Why Datadog Is A Best Of Breed - Seeking Alpha

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It has been a very challenging macro environment for high-growth stock investors. The Nasdaq just had its worst month since the Great Recession of 2008. In addition, the American Association of Individual Investors recently revealed that more than half of individual investors are bearish, the highest level since 2009.
Most growth stocks are down 40%, 60%, or 80% from their previous high. And the stock du jour, Datadog (NASDAQ:DDOG), is no exception.
Cloud software valuations have come down toward the lower end of their spectrum. While things could get worse before they get better, some high-quality companies offer their most attractive entry points in years.
In this context, if you have a multi-year time horizon, developing a buyer mentality is essential. After all, Warren Buffett said we should be “greedy when others are fearful.”
I’m a rule-based and process-focused investor. I explain my approach in my article covering 4 Rules To Protect Your Portfolio. I invest a fixed amount every month, so I’ve been a happy buyer lately. However, focusing on quality is paramount. And talking about quality, you’d be hard-pressed to find a business firing on all cylinders like Datadog.
Let’s review what makes DDOG a best-of-breed company, digest the numbers behind the recent quarter, and put its expensive price tag in perspective.
In a world where most businesses are shifting their operations to the cloud, the need for development, operations, and security teams to work together seamlessly has become more critical than ever. Yet, it has historically not been the case. What Datadog wants to achieve is for all departments to see the same problems as they arise and to work together to fix them.
This notion is present in the company’s mission:
To break down silos and fight complexity for our customers.
Datadog’s management believes that offering a unified platform used by all departments can improve visibility and communication.
The company was founded 12 years ago as a unified, real-time data platform (data integration and collaboration interface). Over time, the company added new products:
Datadog History of Innovation (May 2022 Investor Presentation)
Datadog’s approach is called product-led growth. It’s a business methodology in which the product is the most significant driver of growth (as opposed to sales and marketing). The acquisition, retention, and monetization are all driven by the product experience. The product “sells itself,” if you will.
This approach can only be achieved by the products that work well, by offering a frictionless entry point, adding advanced features and valuable integration, and delivering a delightful experience for the user. It can lead to a form of viral adoption we’ve seen in other businesses such as Slack or Twilio (TWLO).
Management prioritizes significant investments in innovation as the go-to-market strategy.
A critical aspect of Datadog’s success is how well it works with other products:
Security has become a significant initiative for the company. But Datadog is tackling security from an observability point of view, which puts it in a unique position of strength.
The company announced it would acquire Hdiv Security, a leading security-testing software provider. This new addition will enable a more comprehensive approach to application security, with highly accurate detection of known or unknown vulnerabilities.
Datadog follows a familiar “land-and-expand” model. I’ve discussed this approach in my articles covering HubSpot (HUBS) and MongoDB (MDB). The company offers a free trial and then charges based on the customer’s needs.
The company has designed products that are easy to adopt. Later on, customers expand their usage or start adopting other products available on the platform. As a result, Datadog has a best-in-class dollar-based net retention, above 130% in the past 19 quarters.
Enterprise customers pay per “host:”
Host Definition (Company Website)
Datadog has a transparent pricing policy. All products offer a free trial. Plans can go from $15 per host for an infrastructure plan to $70 per host for database monitoring. Some products such as Cloud SIEM (security information and event management) are priced per GB of analyzed logs.
Datadog Pricing Policy (Company Presentation)
Customers increase their spending on the platform over time. As a result, Datadog can grow its revenue significantly even without adding new customers. Below is a graph that breaks down Datadog’s customer cohorts by year. It’s my favorite way to appreciate how a high dollar-based net retention can compound over time. Each annual cohort of customers is yielding higher revenue over time. It can lead to sustainable growth for a very long time. Twilio (TWLO) has a similar profile.
Datadog Customer Cohort Analysis (ARR, in $ million):
Datadog Customer Cohort Analysis (ARR, in $ million) (Company S-1)
Another essential aspect contributing to Datadog’s elevated dollar-based net retention rate is its high gross retention (i.e., the % of customers who keep using the platform over time). The maximum would be 100%. Datadog has steadily increased its gross retention rate over time, reaching 95% in FY21. It’s a stellar performance, comparable to other best-in-class businesses such as The Trade Desk (TTD) or HubSpot (HUBS).
Datadog Retention Metrics (May 2022 Presentation)
In short, Datadog’s customers stick around and spend more on the platform over time. That’s what we love so much about the best SaaS businesses. So, now that we’ve established how Datadog is increasing its revenue per customer quickly, let’s review how the company is growing its customer count.
During the last earnings call, the company provided an updated investor presentation.
Customer Metrics:
Datadog Customer Growth (May 2022 Presentation)
The success of the company’s platform strategy shows in the numbers:
Datadog Product Adoption (May 2022 Presentation)
Datadog’s management regularly updates the CAC Payback Period of the company. It has been around ~5-to-10 months. It means that it takes about two to three quarters for Datadog to recoup its sales & marketing costs via gross profit generated by new customers.
Datadog Sales Efficiency (Q2 FY21 Investor Presentation)
Most public SaaS businesses have a CAC Payback period of more than two years, as illustrated below with Q4 2021 data.
Cloud Software Sales Efficiency (Jamin Ball Blog)
A gross margin adjusted payback below 17 months would already be in the top quartile. Datadog is an absolute best of breed, alongside Atlassian (TEAM).
Q1 FY22 Financials:
The revenue growth barely slowed down from +84% Y/Y in Q4 FY21. As a result, management expects revenue to grow at +74% CAGR from 2017 to 2022.
Datadog Revenue Growth (May 2022 Presentation)
Datadog Guidance (May 2022 Presentation)
It’s essential to note that Datadog has been beating its guidance by 10% on average in the 11 quarters since going public (more on that later). With a comparable beat, Q2 FY22 revenue growth might be in the mid-70s range (though there is no guarantee). Guidance for Q2 FY22 implies an 8pp deceleration from the guidance provided for Q1 FY21.
Let’s put the past year in context:
Management has a history of under-promising and overdelivering. That makes the strong FY22 guidance even more compelling.
If we look at the margin trends, they are exceptional. The gross margin and operating margin improved steadily. In addition, the company is spending less on sales & marketing over time, showing how efficient the go-to-market strategy is.
Datadog Financials (May 2022 Presentation)
Datadog spent $202M on stock-based compensation in the trailing 12 months (18% of revenue). That’s the main difference between GAAP and non-GAAP margins. However, from a dilution perspective, the impact is relatively small.
The company had an excellent operating cash flow margin in FY21 (28%, +10pp Y/Y). This margin profile is similar to Atlassian’s.
We can summarize the recent results as follows:
Datadog’s unified platform combines functionality from numerous single-point solutions. So we have to consider a range of competitors by functionality:
When I invest in a category, my preference generally goes to the leaders. And evidence shows Datadog is among the very best companies in observability.
The chart below shows the companies involved in the observability space, which goes beyond search and includes security and monitoring. Datadog appears on the right of the chart because of its unified platform aggregating multiple solutions.
Observability Competition (GigaOm 2021)
Below is the G2 Grid for APM (Application Performance Monitoring). You can find Datadog in the top right of the chart among the leaders.
G2 Grid for APM (G2 – May 2022)
Dynatrace and New Relic are the closest competitors from a user review standpoint, but they don’t come close from a revenue growth standpoint.
Datadog also appears as a clear leader in the Forrester Wave for Intelligent Application and Service Monitoring (see below). Other leaders in the field highlighted by Forrester are Dynatrace, Zenoss (private), and ScienceLogic (private).
Intelligent Application and Service Monitoring (The Forrester Wave)
The Gartner Magic Quadrant for Application Performance Monitoring also shows Datadog as a leader, alongside New Relic, Cisco, and Dynatrace.
Magic Quadrant APM (Gartner)
These APM graphs don’t entirely do justice to Datadog’s superior profile because they focus on a single-point solution. Instead, Datadog is a platform that excels at gathering more products under the same roof, leading to its exceptional growth.
Below is a comparison of Datadog and Dynatrace on Gartner Insights. Both are highly reviewed.
Datadog Reviews (Gartner Peer Insights)
So what is the moat? To fend off competition, Datadog benefits from:
Application monitoring is not an area a company would want to compromise. So, I see Datadog’s business as resilient.
What gives Datadog a long-term edge is the speed of innovation, as illustrated in the chart below, with an avalanche of product releases over the years.
Datadog History of Innovation (May 2022 Investor Presentation)
In addition, the expanding library of out-of-the-box integrations of Datadog with a wide range of tools is likely to maintain its edge against the competition. And the existing list of high-profile customers who chose Datadog adds to the credibility and track record of the company.
Competition is a fact of life for all the best businesses globally. However, I like Datadog’s position and odds of success given its platform approach.
Datadog has a critical edge over its competition regarding talent acquisition and retention. The company is celebrated for its unique culture as one of America’s best places to work. In addition, CEO Olivia Pommel has an excellent approval rating, which is not the case for a direct competitor like Splunk.
Datadog Awards & Accolades (Glassdoor)
Datadog Reviews (Glassdoor)
There is no doubt that Datadog is addressing an important, emerging industry.
According to Gartner, Observability is expected to grow at +9% CAGR in the next four years. This estimate alone shows the large runway ahead for Datadog, given its position as a leader and its current annualized run rate of ~$1.2B.
Datadog Market Potential (May 2022 Presentation)
Thanks to its platform approach, Datadog has been expanding its use case and, in turn, its total addressable market. Today, management sees great potential for security, but it could also target additional products over time (e.g., developer workflows, IT service management).
Datadog Future Opportunities (Q2 FY21 Investor Presentation)
Datadog may have a winning strategy with security because it looks at all metrics. In addition, it’s simple to implement and allows customers to look for anomalies in the metric data and perform root cause analysis.
Observability as a platform for security (Q2 FY21 Investor Presentation)
CEO Olivier Pommel discusses how security is “shifting left,” meaning earlier into the development process. Datadog can solve some of its customers’ problems by helping implement security in the earlier stage environments.
Observability Trend (Q2 FY21 Investor Presentation)
Datadog’s key vectors to drive growth looking forward are simple:
In 2018, 24% of Datadog’s ARR came from outside of North America. This portion increased to 29% in 2021 and should continue to rise.
Just like many other positions in the App Economy Portfolio, Datadog is well-positioned to benefit from two secular trends:
US Cloud computing alone is expected to grow at +18% CAGR, illustrating the growth potential ahead for the leaders in these categories.
Cloud Transition (Benedict Evans)
Datadog is a ~$34B company today after erasing most of the past year’s gains.
While we use EV-to-revenue to evaluate the valuation of cloud software companies, it’s essential to note that DDOG has a free cash flow margin of 36% in the most recent quarter (and growing).
Since the IPO, DDOG has always been an expensive stock. If we exclude the few weeks around the March 2020 bottom related to the COVID market meltdown, DDOG has always traded between 30 and 70 times trailing sales.
DDOG is now trading at about 33 times trailing sales despite improving KPIs and a history of re-accelerating revenue growth. The stock is also on the low end of its valuation range if we focus on forward-sales multiples, at about 21 times forward sales.
Let me be clear: it’s not a cheap stock—quite the opposite. My only point here is that it was never cheap since the company is public.
Here is more context on Datadog’s valuation based on estimates:
Given the FCF margin, the company is trading at less than 30 times FY24 FCF. So as you can see, even assuming Datadog will merely meet Wall Street’s expectations moving forward, it will “grow into” its valuation multiple pretty quickly.
Since going public, the company has a stellar track record, beating expectations by 10% on average over 11 quarters.
Datadog Revenue Surprise (Seeking Alpha)
This type of overperformance can compound. For example, Q2 FY22 revenue was expected to be $221M two years ago. The most recent guidance from management is $378M (+71%). So Wall Street’s estimates for FY23 and beyond could prove to be conservative.
Most analysts assume a standard growth normalization in their models. However, based on the track record of innovation and the consistency of the retention metrics in the past few years, Wall Street is more likely to under-appreciate the trajectory of the company.
Datadog is a stellar business that checks most of my favorite boxes.
Given its explosive customer growth and exceptional retention metrics, I believe it’s only a matter of time before it grows into its valuation.
The company has proven to be capital efficient and has ample opportunity to fund its growth path forward.
What about you?
Let me know in the comments!
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Why Datadog Is A Best Of Breed - Seeking Alpha
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Discipline and consistency win the game over time. Unfortunately, many investors violate their own model or strategy when their portfolio performance is temporarily disappointing. I would rather sell too late than too early, so I tend to never sell. I let my winners compound to a significant portion of my portfolio and let my losers become insignificant over time.

All App Economy Insights contributions to Seeking Alpha, or elsewhere on the web, are personal opinion only and do not constitute investment advice. All articles, blog posts, comments, emails, and chatroom contributions by App Economy Insights – even those including the word “recommendation” – should never be construed as official business recommendations or advice. In an effort to maintain full transparency, related positions will be disclosed at the end of each article to the maximum extent practicable. The premium service App Economy Portfolio is a research and opinion subscription. I am not registered as an investment adviser. The majority of trades are reported live, but this cannot be guaranteed due to technical constraints. Investors should always do their own due diligence and fact-check all research prior to making any investment decisions. Liability of all investment decisions reside with the individual investor.
Disclosure: I/we have a beneficial long position in the shares of DDOG AMZN CRWD ESTC GOOG HUBS MDB TTD TWLO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.


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