The tech bear market is in full swing with the Nasdaq Composite index down more than 31% year to date. Many tech stocks are down even more, including Datadog (DDOG -2.77%), which has declined 51% in 2022.
The need for application performance observability and monitoring has been omnipresent as businesses have adopted more digital platforms. This is a large industry, and Datadog (DDOG -2.77%) is the top player in this space, according to Gartner's Magic Quadrant. As the leader, this company has seen incredible adoption across the board. I took advantage of this recent decline and bought more shares. Here's why you should too.
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The leader in a $53 billion industry
Saying that the observability and performance monitoring space is large and growing is an understatement. In reality, it's massive: Datadog believes its current opportunity is worth $42 billion, and it's predicted to rise to $53 billion by 2025. Talk about fishing in a stocked pond.
More importantly, Datadog looks poised to capitalize on this for a few reasons. The first is the company's switching costs. It is likely painful and expensive to migrate all of a business's data and operations to another platform once it has embraced multiple tools from Datadog, meaning the company will retain much of its current customer base. With over 21,000 customers -- 2,420 of which are spending $100,000 annually -- this gives Datadog a strong foundation. Additionally, the company has seen consistent churn in the mid to low single digits, showing that these switching costs are already playing out in the company's favor.
The second reason Datadog could capitalize on this market is because of its history of out-innovating its peers. The company continues to roll out new solutions to its customers, making its product suite of over 30 tools increasingly valuable. This year alone, the company has already launched six new tools with plans to launch more by the year's end.
How can it do this? Cash flow. With $354 million in free cash flow on a trailing-12-month basis, the company is generating more cash than its two main rivals -- Dynatrace and New Relic -- combined. The company uses this cash to develop best-in-class products, making its value proposition more attractive within the industry.
This top dog is posting jaw-dropping growth
These sturdy competitive advantages and the criticality of its services have resulted in healthy, stable demand. Even during the second quarter, when businesses saw budgets tighten and inflation rise, Datadog reported incredible adoption. Second-quarter revenue soared 74% year over year to $406 million while the number of customers spending over $100,00 annually shot 54% higher over the same period.
Datadog further impresses with its ability to expand its relationship with customers -- 14% of all customers use six or more products as of the most recent quarter and 37% use four or more. Just two years ago, no customers were using six or more products, and just 15% were using four or more. This trend has been a considerable driver of its outstanding top-line expansion, and as the company continues to roll out new best-in-class tools, it will likely become more prevalent.
Not only is Datadog improving its top line but also its profitability. Over the past six months, Datadog's free cash flow reached $190 million, representing a 25% margin and a year-over-year increase of 119%. Additionally, while generating net income is not the current focus for Datadog, this has also shot higher. GAAP net income over the past six months reached $4.9 million, up from the $22.4 million loss it posted in the year-ago period.
You get what you pay for
Given how strong this business is, shares trade at a staggering premium. Paying 20 times sales and 79 times free cash flow is expensive for any company. Despite this, Datadog looks like one of the highest-quality software stocks on the market today, given its cash generation, deepening customer relationships, and competitive advantages. When you find a high-quality business, you often have to pay a premium, which is certainly the case with Datadog.
In this light, Datadog is a stock tech investors should own. Shares could surge higher from these depressed levels, and that's why I recently bought more shares on the dip.
