annual recurring revenue, as of the second quarter of 2022. This was a massive increase from the 1,570 larger customers a year ago. This strategy of moving “upmarket” makes complete sense as larger customers tend to have higher retention rates and are easy to manage in a focused manner.
In the second quarter, the company also announced new features such as "observability pipelines," which help companies to control and manage their “big data” in a much more effective manner. In addition, an “audit trail” was introduced to help customers audit changes inside the Datadog platform.
Datadog also achieved Amazon (AMZN, Financial) Web Services Education Competency Status. This is a major deal as it gives Datadog the credibility to support mission critical workloads of higher education institutes and schools who are transforming to the cloud.
In regards to financials, Datadog generated a GAAP operating loss of -$3.1 million. Part of this was because the company invested $178 million into R&D and $115 million into sales and marketing. Thus, they could be more profitable on a traditional basis but would rather invest to grow and improve their product. The company will also be able to carry across any tax losses in the future.
Non-GAAP operating income was actually $84.7 million, with a 21% non-GAAP operating margin. The GAAP net loss per share was $0.02, but on a non-GAAP basis, net income per share was $0.24, which beat analyst expectations by $0.09.
Datadog generated strong operating cash flow of $73.0 million in the quarter, with free cash flow of $60.2 million.
Tepid guidance
Moving forward, management did announce tepid guidance, with a revenue estimate of between $410 million and $414 million next quarter. This would only be up approximately 0.9% to 2% from the $406 million produced in the second quarter. The main reason for this comes down to macroeconomic uncertainty and the fact some companies may delay spending temporarily.
For the full year of fiscal 2023, management is forecasting between $1.61 billion and $1.63 billion in revenue, which would represent a growth rate of 60% year over year.
Datadog has a strong balance sheet with $1.7 billion in cash, cash equivalents and marketable securities and total debt of $808 million.
Is the stock undervalued?
In terms of valuation, Datadog trades at a forward price-sales ratio of 21, which is approximately 25% cheaper than its five-year average.
The GF Value line also indicates a fair value of $177 per share, which means the stock is undervalued at a ~$109 share price at the time of writing. However, GuruFocus also warns of a possible value trap due to lack of profitability combined with the low share price.
Final thoughts
Datadog is a tremendous company and is truly the “top dog” when it comes to IT observability. The company has produced another blockbuster quarter with blistering growth. However, the macroeconomic uncertainty has caused a little volatility in the stock. Overall this looks to be a great long term value opportunity in my opinion based upon the digital transformation of enterprises.
