As the overall economy slowed in 2022, it negatively impacted the information technology (IT) sector, slowing demand for Datadog's (DDOG 4.95%) observability and security products for the cloud, and leading to revenue growth declines. Growth investors took little time to lose interest in the company, and the stock dropped 59% during the year.
Prospects for revenue growth reaccelerating and investors renewing their interest in the company were gloomy until Datadog reported better-than-expected revenue and earnings in its first-quarter 2023 earnings report. Consequently, the stock price surged 45% in May, ending a stagnant period for the company. Although its relatively high price-to-sales ratio of 19.29 may make some investors hesitant about investing in the stock today, now is still an excellent time to consider investing in Datadog. Here's why.
The exponential increase in data drives revenue growth
Datadog is a valuable platform that allows businesses to gather, display, and evaluate data from their IT infrastructure. Collecting relevant data is essential for developers, operations engineers, quality assurance engineers, and the IT department to keep track of the performance of servers, applications, databases, and other cloud-based services. This collected data helps teams to detect problems, troubleshoot issues, and identify areas for improvement. Datadog also provides tools for alerting, troubleshooting, and capacity planning.
Datadog has seen tremendous revenue growth in the past three years, primarily due to a significant increase in data generated by the proliferation of the Internet of Things, artificial intelligence (AI), mobile technology, and big data analytics. Many experts expect this trend of data consumption will persist and even intensify as various businesses and industries adopt these technologies and employ data as a crucial catalyst for progress and innovation.
Management projects its core observability and monitoring market will grow at a 10.89% compound annual growth rate (CAGR) from $41 billion at the end of 2022 to $62 billion at the end of 2026. Thus far, Datadog has only captured a 4.36% share of this market, so the company has a long runway for growth.
The market is highly competitive
The observability and cloud monitoring market is a highly competitive space that presents various challenges for Datadog. To remain at the forefront of this industry, it must navigate direct and indirect competition from other platforms like New Relic, Splunk, and Dynatrace. These formidable competitors offer similar features and constantly innovate to counter Datadog's moves.
Furthermore, Datadog must contend with indirect competition from companies that provide monitoring and management solutions for specific areas of IT infrastructure, such as SolarWinds and Microsoft's Azure Monitor. While these companies may have a smaller feature set than Datadog, they may be better suited for organizations that need to monitor particular aspects of their IT environment closely.
There is also an influx of new players like Better Stack, SigNoz, and Honeycomb, which bring fresh ideas and technologies to the table, challenging the status quo and incumbents. Despite these challenges, Datadog remains committed to delivering the best possible solutions to its customers and staying ahead of the curve in the ever-evolving observability and cloud monitoring landscape.
High future growth expectations for Datadog
Among the reasons the stock took such a leap upward after the company delivered its earnings report in May is that investors are increasingly optimistic that the worst is over for the company. Many believe that its revenue growth will improve because of the rapid adoption of generative AI and chatbots like ChatGPT, which should increase data consumption and future demand for Datadog's cloud monitoring tools.
According to Simply Wall St, analysts estimate that Datadog's revenue will grow at a CAGR of 20.9% over the next three years, significantly higher than the growth rate of 11.5% those analysts expect for its industry and the 7.5% growth rate for the overall market.
Investors are also attracted to Datadog because it's a software-as-a-service (SaaS) company. These companies often maintain robust gross margins due to their lack of manufacturing or shipping expenses, typically leading to a low cost of goods sold (COGS). According to a study by Baremetrics, the average gross margin for SaaS companies is 73%. Datadog reported a gross margin of 79.25% in its first-quarter 2023 earnings report.
Some analysts believe Datadog's gross margin will continue to rise. The theory is that as its revenue base increases, it should be able to distribute its COGS over more customers, lowering those costs as a percentage of revenue and increasing its gross margin. If this dynamic holds, its gross margin should rise into the 80s as its revenue grows.
Investors often award higher valuations to companies with higher gross margins because the management of such companies has more cash to allocate between:
- Funding research and development, marketing, or acquisitions to accelerate revenue growth.
- Lowering prices to lure customers away from their rivals.
- Returning cash to shareholders in the form of dividends or share repurchases.
- Retaining the money, making it easier to achieve bottom-line profitability.
Investors also like Datadog's prospects for cash dropping down to the bottom line. Software analysts believe Datadog will break even in approximately two years. They expect a final loss in 2024 and bottom-line profitability in 2025.
Based on the assumption that the company can maintain its robust revenue growth while achieving profitability in the next few years, the current stock valuation still appears reasonable. Consider buying a few shares if you want a solid growth stock in the coming bull market.
