Is It Too Late to Buy Datadog Stock?

Datadog's (DDOG 4.95%) stock price sank 17% on Aug. 8 after it posted its second-quarter earnings report. Its revenue rose 25% year over year to $509 million and exceeded analysts' expectations by $8 million. Its adjusted net income grew 50% to $125 million, or $0.36 per share, and cleared the consensus forecast by eight cents.

Unfortunately, Datadog's gloomy guidance overshadowed that earnings beat. Let's see how bad those numbers were -- and if it's too late to buy Datadog's stock.

Image source: Getty Images.

Another quarter of decelerating growth for Datadog

Datadog's platform collects real-time diagnostic information from an organization's servers, databases, and applications. It aggregates all of that data onto unified dashboards, which makes it easier for IT professionals to spot potential problems.

Datadog went public in 2019, and its annual revenue grew at a compound annual growth rate (CAGR) of 67% between 2019 and 2022. Its number of large customers, which generate more than $100,000 in annual recurring revenue (ARR), more than tripled from 858 at the end of 2019 to 2,780 at the end of 2022.

Datadog's number of large customers grew another 24% year over year to 2,990 in the second quarter. But as the following table illustrates, its year-over-year growth in large customers and total revenue decelerated significantly over the past year.

Data source: Datadog. YOY = Year-over-year.

Datadog's guidance suggests that the slowdown isn't over yet. It expects its revenue to only rise 19%-20% year over year in the third quarter, which broadly misses analysts' expectations for 23% growth.

For the full year, it expects its revenue to grow 22%-23%, compared to the consensus forecast for 24% growth and 63% growth in 2022. It had previously told investors to expect 24%-25% revenue growth for the full year.

During the conference call, CEO Olivier Pomel attributed its slowdown to the macro headwinds, which drove its larger customers to closely "scrutinize costs and optimize their cloud and observability usage." Pomel said while it was "seeing signs" of improvement, it was "too early to call an end to cloud optimization and a significant level of macro uncertainty remains."

Trying to stabilize Datadog's margins as its growth cools off

Datadog's growth is cooling off, but its adjusted gross margin still expanded by less than a percentage point both sequentially and year over year to 81% -- which remains well above its long-term gross margin target of the "high 70s." Its adjusted operating margin also expanded three percentage points sequentially and stayed flat year over year at 21%.

CFO David Obstler attributed that stability to its improved efficiency in cloud costs, its slower pace of hiring, and other cost-cutting initiatives. For the third quarter, it expects its adjusted operating margin to dip sequentially but rise two percentage points year over year to 19%. For the full year, it expects its adjusted operating margin to stay flat year over year at 19%.

Datadog expects its adjusted EPS to rise 43%-52% in the third quarter, which easily surpasses analysts' expectations for 26% growth. It expects its adjusted EPS to grow 33%-37% for the full year, which is also much higher than the consensus forecast for 20% growth and its prior outlook for 15%-22% growth.

That higher-than-expected earnings guidance was encouraging, but investors should note that Datadog is still unprofitable on a generally accepted accounting principles (GAAP) basis -- mainly due to the stock-based compensation expenses which rose 55% year over year in the first half of 2023 and consumed 23% of its total revenue. That red ink could make Datadog unappealing as long as interest rates stay elevated.

Datadog's valuations are still too high

Datadog has an enterprise value of $28 billion, which is nearly 14 times its estimated revenue for 2023. That EV/Revenue ratio isn't cheap for a company that is growing its revenue by just over 20%.

Snowflake, which is expected to generate 34% revenue growth in its current fiscal year, trades at 18 times that estimate. ServiceNow, the cloud-based digital workflow services provider which is expected to grow its revenue by 23% this year, trades at 12 times that forecast.

Datadog's high valuation, slowing growth, and lack of GAAP profits could all limit its upside potential in this turbulent market. While I don't think it's too late to buy Datadog's stock as a long-term investment, I believe it would be prudent to stick with more balanced tech stocks until its valuation cools off to more sustainable levels.