Datadog (DDOG 1.01%) was one of 2019's most successful IPOs. Shares were priced at $27 but ended their first day of trading at over $37 per share. Today the stock is up over 20% from where it closed that first day, and up over 40% from where the IPO priced. Considering the company's third-quarter 2019 revenue grew 88% year over year, it's easy to understand why Wall Street loves this company.
Investing is always a forward-looking activity. And looking five years into Datadog's future, business should still be booming.
Image source: Datadog.
First, a look back
Datadog's full-year 2019 revenue is expected to come in at $350 million to $352 million -- good for 77% to 80% growth over 2018. This mind-blowing growth demonstrates how important its product is. Companies these days use many cloud products, from cloud computing services like Amazon's AWS, to communication apps like Slack. The diversity makes enterprise technology complicated, but Datadog, calling itself "cloud agnostic," integrates everything to provide a centralized real-time monitoring platform.
Before it went public, Datadog operated at a smaller loss than it does right now, and was even profitable some quarters. But in the year leading up to its IPO, expenses from research and development outpaced revenue growth, as did sales and marketing expenses. Although this spending makes the company unprofitable, we'll see why it's actually money well spent.
Image source: Getty Images.
Now a look forward
Datadog, while currently unprofitable, isn't burning through an exorbitant amount of cash. Free cash flow in Q3 was negative $3.7 million, and negative $10 million through the first nine months of 2019. However, the proceeds from its IPO put Datadog in a well-capitalized position. The company has $771 million in cash on the balance sheet and no long-term debt. In short, Datadog can pursue its opportunities over the next five years.
According to a report by IDC, sponsored by data-storage company Seagate, 175 zetabytes of data will be created in 2025. Enterprise is expected to create 80% of that data. Not all data will be stored or tracked, but enterprise will certainly see a growing data pile needing to be addressed from a variety of angles, including what Datadog offers. So, the relevance of its service is only increasing.
Further, Datadog still has many potential enterprise customers to pursue. When it went public, only around 35% of Fortune 100 companies used Datadog, and it still has low market penetration overall. The company estimates its current addressable market at $35 billion -- roughly 100 times Datadog's revenue. Therefore, the increased spending in sales and marketing is a solid choice.
Also, Datadog is a software-as-a-service (SaaS) company. When investing in a SaaS company, it's crucial to examine the dollar-based net retention rate. This metric tracks existing customer spending. Datadog is constantly introducing new products, which boosts the dollar-based net retention rate as customers upgrade. When Datadog went public, the dollar-based net retention rate was 146% -- quite high. Not only does this demonstrate how much Datadog's customers love it, it also shows why the increased spending in research and development is another solid choice.
Competition and valuation
While Datadog obviously has a great product and opportunity, investors should consider the competition. Specifically, Splunk (SPLK +0.00%) recently announced a $1 billion acquisition of SignalFX -- an application-monitoring company similar to Datadog. An impressive 90 of the Fortune 100 companies are already Splunk customers. As SignalFX integrates into Splunk, those customers could just choose to use Splunk's application monitoring rather than go with Datadog.
Not winning over enough new customers, or even losing customers to the competition, would slow Datadog's revenue growth. And that would likely be devastating to Datadog's stock. It currently trades at 44 times sales -- one of the highest price-to-sales ratios out there. For comparison, Splunk trades at around 12 times sales, but its revenue is only growing 30%. The market justifies Datadog's higher valuation because of its 88% revenue growth. But if the growth rate slows significantly, Datadog's valuation would get adjusted.
That said, competition goes both ways. While investors should assess the risk of Splunk and others, Datadog could likewise introduce products to steal business away from Splunk. The company introduced 15 new products and functionalities in Q3 alone. So it's possible this company will keep punching above its weight class.
Closing thought
The stock isn't without risk, but there's reason to believe Datadog can keep growing at a very high rate. Enormous data creation will keep its product in demand. Low market penetration gives it the opportunity to keep growing. And high net-dollar revenue retention shows current customers like it enough to expand the relationship -- suggesting more companies will like Datadog if they try it.
