Datadog, Inc. (NASDAQ: DDOG) Summary Research Report
Buy Recommendation
Hi Everyone,
I hope you all had a nice week. In this week’s edition of the Seifel Capital Newsletter, we will review an investment analysis of Datadog. Please reference the detailed analysis here if you would like to learn more. If you read last week’s detailed report on CrowdStrike (linked here), you will see that the I have expanded the Datadog report to include an in-depth review of the company’s products. I anticipate adding a review of analyst estimates and the company’s past performance against such estimates in future reports.
Before we dive in to the analysis on Datadog, please make sure to share this newsletter, share this post, or subscribe (if you have not already) if you like the content! You can use the buttons here to do so:
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With that, please enjoy this report on Datadog, Inc. (DDOG)!
Investment Overview
Executive Summary
Datadog, Inc. (“Datadog” or “DDOG”) is the fastest growing company in a high growth industry, as it is more than doubling the growth of its two closest competitors, New Relic and Dynatrace. The combination of a leading monitoring and analytics platform with the newly released cybersecurity product makes for a holistic offering that adds immediate value to an organizations DevOps. The utilization of machine learning and a simple user interface makes the Datadog product attractive to market participants, as indicated by continued adoption and expansion within the current customer base. Founders Olivier Pomel (CEO) and Alexis Lê-Quôc (CTO) set out to provide full monitoring and analytics of an organization’s entire IT stack, and they are successfully executing on this vision.
Datadog’s cloud agnostic and customer-centric solution serves as the foundation for its ability to execute better than its competitors. The company is benefiting from industry tailwinds, as cloud usage and app adoption continues to grow since these markets are relatively untapped (under-penetrated). While there are certainly risk factors involved with investing in Datadog, Seifel Capital Management (“SCM”) sees the probability of a successful investment outweighing the downsides. The market is not appreciating the sustainability of the company’s growth profile and ability to maintain industry leading margins. This company is the ideal example of an “asset-light compounder,” which can provide a critical service to all enterprises in the modern age.
Company Overview
Datadog is the leading cloud-native monitoring and analytics platform for developers, IT operations teams, and business users. Its SaaS platform integrates and automates infrastructure monitoring, application performance monitoring, log management, and security monitoring to provide unified, real-time observability of its customers’ entire technology stack. It claims to be the first company to allow end-to-end monitoring and analytics. Datadog is used by organizations of all sizes and across a wide range of industries to enable digital transformation and cloud migration, drive collaboration among development, operations and business teams, accelerate time to market for applications, reduce time to problem resolution, understand user behavior, and track key business metrics. Customers are able to process and analyze key metrics and events from its infrastructure, applications, and services by utilizing the Datadog platform. The company is focused on building a solution around “three pillars of observability”: 1) Infrastructure Monitoring, 2) Log Management, and 3) Application Performance Monitoring (APM).
Industry Overview
In its S-1, Datadog estimated its market opportunity to be roughly $35B.
Gartner’s report on Global IT Operations Management Software reveals that the market grew 10% in 2019, reaching $30.9 billion, as cloud-native, best of breed and OSS vendors continue to challenge the market position of established ITOM providers that have declined to an estimated 16% share. Additionally, Gartner believes the market represents a $37B opportunity by 2023.
Gartner adds that enterprises will quadruple their use of APM due to increasingly digitized business processes from 2018 through 2021 to reach 20% of all business applications, and only 5% of applications were monitored as of 2018.
IDC expects global spend on public cloud services, including Infrastructure-as-a-Service (“IaaS”) and Platform-as-a-Service (“PaaS”), to increase from $60 billion in 2018 to approximately $173 billion in 2022 (30% CAGR).
The total proportion of IT budgets currently being spent on the cloud is only 20.1%, a figure that is expected to increase to 43.9% by 2025. Additionally, only 25% of current applications workloads are in the cloud, which is expected to increase to 49% by 2023.
A detailed discussion of the following trends, competitor solutions, and Datadog’s approach can be found in the detailed report. To summarize, the monitoring and analytics industry is changing based on the following trends:
Digital Transformation of Businesses to Stay Competitive: Poor technology performance negatively impacts user experience and results in lost revenue, customer churn, negative brand perception, and reduced employee productivity.
Secular Transition from On-Prem to Cloud Solutions: There is a secular shift from static on-prem IT architectures to distributed, dynamic multi-cloud and hybrid cloud architectures with transient technologies such as containers, microservices, and serverless architectures becoming increasingly common.
IT Challenges Created by Modern Technologies: Technologies such as containers, microservices, and serverless computing create IT environments that are highly dynamic in nature compared to static legacy on-premise environments.
DevOps Collaboration: DevOps is defined as a practice and culture characterized by developers and IT operations teams working together collaboratively, each with ownership of the entire product development cycle.
Legacy Solution Capabilities are Limited: Monitoring and analytics solutions in the on-prem environment were designed to be rigid and static. As such, they fall short of meeting the business needs discussed above.
Not Built for Dynamic Infrastructure
Limited Technology Integration
Not Built for DevOps
Not Built for Cloud Scale
Lack of Advanced Analytics
Pitfalls of Modern Solutions: Modern solutions that seek to solve the issues of the on-prem focused solutions have their shortcomings:
Lack Depth of Visibility and Insight
Disparate Tools Results in Delayed Alerts
Difficult to Install and Use
Rigid and Not Scalable
Datadog: Poised to Capitalize on the New Paradigm
Alexis and Olivier founded Datadog on the premise that the old model of siloed developers and IT operations was broken, and that legacy tools used for monitoring static on-prem architectures do not work in modern cloud or hybrid environments. Datadog’s architecture is fundamental to the company’s successful land-and-expand go-to-market strategy. Specifically, the platform is:
Built for Dynamic Cloud Infrastructures: The platform is cloud-native and was built to work with ephemeral cloud technologies such as microservices, containers, and serverless computing. The data model was built to work at cloud scale with highly dynamic data sets and can process more than 10 trillion events a day.
User-Friendly: The platform is easy-to-use with out-of-the-box integrations, customizable drag-and-drop dashboards, real-time visualization, and prioritized alerting.
Integrated Data Platform: Datadog claims to be the first to combine the “three pillars of observability” (metrics, traces, and logs).
Focus on Collaboration: Datadog provides development and operations teams with a common set of tools to develop a shared understanding of performance and insights into the infrastructure supporting the applications.
Cloud Agnostic: The platform can be deployed across all environments, including public cloud, private cloud, on-prem, and multi-cloud hybrid environments.
Ubiquitous: Datadog is frequently deployed across a customer’s entire infrastructure.
Integrates with Complex Environments: With over 400 out-of-the-box integrations, Datadog users can benefit from a wide variety of SaaS and open source tools.
Powered by Analytics and Machine-Learning: The platform ingests a massive amount of data into a unified data warehouse. Customers can develop actionable insights by using the platform’s advanced analytics capabilities.
Scalable: As a SaaS platform, it is delivered through the cloud and is highly scalable, evidenced by its ability to monitor more than 10 trillion events a day and millions of servers and containers at any point in time.
Investment Thesis
Secular Shift to Cloud Environments: Datadog will continue to take market share from incumbent (legacy) players with static on-prem solutions as companies continue to transition to cloud environments and applications.
Importance of Monitoring and Analytics: Data proliferation is a direct result of the digital transformation and companies will need a monitoring and analytics solution.
Innovation: Given the company’s growth rate relative to its peers, it seemingly has the leading solution in the market and continues to innovate, as recently displayed by its launch of numerous products on August 11,2020.
Customer Base: The company continues to onboard customers at a rapid pace, which has been accelerating. Additionally, the company has extremely low churn (90-95% retention) and has been able to grow within its existing customers due to the aforementioned product expansion and execution of the sales team to cross-sell products.
Great Management Team: Olivier Pomel (CEO) and Lê-Quôc (CTO) founded the company in 2010 after leading the Development and Technical Operations teams, respectively, at Wireless Generation.
Robust Growth: The company was consistently growing top line at +80% YoY for eight out of the previous nine quarters before it released FY Q2 2020 earnings.
Future Outlook: The company’s continuous innovation and market leading solutions, coupled with strong industry tailwinds, will allow the company to sustain above average growth for many years and generate a sustained competitive advantage (meaning ROIC > cost of capital).
Investment Framework
Critical Factors
1. Number of Customers
- Market View: The Street seems to expect a slowdown in FY 2021 to 21% growth, representing an end of year balance of only 16,550 (6% differential to SCM).
- SCM View: SCM forecasts 27.5% customer growth in FY 2021, which would lead to an ending year balance of 17,600.
2. Average Contract Value (“ACV”)
- Market View: Analysts seem to be expecting a dramatic slowdown in FY 2021 Renewal ACV from 32.1% in 2020 to 12.7%. As mentioned below, there seems to be a disconnect between the company’s recent product launches and analyst forward estimates.
- SCM View: SCM maintains consensus view of a 32.1% increase in renewal Total Contract Value (“TCV”) billed for FY 2020, which would result in an ACV of $60K. It is FY 2021 growth that the Street misses the mark. SCM expects 31.5% growth in Renewal TCV (in line with DBNRR). This would result in a FY 2021 ACV of $78.8K.
3. Speed of Cloud Adoption
- Market View: Wall Street may be slightly more conservative in its estimate of cloud adoption, however it is difficult to quantify.
- SCM View: SCM has conviction in the speed of cloud adoption (further discussed in the company and industry overviews), regardless of COVID-19 headwinds or tailwinds.
Conviction Level: Why SCM View is Right
1. Behavioral Advantage: Recent run-ups and subsequent sell-offs post-CY Q2 2020 earnings reports seem to have made analysts more conservative regarding the SaaS space and coming cloud adoption.
2. Analytical Advantage: The company continues to see excellent adoption of the products it released in 2019 (i.e. Synthetics, Real User Monitoring, and Network Performance Monitoring). This has allowed the company to maintain greater than 130% DBNRR. SCM expects continued adoption and performance through 2021 as a result of the recent product launches.
The market is underestimating the growth potential of Datadog and its ability to continue expanding both within its customer base and with new customers, resulting in a muted forecast of new customer additions, flowing through to lower revenue estimates and associated price targets. There has been an error in the processing of information that has been made public through published press releases, conference call transcripts, and financial reporting.
Mispricing Impact:
Customer Forecast: The difference between SCM and Street forecasts of 17,600 and 16,550 end of FY 2021 customer forecasts, respectively, is a net difference of 1,050 customers. At a new customer TCV of $17K (note this is lower than for existing customers due to the nature of a land-and-expand model), this results in a FY 2021 Revenue difference of $17.9MM. At the median EV / NTM Sales Multiple of 31.0x, this difference results in a ~$550MM Enterprise Value differential. This leads to a difference of ~$2 / share in forward price estimates.
ACV Forecast: While the Street expects FY 2021 ACV to come in around $68K for existing customers, SCM forecasts an ACV of $79K for the year. Utilizing the Street’s estimate of 13,800 existing customers in FY 2021 would result in a revenue differential of $152MM. At a 31.0x EV / NTM Sales Multiple, this results in an Enterprise Value differential of $4.7B, or $15.5 / share.
Note: The combined $17.5 / share differential can be tied to SCM’s median estimate of $105.92 less the closing price on 08/20/2020 of $85.78, or roughly $20 / share.
The Catalyst for Each Critical Factor (Calendar)
Number of Customers: Q2 2021 Earnings Report – analysts will release the company is going to handily beat Street estimates by the middle of the year.
ACV Forecast: Q2 2021 Earnings Report – Same as for the customer forecast, the Street will need a couple of quarters to release it is lagging behind on its ACV forecast. Successful product adoption will be a key factor.
Market Cloud Adoption: This will be ongoing with industry reports and surveys.
Risk / Reward
SCM sees the downside being that Datadog’s multiple contracts by as much as 30% to 25.0x, which would result in a price target of ~$86. This is in line with the the closing market price of $85.78, and within SCM’s 5% loss rule.
Additionally, SCM’s FY 2021 revenue growth forecast of 70% could be too aggressive. A downside scenario would be revenue growing only 50% over FY 2020, which would result in FY 2021 revenue of $895.5 (11.5% differential). At $895.5 FY 2021 revenue and a 31.0x median multiple, that would result in a price target of $93 / share. This is still above the current price and should not be a limiting investment factor.
Pre-Mortem and Who’s on the Other Side?
Investment in DDOG failed, what went wrong?
Market multiples contracted significantly.
Datadog’s new products failed to be as successful with customers as previous product launches, reducing product adoption, lower dollar-based net retention, and lower ACV.
Open-source and home-grown technologies gain traction as cheaper alternatives.
The company suffers delays in rolling out more products.
The sales team becomes less effective and is unable to effectively cross-sell as it has in the past.
Server space becomes limited and pricing increases on the company, eating into gross margins.
More competitors enter the space and the product becomes commoditized.
Slowdown in the transition to cloud environments and applications.
Who’s on the other side of the trade and why are they selling? Why could they be right and SCM be wrong?
Institutions seem to have sold the stock after earnings, but the ownership profile is still extremely attractive.
Valuation may have gotten too far ahead of itself, which will require multiple contraction. We have modeled this scenario above and believe the company will still be able to grow into its multiple.
SCM’s belief in Datadog’s ability to differentiate itself through a superior solution and best-in-class go-to-market strategy may be overstated
The market could also have the view that other observability companies and private, venture capital backed firms, pose more of a challenge to DDOG than SCM ultimately thinks they will.
Appendix - Financial Summary and Valuation
