All eyes are on tech stocks this earnings season as many investors contemplate how inflation and a potential recession will impact business spending. Datadog (DDOG 3.58%), a notable and high-flying tech stock, is in the spotlight this week.
The cloud infrastructure observability platform reports on Thursday, Aug. 4, before the market opens, and expectations are high. Wall Street is anticipating revenue to reach $379.4 million this quarter, a 62% jump over the year-ago period.
That's an optimistic forecast from Wall Street, but here's why Datadog could meet -- and maybe even exceed -- those expectations.
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Tightening business budgets could weigh on Datadog
Investors have been concerned about tech performance in the second quarter for a while. Inflation and recession fears are pressuring businesses, causing many to pull back spending. One of the ways these companies are cutting costs is by reducing their usage of dispensable software platforms.
Investors are especially concerned about highly valued companies. The higher the valuation, the greater the expectations are for the business. If richly valued companies don't live up to optimism, look out below. At 27 times sales, Datadog is nearly priced for perfection.
Datadog is a software platform that enables businesses to monitor application performance. The company offers a subscription-based service, so, in theory, businesses can easily pull back how much they spend on Datadog every month. In reality, however, the probability of rising customer churn at Datadog is quite low given how critical its services are.
Why Datadog could prevail
Observability and application performance monitoring are necessary for modern businesses today, and Datadog is the top dog in the space. The company has more than 25 products to help businesses monitor their cloud infrastructure and keep their applications secure and operating properly.
In short, the company provides need-to-have products to businesses, and the company's financials have proven that. Datadog's churn in the first quarter was in the mid- to low-single-digit percentage range, and for the past 19 quarters, the company has had a net retention rate above 130%. Lastly, 2,250 customers spent $100,000 or more annually on Datadog's platform as of Q1, signaling how important its services are for many businesses.
While it is certainly possible that companies could stop using Datadog in an attempt to save some money, it looks unlikely. Even if demand slows in the short term, the long-term thesis remains intact. Management believes the observability market will be worth $53 billion by 2025; even if the U.S. enters a recession, that forecast likely won't change.
Also, Datadog could potentially come out stronger on the other side of a recession because of its impressive cash generation. Over the trailing 12 months, the company has generated over $336 million in free cash flow. Comparatively, Dynatrace -- one of Datadog's primary rivals -- only generated $233 million over the same period. If both companies saw activity decline during a recession, Datadog would likely have more cash to continue investing in innovation to further its leadership, whereas Dynatrace might have to pull back investment to preserve its business.
Key metrics to watch on Thursday
While high customer churn is improbable, Datadog could see customers pull back their additional spending. Instead of spending 30% more than they did in the year-ago period, customers could only spend 20% more or keep their usage flat year over year. Therefore, it will be important to monitor its net retention rate this quarter. The same goes for customers spending over $100,000, another indicator of increasing customer spend.
Wall Street estimates of 62% year-over-year revenue expansion set a high bar, but Datadog is a high-quality business. Over the past four quarters, the company has handily beat Wall Street's earnings estimates, and internal guidance for this quarter puts Q2 revenue at $378 million -- just $1.4 million less than what analysts are predicting.
Datadog's products are seen as essential to businesses by many, but this quarter will put that to the test. If the company can keep revenue growth high while seeing continued consumer spending increases, it's safe to say that Datadog's products are extremely valuable. That said, even if the short term is bumpy, the long-term future looks bright for Datadog. You might want to consider owning shares of the company, no matter how it performs financially in Q2.
