An Update - Datadog

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The situation today

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While we no longer hold Datadog (DDOG) in our public equities portfolio, we wanted to highlight its consistently outstanding business execution in increasingly challenging environments. While its relative valuation has declined considerably along with other long duration, growth oriented equities of all kinds, DDOG’s fundamental performance has been spectacular. Amongst publicly traded enterprise software firms, DDOG and SNOW are perhaps the most impressive examples of land and expand business models. 

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Performance

DDOG’s Q2 2022 revenue was $406M, a growth of 73.9% over the previous year, against a guidance of around $380M or 61.8% annually. DDOG is now well known in the public markets for guiding conservatively and consequently outperforming substantially, but even its low-end guidance would be ambitious for most firms of a comparable size. 

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Development

DDOG continues to invest heavily in research and development, which undergirds the continual expansion into new product lines, which is in turn the basis of its high (>130%) dollar based net retention rates. DDOG’s ratio of R&D to S&M spend is around 1.54; as Peter Offringa of Software Stack Investing points out nearly all other enterprise software companies have ratios below 1. DDOG’s close competitors such as Dynatrace and Elastic have ratios of .46 and .66 respectively. 

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Despite a disproportionately higher focus on research and development than Dynatrace or Elastic, DDOG’s revenue growth is close to twice that of the latter pair. This suggests that its R&D and product driven growth model allows it to spend meaningfully less on sales and marketing, and consequently manifests as a durable competitive advantage. 

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Orthogonal to one’s belief about the risk-reward balance for investing in DDOG at current valuations, it is difficult not to admire the company’s performance. Of future interest is how they manage the slowdown in customer spend that will accompany worsening macroeconomic conditions, something DDOG management has recently highlighted. 

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As an addendum, see our original piece written on 12/02/2021

We liked Datadog, but we had to part from it momentarily

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Shortly after the massive market retrenchments in March 2020, a number of software as a service companies became available to purchase at heavily discounted prices. Knowing that software companies, especially those related to cloud computing, would benefit from a work-from-home environment, positions were taken in a number of these equities, with Datadog (DDOG) chosen as the largest stake. 

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The company was growing its revenue at a breakneck pace of about 80% per year, but its primary attraction was the quality of its product and its excellence in distribution. Since Datadog’s Application Performance Monitoring (APM) service had been used internally at Beaconsfield, there was institutional knowledge about how vital such software is to managing a modern cloud-native technology stack. Similarly, market research, both internal and external, demonstrated that the product was superior to that of its competitors, such as Dynatrace and New Relic, which were correspondingly growing at only half Datadog’s rate. 

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Perhaps even more important was that Datadog was consistently augmenting its product with intelligent acquisitions and product line extensions, which induced existing customers to spend more, resulting in a net dollar retention of 146%. Simultaneously, those acquisitions and product extensions allowed Datadog to more easily attract new customers by offering a synoptic and comprehensive APM platform with the most native integrations to popular cloud services and open source products out of its competitors; developers consequently loved the product’s ease of use. Of particular note was their launching of their synthetic testing service in March 2019, which likely had >95% contribution margins. 

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The Datadog position was disposed of entirely by November 2020, along with most of the enterprise SaaS exposure, having returned ~150% in eight months. While Datadog’s product quality and execution remained excellent, it became clear there were systemic issues in enterprise SaaS stocks. First, the valuations priced in a rapidity of growth that few companies could maintain. Second, it became clear that all the leading enterprise SaaS companies, given their extremely high net dollar retention, were cannibalizing their own growth, since definitionally net dollar retention cannot indefinitely exceed the rate of the growth of their customers’ revenue without taking share from other software spend. By approaching the issue of software microeconomics systematically and selling accordingly, the stake was exited near its all-time high.