Is Datadog Stock a Buy Now?

Datadog's (DDOG 0.50%) stock dipped 2% after the cloud-based data visualization company posted its second-quarter earnings report. Its revenue rose 74% year over year to $406 million, beating analysts' estimates by $25 million. Its adjusted net income surged 160% to $84 million, or $0.24 per share, which also cleared expectations by nine cents.

Those headline numbers looked impressive, but a few issues prevented the bulls from rushing back to the stock, which has tumbled nearly 35% this year amid rising interest rates and other macroeconomic challenges. Let's examine Datadog's strengths, flaws, and valuation to see if it's still worth buying.

Image source: Getty Images.

Slowing growth in large customers

Datadog pulls diagnostic data from a company's databases, servers, and apps in real time, then aggregates all that information in unified dashboards. That silo-busting approach saves money and makes it much easier for IT professionals to identify potential problems.

The company ended the second quarter with 2,240 customers that generated annual recurring revenues (ARR) of at least $100,000. That represented 54% growth from a year ago -- but a loss of 10 customers from the previous quarter.

Data source: Datadog.

It attributed that sequential decline to slower spending across the consumer-discretionary sector, especially among e-commerce, food, and delivery companies, which experienced post-pandemic slowdowns. On the bright side, Datadog's dollar-based net retention rate, which gauges its revenue growth per existing customer, has remained above 130% for 20 straight quarters. However, its year-over-year revenue growth has still slightly decelerated over the past two quarters.

Data source: Datadog. YOY = Year-over-year.

Management's guidance suggests that slowdown will continue with revenue expected to rise 52% to 53% year over year in the third quarter while growing 56% to 58% for the full year.

Those estimates matched analysts' expectations, but investors were likely looking for even higher estimates to justify buying the stock at about 23 times this year's sales. By comparison, Snowflake -- a cloud-based data warehousing company which is growing slightly faster than Datadog -- trades at 28 times this year's sales.

Datadog also continues to acquire more companies to gain new customers. It purchased Timber last year to launch its new Observability Pipelines product, and it recently agreed to buy another observability platform called Seekret. It's natural for growing companies to expand via acquisitions, but it could also indicate Datadog is running out of room to grow organically.

Declining operating margins

Datadog's gross margins expanded sequentially and year over year by GAAP (generally accepted accounting principles) and non-GAAP metrics in the second quarter. However, its operating margins declined sequentially by both measures -- and its GAAP operating margin turned negative again after two positive quarters.

Data source: Datadog.

Datadog attributed that contraction to a return to in-office attendance, business travel, and events in a post-lockdown world, as well as rising research and development, sales, and marketing investments in its new products.

It expects that pressure to continue and reduce its non-GAAP operating margin to about 13% in the third quarter. However, it also expects that figure to stay roughly flat at 16% for the full year.

Datadog is also guiding for adjusted EPS to rise 15% to 30% year over year in the third quarter, and to grow 54% to 69% for the full year. Once again, those estimates matched analysts' expectations. Based on those forecasts, the stock still trades at more than 150 times forward earnings.

Is it the right time to buy Datadog?

Datadog's business is firing on all cylinders, but its stock is priced for perfection and it's too easy to spot the imperfections. Macroeconomic headwinds could cause its sequential growth in large customers to remain sluggish over the next few quarters, and its near-term margins will likely be squeezed by a combination of rising post-pandemic costs and higher investments.

If the stock were a bit cheaper, it would be easy to recommend. But at its current valuation, the company needs to hit home runs -- not doubles or triples -- every quarter to spark meaningful rallies. Investors can nibble on this promising growth stock today, but they shouldn't be surprised if it pulls back further in this challenging market for hypergrowth companies.