Analytics and cloud observability stock Datadog (DDOG 4.95%) is off to the races again. After a dip through the late summer and autumn months, shares have rallied, boosted by yet another stellar quarterly earnings update despite slowing software industry growth. Shares are now up over 50% so far in 2023.
The stock's valuation remains quite high, though, even as Datadog makes rapid progress on its key profitability metrics. Is it really a top stock to buy right now?
Datadog is now profitable on nearly all counts
The big headline from Datadog's third-quarter 2023 earnings report was that revenue increased 25% year over year to nearly $548 million, and the outlook for the fourth quarter is for as much as $568 million -- a nice sequential increase of 3.6%, and implying a year-over-year increase of as much as 17%.
These are encouraging numbers, given a widespread slowdown in software spending this year as the economy slowed and organizations looked for ways to cut expenses and conserve cash. Datadog's trajectory certainly slowed as well (it grew 63% in 2022), but it's still performing admirably on the top line and very much still a growth business.
But of greater importance at this point is Datadog's profitability. The market has been punishing businesses that ignore the bottom line now that the U.S. Federal Reserve and other central banks raised interest rates and tightened easy-money policies. Datadog reported its first positive generally accepted accounting principles (GAAP) net income since the first quarter of 2022, notching a net profit of $22.6 million last quarter (compared to a GAAP net loss of $26 million in the prior year quarter).
Additionally, free cash flow (FCF) also continues to be steady. It was $147 million in Q3, representing an FCF profit margin of 27%. Good Datadog.
Data by YCharts.
How rich is too rich?
Of particular note, Datadog was able to report net profit last quarter, due in large part to interest income of nearly $30 million, a result of its massive $2.34 billion in cash and short-term investments on balance. GAAP operating income remains slightly in the red.
Free cash flow does subtract the $123 million in employee stock-based compensation (SBC) in Q3, which was up 22% from last year's Q3 SBC. Clearly, Datadog still has some new tricks it can learn to improve its profit margins, especially as it anticipates its growth rates to further slow down.
In all, this is why I continue to call out what appears to be a too-rich valuation of over 70 times trailing-12-month free cash flow. Make no mistake -- Datadog has some great things going for it. All of that cash on balance could be fuel for years of strong growth if the company can deploy it toward new product development and/or strategic acquisitions. But Datadog isn't as profitable as it appears, and the decelerating revenue growth can cause some issues going forward if those GAAP net income and free cash flow margins don't meaningfully increase.
As in times past, for investors who really like the long-term potential of this top data analytics and cloud computing infrastructure business, a dollar-cost average plan looks like a prudent way to buy. But I'm staying on the sidelines and watching Datadog stock from afar right now.
