Higher Uncertainty of Future Cashflows Priced into Present Valuations of Fast Growers
Heightened skepticism amid declining macro outlook is compounding the free fall of next-generation companies in the stock market. By Benjamin Tan
As transformative and innovative many best-in-class technology companies may be, almost all got pummeled by overwhelming bearishness last week. Even established names like Tesla ($TSLA) and Nvidia ($NVDA) were taken to the woodshed. Newer ones suffered worse declines, regardless of what potential they may have as the next-generation F.A.N.G. It was indiscriminate and all-around brutal. Turn on Twitter and you will see plenty of charts illustrating how many former high-performing stocks are now trading at a fraction of their peaks. Even if one had bought them for fundamental reasons well before their sonic ascensions, the massive drops in 2022 still hurt.
For faithful investors, regardless of entry prices, it is like getting punched in the face. At least that’s how I feel when I open my brokerage app!
Datadog: A High Performer Well-Backed by Long-Term Investors
Take Datadog ($DDOG) as an example. It peaked at $200 per share in November 2021 and since then, it has fallen to around $70. Q3 2022 results (released last Thursday, Nov 3) were strong, especially considering its consumption-based model in a restrained spending environment. Revenue growth exceeded 60% and non-GAAP EBIT margin clocked in at 17.1%. Despite many companies pausing spend as macro conditions deteriorate, Q4 2022 revenue should still grow by at least 40%, if past outperformance above guidance is repeated.
Datadog has multiple attributes of a software company that is fast becoming a mainstay in enterprise technology stacks. Well-positioned in the core cloud infrastructure monitoring market, the company continues to consolidate incremental workloads onto its expanding platform, with DBNR sustained above 130% for years running. An efficient self-serve model makes for rapid adoption (and iteration) of newer products, and its go-to-market sales force is reputed to be among the best in the industry. While they have many SMBs, 85% of its ARR is derived from its $100k+ cohort, thanks to continuing success with upmarket motion and scoring more marquee customers with multi-million dollar contracts. Having blue-chip customers is an important defense in this macro environment, since they tend to endure headwinds much better.
Why is Datadog Share Price Still Underperforming?
With strong fundamentals and healthy cashflows, Datadog is not reliant on capital raises to sustain itself, so current market conditions should not impact its long-term growth plans as far as funding is concerned. It has reached escape velocity with annual revenue in excess of $2bn and cashflow margins above 20%.
If we assume a flat 40% revenue growth rate for the next four fiscal years, and a CFO margin of 30% (from the current 20%+ due to improving leverage) by the end of the forecast period, we are looking at an implied FY 2026 revenue of $6.4bn with CFO of $1.9bn. Applying an EV/CFO multiple of ~25x in FY 2026, forward share price is ~$140, or 7.5x EV/FY 2026 revenue. Not an aggressive set of assumptions, considering its historical financial performance, and how it is now trading above 50x EV/ FY 2022 CFO or 12x EV/FY 2022 revenue. Discounting the share price by 10%, it should end up at ~$95 in today’s price.
Current market is, however, pricing something more dire for Datadog. Granted, extrapolating historical revenue growth into the future requires a leap of faith and we do not know what we do not know. There are plenty of unknowns that lie ahead. How entrenched will Datadog be in the coming years, despite current retention and expansion rates? Even with its track record of displacing competition like Splunk ($SPLK) and New Relic ($NEWR), Datadog may still find itself getting displaced by newer entrants or an existing software company like Crowdstrike ($CRWD) encroaching into the observability space. Many things can happen over the next few years.
A Different Era for Growth Companies
Markets last year had been more generous on how high-growth companies were going to execute into the future. Now, growth plans are discounted by skepticism, in addition to higher interest rates and murkier macros. Never mind how they did in the past and what blue-sky scenarios are shared with shareholders. If Netflix ($NFLX) wants to expand into gaming and advertising, it has to execute and show traction, even if it was the trailblazer that wrote the playbook on our subscription economy. Meta ($META) doubling down on the metaverse is now priced like it is going to destroy value given its potential costs; markets have shrugged off any reward that may transpire with its new pivot.
On the same day that Datadog announced its third quarter results, Cloudflare declared its bold plan to achieve $5bn in revenue in 5 years, alongside a robust set of earnings. Said Matthew Prince, co-founder & CEO of Cloudflare:
Now, we’re focused on the path to organically achieve $5 billion in annualized revenue in 5 years, and we're confident we have the products already in-market to get us there
Matthew Prince is underwriting a 5-year revenue CAGR of almost 40% - in the current macro environment, no less. Rather than pricing in this new upside target, the market sent its stock down by more than 10% in the after-hours.
Talk about getting punched in the face.
Such is the new reality: a “show-me” era. Patience is even more of a virtue among long-term investors now. As long as investee companies are able to execute well, eventual share price will reflect value creation.
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