Datadog Could Potentially Double On Valuation Reflation (NASDAQ:DDOG)

Growth stocks have been obliterated in the past twelve months, much more so than the broader markets. Many of the once highest flying growth names are down 70% or 80% (or more), but it is my belief that we’re on the cusp of an inflection point where Wall Street is going to start buying these names again.

Interest rates topped some time ago and I do not believe we’ll see long-term rates make new highs. The recession narrative is priced in, in my view, so apart from some new shock we’re not yet aware of, the time to accumulate growth is now.

One such name I like for accumulation is Datadog (NASDAQ:DDOG), which I’ve called out before as one of my favorite growth names. Last time I visited Datadog was in the summer, when I incorrectly called it a buy. We’re down over 20% since then, so I was wrong. It happens, and that’s why we use stops.

However, the picture is much improved for growth stocks, and Datadog in particular, so I’m sticking with a buy rating. Permit me to explain.

Finally the bottom?

That’s the big question. I said we had a bottom last time, so I wouldn’t blame you for rolling your eyes at my assertion that we may be bottoming here. I’ll note that Datadog reports earnings in a couple of weeks, and that has the potential to send the stock flying or plummeting with no warning. For now, however, let’s take a look at the current setup.

The solid blue line on the price chart is the major downtrend line the stock needs to clear on a closing basis to truly cement we’ve got a bottom. It’s failed numerous times so far, so that will be the first clue the selling is letting up.

Now, I’ve drawn in a dotted blue line on the chart that shows the multi-month, major positive divergence that’s being put in on the PPO. Basically, a positive divergence is where momentum rises while price falls. This often portends a trend change, as seller exhaustion builds and therefore, the bulls start to outnumber the bears. We have evidence of that here, which I see as a major positive.

On the not-so-bullish side, we have the 14-day RSI failing to make any sort of confirmation of bullishness for several months. Bull moves tend to produce 14-day RSI readings of 80+, but Datadog hasn’t crested 60 for ages. That’s another sign the selling is done; if we can get an overbought 14-day RSI reading, that’s a game changer.

On the 10-day rate of change chart, I’ve drawn in a dotted line at the ~12% mark, meaning the stock has risen 12% in the preceding 10 trading days. That’s where rallies have died recently, and we hit that level on Friday, so this is a spot where the bears should take over and send it lower. Will it happen? We shall see.

Finally, relative strength in the bottom two charts has been awful. Software is down 11% against the S&P 500 since August, and Datadog is down 29% against software in that time. We know growth stocks have been crushed, but this drives it home in terms of magnitude. I do not think this is a permanent impairment, and the value situation has improved markedly because of it. More on that below, but let’s first recap the fundamental story.

So…much…growth

That’s the name of the game here, as Datadog is likely in the early innings of a very attractive growth story. I’ve detailed why I like the business model before, so please take a look if you’re interested; we’ll spend this time looking at the implications of it rather than the model itself again.

I won’t read the snapshot above to you but the impressive things about Datadog include its operating margin above 20%, its 130%+ dollar-based net retention rate, and of course, its 74% revenue growth. The thing is that Datadog could theoretically continue torrid rates of growth for a very long time, given it only has 22,200 customers, and only 2,600 of those generate more than $100k in annual revenue. Given the services Datadog provides are pretty much universally useful to any company, and that it doesn’t have many customers yet, the runway is very long.

Now, the kinds of growth rates we’ve seen in the past have to slow down. There isn’t a company on Earth that can grow at 75% per year indefinitely. However, even “slower” rates of growth, with the prospects of higher rates and a recession priced in, are in the 35%+ range. I believe there could be some upside to these estimates should the recession either be mild, or not show up at all, but for now, 35% growth is a great place to be regardless.

I mentioned the runway for growth, and that’s largely due to customer acquisition. Datadog, over all time frames, shows outstanding customer growth. There is perhaps no better way to demonstrate a product’s value than to show how many people are buying it, and Datadog is fully in growth mode. Customer growth in Q3 of 2022 was ~27% year-over-year, and while the percentage gains may get smaller over time, so long as the company is boosting its customer count by thousands every year, revenue will continue to grow and with it, profitability.

The reason revenue is growing more quickly than customer growth is because the vast majority of customers buy more than one product. We can see 80% of them have at least two, 40% of them have at least four, and 16% of them have at least six. The 4+ and 6+ categories continue to show strong growth, which are going to be Datadog’s best customers. So long as those buckets continue to grow, there’s going to be strong revenue growth.

Here’s a quick look at what that looks like when we combine customer and product usage growth together. Again, don’t get too concerned if growth is slowing down when the base is 75%; that’s obviously unsustainable. The key is whether or not customers continue to grow, and if usage among those customers continues to grow; that’s what I’m seeing.

I mentioned profitability above, and that’s clearly one of the strong suits of a software business. However, it takes scale to build profitability, so let’s check in on Datadog’s ability to turn revenue into earnings. Below we have trailing-twelve-months gross margins and S&GA costs, which are the two primary components of operating earnings.

The gap between the two was 25% at the end of 2019, but was 43% at the end of Q3 2022. That’s the sort of scale and operating leverage we want to see with a software business, and it means not only is Datadog capable of strong profits once it matures, but this level of profitability affords it the ability to invest in the business for years to come. This is a major building block of a sustainable, highly profitable software business, and Datadog certainly checks the box as far as I can tell.

Let’s value this thing

We cannot value Datadog using P/E because earnings are not meaningful yet. However, we can use forward price-to-sales, which I’ve plotted below for the entirety of Datadog’s history as a publicly-traded company.

The stock started life pre-COVID at ~25X forward sales, and briefly hit double that level during the tech buying spree that began after the initial COVID-fueled plunge in stocks. We can see that since the top for tech stocks in late-2021, the valuation has gone from ~47X sales to 11X today. That’s an enormous reduction to say the least, and I think it’s overdone.

If anything, Datadog’s business is much more attractive today because it has proven staying power, it has proven it can operate with increasing profitability, and it has proven it can scale customers to buy more and more as it also adds new customers. I’m not sure what else one could want, but compared to two years ago, this business is much larger, more mature, and more proven. However, the valuation is just one-quarter of what it used to be.

If we get 25X sales again, which is lower than the historical average of 30X, that would be $2.2 billion in estimated 2023 sales times 25, or $55 billion in market cap. That’s 137% higher than the price today, so whether you think that’s outlandish or not is up to you. However, remember that a 65% decline from the highs in 2021 probably would have seemed outlandish at the time as well.

The bottom line is that I think Datadog is too cheap, the chart looks like the bears are finally starting to lose momentum, and I see this as a growth story that could play out for years to come. I’m sticking with my buy rating on Datadog heading into Q4 earnings in a couple of weeks.