What happened
Shares of cloud monitoring and cybersecurity company Datadog (DDOG +2.54%) jumped more than 7% in early trading on Friday. As of 3 p.m. ET, the stock was still hanging onto most of those gains, and up about 4.7%.
That's actually surprising, though, considering what just happened to Datadog.
Image source: Getty Images.
So what
I'm referring to SMBC Nikko Securities' (that's a subsidiary of Japan's Sumitomo Mitsui Financial Group, by the way) decision to initiate coverage of Datadog today with only a neutral rating and a $136 price target that implies Datadog's stock price will go down, not up, over the next 12 months.
As SMBC explained in today's note covered on StreetInsider.com, "DDOG has a favorable market position as a key enabler of cloud DevOps and workload migrations, a winning platform strategy, strong execution capabilities, and attractive unit economics."
So far, so good. But here's the problem, in SMBC's opinion, "On the flip side, its valuation makes it especially vulnerable to any market correction or unexpected loss of momentum, its market capitalization is relatively large compared to its [total addressable market,] its top line is likely to decelerate meaningfully starting in 2Q22/ June, and unforced sales employee turnover has increased significantly."
Now what
Now let's break that down a bit. As regards valuation, Datadog costs about $47.6 billion in total -- about 43 times sales -- and the company is not profitable as defined by generally accepted accounting principles (GAAP). The company does generate substantial positive free cash flow, about $276.5 million last year. But even so, that works out to a price-to-free cash flow ratio of 172 on the stock -- which seems quite expensive.
The argument in favor of Datadog stock, of course, is that its valuation multiple will come down quickly if Datadog grows its revenue and free cash flow (FCF) as fast as analysts predict. Sales are expected to grow about five times in size from 2022 through 2026, and FCF about four times. But that just serves to illustrate SMBC's point.
If Datadog suffers any "unexpected loss of momentum," or even if the market simply falls out of love with growth stocks and causes a market correction, Datadog's stock price will surely decline. For this reason, SMBC can't quite bring itself to recommend the stock despite its positives.
Neither can I.
