While 2022 may be remembered for many things, it won't be considered a great year for tech stocks. The S&P 500 tech sector is down nearly 30% compared to the broader market's 20%. Much of this decline came from the overvaluation of software stocks, but 2023 could mark a potential reset year.
Some software stocks have seen their revenue growth grind to a halt, but others are still thriving. Two companies still growing at an unbelievably fast pace are Cloudflare (NET 3.77%) and Datadog (DDOG 3.58%). Both are primed for a great 2023, and I think they should be at the top of investors' shopping lists.
Cloudflare
With the rise of cloud data centers, the internet is transitioning into a new growth phase. Rather than individual companies hosting their own websites, they can contract out to Cloudflare, which will host their websites using its data centers. With more than 275 data centers spread globally, 95% of the world's population lives within 50 milliseconds of a Cloudflare data center. That means websites hosted on Cloudflare have unparalleled speeds, and if one data center goes down, there are multiple others to redirect traffic to.
Along with hosting, Cloudflare provides cybersecurity services to its clients so they aren't as exposed to threats like breaches, distributed denial-of-service (DDoS), or bot attacks. Cloudflare has a massive customer base, with over 156,000 customers and 1,908 spending more than $100,000 annually. Unfortunately, customer growth is beginning to slow, with its total rising by 18% in the third quarter. But the business is shifting to focus on large customers, which rose 51% over last year.
This is a crucial metric for investors, as spending expansion is critical when customer growth slows. In Q3, Cloudflare's retention rate was 124%, meaning existing customers spent $124 for every $100 they spent last year.
One area of concern is Cloudflare's profitability. Its operating loss margin in Q3 was 18%, driven mainly by stock-based compensation of $55.9 million, or about 22% of revenue. That's a significant gap to close, and Cloudflare must grow its revenue faster than its operating expenses to start closing it. (Cloudflare grew its operating expenses and revenue at the same rate in Q3.)
Cloudflare has some investment risks (namely its profitability state), but it's operating in a market expected to be worth $135 billion by 2024, so there is a massive investment opportunity here. It appears 2023 should be another fantastic year of revenue growth for Cloudflare. With its price-to-sales valuation near the lowest it has had as a public company, stock price appreciation could follow.
Datadog
With all the various data-driven solutions companies use, it isn't easy to understand why an application isn't functioning correctly. Datadog's cloud monitoring software solves this issue by giving IT teams the visibility they need to see how various applications interact.
Users can also set up automated responses to incidents and generate metrics to understand how and if new products provide tangible business effects. According to third-party Gartner, Datadog's application program management and observability product was named a leader in the space, with the highest ability to execute. Datadog has also recently expanded into cybersecurity, giving investors another reason to consider this company.
Datadog's customer count is much smaller than Cloudflare's at 22,200. However, about 2,600 spend more than $100,000 annually. It's also growing faster than Cloudflare, with 61% revenue growth to $437 million in Q3.
From a profitability standpoint, Datadog still loses money. However, it only posted a 7% operating loss margin in Q3, and analysts expect it to break even in 2023 or 2024.
Like Cloudflare, a key indicator for Datadog is its retention rate, which was about 130% for Q3. Another similar metric is how many products customers use, which has trended positively.
| Percent of Customers Using Products | Q3 2020 | Q3 2021 | Q3 2022 |
|---|---|---|---|
| 2 or more products | 71% | 77% | 80% |
| 4 or more products | 20% | 31% | 40% |
| 6 or more products | 0% | 8% | 16% |
Data source: Datadog.
If Datadog can control its operating expense growth (operating expenses grew faster than revenue in Q3), then it has the potential to be another strong investment for 2023. Additionally, if it can upsell customers on multiple products, that will be a key indicator of how Datadog is doing.
Growth names aren't currently "in style," but that could change in 2023. If it doesn't, don't be surprised if these stocks are sold off further. Because of that, investors should take their time establishing positions instead of rushing all in. Still, these companies are planning for the long term and have a massive opportunity. So if investors share their vision, they should sign up for a long-term holding, even if the stock moves down in the short term.
