Datadog (DDOG) shares were on sale after the company reported quarterly results for the second quarter of 2020. Although results managed to beat analyst estimates on both top and bottom lines, they still failed to meet the high expectations of very demanding investors. It is easy to see why. The stock was selling for above 50 times trailing revenues before the report and the market was expecting pandemic-induced strength in product usage, which did not materialize. On paper, the results look great: healthy growth, higher margins, strong net retention, strong product adoption, and more. But customer growth was soft, and there are reasons to believe that the next quarters may disappoint investors and generate downward pressure on the stock price.
Source: S-1 filing
What happened in the quarter?
If you were an investor betting for the pandemic to somehow benefit Datadog in its latest quarter, you would be disappointed. But, if you take into account that Datadog managed to keep a hyper growth rate in a recession, where many software providers are experiencing a slump in sales, then you would understand how great these results were.
Here is a snapshot of the quarter’s performance:
Source: Earnings Release
Revenue for the quarter was $140 million (up 68.3% Y/Y), a number that beat estimates by only 3.4%, a small surprise relative to prior ones (10.6% in 4Q19 and 10.1% in 1Q20). This growth represents a deceleration of almost 20 percentage points over that of the prior quarter. But the most worrying figure is a Q/Q growth of only 6.7%, which equates to a compounded annual rate of roughly 30%. Have in mind that if this trend does not reverse over the next quarters, the stock valuation will shrink considerably.
Here is a chart with the recent trend in revenue:
Let us dig into the two factors that caused the above deceleration.
Datadog generates revenue through a mix of fixed subscriptions and product usage. Therefore, revenue growth is made of:
- Addition of new customers
- Upselling and cross-selling to existing customers (affects net retention rate)
- Increase in product usage by customers (also affects net retention rate)
So, what failed?
Answer: customer acquisition and product usage
During the quarter, the company signed a net amount of ~600 customers, 400 less than the customers acquired during each of the two quarters before this one. And we say “net amount” because the management specified that the gross number of new customers during the quarter was the same as that of the prior one.
The company must have lost an extra 400 customers than its average customer churn per quarter. We believe this increased churn is related to the most pandemic-affected customer cohort (travel, hospitality, etc.) and may continue to be a headwind for growth as long as current conditions prevail.
Similarly, the company experienced a slowdown – or a normalization, depending on how you see it – in product usage from top customers that simultaneously paused further spending on IT and tried to find ways to optimize their investments in that area. The management mentioned that this behavior has repeated a few times in the past. It also stated that companies with large cloud deployments are often doing this, although it tends to happen in isolated cases.
This behavior made the net retention rate to decrease, although it remained above the 130% threshold established by the company.
One thing related to growth that we liked was the strength in product adoption. At the end of the last quarter, 15% of customers were using four or more products, while in the year-ago quarter, there were none. This is a fantastic adoption. And in combination with a high rate of product releases, this is a formula for continuous growth.
Although the pandemic is affecting the growth side of Datadog’s equation, it is helping its margins, as we have seen among other SaaS companies.
As you can see in the chart below, gross margin was 80% during the quarter, an expansion of 5 points from the year-ago quarter.
Items are non-GAAP. Source: Author
Also, operating expenses are decreasing as a percentage of revenue. With the sales and marketing margin contracting, the most (10 points) to 32.6%, as remote sales decreased expenses.
In the same fashion, profitability ratios expanded from negative territory to well ahead positive territory (10%+), a 15-point increase from the year-ago quarter, and, mostly, in line with the prior quarter.
Furthermore, though revenue surprised by a small margin, earnings per share were a hit. EPS beat analyst estimates by 100% on a GAAP basis and a staggering 400% on a non-GAAP basis. Between the pandemic-induced decrease in sales expenses and the natural efforts to boost profitability, the company is delivering very nice figures. And all of this with just 12% of revenue as stock-based compensation, which is very positive given the high growth rate of the company. Seeing Datadog growing so fast without burning cash justifies its high valuation – at least to some degree.
And then, we have a strong balance sheet. The cash balance is $1.5 billion. Outstanding convertible debt stands at $560 million. The debt is payable in 2025 and carries a very favorable interest of 0.125%, which is almost free credit.
Source: Earnings Release
Beyond financials, we like that Datadog continues to innovate at a strong pace. These are the products announced or released during the last quarter:
- Private Locations for Synthetic Monitoring to enable “dev and ops teams to proactively monitor internal applications that are not accessible from the public internet, so they can understand the performance of these applications from any location”.
- Datadog mobile app to provide “access to dashboards, alerts, and integrations with on-call notification systems on the go”. This has been a concern for many customers for some time. It appears that the user interface does not run well in mobile devices, so this may add significant value to the Datadog platform.
- Support for Amazon Kinesis Data Firehose to “enable streaming logs directly from AWS services to Datadog”.
- Datadog IoT agent to “provide visibility into Internet of Things devices”.
- New integrations:
- Amazon Elastic File System for AWS Lambda
- Apache Ignite
- AWS 1-click integration to “automate configuration with AWS services like EC2 and Lambda”
On August 11, the company hosted its annual user conference Dash and added further products to this list:
Do not buy now, there must be better opportunities in the short run
DDOG is one of the most expensive stocks these days. In normal conditions, we would say that it is a buy. But these are not normal conditions, this market is anything but normal.
Right now, DDOG remains with a valuation that somehow implies that everything will be fine in both the next few quarters and the long run. We don’t question the long-term opportunity for Datadog and its ability to constantly expand its total addressable market, as it did in the second quarter and as it did in August with its Dash conference’s announcements. And, as the management pointed out, the pandemic is accelerating the migration to the cloud [once the economy starts to recover].
But we are wary of the near-term prospects. Just what was supposed to be a great performance ended up causing a 20% correction in the stock price. The company experienced weakness in customer acquisition and product usage, which reflected in a loss in revenue growth of 20 percentage points. What if the next two or three quarters are alike? What if Datadog’s annual recurring revenue growth falls to the forties by year end?
As it was mentioned before, the sequential growth in the last quarter was 6.7%, down from 15.5% in Q1 2020, and 18.5% in Q4 2019, and even down from 18.8% in Q2 2019. This was supposed to be a seasonally strong quarter for Datadog, so Q3 2020, which is a seasonally weaker quarter could be worse. And remember, this sequential growth implies annual growth of 30%.
Up to now, a short position starts to make sense. But the management mentioned that July was showing signs of improvement in the product usage matter. The risk that this dynamic continues over the current quarter decreases our conviction in a short position. Furthermore, other SaaS names have been reportedly affected by the pandemic, but investors have opted to add to their position. Such is the case of The Trade Desk (TTD), which provides advertising-related software. TTD is a fast grower but the coronavirus is making revenues to decline.
The last quarter showed the market what is like for Datadog to go through three months amid the pandemic. And investors did not like it. If this performance continues while the pandemic is present in the next few quarters, the DDOG’s price will experience downward pressure. But, as we have low conviction on going short a SaaS darling in the current market dynamics, a neutral rating seems the most appropriate.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.