Outsourcing is a trend that is at the intersection of two major structural tailwinds:

1) the rise of the cloud environment and

 2) transition to hybrid and remote work.

The concurrent rise of these two microtrends allows companies to be decentralized and access talent on a global scale. This has created a unique environment that is well-suited for outsourcing firms, which we expect will grow strongly going forward.

Outsourcing helps solve labor supply imbalances, such as the need for skilled and/or cheap labor. Furthermore, not all outsourcing firms are the same and some are positioned better than others for the current environment.

In the following analysis, I discuss three different firms across the outsourcing market: Grid Dynamics, TaskUs and Fiverr. Each of these firms is uniquely positioned to address different types of labor demands, such as the need for highly technical labor (Grid Dynamics), lower cost labor (TaskUs) or freelance workers (Fiverr). I begin my discussion with Grid Dynamics, the firm we believe is best positioned to outperform in the current environment.  

Grid Dynamics: digital transformation trend drives demand

The outsourcing firm we like best is Grid Dynamics (Grid, ticker: GDYN), a $2.5 billion company that was founded in 2006 in Menlo Park, California. Grid is focused on outsourcing highly technical labor to work on big ideas such as NoSQL, cloud computing, and AI/machine learning. The firm’s sales are accelerating and its business structure is low risk, which we believe sets the company up well to capture share in enterprise-level digital transformation, a $700 billion market that is expected to grow at a CAGR 22% for the next decade.

Grid is capturing share in this massive market, demonstrated by its robust 120% YoY growth rate in the most recent quarter. As shown below, enterprises are rapidly migrating to the cloud and digitally transforming their businesses, and we are in the early stages of this massive secular shift impacting nearly every business.

We can proxy the pace of demand for digital transformation by looking at FAANG+M Capex. As enterprises migrate to the cloud and digitally transform their businesses, this spurs capacity expansion at FAANG+M. As shown below, the major cloud providers are ramping capacity expansion. For instance, FAANG+M Capex increased 34% in Q3 to $36 billion and has increased 30% or more for 4 consecutive quarters.

Furthermore, FAANG+M capex is up 42% in the last twelve months to $132 billion. To put this into perspective, this would rank 59th in global GDP if FAANG+M capex was its own country. This analysis helps illustrate how digital transformation is a massive trend that is growing very fast, and Grid is uniquely positioned to benefit from this secular tailwind.

Grid’s Opportunity

Grid Dynamic’s clients are primarily US based, but only 10% of Grid’s workforce is based in the US. In fact, 90% of its employees are based overseas in Central Eastern Europe (CEE), a region that is known for its STEM expertise, especially in programming and computer science.  

Grid explained in its 10K that its supply of CEE labor gives it a competitive advantage in the current environment due to its focus on STEM (emphasis added):

“CEE is increasingly known for the quality of its software development talent, enabled in part by decades of focus on fundamental STEM disciplines in higher education. CEE-based teams and individuals are frequent winners of programming contests such as the ones held by the Association for Computing Machinery, or ACM, TopCoder and Kaggle. Grid Dynamics believes that this disparity between the supply and demand for technical talent can be a significant opportunity for Grid DynamicsGrid Dynamics believes that this disparity between the supply and demand for technical talent can be a significant opportunity for Grid Dynamics”

According to DataArt, CEE-based programmers placed 1st, 2nd or 3rd 73 times in the five most prestigious programming competitions in the world, or nearly half of all podium spots available (2011-2020). These competitions are intense, and the most recent competitions had 182,000 registered participants. CEE’s success in these competitions highlights the regions expertise in programming, a skill that is in high demand due the rapid rise in digital transformation discussed above.

A growing digital economy, accelerated by the rise of cloud computing and remote work, is a driving force behind heightened demand for highly skilled programmers, regardless of nationality. Grid explained in its 10K that it “targets the top 10% of technical talent from top technical universities. Nearly 100% of Grid Dynamics’ engineering personnel have advanced degrees in computer science”. We can see that Grid’s labor supply is in high demand, as sales recently accelerated to 120% YoY growth, and there are signs that this acceleration may continue into Q4. I discuss Grid’s recent financial performance in more detail below.

On top of providing access to highly skilled (and cheaper) global talent, Grid is also benefitting from a unique dynamic as job openings in the US have reached record highs (shown below). For instance, a recent Gartner survey highlight that “IT executives see the talent shortage as the most significant adoption barrier to 64% of emerging technologies, compared with just 4% in 2020”.

Software Developer Salaries in USA v Eastern Europe  

Source

10-Year Trend in Number of US Job Openings (in thousands)

Grid is well positioned to benefit from the rapid rise of cloud computing, transition to remote work and the supply imbalance of labor in the US. Grid’s supply of highly technical labor should do well going forward, especially as companies accelerate their digital transformation. Highlighting its strength in digital transformation, Grid Dynamics recently earned Google Cloud Premier Partner Status, a status reserved for the top 3% of Google partners. Grid was also labeled a leader in midsize software development service providers by Forrester (below).

Midsize Software Development Service Providers

Grid’s topline growth is accelerating

Due to the tailwinds mentioned above, Grid is growing rapidly and the growth is accelerating. Q3 sales grew 120% YoY to $58 million, an acceleration from the 113% and 21% YoY growth rates in Q2 and Q1, respectively. Absent recent acquisitions, organic sales grew 68% YoY or 15% QoQ to $44 million, which is well above peers (shown below) but slightly below its organic growth rate of 72% in Q2.

It should be noted that Grid’s sales declined in 2020 as spending was cut by its largest vertical (retail/ecommerce). However, this was offset with a rapid rise in its Tech, media and telecom vertical, which has increased sales by 39%, 35% and 43% YoY in Q3, Q2 and Q1, respectively. Furthermore, sales have been growing strongly on a sequential basis, and have increased QoQ every quarter since bottoming in Q2 2020.

Looking forward, management guided for Q4 sales to grow 94.2% YoY and organic sales to increase 52.7% YoY. For reference, Grid guided Q3 sales to grow 93.7% YoY and organic sales to grow 51.9% YoY. This guide may be conservative, considering Q3 sales came in well above guidance, which is typical in the tech industry. Assuming Grid beats by a similar amount in Q4 as it did in Q3, then Q4 sales will accelerate, as well.

Earnings are also robust as gross margin increased 125 bps YoY to 44% which was well above the three-year average of 40%. EBITDA (not adjusted) turned positive in Q3 and YTD adjusted EBITDA is up 227% YoY from $8 million to $27 million, which resulted in an adjusted EBITDA margin of 19%. Q3 adjusted EPS increased 120% YoY to $0.11/share, which beat estimates by 40%.

Grid also has a strong balance sheet and cash is its largest asset at nearly $200 million, or 65% of total assets. The majority of Grid’s customer contracts are under low-risk master service agreements (MSA), which carry little to no risk of cost overruns. Contract types are often an overlooked area for service providers, but high-risk contracts such as fixed-price contracts, can temporarily juice sales but can result in large losses in the future. Grid’s ability to accelerate growth and capture market share while utilizing low-risk MSA contracts is a sign of strength.

Risk

A key risk with Grid Dynamics is its small size and high customer concentration. Grid’s top 5 customers accounted for 42% of sales in Q3, while its top 10 customers accounted for 58% of Q3 sales. However, this is improving, and its top 5 and 10 customer concentration is down from 60% and 78% in Q3 2020, respectively.

Furthermore, Grid is exposed to foreign currency risk as it is paid in US dollars but pays its employees in their local FX. However, Grid has agreements that pay employees in a US equivalent amount, which naturally hedges foreign currency risk to a degree.

Another risk is reputation risk. Providing a service (such as outsourcing) is highly dependent on having a strong reputation and any damages to Grid’s reputation could impact Grid’s ability to win new contracts. However, Grid’s management team appears sound and the CEO (who is from Eastern Europe) has been with the firm since 2014. It is noteworthy that Grid’s founder recently left the company in August 2021 and founded a new company. However, according to her LinkedIn, the company she founded is not an outsourcing firm and does not compete with Grid’s core market.

We really like Grid’s robust growth and low risk business model. Looking forward, Grid appears well positioned to capitalize on the digital transformation trend, a structural tailwind that is expected to grow strongly for the next decade. We will be watching this company closely and might initiate a position given the company’s strong fundamentals. Next, I discuss TaskUs, another fast-growing outsourcing firm that specializes in outsourcing labor to digital-native companies.

TaskUs: backend operator for the tech industry

TaskUs (Task) is a fast-growing, digitally native outsourcing firm that was founded in 2008 in the Philippines and went public this year. Task is increasingly becoming the operation infrastructure provider of choice for digitally native companies, such as Zoom, Coinbase, Facebook and others. Task’s sales recently accelerated to 64% YoY growth, and the company will likely continue to grow strongly going forward. However, Task has high exposure to risky contracts which diminishes the quality of recently reported growth, which is keeping us on the sidelines for now.

Task’s opportunity

Task focuses on providing non-voice customer service, content moderation, and annotations/transcriptions to companies in the digital economy. Task’s employees are primarily based in the Philippines and provide the operational infrastructure for its US-based digital customers.

Task explains that there is demand for its services because technology companies are focused on new products and services and “often lack the desire, expertise, scale and/or geographic presence to build the operational infrastructure to support their growth”. The company claims that since it was founded just 12 years ago, it “grew up” in the cloud environment, which allowed Task to enter the market without investing in expensive, legacy infrastructure.

The company’s model is also highly profitable and produces strong cashflows. Task was profitable throughout 2020 and sales have grown sequentially every quarter since at least Q3 2019 (earliest date of public info). This high profitability and robust cashflow generation are due to the company’s focus on non-voice, digital channels, which accounted for 94% of 2020 revenues. Task explained in its S-1 that non-voice channels allow the company to utilize resources more efficiently, driving higher profitability. 

Task’s recent results and outlook

Task’s three sources of revenue are Digital Customer Service, Content Security (Moderation) and A.I. operations. Digital Customer Service provides customer care services through non-voice channels. This is Task’s largest segment and grew 64% YoY and accounted for 62% of Q3 sales.

Content Security (Moderation) deals with misinformation, offensive content, and critical policy issues. This segment experienced strong demand in 2020 during the election cycle and sales grew at a CAGR of 157% between 2017 to 2020. Content Security sales growth has since deaccelerated in 2021 and grew 34% YoY in Q3 2021 and accounted for 23% of sales.

Task’s fastest growing segment is A.I operations, which grew 145% YoY to $30 million, or 15% of Q3 sales. A.I. operations consist of data labeling, annotating and transcription services for training AI and ML algorithms. Management explained that demand is being driven by autonomous driving, which requires annotations by humans down to the pixel level.

Task’s aggregate Q3 sales increased 64% YoY to $201 million, which beat by $9 million and represented an acceleration from the 57% and 49% YoY growth rates in Q2 and Q1, respectively. On the Q3 call, management highlighted that wage pressure in the US is “pushing clients to move more quickly to an overseas delivery mode” which is driving demand for Task’s outsourcing services. On a sequential basis, sales increased 12% QoQ, which slightly lagged the 13% QoQ rise in Task’s headcount. It will be important to monitor this trend going forward to ensure that Task is able to improve efficiencies and grow sales faster than headcount growth.

Gross margin declined 251 bps YoY to 44% and adjusted EBITDA margin also declined by 70 bps YoY to 24% but beat management’s initial Q3 guide by 50 bps. The decline in margins was driven by costs related to the IPO and investments in new initiatives (Q3 call). Despite the decline in margins, GAAP net income rose 2% YoY to $12 million and adjusted EPS increased 25% YoY to $0.30/share, which was in-line with the consensus estimate.

Looking forward, management raised their full-year guide and now expect 2021 sales to increase 57% YoY to $749 million, up from the prior guide of 48% YoY growth (at the midpoint). Q4 sales are also expected to grow 55% YoY to $215 million. The Q4 guide for 55% YoY growth was an acceleration from the Q3 guide of 50%, and if Task outperforms its guide similarly in Q4 as it did in Q3, then sales will accelerate in the upcoming quarter.

Task’s recent performance has been strong as sales accelerated, margins remained robust, and guidance suggests a further acceleration in sales growth. However, there are some key risks that investors should be aware of going forward, which I outline in more detail next.

Risks

While Task has strong operational metrics, there are some key concerns that are keeping us on the sidelines for now. For instance, Task’s customer agreements include risky fixed-price contracts, meaning that Task carries the risk of project cost overruns. While not directly disclosed, we can proxy the company’s exposure to fixed price contracts by looking at the balance sheet for unbilled receivables, which are a direct result of fixed-price accounting. Utilizing this approach, it appears that around 34% of Task’s sales are from fixed-price contracts. As the name implies, the contract amount is fixed, which introduces the risk of cost overruns in the future.

Customers prefer fixed-price contracts since it passes the risk of cost overruns onto the contractor. This tradeoff can make it easier for the contractor to win new contracts but increases the risk of losses going forward. Task has a relatively high exposure to fixed-price contracts relative to peers. For instance, Grid Dynamic’s fixed-price exposure was around 10% of total sales, as Grid primarily utilizes low-risk master service agreements instead of risky fixed-price contracts (discussed in more detail above).

Task also has significant fixed expenses, which may be supporting earnings as expenses are temporarily stored on the balance sheet. For instance, Task’s Q3 capex increased 393% YoY to $15 million, or 8% of three-month sales. Furthermore, Task’s net property, plant and equipment (PP&E) has increased 27% YTD to $72 million, or 10% of total assets. This is high relative to Grid, which reported that quarterly capex was just 1% of Q3 sales and that net PP&E was 1% of total assets. A rise in capex and net PP&E may be shielding expenses from the income statement by storing them on the balance sheet, which temporarily improves margins and earnings.

Included in Task’s net PP&E is a risky account called construction in progress (CIP), which increased $9 million YTD to $14 million. Construction in progress is a unique account that is not depreciated until it is placed into service and is usually utilized by project-based companies (i.e. construction companies) and is not typically reported by outsourcing companies. The YTD rise in CIP was material and accounted 9% of YTD adjusted net income. Furthermore, the account increased by $5 million QoQ, which provided an after-tax $0.04 benefit to earnings during the quarter. Absent the sequential rise in CIP, Task would have missed its Q3 EPS estimate.

Another risk is the company’s significant customer concentration. For instance, Facebook (27% of Q3 sales) and DoorDash (11%) accounted for 36% of Q3 sales, however this is down from 44% in the year ago quarter. Task’s top five and top ten customers accounted for 61% and 76% of total sales in Q3, which also improved YoY from 67% and 81% in Q3 2020, respectively.  

Task is growing its topline rapidly due to its exposure to fast-growing technology companies. However, there are risks, such as Task’s exposure to risky contract types and the rise in fixed costs such as construction in progress. The company also has higher customer concentrations relative to Grid. We will be monitoring Task going forward but will likely hold off on initiating a position until its financials de-risk. In the next section, I revisit Fiverr, a marketplace for freelancers that outperformed during 2020.

Fiverr: marketplace for freelancers

The I/O Fund has covered Fiverr in the past, here and here. Below, I will be providing an update on the company’s most recent results and how they compare to other outsourcing firms such as Grid Dynamics and TaskUs. The key takeaway is that while Fiverr has reported strong growth, there are signs that momentum in its business is slowing, leaving us on the sidelines for now.

What differentiates Fiverr from other outsourcing firms is that the firm is a marketplace for freelancers, and Fiverr does not employ the labor that it supplies. The company saw a rapid rise in demand for its marketplace during the covid-pandemic as unemployment surged and remote work took hold, which was an ideal environment for gig workers to capture share. However, engagement on Fiverr’s marketplace has slowed, which is a concerning trend for future growth. I discuss these trends in more detail below.   

Recent results and slowdown in topline growth

As shown below, Fiverr’s sales have grown strongly, especially during 2020, but there are signs that momentum is dissipating. In the latest quarter, Q3 sales increased 42% YoY to $74 million, yet sales declined on a sequential basis by 1%, the first time sales have declined QoQ since Fiverr went public. Moreover, the 42% YoY growth rate represented a deacceleration from the Q2 and Q1 YoY growth rates of 60% and 100%, respectively, and represented the slowest pace of YoY growth since Q2 2019. This trend compares unfavorably to Grid and Task, which have both reported accelerating YoY growth and strong QoQ growth in the most recent quarter.

However, it should be noted that Fiverr outperformed during 2020, so its comparables are tougher than Grid and Task, which struggled during 2020. Nonetheless, markets are forward looking and enterprises having strongly rebounded in 2021, which are Grid’s and Task’s main customer cohort, while small business have struggled post 2020, which is Fiverr’s main customer cohort. The outperformance of enterprise customers relative to small business owners helps explain the divergent growth trends between Fiverr and other outsourcing firms such as Grid and Task.

Looking forward, Fiverr’s Q4 guide implies a topline growth rate of 37% at the mid-point, which would represent the slowest pace of YoY growth in Fiverr’s history as a public company. Nonetheless, while Fiverr’s sales are deaccelerating, the Q4 guide still represents 157% growth from Q4 2019, highlighting the overall strength in both Fiverr’s business and the general outsourcing market.

Continuing down the income statement, Fiverr’s gross margin slightly declined by 10 bps YoY to 83%, yet this is well above other outsourcing firms such as Grid and Task. The different gross margin profiles are due to the fact that Fiverr does not employ the labor it supplies, so its gross margins are mostly related to maintaining its software and marketplace rather than employees.

Adjusted EBITDA margin improved 180 bps YoY to 9.8%, which was well below both Grid’s and Task’s 20%+ adjusted EBITDA margins discussed above. Furthermore, the $3 million YoY increase in Fiverr’s adjusted EBITDA was entirely driven by an $11 million rise in stock-based compensation (SBC), which is a low-quality trend. This is because SBC is still a cost to shareholders, and signals that true profitability has not improved.  Non-GAAP earnings increased by $3 million YoY and non-GAAP EPS of $0.19 beat estimates by $0.17, yet the beat was driven entirely by a rise in SBC, a low-quality trend.

Risks

The biggest risk for Fiverr going forward is the decline in engagement on its platform. According to similarweb.com, Fiverr’s website visits have declined 2% over the last six months, which is a concerning trend that might signal declining demand for its marketplace.

It is noteworthy that Fiverr’s sales and marketing expense as a percentage of TTM sales increased 300 bps YoY to 54% as of the latest quarter. It is concerning to see that engagement has declined despite the relatively higher levels of marketing spend. Fiverr disclosed in it 20-F that lower engagement is a key risk, stating that “if user engagement on our websites declines for any reason, our growth may slow or stall.”

Another risk to Fiverr’s growth, which applies to most gig companies such as Uber, Lyft and DoorDash, is the political headwinds around gig workers being reclassified as employees. Earlier in the year, there were headlines that the Labor Security supported classifying gig workers as employees. This development could reduce demand for gig workers and thus reduce demand.

Furthermore, as outlined in the I/O Fund’s prior analysis of Fiverr, we explained that “Fiverr benefits from high unemployment and low hiring numbers because companies are looking for ways to save money.  If companies need talent on a budget, freelancing becomes the most attractive option.” The rapid improvement in the labor market could reduce demand for gig workers going forward. This trend may be causing a deacceleration in Fiverr’s business.

We chose Fiverr as a momentum play because hiring environments change and the current environment appears to favor outsourcing firms focused on digital transformation. Fiverr will likely continue to grow going forward, but the decline in engagement is a concerning trend that will need to improve before we reenter the name. In the last section, I conclude my discussion with an analysis of valuations and reiterate why we favor Grid in the current environment.

Valuation and conclusion

Below are the market cap and sales and earnings multiples for key outsourcing companies. Grid has been awarded a premium valuation relative to the peer median, yet this appears appropriate given its stronger growth rate and its exposure to highly technical labor, which is in high demand. Task appears relatively cheap compared to peers, based both on sales and earnings multiples. However, Task has exposure to risky fixed-price contracts and relatively higher levels of fixed-costs, which are high risk and warrant a lower multiple. Finally, Fiverr has also been awarded a premium multiple by the market, but this is likely due to its different business model which is primarily software based. Software companies generally receive premium multiples due to their low overhead and ability to quickly scale.

I wanted to cover outsourcing broadly and horizontally because it provides a clearer picture for what we are positioning for and why. The key takeaways are that the digital transformation trend is a massive tailwind that is driving demand for highly technical labor. Furthermore, cloud computing and hybrid work environments set the stage for outsourcing firms to capture share going forward. Grid appears to be best positioned, given its outsized growth and exposure to low-risk contracts. Nonetheless, Task, Fiverr and other outsourcing firms will likely continue to grow strongly as companies look to access talent on a global scale. We favor Grid for the current environment and may decide to add it to the momentum portfolio, but will also be closely watching Task and Fiverr for improvements in their businesses. We will keep you in the loop as we weigh these decisions.

Beth had previously written a premium analysis on Elastic back in early 2020 that focused on Elastic’s core products. Please read that analysis here if you haven’t yet.

In this article, I will instead discuss why we are now bullish on Elastic and why we think its stock will do well going forward. This analysis focuses on Elastic’s feud with Amazon AWS, its transition from open-source to open-core licensing and the uncertainty that currently surrounds the stock. Importantly, we believe that this uncertainty could provide an opportunity given the stock’s valuation. We conclude our discussion with an overview of Elastic’s recent results and the company’s financial future.

Why we like Elastic:

Elastic recently reported an acceleration in both sales and user growth. We believe that Elastic is well positioned to continue to report strong growth going forward. Elastic’s rapidly expanding total addressable market (TAM, pictured below) supports our belief that there is plenty of runway ahead for Elastic.  
Elastic’s Total Addressable Market (TAM)

Elastic is a search company. As data consumption grows exponentially, search will become increasingly more critical for organizations. Being able to quickly scale and search structured and unstructured data is what Elastic is built for.  Search is also necessary for both preventing and detecting security threats. CEO Shay Banon summarized Elastic’s position during the Q1 Earnings Call when he said that “as data volumes grow, the best and most natural way to explore data is by searching it… We see usage of Elastic just as a general search platform that is very useful to do many, many different things”. In short, growth in data consumption will benefit Elastic’s topline going forward. This is also true for companies like MongoDB and Snowflake as well, yet Elastic has a much more attractive valuation.

Volume of Data consumed worldwide 2010 to 2025

Furthermore, having a founder CEO in a complex space such as enterprise search can be a game changer since success is driven by product. Since no one will understand the product more than the founder, a founder-CEO can provide an edge for a company since product is often paramount, especially in tech.

Despite these traits, Elastic trades at a discount to its peers (discussed below), which we believe is due to the uncertainty surrounding Elastic’s transition to open core and the feud with Amazon’s AWS. We believe that these concerns may subside, and that Elastic will emerge from this uncertainty a stronger company. We discuss these concerns in greater detail next.

From open-source to open-core and the feud with Amazon AWS

Elastic has its roots in open source, which facilitated the rapid adoption of its software and has been a cheap and efficient form of distribution. Elastic makes money by offering certain features of its software available through paid subscriptions. Clearly, Elastic has been able to capitalize on its open-source distribution model, as it reported $608 million in sales in FY2021.

While being open source provides many benefits, the caveat is that its free, and that anyone can make changes to the code and redistribute (sell) it. In 2015, AWS started reselling Elasticsearch as “Amazon Elasticsearch”, which Elastic has contended is an obvious trademark violation. CEO Banon has explained that “this trademark issue [with AWS] drives confusion with users thinking Amazon Elasticsearch Service is actually a service provided jointly with Elastic, with our blessing and collaboration. This is just not true”. Essentially, Amazon has been implying a partnership with Elastic and has effectively taken some of Elastic’s revenue for the last 6+ years.

AWS went even further and in 2019, AWS announced that it will maintain an Open Distro of Elasticsearch, which was similar to a fork of Elastic’s code. ESTC stock sold off 5% that day. Elastic’s founder-CEO responded to the AWS news by highlighting how Elastic has been “forked, redistributed and rebundled so many times I lost count. It is a sign of success and the reach our products have. From various vendors, to large Chinese entities, to now, Amazon. There was always a "reason", at times masked with fake altruism or benevolence. None of these have lasted. They were built to serve their own needs, drive confusion, and splinter the community”. Elastic has so far been able to counter AWS’s fork, evident in its rapid user growth (discussed below). The stock is also up 87% since AWS announced the Open Distro of Elasticsearch.

The feud with AWS and Elastic escalated further in early 2021. On January 14th, Elastic announced a licensing change to its Elasticsearch and Kibana products. The change was aimed at preventing cloud providers (i.e., AWS) from selling its free software without contributing back to the open-source project. On January 21st, AWS responded to Elastic’s license change by announcing that “AWS will step up to create and maintain a ALv2-licensed fork of open source Elasticsearch and Kibana”. AWS has since forked the last ALv2 version of Elasticsearch and Kibana and has called it OpenSearch.

As shown below, the AWS announcement on 01/21/21 marked the top in ESTC’s stock. This feud with Amazon AWS has resulted in uncertainty, as the market is concerned that Elastic will not be able to overcome the AWS threat. We note that since January 2021, Elastic’s financials have improved, yet the stock is still below its ATH. We believe that we are presented an opportunity to buy a high performing company at a discounted price due to this temporary uncertainty caused by the AWS fork. We explain why we believe that Elastic will be able to overcome the AWS threat in more detail next.

Elastic’s stock returns since its IPO

Why we believe that Elastic will be able to overcome the AWS threat

It will take time for Elastic’s licensing change to take effect, since only new releases of Elasticsearch software will be impacted. So, we will have to wait a few quarters to know for sure if Elastic is benefitting or not from the licensing change. This uncertainty can be our opportunity.

By taking a step back and observing the situation from a developer’s perspective, we can better gauge the situation. AWS is forking the Elasticsearch software to maintain its use for AWS, not for other uses. If you want to use it for AWS, great. But if you want to use it in a multi-cloud environment, then the software will likely require further modifications. These modifications will accentuate the differences between AWS’s fork and Elastic’s official releases. The two products will likely operate very differently and portability/migration between services will become harder over time. Do you pick AWS’s fork, or Elastic’s core software?

If you operate strictly on AWS, then the AWS fork may be appealing. If you operate in a multi-cloud environment, then the official Elastic releases will likely be a better choice since it was developed for all different cloud environments. Moreover, certain capabilities are absent from the AWS fork, such as machine learning, which is “built into Elasticsearch and readily available to all customers, without dependencies on any specific proprietary external services. [Elastic does] not believe this to be the case with the new forks, which are primarily built for and governed by AWS”. Machine learning is often a key reason why corporations migrate to the cloud, so we should expect users to want this functionality and hence prefer Elasticsearch over OpenSearch.

At the I/O Fund, we believe that multi-cloud environments will dominate going forward, which should drive traffic to neutral and best-of-breed Elasticsearch over AWS supported OpenSearch. Multiple surveys also signal that most companies are already using multi-cloud providers (shown below). Since Elastic collaborates with all major cloud providers, its software will be optimized for multi-cloud environments. The AWS fork of Elasticsearch will likely be biased towards AWS, meaning that AWS operability will be prioritized over other cloud platforms.

We also note that Elasticsearch also observes and monitors a cloud providers performance. We believe that cloud users want an independent party monitoring their cloud environments. For the last six years, AWS has been able to sell its “Amazon Elasticsearch” product by implying a partnership with Elastic using its trademark. This feigned partnership has likely led users to believe that Elasticsearch was developing the software, not Amazon. By changing the licensing agreement, Amazon has been forced to change the name of Amazon Elasticsearch to OpenSearch. This should help resolve the misunderstanding that Amazon Elasticsearch was not independent of AWS. Furthermore, this should also redistribute the revenues that went to Amazon Elasticsearch back to Elastic, benefiting Elastic’s topline. 

We believe that Elastic will benefit from the licensing change as users will prefer the agnostic Elasticsearch versions to search and observe their cloud environments. This should also lead to a redistribution of revenue that Amazon has taken by reselling Elasticsearch as its own product, benefitting Elastic’s topline. The prevalence of multi-cloud environments will also favor Elasticsearch over AWS’s fork. In the next section, we go beyond the licensing change and provide a brief overview of Elastic’s growing presence in cybersecurity and what this could mean for the company going forward.

Security and SIEM

On top of the licensing changes, Elastic recently released a new version of its code which included a new product called Limitless Extended Detection and Response (XDR), which builds on Elastic’s security offerings. Elastic XDR can be used to unify security information and event management (SIEM) capabilities across all endpoints onto a single platform. Elastic explained further that XDR allows users to “ingest and retain large volumes of data from diverse sources, store and search data for longer, and augment threat hunting with detections and machine learning”.

A question we need to answer is if Elastic is expanding into the highly competitive security vertical because it is running out of runway in its core search market or if this is a natural progression for the firm. The latter appears to be the case, as searching data is a great way to detect and prevent threats. CEO Banon explained during the Q1 Earnings Call that “as companies go online, their surface areas become bigger and they generate more data that needs to be used to detect” threats that can remain hidden out of view. Searching that data is a natural way to detect threats and prevent future threats.

CEO Banon also clarified how Elastic will be able to compete with the numerous security vendors on the market during the Q1 call. He explained that a user first needs to be able to observe threats in order to detect them, and searching the data is the best way to observe threats. He stated further that Elastic’s search engine has been built to identify, among other things, threats.

During the Q1 call, CEO Banon painted a clear picture of what the XDR product is trying to solve: which is to provide a unified place where “you can store all data possible and threat hunt extremely fast, either manually or through AI and machine learning algorithms, and then extend to the peripherals so you can detect and prevent”. Elastic’s platform is already built to scale and quickly processes large amounts of data, so it’s a natural progression to use it for threat detection and prevention.

Finally, what really sets Elastic’s XDR product apart is its ability to scale. Elastic is built to scale: you can change the timeframe of your data search from 2 weeks to 2 years and still receive results within minutes (some competing products can take days or fail to ever finish a query if the dataset is too large). Elastic’s 10+ year history and large developer community has contributed to its ability to quickly scale and process large amounts of data. As observability and security continue to merge going forward, Elastic’s platform is well positioned to benefit from these converging trends. We also note that Elastic’s financial performance has improved in recent quarters, which we discuss in greater detail next.

Financials

Elastic reported Q1 FY2022 results on 08/25/21. The results came in strong as sales accelerated 50% YOY to $193 million and beat estimates by $20 million (12%). The beat flowed into guidance, as Elastic raised its topline guide for FY2022 to $811 million at the mid-point, implying a 34% YOY growth rate which was 3% ahead of the Street’s initial estimate. Since the licensing change went into effect in February 2021, Elastic’s sales have accelerated: from 39% YOY growth in the January quarter (Q3 FY21) to 44% YOY growth in Q4 FY21 and then to a 50% YOY growth rate as of the latest quarter. The acceleration in sales implies that Elastic’s licensing change has not dissuaded customers from signing up and/or increasing their usage of Elastic’s platform.

Elastic’s Q1 gross margin improved 131 bps YOY to 74%, which was above the three-year average of 72%. Operating margins declined 174 bps YOY to -16%, as CEO Banon explained on the Q1 Earnings Call that Elastic has front loaded expenses by hiring software engineers to support its growth initiatives. Cashflows on a 12M basis were an ­inflow of $15 million, an improvement from an outflow of -$7 million in the prior year quarter. Non-GAAP EPS was $0.04, which beat estimates by $0.16.

Customer metrics also showed an acceleration in Elastic’s business. For example, after the licensing change took effect in Q4 FY21, customer count growth accelerated. Specifically, Q1 FY22 (Q4 FY21) customer count grew 32% (33%) YOY to 16,000 (15,000), faster than the 31% YOY growth rate in Q3 FY21. Furthermore, Q1 customers with contract values greater than $100k increased 24% YOY to 780, an acceleration from the 20% and 18% growth rates reported in Q4 and Q3 FY21, respectively. The acceleration in customer growth suggests that the licensing changes have been beneficial.

However, despite reporting an acceleration in sales, a top and bottom-line beat, a raise in guidance and improving customer metrics, Elastic’s stock slightly sold off after the strong Q1 print. We believe this was because billings came in low. However, we do not think this is a concern since growth in cloud sales does not increase billings.

Cloud sales, which are 100% subscription based with no free option, increased 89% YOY to $62 million, an acceleration from the 70% and 79% YOY rates reported in Q4 and Q3 FY21, respectively. Elastic cloud is mostly billed monthly, meaning there is no deferred revenue and hence, no billings associated with the sales. However, as cloud customers grow in usage, their contracts will get larger in which point they will likely convert to annual billing. This will then lead to a rise in deferred revenue and a rebound in calculated billings growth. In short, we believe that billings are temporarily subdued due to the growth in cloud sales, which is a good problem to have.

Viewed holistically, we believe that Elastic is a high performing company reporting strong growth, positive cashflows and improving customer metrics. While there are concerns, such as the AWS threat and subdued billings, we believe that these concerns are just temporary issues. In the next section, we briefly discuss Elastic’s discounted valuation.

Valuation

Elastic trades at an 18x Fwd P/S multiple, well below its peer group median of 32x Fwd P/S (peers: DDOG, CRWD, DT, SPLK, MDB). Elastic’s EV/Sales multiple of 21x was nearly half its peer group’s 40x EV/sales multiple. However, Elastic is growing just as fast as its peer group. As shown in the below charts, ESTC’s most recent growth rate is above the peer median, yet its valuation is nearly half the peer median. We don’t believe that Elastic deserves such a large discount relative to its peers. As discussed, the AWS threat and subdued billings growth are temporary concerns which will ultimately make Elastic stronger. For its strong growth and healthy margins, we expect that Elastic will start to trade closer to the peer median.

Elastic’s Sales Multiple Relative to the Peer Median

Elastics Three-month Growth Rate vs Its Peers

Conclusion :

The I/O Fund believes that Elastic is a high-quality company with strong growth and a relatively cheap valuation. We discussed the uncertainty that surrounds the stock which helps explain the discount in Elastic’s share price. We also explained why we think that the AWS threat and subdued billing concerns are just temporary issues. Looking forward, we expect Elastic to continue to grow its topline as its TAM continues to balloon. We also expect that the firm’s valuation will converge towards its peer group once the licensing uncertainty is fully behind the firm, which may take a few quarters. 

Additional Resources:

2020 Elastic Analysis

Overview of Elastic's Q4 2021 Results

Disclosure: Bradley Cipriano and the I/O Fund may own shares in Elastic 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 may own shares in Elastic and have no plans to change their respective positions within the next 72 hours. You can access the I/O Fund’s positions herehere. The above article expresses the opinions of the author, and the author did not receive compensation from any of the discussed companies.

In January of 2020, we wrote an in-depth analysis on Elastic (ESTC), which you can access here. We recommend that you read this report to get a full understanding of Elastic’s product positioning within the cloud and data security sectors. Recently, it started showing up on our screens from all angles. We will likely begin initiating a position soon, and build in layers until we see a major breakout.

In this quick blog, we present some of the recent changes that ESTC made to their positioning within cloud.  We also address some of the concerns regarding their competition with AWS.  We believe these changes will be a boon to their future growth, and want you to get a better idea why we are focusing on ESTC from a fundamental perspective.

Fundamental Overview:

Early in 2021, Elastic modified its open-source license so that it is no longer free for use if it is being repackaged and sold as a SaaS product. This was done to address cloud vendors’ repackaging of Elastic’s opensource code and selling it themselves. Elastic clarified that the vast majority of users will not be impacted, rather “the folks who take our products and sell them directly as a service will be impacted, such as the Amazon Elasticsearch Service.”

AWS responded to this news by stating that it will maintain its open-source fork of Elastic search. Specifically, AWS stated “In order to ensure open source versions of both packages remain available and well supported, including in our own offerings, we are announcing today that AWS will step up to create and maintain a ALv2-licensed fork of open source Elasticsearch and Kibana.” ESTC’s stock sold off in January, possibly in-light of the news that tech giant AWS was going to maintain Elastic’s open source code, which would pressure Elastic’s ability to charge for its software going forward.

However, we believe that Elastic will be able to overcome this AWS threat. This is because cloud customers often want an independent third-party monitoring their cloud stack. Elastic should be able to continue to grow even if AWS maintains a fork of its open-source code. Since Elastic is already embedded in many different organizations and has a large and diverse developer community, we believe that AWS’s open-source fork will not replace Elastic’s open-core platform. We also suspect that the market is wising up to this, as the stock price has recovered most of its losses since the January sell-off.

Being open-source has driven the adoption of Elastic, since being free-to-use increases the size of the ‘cake’ (opportunity). Elastic can get a slice of the cake by charging for certain features. However, cloud vendors such as AWS have been reselling Elastic’s open-source software, so Elastic understandably wants some of that revenue. By changing its license structure, Elastic gets a smaller cake but a bigger slice. The market is still unsure if this is a good path to take, and we will soon find out with Elastic’s results in the coming quarters.

Elastic’s Financials and Outlook

Despite the uncertainty, we have comfort in the quality of Elastic’s recent results and the reasonableness of its forward estimates. For example, Elastic reported high quality revenue in the last quarter (Q4 FY2021). Q4 sales increased 44% YOY to $178 million, while deferred revenue increased 45% YOY to $353 million. Deferred revenue represents cash received upfront, which provides balance sheet support for future sales. Deferred revenue was 199% of three-month sales in Q4, a four-year seasonal high. This is a good trend to see as it means there is relatively more demand for Elastic’s products than in prior years, a sign of strength.

We also see that cash collected from customers also increased in FY2021. We measure cash collections from customers by looking at the YOY changes in accounts receivables and deferred revenue and adding the net change to annual sales. In the below chart, you can clearly see that Elastic has been steadily increasing its cash collections. This is a favorable trend, as it shows that Elastic is not extending payment terms and/or requiring less upfront cash to drive sales. This also validates that there is sustained demand for Elastic’s products. By scaling cash collections from customers to 12M sales, the metric increased to 118%, the highest value since Elastic went public. Stated differently, Elastic is receiving more cash from sales than in any period in its history, another sign of strength. This trend also helped Elastic report positive cashflows in FY2021.

Looking forward, Elastic will report AH on 08/25. The Street expects Q1 FY2023 sales to increase 46% YOY to $189 million, an acceleration from the most recent topline growth rate of 44%. We believe that Elastic will be able to meet its estimates since it has amble support from its balance sheet. As mentioned, deferred revenue increased 45% YOY in the most recent quarter, and was 187% of forward three-month sales.  In the last four years, Elastic’s Q4 deferred revenue balance has been ~180% of forward sales. Given the relatively higher levels of deferred revenue, we believe that an expectation for accelerating topline growth is reasonable.

Following the Q1 FY2022 print that will be released soon, we will want to see that Elastic is still growing despite the AWS fork. We believe that Elastic will be able to overcome this temporary threat, and that the narrative around the stock may soon change, which could lead to a large move in the stock price.

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.