Datadog is a heavy hitter on revenue growth and offers a rare, balanced bottom line. We believe this is because Datadog rides the coattails of digital migrations to AWS, Azure and Google Cloud. As cloud migrations continue – evidenced by growth across The Big 3 – the number of applications and containers to monitor has grown and the complexity has also grown within cloud-native environments. We previously covered this here.
The company is recognized as a Leader in observability and sits comfortably above competing platforms offered by the Big 3 in Gartner’s Leader Quadrant. This is important because Datadog serves the dominant trend of multi-cloud by offering flexibility for companies that prefer to work with more than one cloud vendor (Google, Azure or AWS) while not compromising on quality of observability and security products.
There’s a lot to unpack in the report, but ultimately, we feel it was a strong report and that as more cloud earnings come down the line, Datadog will ultimately stand out among its peers.
Q2 Overview of Financials
Datadog beat on Q2 revenue reporting $406 million for 74% growth compared to a consensus of $381 million, or 63% growth expected. The guide for Q3 came in as expected at $410 to $414 million compared to $410.7M estimated.
The company reported GAAP EPS of ($0.02) with the market expecting ($0.07) EPS. Adjusted EPS also beat at $0.24 reported compared to $0.15 EPS expected.
The GAAP operating margin was at (1%) compared to 2.87% last quarter. Notably, this was a slight improvement YoY with GAAP op margin at (4%) in the year ago quarter although lower sequentially from +3%. As we said with Microsoft and Google, margins that are flat/unchanged are a win right now. This resulted in ($3) million in operating losses compared to a ($10) million operating losses in the year ago quarter.
The company’s operating cash flow of $73 million was down sequentially from $147 million yet was up YoY from $52 million. The free cash flow in Q2 was $60 million compared to $130 million last quarter and $43 million in the year-ago quarter. The company has $1.7 billion in cash on its balance sheet, which is unchanged from last quarter and up $300 million from the year ago quarter.
Stock based compensation more than doubled to $82 million in the recent quarter, up from $34 million in the year ago quarter. SBC this year across two quarters is at $149 million.
Growth of larger customers above $100K ARR grew 54% which is down but not too meaningfully given macro. Last quarter growth was at 60% YoY, and in the year ago quarter, ARR > $100K was up 60%. DBNRR was over 130% for twenty consecutive quarters.
As discussed below, the strength to Datadog is the land and expand, or the upgrades. The company continues to do well here with 79% of customers were using two or more products, up from 75% a year ago. 37% of customers using four or more products, up from 28% a year ago and 14% of our customers were using six or more products, up from 6% a year ago.
The company stated they are aggressively hiring, which makes Datadog an outlier in that regard, and is often a forward-looking indicator.
Datadog guided in line, but the market was expecting the company to raise guidance considering the last two quarters were sizable beats. Q3 guide was for $410 to $414 million with consensus at $410.68 million. The company reiterated the $1.62 billion guide for FY2022, or 58% growth. Adjusted EPS guide for Q3 also came in as expected while full year EPS guide was slightly lower than expected, at the midpoint, with adjusted EPS of $0.74 to $0.81 compared to $0.80 adjusted EPS expected.
Why the Market Got a Little Nervous in the Pre-Market
Although Datadog was able to provide revenue guidance consistent with previous guidance, analysts wanted more visibility into full year guidance as Q4 sits lower than usual if we assume $1.62 billion this year.
Total deferred revenue was $467 million in Q1 with current deferred revenue of $455M and non-current deferred revenue of $12.8 million. In the current quarter this softened to $458.5M in total deferred revenue with $444 million current and $14.5 million non-current. While non-current fluctuates, this was the first decline in current deferred revenue over the past two years. This information was available pre-market.
On the earnings call, Datadog reported Billings and RPO growth that was lower than overall revenue, whereas in the past, these two key metrics typically exceeded revenue: “And pro forma for those adjustments, billings growth year-over-year was in the mid-50s. Remaining performance obligations, or RPO, was $881 million, up 51% year-over-year. Current RPO growth was in the mid-50s year-over-year, and contract duration was slightly lower than the year ago quarter.”
This is down from 85% growth in RPO last quarter and billings growth of 103% last quarter. In the year ago quarter of Q2 2021, RPO was up 103% and billings was up 69%.
The company stated this was due to these three reasons:
1. Due to the land and expand model where customers come in the door and then upgrade:
“As we said in previous quarters, billings and RPO growth can fluctuate significantly and vary from revenue growth, whether higher or lower due to the timing of invoicing and duration of customer contracts. To illustrate this, we note that billings growth for the first half of the year of 2022 was 72% year-over-year.” billings growth for the first half of the year of 2022 was 72% year-over-year.”
2. They believe that even though customers are less likely to commit due to macro, they will still spend in-line and their guidance reflects their expectations: “In addition, we observed that some customers aren't changing their level of usage growth but are being more conservative in their commitments, which impacts billings and RPO growth but not revenue growth.”customers aren't changing their level of usage growth but are being more conservative in their commitments, which impacts billings and RPO growth but not revenue growth.”
3. There was an accounting pull forward to where some customers were billed in Q1 this year yet were billed in Q2 last year: “As in previous quarters, we had some differences in the timing of billings of a few large customers, which were billed in Q2 last year but were billed in Q1 this year.”differences in the timing of billings of a few large customers, which were billed in Q2 last year but were billed in Q1 this year.”
Here is one question on the call about RPO and Billings:
“But if you can help us reconcile your RPO growth. I'm sure there are company specific things that pertain to how you see of your growth on a year-over-year basis, sequential growth basis. How do we look at that in the context of what's happening with the hyperscalers. And they did put up even during an uncertain time, tremendous backlog growth, whatnot. So is there something specific to Datadog? Maybe it's the 18% or so, high teens percentage exposure to consumer discretionary.”
The CEO defended Datadog by saying their growth has exceeded the hyperscalers: “In Q2, we did a lot better than the hyperscalers. So we're growing a lot faster than all of them combined. And they've decelerated actually more than we've done in relative basis. So we actually feel good about the ratio there.”So we're growing a lot faster than all of them combined. And they've decelerated actually more than we've done in relative basis. So we actually feel good about the ratio there.”
The CFO had the following color to add: “So remind everybody that with our land and expand where we start getting used by clients, they scale up the growth and when they get to a certain point through, this has been going on for the whole business model. They go to an increased commit. Because of that, there's variability in the billings and RPO that net-net, over time, on average, go towards the ARR growth. Again, remember, we mentioned that the ARR growth is the best metric. And the way to look at that is that you look at the revenues […]
And I think we said we basically put in there that in the first half of the year, the growth of this was in the 70s, pretty close to revenues. the growth of this was in the 70s, pretty close to revenues. Why? Because there was timing of billing in the first quarter relative to the second quarter Because there was timing of billing in the first quarter relative to the second quarter that moved the first quarter up and the second quarter down, but it really doesn't have much effect on the drivers of our business.”
The other question on analyst’s minds is basically this: Is Consumer Discretionary isolated as the only vertical that is reducing budget and cloud usage oror is Consumer Discretionary simply the first in a row of dominoes with other verticals soon to follow?
Datadog’s answer to this (for their business) is that they are seeing decreased usage in larger customers and not from SMBs. The analysts were surprised by this due to the ongoing reports SMBs are reducing their spend. There was more than one question but here’s an example:
“Good morning. David, I think everyone is still a little confused. You're seeing an inversion with what's happening with SMB and large enterprise. Many companies are kind of weakness in SMB not at large. Can you explain why you think you're seeing this inversion? And are you embedding a more conservative view in the back half?”
The most direct answer was this: “[SMBs] have the same exposure but simply the difference is, what's your time to say, $5,000. Probably not. If you're a much larger customer, it's worth your time to sell $500,000. And that's what we see with those optimizations.”
Datadog didn’t give much improvement in terms of full year guidance.
Here’s what I have right now:
Q1: $363M or 83% growth
Q2: $406M or 74% growth
Q3: $412M at midpoint or 53% growth
Q4: $439M if we factor in FY2022 $1,620 guide or 34.6% growth. Note: Analysts are modeling 45% growth for $471M for Q4.
Management is keeping it safe by remaining with the full year guidance they previously with the word “conservative” mentioned a lot. This is what was stated on the call:
“I wanted to talk a little bit about some of the trends you're seeing in the business and particularly with respect to the guide. I guess the first question is, as the quarter progressed, when did you start to see some of these slower usage trends in some of these verticals? If you could give a comment on that? [..] And then, David, in terms of the guidance in terms of how you were framing it, can you give us a sense of what you're sort of assuming in the back half with respect to Q3 and Q4? Is it some of the trends that you're seeing in July, did that improve or stabilize or worsen?”as the quarter progressed, when did you start to see some of these slower usage trends in some of these verticals? If you could give a comment on that? [..] And then, David, in terms of the guidance in terms of how you were framing it, can you give us a sense of what you're sort of assuming in the back half with respect to Q3 and Q4? Is it some of the trends that you're seeing in July, did that improve or stabilize or worsen?”
The CEO stated, “We saw that start really in late April, May and June. So as we got deeper into the quarter. I should say that this is – if you're thinking of what happened in terms COVID, this is not a sharp pullback as we have seen at that time. But we saw it's just, for some customers still growth, but slower growth for certain types of customers and others than what we would have seen historically”
The CEO later clarified the following on the APM product: “That's a great question. So for APM, there's actually part of APM that looks like logs […] And that's the part on which we've seen some slower growth. It's still growing, but both are actually still growing healthily, but I would say, slower than they were in recent quarters for these types of customers.”
The CFO stated, “On guidance, as you know, we have always been conservative in our guidance by using lower organic growth and other metrics than we've seen historically and continue to maintain that philosophy. I would note that if you look at the raise here and the percentage of the beat that was passed through into the raise from Q2, it is lower, more conservative than we have done in previous quarters. And the reason for that is the macro uncertainty where we can't be as confident about what happens given the macro uncertainty.we have always been conservative in our guidance by using lower organic growth and other metrics than we've seen historically and continue to maintain that philosophy. I would note that if you look at the raise here and the percentage of the beat that was passed through into the raise from Q2, it is lower, more conservative than we have done in previous quarters. And the reason for that is the macro uncertainty where we can't be as confident about what happens given the macro uncertainty.
So I would say there, if you want to take that, there were some incremental conservatism put into this. But I'd remind everybody that we've always been quite conservative in using assumptions that are lower than the past when we give guidance.”there were some incremental conservatism put into this. But I'd remind everybody that we've always been quite conservative in using assumptions that are lower than the past when we give guidance.”
Here is management’s track record in that regard. Notably, this track record was accomplished even given the uncertainty of Covid.
So, for next quarter, we know we need to make sure that Q4 guide comes up to match analyst expectations.
The Gartner Magic Quadrant for APM and Observability came out recently in June of 2022. Datadog’s products are comfortably ahead of what The Big 3 offer.
Conclusion:
I'm guessing by the time we get all cloud Q2 reports, DDOG will be a leader in cloud for both top line and bottom line. The market clearly wants perfection for the higher valuations in cloud and I think DDOG gave us what will be seen “as close to perfection as possible" as we go along. The primary remaining blemish was the company did not raise full year guidance to imply healthy/consistent growth in Q4.
DDOG's report was a bit murky for less defensible cloud companies as they pointed to a slowdown in usage in May and June. DDOG is more defensible due to a few things — it sits at a critical piece in the stack (last to be cut even if there is softness in commitments, revenue growth can still occur as planned), is well diversified across many verticals and is the best direct correlation to cloud IaaS growth (ref. our previous analysis one example is here).
I've felt for some time that if we see AWS, Azure, etc., start to slow then maybe time to look at our (very high) DDOG allocation, otherwise, our goal is to ride on these coattails. DDOG could still have some nice growth once cloud infrastructure slows — it's simply one data point I use when we determine the allocations since it’s so closely correlated.
Knox trimmed 1% from Snowflake because SNOW is certainly more exposed to usage trends as is Confluent. I know Confluent had a nice quarter today, however, it appears their growth is slowing to mid-30% by Q4 and analysts are in agreement with this. Perhaps the company will raise guidance as they go along.
Takeaway:
We already cut ASAN to reduce exposure to discretionary spending. We also cut TWLO due to discretionary cuts we saw from ad-tech and other signs although I suspect we will be back into Twilio by H2 2023. Our goal is to not "call earnings" rather to reduce exposure and add back in when the skies are bit clearer plus we want to allocate to any companies showing strength for 2022. Snowflake could do well but there is exposure to discretionary spending and the company bills on a usage basis – we covered this here.