What happened
Shares of Datadog (DDOG 4.95%) rose 33.9% during the first six months of the year, according to S&P Global Market Intelligence. That's well ahead of the S&P 500's 16% gains, but it was roughly in line with the Nasdaq's performance.
The stock rallied in May after a well-received earnings report. It also rode a wave of momentum for growth stocks that was triggered by promising economic news.
So what
Datadog provides monitoring and analytics software services for cloud computing systems. Customers benefit from enhanced transparency into their software applications, which improves operational efficiency and threat detection. That's a compelling value proposition, but macroeconomic weakness is hampering demand right now. Enterprise customers are less willing to spend freely, and they are applying more scrutiny to vendor deals.
Image source: Getty Images.
This is causing Datadog's growth rate to drop in the short term. While the company still reported 33% growth in its most recent quarter, that's significantly lower than it had previously achieved.
DDOG Revenue (Quarterly YoY Growth) data by YCharts
This should be expected for a maturing company in an uncertain economy, but it can still be a harsh wake-up call to ever-optimistic bullish investors. Following Datadog's February quarterly earnings announcement, analysts cut their revenue and earnings outlook for next year. The stock tumbled through the first quarter of 2023, erasing previous gains and wiping out over 25% of its value.
The stock staged a big rally in May, however. Datadog's first-quarter earnings results exceeded analyst expectations, despite growth slowing once again. Notably, the company reported higher adjusted profits than they had previously forecast, suggesting that they are effectively managing expenses while maintaining their expected growth trajectory. Neither Datadog nor analysts drastically changed their forecasts, but this was received positively by Wall Street.
The Federal Reserve's decision to pause rate hikes gave investors hope that the macroeconomy would be more business friendly in coming quarters. High interest rates have growth investors on edge, but many seem to think that the worst-case scenario has been avoided. This is fueling a surge in risk appetite, which is inflating the valuations of growth stocks like Datadog.
The stock's price surged relative to sales, forecast earnings, and cash flows in May. This accounted for essentially all of Datadog's gains this year.
DDOG PS Ratio data by YCharts
Now what
Datadog has excellent long-term catalysts. It's a leader in a valuable growth industry that supports many of the exciting technology megatrends, including AI and cloud computing. The company is likely to enjoy strong demand for years to come, so it could be a compelling buy for long-term investors.
Unfortunately, it's not exactly a slam dunk because the stock is so expensive. Datadog's price-to-cash-flow and forward P/E ratios are both over 80, and its price-to-sales ratio is nearly 20. That means that significant growth and financial success is already priced into the stock. Any indication of sales weakness or cash flow issues are likely to hit the stock hard, and it will remain highly sensitive to macroeconomic data. That should create volatility for at least a few years, which makes it unsuitable for investors who don't have much appetite for risk.
