Tech growth is a certain style of investing; it’s a mix of grand slams but more strikeouts. Value investing is a mix of singles, doubles and even bunts, but with fewer strikeouts. Investing style and risk appetite runs a large spectrum from high risk/high reward to low risk/low reward.
Similarly, there are different management styles. Datadog falls firmly in the candid, conservative style of management. They are the best-of-breed team that is least likely to overpromise and under-deliver, hence the perfect record on beating on the top line and bottom line.
Both the CEO and CFO will tell investors exactly like it is, even it’s hard to hear. This is very different from other management teams that will take risks on guidance, with the hope of meeting the numbers somehow, and will smooth over anything negative so as not to raise alarm bells.
Datadog’s guide does not necessarily foreshadow lower growth than other cloud companies that have reported, especially as we can assign a high level of probability the actual report will come in higher than the guide. Rather, it was the tone on the call that was very different. Ultimately, as we covered in our Q1 Earnings Prep Webinar, there is a lot of built-up anticipation for a H2 rebound. The rebound may or may not happen; I imagine next earnings season will be a real line in the sand given it takes place four to five months into the year.
The rebound comes from analyst estimates, so of course, analysts are keen to make sure their estimates are correct with the bulk of questions aimed at what 2023 will look like. Datadog told analysts on the call they do not see evidence of a rebound yet, and with what they know today, their guide assumes optimization will continue throughout the year. They do believe eventually optimizations will slowdown, and that cloud migration will again become a tailwind. They are unwilling to provide guidance on when this will happen.
Management specifically called out a bigger slowdown in December on usage than what they saw in October and November. So far, 2023 has more closely resembled December. They also specifically called out larger customers as the primary cohort optimizing and lowering usage and/or spend, while smaller customers are seeing little to no change. Large customers have more to gain from lowering costs, and face more uncertainty.
Datadog’s financials are similar to what we posted on the forum, which is a slowdown from this time last year (to be fair, all cloud has slowed on a YoY basis from Q1 2022 to Q1 2023E). RPO was flat but Billings were down QoQ. Datadog still has a top position for bottom line strength in best-of-breed, although notably, the bottom line has softened.
Financials:
Datadog beat estimates in the current revenue, yet guided below analyst consensus for Q1 and FY2023.
In the current quarter, revenue of $469.4 million represents growth of 44% year-over-year. This beat previous management guidance and analyst consensus of $449M, for a beat of +6% on the top line. This led to a beat on FY2022 revenue at 63% growth compared to 60.8% expected.
Guidance for Q1 is for $460 to $470 million, for growth of 28%. Due to being conservative, as discussed in the intro, the fiscal year guidance is lower than Q1 at 23.8% for $2.08 billion.
You can reasonably assume these estimates will be beaten with a 5% to 10% beat, if we rely on previous earnings surprises, but there’s no guarantees, of course.
Adjusted EPS of $0.26 comfortably beat estimates of $0.19. GAAP EPS came in at ($0.09).
Q1, Datadog management provided a guide in line at $0.22 to $0.24 compared to estimates of $0.24. For FY2023, there was a miss with guidance of $1.02 to $1.09 compared to analyst estimates of $1.13.
Cash flow was up sequentially due to seasonality yet was down on a year-over-year basis. Despite Datadog decelerating, it still ranks high on FCF margins for cloud best-of-breed. Operating cash flow margin was at 24.3% and free cash flow margin of 20.50% equaling $96.4 million in cash flow.
Let’s say we have a deeper recession than expected. Datadog is likely to survive this, but at what valuation is the question. There’s a solid chance cloud remains range bound at these valuations until there’s a return to growth, which means fluctuations up in price/down in price that ultimately provide little movement or gains. I don’t think Datadog is going to be the company that has an unpleasant surprise from an unexpected miss in their earnings report, which is my preference certainly for management style. Rather, they will take the hit up front, like we saw today.
The company has cash and marketable securities of $1.9 billion on the balance sheet with fairly high stock based compensation of $112 million.
Margins:
· Datadog has a high gross margin of 79.3%.
· GAAP operating margin beat at (7%) actual compared to (10%) guide. This is a deceleration from 3% in the year ago quarter.
· Adjusted operating margin was 18% compared to 22% in the year ago quarter.
· GAAP net margin of (6%) compares to 2% net margin
Key Metrics:
· Datadog reported RPO of 30% YoY which was flat from the previous quarter. Notably, the Q4 to Q1 quarter tends to be flat for Datadog with more variability in Q2.
· Billings softened to 31% growth YoY compared to 86% in the year ago quarter. This was a deceleration from Q3 with billings of 51%.
· Customers with ARR of > $100K grew 38% compared to 64% last year
· Customers with ARR > $1 million grew 46.7%. This is a newer metric for Datadog with no year-over-year comp available
· DBNRR is above 130 but management stated on the call they expect this to dip below 130.
Earnings Call:
In the opening remarks, the company stated the following about large customers in Q4:
“Now moving on to this quarter's business drivers. Overall, we observed slower usage growth with existing customers while continuing to scale our new logo acquisition and new product cross-sells. Starting with usage. Usage growth of existing customers in Q4 was overall slightly lower than what we observed in Q2 and Q3, which we attribute first to a continuation of cloud cost optimization by our larger spending customers; and second, to a seasonal annual slowdown in the second half of December that was more pronounced than in previous years.
As in Q2 and Q3, we continue to see more optimization from customers as a larger cloud footprint, while our smaller spending customers are exhibiting higher growth.”
The CFO later provided more color in his opening remarks:
“Next, similar to Q2 and Q3, we saw larger-spending customers grow slower than smaller spending customers. As with Q2 and Q3, we saw relatively more deceleration in the consumer discretionary vertical, particularly in e-commerce and food delivery. Geographically, we saw solid and relatively similar growth across all regions.”
And the CFO also stated this:
“We are incorporating an expectation for seasonally weaker growth in the first quarter due to the subdued growth in the month of December that creates a lower growth trajectory to start the first quarter. While our customers are continuing to expand with us, we are assuming in our guidance that cloud optimization continues to affect our expansion rate in 2023.”
In regards to Datadog’s specific business, they essentially believe they are the next in line on optimization following cloud hyperscalers. In other words, companies are optimizing with the hyperscalers now and working their way through the stack with Datadog second in line, in terms of what order makes the most sense:
“What we see, though, is that customers save money where it matters, which tends to be the very large line items, which for customers that are fairly far along into the cloud, is going to be, first, their cloud provider deals that are, again, one or two others are larger than their observability bills.
And then we're going to be affected by that and maybe with some optimization more specific to observability as well. So that's what we see there.”
Also, management clarified with analysts the slowdown (for Datadog) is not related to headcount, given the many layoffs announced, rather it’s more usage based and related to reducing budgets.
In regards to the larger trend of cloud migrations, Datadog said the following:
“So that's where we're going. I think you're right, though, that the underlying wave that is — has been a tailwind throughout the of the company was cloud migration and digital transformation. I think that we might be a bit more of a headwind over the next few quarters. But we strongly believe that it will become a tailwind again in the future.”
Conclusion:
Datadog is a company we will watch closely and return to in the future. Knowing that I can’t control macro, it feels like 2023 should be used as an opportunity to build tech generals in the belly of a recession rather than guess on companies that are reporting tapering growth (although formally were very high growth). Please note, many companies are reporting tapering growth despite the market rewarding the companies with earnings pops. This is entirely based on expectations for future growth which may or may not materialize.
It’s our preference to take advantage of the lower prices by focusing more on key tech generals for now while allowing time for smaller companies to prove their ability to withstand macro pressure. This strategy can be a win-win, because if we see a deeper recession than normal, the risk of picking the wrong company is much lower than if we bet on decelerating growth from less defensible companies. However, if we see a soft landing, then we are still positioned to participate in growth.
We will continue to identify outliers, such as AEHR, with a heavy focus on this in March and early April. Look forward to new coverage and deep dives coming soon as we wrap up the last of our portfolio’s earnings season next week.