The monitoring and analytics software-as-a-service (SaaS) company Datadog (NASDAQ:DDOG) has been growing rapidly. But its impressive performance comes with a lofty valuation that the company's competition could damage.

An impressive performance

Datadog sells products that monitor and analyze every element of cloud-based and in-house IT (Information Technology) infrastructure. According to studies, the infrastructure monitoring and application performance management (APM) markets in which Datadog competes will grow annually by 6.6% and 11.84%, respectively, over the next several years. In contrast, Datadog grew its revenue by 96.6% and 79.5% year over year in 2018 and during the first half of this year, respectively.

The company's low revenue base -- $266 million over the last 12 months -- favors its fast growth. In comparison, Datadog's SaaS competitors New Relic (NYSE:NEWR) and Splunk (NASDAQ:SPLK) posted revenue of $512 million and $2 billion, respectively.  

Cloud computing

Image source: Getty Images.

Datadog's unique offering also contributes to the company's growth.

For instance, public cloud giants such as Amazon with Amazon Web Services (AWS) each offer their own monitoring capabilities. Many other legacy tech vendors don't propose a single integrated monitoring solution, either. For instance, since Cisco partnered with Splunk to enhance its monitoring portfolio, Cisco's customers must manage different tools to monitor and analyze their IT infrastructure. But Datadog's customers can monitor their different cloud and legacy-tech deployments with one single product, instead of having to deal with a different monitoring solution for each vendor. 

Thanks to its competitive offering, Datadog has generated higher revenue growth compared to other fast-growing SaaS vendors, with lower sales and marketing expenses (see table below).

The company's annual retention rate of 146% shows existing customers are willing to increase their consumption of the company's products, and existing customers may involve reduced marketing efforts. Since 40% of the company's customers use more than one product, cross-selling opportunities may lower the company's sales and marketing expenses as well. 

Company

Sales and Marketing As a Percentage of TTM Revenue

Year-Over-Year Revenue Growth

Datadog 45.2% 79.5%
CrowdStrike (NASDAQ:CRWD)

64.1%

73.5% 
Zscaler (NASDAQ:ZS)

56.1%

59.2%
Splunk 

56%

36.1%
New Relic 

54%

33.6% 

Data source: Datadog, CrowdStrike, Zscaler, Splunk, New Relic. YOY = year over year.

Lofty valuation

In any case, Datadog's market cap around $10 billion  and corresponds to a lofty TTM price-to-sales ratio of roughly 37. In comparison, the market values Crowdstrike, which reported similar revenue growth, at a lower -- but still elevated -- price-to-sales ratio of 25.2.

Besides, excluding $5 million of one-time tax-related benefits, Datadog posted a loss of $18.44 million during the first half of the year. The company's sales and marketing expenses, albeit lower than its competitors, remain too high for the company to post a profit.

Thus, given Datadog's high valuation, investors expect the company to keep on generating strong revenue growth over the long term while improving its margins. 

Competition is a significant risk

But Datadog is exposed to intensifying competition, and the attractiveness of the company's integrated platform may wane as competitors develop similar offerings.

For instance, following its recent agreement to acquire SignalFx, Splunk will enter into the APM business. Cisco is also developing its monitoring portfolio. After its $3.7 billion acquisition of AppDynamics in 2017, Cisco recently reinforced its partnership with Splunk. Given its cross-selling opportunities with its IT portfolio and its scale with its $51.9 billion of TTM revenue, Cisco's potential to build an integrated monitoring solution constitutes an increasing threat to Datadog.

Besides, Datadog's ability to stay competitive with a much lower R&D budget than some of its competitors represents a significant risk. The company's TTM R&D expenses of $78.7 million represented 29.6% of its revenue. In contrast, Splunk's and New Relic's R&D represented only 24.8% and 22.8% of their respective revenue. But thanks to their bigger scale, these two companies dedicated a much higher amount -- $507.6 million and $116.6 million, respectively -- for their R&D. 

A risky bet, even for speculative investors

Datadog's high valuation compared to other fast-growing SaaS companies constitutes a real danger, as CrowdStrike's recent situation illustrates. Despite better-than-expected results and lifted guidance, CrowdStrike's stock price dropped after its latest earnings. Crowdstrike'selevated price-to-sales ratio above 57 before its earnings is my only explanation for the negative market reaction.

Even with Datadog's strong performance, buying into in the company at a price-to-sales ratio above 35 remains a risky bet for investors – especially given its exposure to extra competition.