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Datadog Inc: A Best-in-Class SaaS Company?

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As a B2B (business-to-business) cloud software provider, Datadog Inc (NASDAQ: DDOG) may not be a household name to non-developers and IT engineers.

However, it definitely caught my attention.

The monitoring and analytics platform for developers, IT operations, and business users is one of the fastest-growing software-as-a-service (SaaS) companies and has some of the best-in-class metrics to boot.

Despite less than a year as a public company, Datadog’s share price is already double from its first trading day in September 2019.

In this article, I share my thoughts on Datadog.

A Huge Market Opportunity

Companies that house their data in the cloud can end up with a complex web of data and information that is difficult to monitor.

This is where Datadog’s platform can help.

Source: Datadog IPO prospectus

It provides monitoring services across public cloud, private cloud, on-premise, and multi-cloud hybrid environments.

Datadog estimates that the IT Operations Management market will represent a US$37 billion market opportunity in 2023, with the company’s services addressing US$35 billion of that.

Compare that to Datadog’s 2020 first-quarter annual revenue run-rate of around US$524 million, and you can see just how much potential lies ahead.

Growing Into Its Own

Datadog is doing a great job in executing its growth strategy.

The SaaS company saw its revenue grow by 98% and 83% in 2018 and 2019, respectively.

Source: Datadog IPO prospectus

In the first quarter of 2020, revenue increased by 87% year-over-year as the number of large customers (with an annual run rate of US$100,000 or more) surged to 960 from 508 a year ago.

Moreover, management expects revenue to increase to between US$555 million and US$565 million for the whole of 2020.

Growing Customer Base

But, to me, the most appealing thing about Datadog’s business is that the company has some of the best-in-class metrics for SaaS companies.

Datadog has recorded gross margins of 75% to 77% over the past three years and even had positive GAAP (generally accepted accounting principles) operating income in the first quarter of 2020.

Recording a profit is pretty amazing for a company that is growing as fast as Datadog is.

The reason why Datadog can be so operationally efficient even at this high rate of growth is that it has one of the best-in-class customer acquisition cost (CAC) ratios.

The CAC payback period, an inverse of CAC ratio, measures how long the company takes to earn back the marketing dollars spent to acquire a new customer.

It is calculated as the implied annual run rate gross margin from new customers divided by sales and marketing spend of the prior quarter.

Alex Clayton, general partner at venture capital firm Meritech Capital, recently provided a fantastic chart comparing Datadog’s CAC payback period against other listed SaaS companies (note, the lower the number, the better):

Source: Medium.com article by Alex Clayton

From the chart, you can see that Datadog recovered all its marketing cost to acquire a new customer in around 10 months.

That’s only behind video-conferencing software provider Zoom, and well below the 30-month median for SaaS companies.

Customers Spending More on Its Platform

Datadog’s existing customers also continually spend more on its platform.

In the first quarter of 2020, Datadog’s dollar-based net retention rate (DBNRR) was above 130% for the 11th consecutive quarter.

The DBNRR measures the change in spending for all of Datadog’s customers a year ago compared to the same group of customers today; it includes positive effects from upsells and negative effects from downgrades and customers who leave.

Datadog charges customers base on usage, so the more users (the customer’s employees) that use the platform, the more the customer pays Datadog.

In addition, Datadog has consistently introduced more products on its platform.

Datadog uses a land-and-expand growth model. The company first wins customers over to use one product before cross-selling other products to them.

The chart below, taken from Datadog’s IPO prospectus, shows the annual revenue run rate of cohorts (customers that started using the platforms) from 2012 to 2018:

Source: Datadog IPO prospectus

As you can see, each colour on the graph fattens over the years.

This means that the cohorts are collectively spending more money on Datadog’s platform.

Robust Balance Sheet

Datadog raised around US$648 million during its September 2019 IPO.

As of March 2020, Datadog had US$794 million in cash, cash equivalents, and marketable securities and no debt. This is a great financial position.

In addition, Datadog announced in late May 2020 that it is raising US$650 million through a convertible note offering. The conversion price of US$92.30 per share represents a 21% premium to the company’s share price at the time of writing.

The offering should further strengthen Datadog’s balance sheet. The convertible price after five years should not dilute shareholder interests by too much as well.

As the company is already free cash flow positive (more on this below), I expect management to use the new-found cash to make strategic acquisitions to improve its core offering or invest in R&D to launch new products.

Free Cash Flow

As mentioned above, Datadog is already generating free cash flow.

In fact, the company generated positive operating cash flow in 2017, 2018, and 2019; and had positive free cash flow in 2018 and 2019. In the first quarter of 2020, Datadog had US$19.3 million in free cash flow.

That’s equivalent to a free cash flow margin of 14.7%, decent for a company that is seeing such strong growth.

As the company grows, I expect Datadog’s free cash flow margin to widen and easily settle at 30% or more.

History of Successful Innovation and New Product

Much of Datadog’s success has come from its constant innovation and creation of new products.

The firm initially offered just infrastructure monitoring but soon expanded its service to monitor the entire technology stack.

This single pane view of the entire technology stack proved extremely popular and is one of the reasons why the company’s DBNRR is so high.

Going forward, innovation and technology upgrades will be key in ensuring that Datadog maintains its market position in this highly competitive space.

Final Words

Datadog has the potential to become one of the top dogs in its industry.

But there are also risks such as execution risk and the threat of competition.

It’s also hard to ignore Datadog’s extremely rich share price: the company’s market capitalisation is around 45 times its annual revenue run rate (based on revenue for 2020’s first quarter).

This means that a lot of Datadog’s future growth is already being baked into its share price.

However, if Datadog manages to fulfil its potential and captures just 10% of its market opportunity, I think its future market capitalisation will be much higher than it is today.

Moreover, given its recurring income stream, position as a leading player in its space, high margins, operational efficiency and history of innovation, I think Datadog has a good chance of rewarding shareholders five to ten years down the road.

This article first appeared on The Good Investors and is part of a content syndication agreement between The Good Investors and Seedly.

The Good Investors is the personal investing blog of two simple guys, Chong Ser Jing and Jeremy Chia, who are passionate about educating Singaporeans about stock market investing.

If you have any questions about this stock and other stocks in general, why not head over to the SeedlyCommunity to discuss them with like-minded individuals?

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