Pulling My Buy Rating From Datadog (NASDAQ:DDOG)

The rally we’ve seen in equities in recent months has been epic. We know tech stocks have led the way to a large extent, and that has been concentrated further in high-growth areas like semiconductors and software. The latter is the subject of this article and specifically, cloud observability company Datadog (NASDAQ:DDOG).

The last time I covered Datadog was about 11 months ago, and I slapped a buy rating on the stock at that point. Shares are up 73% since then, nearly tripling the return of the S&P 500 over that time frame. That’s pretty good if you’ve been holding Datadog, but we cannot go back to 11 months ago and buy it; what does it look like now? I see a mixed picture, so I’m actually pulling my buy rating and going with a hold as we enter the spring months of 2024.

Will the bulls make a stand?

That’s the key question right now on the price chart, as DDOG has fallen back to what is a very important price support level near $118. However, the stock is below the major moving averages, so I’m not entirely sure it’s going to hold.

We can see two successful tests of the ~$118 level in March, and we have a bullish crossover of the PPO histogram in the bottom panel. That shows improving momentum, and with it happening right at support, it seems the bulls are at least going to try and make their stand here.

What I don’t like is the lower highs that are being made, and as I mentioned, the stock is below the major moving averages. Taking all of this into account, DDOG is technically a long candidate above that support level, but I’m not entirely sure it’s going to hold. On balance, I’m neutral on technical picture unless and until support breaks, but let’s have a look at the fundamental outlook.

Growth may be slowing

DDOG is very much in its high-growth stage, characterized by slim profits and heavy investment in customer growth and retention for the future. That works so long as growth continues higher, otherwise, we see investors lose patience and we see valuation multiples compress.

Today, DDOG is seeing more gradual growth rates than it has in the past, and while that’s expected given it becomes more difficult to grow as the base expands, I’m not sure that’s all this is.

Customer growth, as well as the number of platforms each customer uses, are absolutely critical for DDOG.

The number of customers using just 1 product is about 17% today, while we’ve seen excellent growth in the 4+ and 6+ customer segments. While the relatively low adoption rates of 6+ products leaves a lot of room for potential growth, progress here has been slower than I would have thought a year or two ago.

That’s translating to much slower revenue growth, as we can see above. Guided revenue for this year is ~$2.6 billion, but if we look at FQ1 revenue, it’s likely it will be lower than FQ4. That is not what high-growth, high-multiple companies normally do, and while full-year guidance is for strong growth once again, is this the start of something larger? We won’t know for a few quarters, probably, but it’s not a good start to the year.

Pessimism abounds among analysts, as revenue revisions have been mixed, but zero out of 30 EPS revisions in the past three months have been higher. Yikes.

We’ve just seen revenue, but let’s take a look at margins via gross margins and SG&A costs.

Gross margins have gradually drifted higher, but gains have been incremental. SG&A costs over time have come way down, as is typical with growing software companies, but progress has largely stalled there. Indeed, SG&A costs in the most recent 12 months were actually higher than the 12 months ended March 2022. We know DDOG is investing in growth, and you see that show up in SG&A. However, with revenue soaring, I’m disappointed by operating leverage right now.

One final note is on the share count, which management suggests is going to rise about 3% a year due to stock-based compensation.

This is normal, obviously, but DDOG won’t be in a position to buy back stock for a very long time given the way it’s investing in growth, so just expect a ~3% headwind to EPS annually due to higher share counts.

Given this share count headwind, as well as disappointing margins, analysts have been cutting EPS estimates mercilessly.

For instance, 2029 estimates have fallen from almost $9 to under $6 in the past few months. All years are lower than prior, and there’s absolutely no evidence of any kind of improvement just yet. If we consider revenue is essentially not growing in FQ1, and operating leverage has slowed materially, it’s not a stretch to see why these estimates would come down.

A valuation only a mother could love

As I mentioned above, DDOG doesn’t have enough earnings to do a traditional P/E ratio, but we can reengage with the P/S ratio, as we did 11 months ago. Right now, the P/S ratio is ~16X, which is quite elevated against the past year.

The average valuation in the past year has been ~14X, so it’s not egregiously overvalued, but given the fundamental issues we walked through, I want the valuation to be lower than average, not higher. In other words, the stock looks fairly significantly overpriced to me right now given sales growth is slowing.

Seeking Alpha’s Quant Rating shows a Hold rating, and I agree. The valuation is something I’d put better than an F, but I largely see the same issues with DDOG as the Quant Rating does. The end result is the same, which is that I am not interested in owning DDOG here.

I see the risk of a technical breakdown as too high, and I’m not particularly enthusiastic about its fundamental progress in recent quarters. I’m pulling my buy rating and going with a hold as a result.