Overview:
By Beth Kindig
Last May, we covered Datadog’s Q1 earnings report and indicated we would do a deep dive on the company soon. The simplified thesis as we rounded the corner into tough Q2 covid comps, was that the company allows us exposure to the market that AWS, Azure and Google Cloud participate in but with a pureplay. We specifically stated, “If the tech giants are communicating that cloud infrastructure-as-a-service is one of the most critical markets in the future, then who are we to argue with this by not investing in the leader across cloud monitoring products?”
In that write-up, we quoted the CEO on why the company had been so resilient up to Q1. With Q2, the company has further shown its resilience.
I’ll quote what we had written as it’s straight forward and gets to the heart of why they can compete with even an open-source competitor not on the market’s radar:
What matters is to solve the end-to-end problem for our customers. And to make it as easy as possible for them to just plug us in and everything just work everything to show that we don’t get our mess, a gigantic mess with all these different technologies and applications and clouds, everything else. We turn that into something that the understanding is well ordered, without any effort.” -Datadog Olivier Pomel on Q1 earnings callon Q1 earnings call
At the time, we thought Datadog was capable of coming in above guidance, which did occur in Q2. The company came in quite strong at 67% year-over-year growth to $234 million, an acceleration from the 51%, 56% and 61% YOY growth rates in the previous three quarters.
Our original thesis from January of 2020 pointed out that we thought Datadog would do well on hybrid cloud when we said, “Datadog serves hybrid cloud customers and allows for monitoring of both environments. New Relic, on other hand, is SaaS-only (or cloud only). From my perspective, the most growth will come from hybrid over the next few years as the majority of companies today have resisted sending data to another company’s servers and must eventually choose a solution to remain competitive on AI and ML. In my opinion, the future growth of hybrid is an important catalyst and market opportunity for Datadog. You can read more about Datadog’s hybrid offering here. ”hybrid offering here. ”
About nine months later, Datadog announced an integration partnership with Azure, the leader on hybrid cloud environments.
We are especially bullish on the Sqreen acquisition as this helps Datadog take advantage of the trend towards microservices and Kubernetes rather than monolithic architectures. I’ve covered Kubernetes in an editorial here when I discussed Google Cloud, Azure and AWS. Generally speaking, Kubernetes can introduce vulnerable clusters due to default configurations. In the past, the demonstrations at BlackHat, the annual security conference held in Las Vegas, have exploited features in Kubernetes default attack surface rather than bugs. Sqreen specializes in protecting code-level risks across distributed applications by protecting application logic. Sqreen’s main goal is to deliver security solutions to developers and the operations teams, as well, i.e., to “democratize” and emphasize security testing and implementation during the development process, often called DevSecOps. These are the two main points on this acquisition – more market share across security for microservices and more stakeholders at a company who can buy and deploy Datadog products outside of the security team.
We think it’s fairly clear that Datadog’s product is quite strong and able to out-perform competitors. Therefore, we think it’s prudent to focus more on valuation and look for clues as to how the company will perform under the pressure of being one of the more richly valued tech stocks.
As most of you know, we’ve added a CPA to the team. We think a strong financial analyst compliments my analysis on tech products and Knox’s technical analysis and portfolio management quite nicely. Below, Bradley goes through the financials on Datadog and why the company may be able to live up to its valuation.
We published on the forum the following introduction to Bradley Cipriano:
Please welcome Bradley Cipriano to the team. He will be our team member who dots the i's and crosses the t's on financial reports and who is incredibly detailed with a sharp eye for numbers. We couldn't be more excited to have his specific skillset join the analysts on the site as we feel confident we will see an immediate impact from having a detailed CPA on the team.
We think growth-hope investing is rampant. I would define this as "the growth is there, let's hope the stock goes waaaay up!" We want to do the opposite at the I/O Fund. We say "the growth is there, now let's reduce risk with product analysis (Beth), technical analysis (Knox) and financial analysis (Bradley) to find the one gem out of a list of ten or twenty.
Bradley will help us sort through quality candidates to help us improve our batting average. He is specifically trained to find issues that nobody else sees — and vice versa, to identify opportunities that check out after rigorous financial analysis. Please welcome him on the forum, where he will be spending time daily and weekly, plus keep an eye out for his thoughtful analysis via blog updates.
Here's his bio:
Bradley previously worked as a forensic equity analyst at Gradient Analytics, where he focused on assessing the quality of revenue and earnings for both domestic and internationally listed stocks for institutional asset managers. Bradley has been able to utilize his strong accounting background to identify issues and concerns that the Street may be overlooking, such as low-quality earnings beats and unsustainable revenue growth. He received his BS degree in accountancy from the W.A. Franke College of Business at Northern Arizona University. Bradley is a licensed CPA in the state of Arizona and is also pursuing the CFA charter.
Datadog Deep Dive on Financials and Valuation
By Bradley Cipriano
Datadog reported Q2 results on August 5th and beat the consensus top and bottom-line estimates while forward guidance for Q3 came in ahead of expectations. The stock is up 15% after the Q2 print and is also up 34% YTD, outperforming the Nasdaq’s 13% YTD gain.
At $133/share, Datadog trades at a premium of 43x forward P/S multiple by the market, well above its peers in the cloud monitoring market (shown below). In the discussion that follows, we outline Datadog’s unique opportunity and strong financial performance, which we believe supports Datadog’s premium valuation.
Table 1. Datadog’s Multiple Relative to the Peer Median
While a 43x Fwd P/S multiple appears high at first, Datadog is uniquely positioned to continue to benefit from corporations transitioning to the cloud.
Gartner estimates that spending on public cloud services will reach $661 billion by 2025, more than doubling from the ~$270 billion spent in 2020. Of this, approximately $34 billion will go to infrastructure monitoring by 2024. More specifically, the post-Covid estimates for application performance monitoring market is $12 billion by 2026. Datadog participates in other markets, such as network performance monitoring, as well.
You can read more about our stance on cloud here in the H1 2021 update. On key takeaway from the February report is this: “Gartner’s survey indicates that there is still quite a bit of growth ahead despite the harder comps the cloud software leaders face in 2021. The data shows that 70% of organizations using cloud services plan to increase their spending, stating “the proportion of IT spending that is being allocated to cloud will accelerate even further in the aftermath of the COVID-19 crisis.” plan to increase their spending, stating “the proportion of IT spending that is being allocated to cloud will accelerate even further in the aftermath of the COVID-19 crisis.”
Datadog is more insulated in terms of competition as the company is able to benefit from the growth of Amazon’s AWS, Microsoft’s Azure and Google Cloud. This is because cloud customers prefer an independent software provider monitoring their cloud environments rather than use the cloud IaaS provider for the monitoring of applications. Imagine if a customer of Amazon’s AWS had an issue that she thought was due to AWS, but Amazon was saying the issue was on her end. Having an independent third-party helps resolve this potential conflict of interest and also allows the customer to pursue best of breed products across a multi-cloud environment.
While Datadog compliments the bigger players in cloud IaaS, the company faces competition from its peers. However, Datadog has led the competition, evident by its robust growth rate. As pictured below, Datadog has reported the strongest topline growth rate amongst its peers and its outlook for three-month and next twelve-month (NTM) sales growth is also the most robust in its peer set. Given Datadog’s premium valuation, the market believes that Datadog is the favorite to succeed in this space, and we agree. The cloud market is enormous, and if Datadog can continue to capture share, then the firm has plenty of growth ahead of it. We explain why we think Datadog will continue to outperform in greater detail below.
Chart 1. Trailing and Forward Growth Rates for Datadog and its Peers
You can read more about Datadog’s competitors including AppDynamics (Cisco) here.about Datadog’s competitors including AppDynamics (Cisco) here.
Datadog’s Opportunity
One of the things that sets Datadog apart from the competition is that it is easy to set up. For example, Datadog recently partnered with Microsoft to natively embed Datadog into Azure. Datadog explained that “this first-of-its-kind integration of a third-party service into a public cloud provider reduces the learning curve for using Datadog to monitor the health and performance of your applications in Azure”. This is significant, as Azure is the second largest cloud provider, accounting for ~20% of total cloud market share, according to Gartner. Coming pre-installed is a significant advantage relative to other monitoring peers such as Splunk, which requires highly skilled (and expensive) engineers to configure the software. Being pre-installed also significantly reduces the sales cycle, allowing Datadog to grow its sale faster.
Likely contributing to its easy set-up and installation in the cloud, Datadog was built specifically for the cloud. In other words, Datadog is entirely cloud-native. Before Datadog, Splunk was the market-leader in log management, but Splunk was built for on-premise infrastructure, which is inherently different from the constantly evolving cloud environment. Splunk missed the tectonic shift to the cloud, while Datadog seized the opportunity. This is a rare instance in tech of a first-mover (Splunk) losing its market dominance to a younger company (Datadog).
Another key differentiator for Datadog is its leadership. The company was founded in 2010 by its current CEO, Oliver Pomel. CEO Pomel’s vision from the start was to be entirely dedicated to the cloud, and portable to all different cloud environments. His vision was spot on as cloud spending vastly outpaced on-premise spending in 2020 (shown below). With global cloud spending expected to increase ~23% in 2021, Datadog can be expected to maintain its strong growth rate for the foreseeable future.
Chart 2. Enterprise Spending on Cloud and On-Premise Data Centers
In a rapidly growing and constantly evolving cloud environment, it pays to have a founder CEO with a deep understanding of technology leading the company. We can see the consequences of having the wrong leadership in place by looking at Splunk’s fall from grace. For instance, Splunk’s founder exited years ago and he was replaced with a CEO with a background in technology sales. The assumption at the time was that Splunk had the tech, it just had to sell it. This likely contributed to the company missing the tectonic shift to the private/public cloud and hybrid cloud as the CEO was focused on selling the product rather than adapting it to the changing environment. Now, we see Datadog benefiting from multi-cloud, as well.
CEO Pomel has also done a great job of staying ahead of the competition. He states that Datadog’s focus has been “mostly greenfield, new environments” where the company does not encounter competition. When asked on the Q2 Conference Call about the competitive backdrop, and if there’s been any changes, CEO Pomel replied that “its very boring” and that the competitive landscape hasn’t changed much. This does not happen by chance, rather it takes a leadership team with expertise and a deep understanding of their customer’s needs to anticipate where the “greenfield” opportunities will be, and to get there before the competition.
A big theme going forward for Datadog will be the ‘standardization’ of cloud vendors. CEO Pomel explained this trend at length during Datadog’s Q2 Conference Call. He gave an example of a 7-figure upsell w/ an e-commerce company that had a strategic initiative to “consolidate and reduce costs by standardizing on Datadog.” He gave another example of a different 7-figure upsell for a global firm that was “experiencing rapid growth with their online product and its teams were forced to jump from tool to tool to try and mitigate problems.” He added that by standardizing on Datadog, the firm was able to “decrease mean time to resolution and free up internal resources”.
Standardizing means interoperability between various cloud environments and integrated interfaces. This is especially important with multi-cloud or hybrid cloud where companies have more than one environment. This is becoming the new normal to prevent vendor lock-in. The word standardization/ standardize was mentioned 20 times on the Q2 Earnings Call, highlighting its importance to Datadog’s story going forward. If corporations continue to standardize on Datadog’s platform, then the company will continue to capture market share.
Since dealing with multiple cloud vendors quickly becomes cumbersome, there is a natural tendency to standardize in tech, especially with software. Moreover, cloud applications need to communicate, so having everything on one platform can make detecting and resolving issues less complex and costly. We believe that we are on the cusp of this standardization trend with cloud software vendors, with Datadog leading the way. We believe that Datadog is best positioned to benefit from both the rise in cloud usage and the standardization of cloud software.
Viewing Datadog’s opportunity holistically, we can better understand its premium 43x forward sales multiple. The firm is the fastest growing company in a market that is riding on tailwinds from the tech giants. Its market is rapidly growing, and this growth is expected to continue for the foreseeable future. Furthermore, customers are starting to consolidate cloud vendors to reduce complexities and costs. This trend will allow Datadog to quickly capture market share, adding more fuel to its topline growth rate. Lastly, Datadog also has a founder CEO leading the company, coupled with a proven management team capable of adapting to the constantly evolving cloud environment. We believe that these trends help justify Datadog’s premium valuation. In the next section, we discuss Datadog’s recent financial performance and compare key metrics to industry peers. We highlight both favorable and unfavorable trends, and important metrics to watch going forward.
Datadog’s Financials
Datadog’s Q2 sales beat expectations by $21 million and increased 67% YOY to $234 million, an acceleration from the 51%, 56% and 61% YOY growth rates in 1Q21, 4Q20 and 3Q20, respectively.
Gross (operating) margin was 76% (-4%), in-line with (above) the trailing three-year average of 76% (-5%). Non-GAAP EPS was $0.09, up 80% YOY, and beat the consensus estimate of $0.03 by $0.06. Quarterly cashflows from operations doubled YOY from $25 million to $52 million while TTM free cashflows increased 193% YOY top $132 million. It is impressive to see both sales and cashflows grow at a rapid pace, highlighting how Datadog’s business is firing on all cylinders.
Datadog’s strong topline growth and positive cashflows lends credence to the firm’s premium valuation. Furthermore, Datadog’s outlook for Q3 also came in well ahead of expectations, as Q3 sales and EPS estimates have recently been revised up by 10% and 105%, respectively.
We also note that certain non-GAAP metrics highlight Datadog’s premium position in its industry. For instance, Datadog’s dollar based net retention ratio (DBNRR) has been >130% for 16 consecutive quarters. A DBNRR metric above 100% signals that Datadog’s customers are expanding the amount of Datadog products they use, highlighting how Datadog has been executing on its ‘land and expand strategy’.
Looking forward, we could expect a slight normalization in Datadog’s DBNRR metric. This is because CEO Pomel explained on the Q2 Earnings Call that new customers are starting larger, meaning they are purchasing more products upfront. This is a favorable trend, as it immediately increases revenues, but will be a headwind to DBNRR going forward as there will be less products to expand into. If DBNRR starts to trend back to 100%, we will need to determine if it is because of higher average selling prices for new customers (a favorable trend) or because of an increase in churn/decrease in usage of products (an unfavorable trend).
Another important trend to watch is if Datadog is collecting cash upfront when it signs a customer contract. Datadog’s Q2 current deferred revenue balance increased 63% YOY to $265 million, or 113% of three-month sales. Furthermore, net deferred revenue (deferred revenue less accounts receivables) increased 88% YOY to $78 million, outpacing the 67% YOY rise in Q2 sales. The outsized growth in net deferred revenue shows that Datadog has collected relatively more cash upfront from subscription sales than last year, a sign of strength. Having cash upfront for sales also improves the quality of revenue, which deserves a higher premium relative to sales accrued without cash.
Finally, we also believe that its critical to monitor Datadog’s research & development (R&D) expense going forward. We want to see that Datadog continues to invest in its future, but we also want to see that R&D expense remains under control. As pictured below, Datadog’s R&D expense margin has steadily increased over the years. This makes sense, considering the constantly evolving cloud environment.
In the most recent quarter, R&D expense rose 108% YOY to $95 million, this represented the fastest pace of growth since Q1 2019. While the acceleration in R&D expense has helped Datadog secure its greenfield opportunities, R&D’s current growth rate is ultimately unsustainable.
We also note that Datadog has reported a rise in capitalized software, which stores R&D expense on the balance sheet and temporarily inflates earnings by reducing R&D expense. For instance, capitalized software increased $8 million QoQ ($33 million YOY) to $66 million. The capitalization of R&D expense is up to management’s discretion, and a sharp rise in capitalized R&D expense can signal that a company may be trying to manage its expenses. Had Datadog instead expensed the $8 million QoQ rise in capitalized software as R&D expense, its Q2 EPS would been lower by ~$0.03. Nonetheless, Datadog still would have beat estimates after including this expense adjustment.
Going forward, we will need to monitor both R&D expense and capitalized software to make sure Datadog’s results are sustainable. For instance, the sequential increase in capitalized software plus three-month R&D expense was $103 million, which was below the firm’s quarterly gross profit of $176 million. The trend will likely become unsustainable once the sum of the sequential rise in capitalized software plus R&D expense is greater than Datadog’s quarterly gross profit.
Chart 5. Recent Trends in Datadog’s R&D Expense Margin and Capitalized Software Expense
After reviewing Datadog’s financials, we can see why the firm has been awarded a premium multiple. Datadog has reported accelerating sales growth, a strong outlook and robust cashflows. The company’s DBNRR has remained above 130% for 16 consecutive quarters, demonstrating that the company is executing on its land and expand strategy. Datadog also has cash support for future sales stored in deferred revenue, which improves the quality of revenue and warrants a higher premium. While the current growth rate in R&D expense is unsustainable, the trend is not yet of concern. Taken together, we believe that Datadog’s premium multiple is appropriate given Datadog’s strong financials.
Conclusion
In light of Datadog’s premium multiple, we revisited the story to make sure the company’s valuation remained reasonable. Considering the firm’s unique position in a rapidly expanding market which is ripe for consolidation, we believe that Datadog’s topline has plenty of room to run. Furthermore, Datadog’s founder-led management team has proven resilient in a constantly evolving cloud environment. We also considered Datadog’s financials which appeared robust but were not without concerns. For instance, Datadog’s sales are growing at an accelerating rate and its cashflows appear healthy. However, Datadog’s R&D expense growth rate is currently unsustainable, and the expense has been artificially lowered by the capitalization of software expense. Nonetheless, Datadog’s results remain robust after these adjusting for these considerations. We continue to believe that Datadog is best positioned to benefit from the tectonic shift underway as corporations migrate to the cloud, which helps justify Datadog’s premium valuation.
Disclosure: Bradley Cipriano and the I/O Fund own shares in Datadog and have no plans to change their respective positions within the next 72 hours. You can access the I/O Fund’s positions here. The above article expresses the opinions of the author, and the author did not receive compensation from any of the discussed companies. Disclosure: Bradley Cipriano and the I/O Fund own shares in Datadog and have no plans to change their respective positions within the next 72 hours. You can access the I/O Fund’s positions here. The above article expresses the opinions of the author, and the author did not receive compensation from any of the discussed companies.