Datadog (NASDAQ:DDOG (NASDAQ:DDOG)) is one of the best growth investments I have found in recent months. It is on the path to expand its net margin significantly after already proving great strength in its free cash flow generation. While its valuation ratios are high compared to the wider industry, historical market sentiment and the likelihood of strong growth in the medium-term to long-term horizon reveal evidence that a high valuation will be sustained. Based on my valuation analysis and growth estimates, I anticipate the companys market cap will increase by 23.2% over the next 12 months.
Operational analysisDatadog is a leading cloud-based monitoring and analytics platform designed to provide comprehensive visibility into an organizations IT infrastructure. Its key offering is a unified platform combining over 700 integrations to monitor infrastructure and application performance, including AWS (AMZN), Microsoft (NASDAQ:MSFT) Azure, and Google (NASDAQ:GOOGL) (GOOG) Cloud. Its platform is used by developers, operations engineers, security teams, and business executives, among other professionals.
This is a growth investment, and the growth thesis is supported by its land-and-expand model. This strategy helps the company to focus on initially acquiring customers with one or two products and then expanding their usage across more products over time. Datadog's dollar-based net retention rate is over 130%, indicating that the company is successfully increasing revenue from its current customers through upselling and cross-selling, more than offsetting revenue losses due to customer churn or contraction. As of Q2 2024, 83% of customers use two products or more, 49% of customers use four or more products and 11% use eight or more products. As these metrics have been expanding over time, this outlines a very strong growth horizon.
There are several competitors to Datadog in the cloud-based monitoring and analytics field, including Dynatrace (NYSE:DT) and Elastic (NYSE:ESTC (NYSE:ESTC)). There are other competitors, including New Relic (but it has been acquired by Francisco Partners and is no longer publicly listed) and Splunk, which has been acquired by Cisco (NASDAQ:CSCO). Therefore, the focus of this articles peer analysis will be on Dynatrace and Elastic in comparison to Datadog. Both Dynatrace and Datadog compete directly in the observability space, offering application performance management, infrastructure monitoring, and log management. Elastic competes with Datadog in log management and analytics; Datadog has a more integrated platform for full-stack observability, but Elastic more heavily emphasizes flexibility in data analysis.
As Datadog is currently the largest of the three companies by a significant margin, it arguably offers stronger security in the investment thesis on an operational front. However, it is the most richly valued, opening up volatility risk, which I will outline in detail in the following section.
Before that, it is important to understand the growth horizon of these companies in the context of broader industry trends. IT workloads are increasingly moving from on-premises systems to cloud environments, positioning Datadog well. The company is continuously innovating, including recently offering its LLM Observability for AI applications, which will help the company capitalize on the 12.2% global market CAGR for data observability from 2024 to 2030 forecasted by Grand View Research. Among broader trends in digital adoption and the scaling of AI workloads, I consider Datadog and companies like it to be very strong investments on an operational front. However, the caveat with the investment thesis comes in the fact that the market is already well aware of the long-term opportunity here.
Financial and valuation analysisCurrently, the consensus is that Datadog will achieve a 22.2% annual EPS without non-recurring items growth rate over the next three years. The consensus is also that it will achieve a 23.4% annual revenue growth rate over the next three years; this is a significant contraction from the 44.6% revenue growth rate achieved over the past three years.
However, the company is likely to show strength in earnings moving forward, as it has only recently turned profitable in 2023. Prior to this, the company had strong and rapidly growing free cash flow, which is an element of the business I am very confident in, largely supported by stock-based compensation. While I understand some investors will not like the dilutive effects of this on shareholder value, I see it as a viable long-term investment in the companys workforce. The free cash flow generation is a strong sign of internal efficiencies, which I believe will positively compound and reflect in the companys net income in future years.
In terms of valuation, I consider Datadog to be reasonably valued right now, even though its valuation multiples are high relative to the broader software industry. The companys price-to-free-cash-flow ratio of 66.6 is a significant contraction from historical levels, which is to be expected given its strong growth in this area. However, its price-to-sales ratio shows a much less significant contraction. Additionally, its undervaluation is evidenced by its EV-to-EBITDA ratio, which is currently 15.7. In fact, when charted on a three-year basis, it is clear that the stock is undervalued based on all three of these metrics right now. Furthermore, as I expect slower top-line growth for Datadog moving forward compared to historically, the undervaluation isnt as stark as the following chart initially indicates. Much of the high-growth thesis will be dependent on how management maximizes internal efficiencies to drive net income and free cash flow. Given its recent track record in free cash flow generation, I am quite confident in the companys capability in this regard.
I estimate Datadog could achieve a 25% EPS without non-recurring items growth rate over the next three years, slightly higher than the consensus. Based on the chart I constructed above, I dont think it is likely that the price-to-sales ratio will contract much, but the price-to-free-cash-flow and EV-to-EBITDA ratios are likely to contract further and significantly. I would like to see a slight contraction in the free cash flow margin now in favor of an expansion of the net income margin, as I believe this would help to support sentiment in the market more strongly. This could be achieved by tapering stock-based compensation moving forward, which I believe to be favorable at this time to avoid too much share dilution. If management adopts this strategy, the free cash flow margin may contract to 26% over the next 12 months, and if the company has total revenues of $3.2 billion in December 2025 (which is my forecast aided by the consensus), its free cash flow will be $832 million. If its price-to-free-cash-flow ratio is 60 at that time, the companys market cap will be $49.92 billion. This indicates a 23.2% growth from the current market cap of $40.54 billion.
Peer and risk analysisI mentioned Dynatrace and Elastic above, and increasing competition in the market could put pressure on Datadogs pricing. Moreover, as services surrounding the cloud markets are incredibly popular right now, companies like Datadog are highly vulnerable to commoditization as the market becomes more saturated. This is another area where the company could suffer in terms of pricing, putting pressure on my free cash flow-oriented market cap target outlined above. Such a competitive market is also likely to require higher levels of innovation to sustain growth, increasing R&D requirements and potentially lowering margins over time as a result.
All three companies offer strong investment opportunities right now. However, Elastic has the best price-to-GF-Value ratio. This means that the stock is likely to have the greatest near-term upside based on GuruFocus valuation algorithm.
However, the highest growth is most likely to be achieved by Datadog, and I believe this is primarily what makes it the most attractive long-term investment at this time. This is indicated in its historical revenue growth compared to its peers. Based on all of these elements, I consider Elastic the best investment of the three for value-oriented investors and Datadog for pure-growth investors.
There is also an important broader industry risk that affects all three of these companies, which I believe is worth mentioning. The observability market is becoming saturated with specialized tools. Therefore, this opens up an opportunity for smaller players to capitalize on distinct market needs with more tailored solutions. If Datadog and large companies like it are not careful, this could significantly fracture their market share over time. Datadog does offer distinct services that can be purchased separately, and its tiered pricing model is also consumption-based, so management has definitely worked to create a cost-competitive business model here for its customers. That being addressed, the threat from emerging smaller players in niche areas remains, and this is a challenge that could be compounded by novel AI software development capabilities.
ConclusionAs far as growth investments go, this is one of the best I have identified recently. I believe the company has shown a strong indication of long-term profitability through its rapid free cash flow generation. Furthermore, I consider its valuation to be appealing compared to the historical sentiment that the market has held for the stock. Based on my free cash flow-oriented market cap target, the company may have a market cap of $49.92 billion in approximately 12 months. However, industry competition is likely to increase over the coming years, which could pressure its margins and reduce its future growth rates considerably.
This content was originally published on Gurufocus.com
