What happened
Shares of cybersecurity and observability software stocks Datadog (DDOG 4.95%), Cloudflare (NET 1.44%), and Zscaler (ZS 1.28%) were rallying on Monday, up 4.3%, 6.3%, and 4.7%, respectively, as of 1:22 p.m. ET.
Both Datadog and Cloudflare received price-target hikes today from Wall Street analysts, and Zscaler likely rose in sympathy with the Cloudflare upgrade. In addition, these stocks may be bouncing back from last week's sell-off following Microsoft's (MSFT 1.82%) announcement of several new cloud-security products.
So what
On Monday, Datadog received not one but two price-target hikes. Analysts at Mizuho raised their price targets from $82 to $112, and the analyst team at Oppenheimer raised its price target from $105 to $120 per share.
The Oppenheimer analysts appeared especially bullish on the current earnings season, saying,
We're positive on Datadog and believe it can deliver a strong beat to conservatively set targets... The company continues to see solid new logo growth...and success in upselling existing customers.
But was Datadog overly conservative in its last earnings report? After all, the company did handily beat on revenue and earnings on last quarter's earnings call while raising its full-year guidance. However, management only raised revenue guidance from a range of $2.07 billion to $2.09 billion to a range of $2.08 billion to $2.1 billion. Given that Datadog had already beaten the first fiscal-quarter's expectations by more than $10 million -- the amount of the full-year raise -- it seems Datadog wasn't incorporating any more beats for the year.
So, that was perhaps an overly cautious stance. And with inflation coming down, the regional banking crisis appearing to be contained, and jobs growth still solid since early May, management may be less cautious this time around.
Image source: Getty Images.
That would especially be true if enterprise software spending came back. Spending slowed markedly at the end of 2022 and into this year, but with inflation coming back down to target and the economy still strong, it's possible the SaaS sector may be on its way to a recovery.
At the forefront of cloud-based cybersecurity are Cloudflare and Zscaler. Both cybersecurity companies were founded relatively recently, in 2009 and 2007, respectively, as cloud-first software companies meant to provide better cybersecurity alternatives in a world of fast-evolving and increasingly sophisticated threats. Thus far, both companies have displayed strong growth, even in this soft spending environment, with Cloudflare growing its top line 37% last quarter and Zscaler growing revenue by a whopping 46%.
Today, Cloudflare also got a price-target boost from one of its more bearish analysts. This was Mizuho again, whose analyst team raised its price target from $49 to $65, while only keeping a "hold" rating on the stock.
This was interesting in that even with the price-target hike, Mizuho's target is still below the current stock price of around $71. However, when a more bearish analyst appears to "throw in the towel" and raise his or her price target toward where a stock has already moved, that capitulation could be a positive sign.
In addition to the optimism over today's price-target boosts, Zscaler and Cloudflare may have been primed for a good week. Each stock fell last week following Microsoft's introduction of several new cloud-based security products. That announcement didn't affect Datadog as much, as Datadog's expertise is more on the observability and IT health-monitoring side rather than cybersecurity. But given that both Cloudflare and Zscaler had a not-so-great last week, today's price-target boosts and general optimism over the economy are likely giving today's rally some extra ammo.
While Microsoft could be a threat, investors may have panicked too soon. Customers will likely want a cybersecurity solution that works across different clouds to prevent "lock-in," and cybersecurity is so important that many may wish to go with a best-in-class "pure play" solely focused on security and not any of the other things Microsoft does.
DDOG PS Ratio data by YCharts.
Now what
These three new-age SaaS stocks are in terrific businesses with great product offerings that very much fit into today's software-defined cybersecurity and application-monitoring environment. But their stellar growth also comes with high valuations, with price-to-sales ratios between 14 and 22. Moreover, none of these companies are profitable yet on a generally accepted accounting principles (GAAP) basis when factoring in their high stock-based compensation.
Those are exceptionally high valuations and would likely require not only for these companies to continue growing for years while expanding margins, but also for interest rates to come down from where they are today. That may happen, but a lot of things still have to go right.
I'm still not sold that high-growth SaaS companies will get back to their lofty 2021 heights anytime soon, but today's upgrades certainly do seem to indicate the worst may be over for the group. We'll see how enterprises return to spending on digital transformation, or not, during the upcoming earnings season.
