Cloud-based IT analytics company Datadog (DDOG -1.43%) was a pandemic winner, soaring more than 300% between 2020 and 2022. But shares have since fallen, sitting more than 60% off highs today.
Does Datadog deserve the cold shoulder it's gotten in recent months? Here is why investors shouldn't dismiss the stock as a fad and why the company could again produce tremendous gains for patient investors.
Datadog's fundamental excellence at work
Think about how many computers, devices, and software apps you run into at your workplace. A company's technology assets (tech stack) have many moving pieces, so getting everything to work together correctly and efficiently can be challenging. What if there's an error somewhere, a malfunction where an IT employee needs to find the cause of the problem, sifting through endless amounts of data and computer logs?
Datadog solves this problem; it's a cloud-based software company that observes an enterprise's devices and servers, networks, and software applications, and tracks everything happening. IT professionals can troubleshoot problems, secure their systems, and ensure the technology stack runs efficiently by searching through the information Datadog collects.
Look to Datadog's operating results to see its value to its customers; the company's already approaching $2 billion in annual revenue and is cash-flow-positive, generating $0.21 in free cash flow for every revenue dollar earned.
DDOG Revenue (TTM) data by YCharts.
The company has approximately 23,200 total customers and a net-dollar revenue-retention rate higher than 130%. In other words, Datadog could stop picking up new clients and still grow revenue by 30% because of how its customers spend more over time. Management estimates that its total addressable market could grow to $62 billion by 2026, meaning that Datadog has a lot of room to expand over the coming years. The company's aggressive investments in research and development signal that Datadog will be pursuing that growth.
How long will Datadog stay cheap?
Some people may argue that Datadog is an expensive stock, but sometimes you get what you pay for. Datadog's long runway to growth and strong cash-flow generation (something many other growth stocks lack) does make a solid argument that the stock should fetch a higher valuation than some other software as a service (SaaS) stocks. The stock's current price-to-sales (P/S) ratio of 14 is near its lowest point since the COVID-19 crash nearly three years ago.
DDOG PS Ratio data by YCharts
Rising interest rates can dump water on stock valuations, so investors shouldn't buy Datadog for a quick profit. The stock's valuation may continue falling, especially in an unstable economic environment that potentially impacted 2023 guidance.
Watch for this potential problem
Many overlook the potential impact that stock-based compensation can have on investment returns. Many technology companies pay employees in stock to preserve cash for the business. But issuing too much stock can negatively impact investors.
You can see below that revenue per share grew much slower than total revenue over the past year because stock-based compensation increased significantly.
DDOG Revenue Per Share (TTM) data by YCharts.
You don't want to see this repeatedly happen over the long term, so investors should watch it moving forward. The good news is that Datadog has about $1.1 billion in net cash (total cash minus debt) on the books; given the company's strong cash flow, eventual share repurchases could begin reeling in that share count. That's more likely as the company matures than while the business is innovating and chasing growth.
Nonetheless, Datadog remains a potential future blue-chip technology stock that could pay handsomely for investors willing to buy and hold shares. It might not happen overnight, but most good things take time.
