Shares of data analytics firm Datadog (NASDAQ:DDOG) have surged nearly 150% since their IPO last autumn. Organizations have loads of digital data that needs to be parsed through and made sense of, and as digital transformation accelerates because of the coronavirus lockdown, data creation and the need to manage it are set to get a big bump.
As a leader in cloud-based software for managing big data and cloud operations, Datadog has a bright future, although much of that future has been priced into its shares at this point.
A large pie that keeps getting bigger
According to tech researcher Gartner, spending on IT operations management is expected to reach $37 billion by 2023. Datadog says it believes this figure doesn't capture the additional spend on cloud and hybrid-cloud operations management, which is a double-digit growth industry at this point. The company helps businesses crunch data in both the legacy IT and modern cloud world. And since Datadog itself was born as a cloud-computing business, picking up market share as organizations migrate to newer systems works in its favor.
Besides its core business, Datadog has been expanding the use of its data monitoring suite to address adjacent IT needs. For example, it launched security monitoring to help IT teams detect unauthorized tampering and orchestrate a response. With a unified software platform, Datadog is trying to break down the barriers between software development, operations, and security.
Thus, its addressable market is massive and still growing. And the company's development of new tools means it should be able to scoop up plenty of new business over the next few years. Based on its easy-to-implement subscription model, the company often signs up new customers using a feature or two, then expands the relationship from there. The beauty of many cloud software providers like Datadog is that they grow as their customers grow -- or in this case, as those customers increase use of cloud-based operations.
The strategy has worked exceptionally well so far. After full-year 2019 revenue increased 83% to $363 million, first quarter 2020 revenue grew another 87% year over year to $131 million. Expected full-year 2020 results imply 54% revenue growth at the midpoint of guidance. Datadog is growing fast, but its slice of the IT management pie is still small. There's plenty of room for the company to keep growing. Margins are thin as the company invests for further expansion, but Datadog is free-cash-flow positive (revenue less cash operating and capital expenses), generating $21 million over the last year.
Not totally risk free
A number of trends are intersecting that could keep the data analytics industry riding higher for years. But the recent pandemic has caused another trend that could work against Datadog: Some organizations are looking to simplify and consolidate the number of IT vendors they use. Legacy firms like Splunk and Palo Alto Networks have already been addressing that possibility the last few years via acquisition and internal development of new tools to address markets adjacent to their original services.
Thus, if Datadog is to maintain its momentum, development of its data analytics platform will need to continue. The company itself acknowledges its sizable competition, including IBM, Microsoft, and even chipmaker Broadcom, which has added infrastructure software management to diversify its hardware business the last few years. Then, there are other firms focused on data analytics, like the aforementioned Splunk, as well as Elastic.
And on the cloud monitoring front are the three biggest names in the business. Amazon Web Services, Alphabet's Google Cloud, and Microsoft Azure each have their own similar offering as well as integration to third-party services like Datadog.
Put simply, with Datadog and its industry growing so fast, plenty of companies have piled onto the bandwagon. For now, this small upstart has been one of the best-performing companies in its segment. But eventually all of the competition will take its toll. Expect its growth trajectory to decelerate over the next five years.
Premium business, ultra-premium stock
Nevertheless, its cloud-native software should serve it well in the coming years. But don't think that Datadog's potential will automatically equate to further share price increases like in the last few quarters. This is a stock priced for exceptional business growth. As profits are plowed back into the business right now, investors are left with the price-to-sales ratio to stick a valuation on the company. And at 40 times trailing 12-month revenue, investors are pricing in at least a couple years' more of performance on par with the recent past. For comparison, here's what Splunk and Elastic go for on a price-to-trailing-revenue basis.
To be fair, Datadog fetches a higher premium because of its higher growth. But Elastic wasn't too shabby, putting up 60% revenue growth in its last reported quarter. And while Splunk's revenue was only up 2% according to its most recent report, annual recurring revenue grew 52% as it makes its transition to cloud-based software service.
With its hefty premium at the moment, Datadog will need to continue outpacing its industry peers by a wide margin to justify its valuation -- let alone continue growing at the rate they have been since the IPO last year. And the keys will be continual innovation of new services and picking up new customers it can expand relationships with, especially as larger peers already provide many of those features.
Datadog has experienced early success and has already established itself as a leader in the IT monitoring industry. I think its business will be much larger in five years than it is today, although I'm not buying at the moment because of the steep price tag.