The Datadog Has Been Maltreated, Foster Some Extra Shares

Source:-seekingalpha.com

Datadog reported Q2 earnings on August 6th, resulting in a revenue beat and full-year guidance raise. However, the stock fell 16% after-hours, leaving some investors puzzled.

The company posted solid Q2 earnings, but the soft guidance and some cost-saving comments are likely responsible for the hard drop.

Management guidance was very conservative, revenue growth remains strong and the product offering keeps improving.

Dollar-cost averaging is the go-to strategy for this stock, and the current mid-$70s level is a perfect starting point to add extra shares.

Introduction

Datadog (DDOG) reported Q2 earnings on August 6th, resulting in a revenue beat and full-year guidance raise. However, the stock fell 16% after-hours, leaving some investors puzzled. Although the beat-and-decline situation happens quite often, I believe this drop allows investors to take a moment to evaluate the potential pitfall in their bull thesis. And so I did it with mine.

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Source

Previous Bullish Thesis and Datadog Q2 Earnings
My previous article on Datadog highlighted the quality of the product offering, the strong customer funnel, and the secular trends promising a bright future.

The quality of the product is becoming more and more evident. The Q2 press release highlighted some more prizes won by Datadog for its products, such as the 2020 Gartner Peer Insights Customers’ Choice for IT Infrastructure Monitoring Tools and the “Best Mission-Based Data Solution” as part of the 2020 AWS Public Sector Partners Awards.

Regarding customer trends, Datadog’s Q2 numbers were solid. High growth continued over Q2 even though at a slower rate compared to the COVID-induced Q1 spike. The company increased the number of customers with ARR of $100,000 or more to 1,015, a 71% increase year over year. The total number of customers has also grown 37% to about 12,100 customers. Last quarter, the percentage increase was 89% YoY for large customers and 40% for the overall number of customers. Looking at the results in absolute numbers, Datadog added 45 large customers over Q2, 102 over Q1, and 131 in Q4 2019. Customer growth is therefore declining, but this decline is not a problem per se, as such high levels of growth will become more and more difficult to be sustained as the company gets bigger. However, Datadog management also commented on the cost-saving attempts of large cloud infrastructure users, which also happen to be Datadog’s largest product consumers. As these customers decrease their cloud usage, Datadog’s business gets hurt consequently. Realistically, cost-saving measures at large corporations are understandable in this economic environment, and it is hard to imagine cloud infrastructure consumption not to go up as the economic environment improves. Moreover, a big portion of these large companies’ IT infrastructures remains off the cloud, presenting an opportunity to increase revenue disconnected by the growth of these companies’ operations. These large customers (with ARR of $100,000 or more) constitute 75% of revenue and therefore their behaviour has a bigger impact on revenue. In fact, smaller customers and organizations less reliant on cloud infrastructure are still seeing stronger growth. The impact of these cost-saving practices can be seen on the slight inflection from Q1 to Q2 in the revenue growth trajectory (Figure 1), now looking a bit less parabolic.

Datadog revenue growth Q2 earnings

Figure 1 – Source: Datadog financials, Figure created by Author

Datadog’s management also raised guidance, with the full year 2020 revenue outlook now set between $566 million and $572 million. With already $131 million in Q1 and $140 million in Q2, guidance for the last two quarters of the year is around $298 million. Q3 is expected to collect around $144 million in revenue, or a 50% increase YoY, leaving Q4 revenue to $154 million, or 35% increase YoY. Indeed, a very conservative guidance, especially since Q4 has been a stronger quarter during the past couple of years.

A catalyst to beat expectation could come from Datadog’s recently expanded product offering. At the end of Q2, 68% of customers were using two or more Datadog products, which is up from 40% YoY and up 5% from last quarter 63%. Moreover, 15% of customers are using four or more products, showing discrete success in cross-selling and significant potential in the strategy.

Gross margins also remained stable at around 80%, representing an increase of 5% YoY.

Datadog Debt offering and Undefined Labs acquisition
On June 2nd, Datadog completed its private offering of $747.5 million aggregate principal amount of 0.125% Convertible Senior Notes due in 2025. The initial conversion price for the convertible notes is approximately $92.30 per share of common stock, which at the time represented a 37.5% premium over Datadog’s stock trading price.

Part of these proceedings was used to acquire Undefined Labs, a provider of observability for dev and test workflows. Undefined Labs was founded in 2018 and counts 9 employees on LinkedIn, with offices in San Francisco and Madrid. The terms of the acquisition were not disclosed, but I am expecting it to account for a fraction of the $747.5 million recently raised. The acquisition confirms Datadog’s focus on improving its product offering.

Datadog Valuation and Stock Price
Datadog stock price Datadog valuation
Figure 2 – Source: Finviz

Datadog’s stock price plunged after earnings despite beating expectations and raising full-year outlook on all metrics. The market was likely expecting a bigger blowout, and as I mentioned above, guidance was very conservative. Datadog management has a history of being conservative, so I am expecting a higher rate of growth than management’s forecast. However, despite Datadog’s business proven to be pandemic proof, this quarter has shown how the macroeconomic environment can still hurt revenue growth.

After the 16% price drop, Price to Sales ratio now stands at 39. That is still relatively high compared to competitors such as Elastic (ESTC), with P/S of 16, Splunk (SPLK) of 13, and New Relic (NEWR) of 5. However, DDOG is still posting revenue growth much higher than peers, so the higher revenue multiple can be justified (Figure 3).

Datadog competitors Datadog valuation

Figure 3 – Source: Seeking Alpha

Moreover, competitor New Relic is having trouble finding a strategic direction, and it’s currently undertaking changes to its platform in an attempt to catch up with market leaders such as Datadog.

Conclusion & Takeaway
There is no doubt that Datadog has had a pretentious run over the last few months, and a correction is understandable. The company posted solid Q2 earnings, and the soft guidance is likely responsible for the 16% plunge. However, management has a history of being conservative, and the cross-selling across different platform products could be the catalyst for a strong beat of full-year guidance by year-end. Dollar-cost averaging is the go-to strategy for this stock, and the current mid-$70s level is a perfect starting point to add extra shares.