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Here’s Why You Must Consider Buying Datadog (DDOG) Shares

Baron Funds, an asset management firm, published its “Baron Global Advantage Fund” first quarter 2022 investor letter – a copy of which can be downloaded here. Baron Global Advantage Fund (the “Fund”) declined 22.8% (Institutional Shares), during the first quarter, compared to the 5.4% loss for the MSCI ACWI Index (the “Index”), and the 9.7% loss for the MSCI ACWI Growth Index, the Fund’s benchmarks. Try to spend some time taking a look at the fund’s top 5 holdings to be informed about their best picks for 2022.

In its Q1 2022 investor letter, Baron Global Advantage Fund mentioned Datadog, Inc. (NASDAQ: DDOG ) and explained its insights for the company. Founded in 2010, Datadog, Inc. (NASDAQ:DDOG) is a United States-based cloud applications monitoring platform with a $37.8 billion market capitalization. Datadog, Inc. (NASDAQ:DDOG) delivered a -32.51% return since the beginning of the year, while its 12-month returns are up by 49.93%. The stock closed at $120.20 per share on May 02, 2022.

Here is what Baron Global Advantage Fund has to say about Datadog, Inc. (NASDAQ:DDOG) in its Q1 2022 investor letter:

“Another example is Datadog, the leading infrastructure monitoring, application performance monitoring and log management software platform. Datadog’s stock declined 15% during the quarter, despite reporting sparkling operational results, with revenues accelerating to a growth rate of 84% year-over-year with 33% free cash flow margins, while guiding for 2022 significantly above expectations. Datadog added 4,600 new customers in the quarter, while existing customers continued to increase their spending on Datadog products at a rapid pace with the number of customers using four or more products increasing to 33% from 22% last year. While Datadog’s stock was down, its intrinsic value has undoubtedly increased. This is enabled by rapid innovation (Datadog released 13 new products in 2021) into a market that is benefiting from the secular growth in cloud, digital transformation, and the explosion in complexity as the number of vendors, diversity of technologies and related infrastructure continued to expand.”

Our calculations show that Datadog, Inc. (NASDAQ:DDOG) fell short and didn’t make it on our list of the 30 Most Popular Stocks Among Hedge Funds . Datadog, Inc. (NASDAQ:DDOG) was in 73 hedge fund portfolios at the end of the fourth quarter of 2021, compared to 62 funds in the previous quarter. Datadog, Inc. (NASDAQ:DDOG) delivered a -17.73% return in the past 3 months.

In February 2022, we also shared another hedge fund’s views on Datadog, Inc. (NASDAQ:DDOG) in another article . You can find other investor letters from hedge funds and prominent investors on our hedge fund investor letters 2022 Q1 page.

Disclosure: None. This article is originally published at Insider Monkey.

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Datadog: Terrific Growth At A Terrible Price

Almost without exception, the entirety of the high-growth/high-valuation tech sector has seen a dramatic correction year to date. Somehow, however, Datadog ( NASDAQ:DDOG ) has been able to dodge most of the pain. This infrastructure monitoring superstar, which has seen its stock price chart trend in a nearly vertical line since its IPO, has shed only ~13% of its value year-to-date, despite losses commonly double or triple that for many of its SaaS peers. Long a Wall Street favorite prized for its seemingly limitless growth, Datadog has managed to retain its patina of untouchability even during a time when the risk-off macro attitude has forced fire sales of many of its peers.

Data by YCharts

This outperformance will be hard to sustain

The question for investors now, however: as we look ahead to a potential near-term rebound within 2022, is Datadog the best stock positioned to capitalize on that rebound? In my view, the answer is no, and I remain bearish on Datadog relative to other growth tech stocks in the current market.

To be sure, there are a lot of positive drivers for Datadog. I’ll acknowledge that Datadog’s fundamentals are something truly rare: even at a >$1 billion annual revenue run rate, Datadog is managing to nearly double its revenue y/y, which is a feat almost unheard of. At the same time, the company has sky-high gross margins and a nearly pure recurring revenue base, which makes Datadog a structurally profitable business that is now starting to see tremendous operating leverage and free cash flow. Many software companies aspire to what is called the “Rule of 40” – where the sum of revenue growth plus pro forma operating margin exceeds 40%. In Datadog’s most recent quarter, the company achieved a Rule of 40 score above 100 – putting Datadog in a class of its own.

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Beyond these purely financial metrics, Datadog’s execution looks terrific as well. The company just received FedRAMP authorization, which allows it to sell to the federal government. As seasoned software investors are aware, federal agency deals represent some of the largest and stickiest contracts in the industry that software vendors compete heavily over. Additionally, Datadog just announced a new partnership with Amazon AWS (AMZN), featuring new integrations and direct placement on the AWS Marketplace that will boost the company’s exposure on the world’s largest cloud platform.

There’s a reason why New Relic (NEWR) and other APM vendors have struggled since Datadog came bursting onto the scene, and this strength is well reflected in Datadog’s “beat and raises” each quarter. We do have to ask ourselves, though: is this strength already baked into Datadog’s premium share price?

At Datadog’s current share prices near $142, the company has a market cap of $44.60 billion (making it larger than some Dow Jones 30 components). After netting off the $1.55 billion of cash and $735.5 million of debt on Datadog’s most recent balance sheet, the company’s resulting enterprise value is $43.78 billion.

Meanwhile, for the current fiscal year, Datadog has guided to $1.51-$1.52 billion of revenue, representing 47-48% y/y growth, well above Wall Street’s $1.40 billion (+36% y/y) consensus.

Datadog FY22 outlook (Datadog Q4 earnings release)

Against this revenue outlook, Datadog trades at 28.9x EV/FY22 revenue one of the richest valuation multiples in the software sector (neck and neck with Snowflake (SNOW)), and a richer multiple of revenue than the S&P 500 is trading as a multiple of earnings.

Now, there’s no doubt that for a company at Datadog’s expected ~50% y/y growth pace next year, near-term valuation multiples are a bit more meaningless. But considering there are a bevy of SaaS peers that have lost 40-50% of their peak values and are now trading at attractive valuations (DocuSign (DOCU) and Coupa (COUP) are some recent decliners that come immediately to mind, which I’ve doubled down on in recent weeks), I’d prefer to allocate more of my portfolio to these stocks that have more headroom from a valuation standpoint to snap back.

The bottom line here: Datadog remains the same story as it always has been: tremendous fundamentals for a huge price. Unfortunately, I don’t think this positioning will work well in a rebound scenario, which will likely lift Datadog’s “fallen angel” peers substantially more.

Q4 download

This being said, I’ll willingly acknowledge that Datadog’s most recent quarterly results were nothing short of exceptional, and did deserve to spark the ~20% rebound that followed the earnings release.

Take a look at the Q4 earnings summary below:

Datadog Q4 results (Datadog Q4 earnings release)

Datadog’s revenue grew at a near-unheard of 84% y/y pace to $326.2 million in the quarter, dramatically outpacing Wall Street’s expectations of $291.4 million (+64% y/y) by a twenty-point margin. Datadog’s revenue growth also accelerated meaningfully from 75% y/y growth in Q3.

Here’s some additional commentary from CFO David Obstler detailing the drivers behind the quarter’s outperformance, made during his prepared remarks on the Q4 earnings call. Broadly speaking, Datadog achieved the trifecta of software execution goals: healthy new logo wins, raising usage within the existing customer base, and minimizing churn:

First, growth of existing customers was strong in Q4. And our dollar-based net retention rate remained above 130% for the 18th consecutive quarter.

Usage growth was very strong. Our customers expanded the usage of our largest products meaningfully. Infrastructure monitoring year-over-year ARR growth accelerated from Q3 levels. And the APM suite and log management products remain in hyper-growth mode. And our newer products are all growing very rapidly.

We also saw strong ARR growth in each geographical region. North America, EMEA and APAC all accelerated on a year-over-year basis compared to Q3. Our go-to-market teams delivered a strong quarter in new logos and new logo ARR. We added 1,300 customers sequentially, a new record for us. And new logo ARR was also a record and included our largest ARR land ever, as Olivier discussed earlier [. ] Our platform strategy continues to resonate with customers with 78% of our customers using two or more products, 33% using four or more products and 10% using six or more Datadog products as of the end of Q4.

Finally, churn has remained low. Our dollar-based gross retention rate has gradually improved over the years and is now in the mid- to high-90s, and it’s similar across customer segments and major products.”

The count of large customers, in particular, has swelled as customers raise their reliance on Datadog and add more products/data ingest over time. As of the end of the fourth quarter, Datadog had 216 customers who generate more than $1 million in ARR, versus just 101 in the prior-year Q4.

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Note as well that billings growth also came in at 86% y/y to $408 million. This billings growth pace in excess of revenue, plus the buildup of deferred revenue, is a strong indicator for forward-looking growth.

Margins were healthy as well. Datadog’s already-high pro forma gross margins rose another two points in the quarter to 80%, driven by improved efficiency in cloud costs (though the company expects margins to trend in the high 70s on a permanent basis going forward).

Datadog margins (Datadog Q4 earnings release)

Pro forma operating margins, meanwhile, soared to 22%, up 12 points from just 10% in the year-ago Q4, demonstrating the economies of scale inherent on Datadog’s high gross-margin business as the company scales to ~2x its prior-year size. As previously mentioned, 84% revenue growth and 22% pro forma operating margins puts Datadog’s “Rule of 40” score at a nearly unheard-of 106.

Datadog’s free cash flow in 2021 also tripled y/y to $250.5 million, representing a 24% FCF margin – up from just 14% in FY20.

Datadog FCF (Datadog Q4 earnings release)

Key takeaways

In my view, despite Datadog’s earnings brilliance, it will be difficult for Datadog to shake the fact that it’s already trading at very rich multiples of revenue, especially when many other SaaS stocks that were once as hyped and beloved as Datadog are still trading underwater. To me, the best move here is to remain on the sidelines.

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