If software eats the world, then solutions that help keep coexisting software applications running smoothly should be great pick-and-shovel plays. That pretty much sums up the appeal of application performance monitoring – or APM – which is enjoying a great deal of growth and attention since Cisco (CSCO) stepped in and acquired the leader in this space – Splunk (SPLK).
Our piece on 5 Application Performance Monitoring Stocks looked at how major players in this place often move around Gartner’s Magic quadrant such that leadership can be lost as quickly as it’s been gained. That’s why we often use revenue as a proxy for market share captured. In 2022, Splunk generated the most revenue of the five companies we looked at with Datadog (DDOG) in second place.
Our follow up piece on Datadog vs Dynatrace vs Splunk: The Best Stock Is? concluded that Datadog was the best way to play the APM opportunity, but we already placed our bets on Splunk. Now that Splunk will likely be acquired by Cisco, we’re left wondering how much gas is left in the APM opportunity tank. That’s a key question that needs answering prior to thinking about a Datadog investment.
The Growth of APM
There may not be much blue ocean opportunity left as the top-three players in APM – Splunk, Datadog, and Dynatrace – collectively claim 40,000 customers. If you’re a large company that’s not using an APM solution, you probably have bigger things to worry about, like not keeping up with technological advancements.
Application monitoring isn’t just internally focused, it also helps you diagnose client-facing problems. At least 91 of the world’s 100 largest companies are using Splunk, and 834 firms out there spend more than $1 million a year on Splunk’s platform. Contrast that to Datadog which has 317 clients spending upwards of $1 million. One obvious question surrounds how much spending can be squeezed out of a large client for APM solutions? Is there room for a $10 million bucket? Some pundits think that growth is only starting.
The Complexity Argument
The application performance monitoring market is set to skyrocket within the next five years due to rapid growth in the IT industry.
Credit: TechTarget
Anyone who has troubleshot a software problem using log files knows how valuable a tool would be that could do the same – in real-time. The first generation of APM tools arrived just before the dot-bomb implosion and explored the relationships among databases, applications, and web servers. That’s from an article by TechTarget which points to the second generation of APM tools arriving in the early 2010s with a focus on customer experience and proactive monitoring as opposed to reactive management. Then things snowballed from there.
If you’re beginning to think that the APM descriptor is becoming overused and a bit blurry, you’re right. Organization infrastructures are becoming harder to understand and monitor, so APM vendors are increasing the scope of what they offer. Security is now becoming a thing, and feature creep runs rampant. Look no further than the below slide that graces Datadog’s investor deck.
We’ve talked before about how vendor consolidation will help larger APM firms with breadth crowd out smaller APM tools with a narrow focus. On average, an organization uses 12 different monitoring tools, and TechTarget tells us, “it’s impossible to find one service or company that can do it all.” The more breadth a platform can offer, the more likely it will displace instead of being displaced. Datadog’s breadth is apparent in the number of competitors they cite in SEC filings.
On-premise infrastructure monitoring: IBM, Microsoft Corporation, and SolarWinds Corporation.
APM: Cisco Systems, Inc., New Relic, Inc. and Dynatrace Software Inc.
Log management: Splunk Inc. and Elastic N.V.
Cloud monitoring: native solutions from cloud providers such as Amazon, Google, and Microsoft
Despite a belief that the market might already be saturated, Datadog continues to see new customers contribute to revenue growth. Approximately 60% of year-over-year revenue growth last quarter was from existing customers, and the remaining 40% was attributable to growth from new customers. A look at the pricing section of their website shows a “menu” of offerings that they continue adding to with consistent acquisitions over the years. What also becomes obvious is that anyone with a credit card can quickly become a Datadog “customer.”
Datadog’s ARR
Datadog has managed to land 26,100 customers, a number that’s easier to understand when you look at their pricing page and see that entry-level pricing accommodates anyone with a credit card. Perhaps that’s why we’re not provided annual recurring revenues (ARR), a key metric for software-as-a–service (SaaS) companies. While Splunk provides “average contract length” as a key metric, that’s nowhere to be seen for Datadog. We’re only given the below revenue buckets to gauge how many large clients they have that might be on a contract instead of a credit card.
If 2,990 customers account for 85% of annual recurring revenues, then 23,100 account for $305.4 million in revenues (let’s use last quarter’s revenues annualized as a proxy for ARR). That means 88% of customers are spending an average of $13,215 a year on Datadog. Someone spending $1,110 a month won’t be giving you access to their key decision makers, which is why Datadog’s usefulness needs to sell itself.
The best metric to measure “landing and expanding” would be net retention rate which is simply stated as “greater than 120%” without getting into much detail. Unlike most SaaS firms, they also provide gross retention rate which is “mid-high 90s” meaning just 5% or less customers stopped using Datadog altogether over the past year. Or put another way, 5% of credit cards failed to renew. Perhaps.
Datadog’s business model is reminiscent of Cloudflare which also offers a massive menu of industrial strength solutions to anyone with a credit card. Will a jack-of-all trades solutions provider lose focus on their core competency, or will the breadth of menu offerings entice customers away from other vendors? Cisco seems to think the 500-lb gorilla approach is the way forward..
Cisco’s Big Bet on APM
Cisco’s core competency is the ability to integrate acquired companies, and Splunk will be their largest so far. After their first APM acquisition of AppDynamics in 2017, Cisco has now added to their portfolio its biggest competitor. Since most large companies use Cisco for any number of products or services, upselling those customers is a lot easier than making cold calls. The billion dollars that Splunk spent in 2022 on sales and marketing will likely plummet given they can leverage Cisco’s existing salesforce. It’s the old “2+2=5” synergy in action.
The reality is that most acquisitions don’t result in synergies. At over 8X the size of Splunk with a market cap of $218 billion, Cisco has more layers of bureaucracy that need to be navigated after assimilation is complete. We get the feeling the Cisco/Splunk marriage will lead to a dominant presence in the world’s largest companies, while Datadog can continue expanding unabated in the small-to-medium space. This value proposition might make for a good investment at a fair price.
A Fair Price
Tesla’s recent earnings call talked about using their free cash flow to invest back into the business. This is intuitive in times of high interest rates. If your business is cash flow positive, using that money to fuel growth makes sense when the cost of capital is high. When share prices are depressed and interest rates are high, raising cash is difficult, so companies that aren’t cash flow positive can’t grow easily and become weaker relative to their competitors. Datadog has $2.2 billion in cash (offset by $866 million in debt), a war chest that grows every quarter as the company is cash flow positive. This is a healthy growing business which means shares will command a premium. With all the ambiguity surrounding future growth potential, paying a fair price is a priority.
Plotting our simple valuation ratio over the past four quarters shows a support level at around 12:
Perhaps we set an objective rule and let the market decide for us. If Datadog sees an SVR below 12, we could open a position while concurrently exiting our Splunk position. The thesis goes something like this.
Why Buy Datadog Stock?
The demand for APM will grow as companies become increasingly complex. Cisco is a major player, but they don’t exactly allow people to purchase their solutions on a website using a credit card. Datadog is providing easy-to-access services to a broad set of customers and then upselling them more solutions. Doesn’t seem like they’re stepping on Cisco’s toes much. If the five APM companies we looked at command $8.5 billion in revenues, and the lowest TAM estimate is $50 billion, there’s still room for everyone to grow.
We predicted the industry would see some consolidation and that might accelerate now that Cisco has made their largest bet on APM. Buying Datadog at a fair price means there will be less likelihood that an acquisition of depressed shares will lock in losses on a position.
Conclusion
Datadog seems like the most appealing way for investors to get exposure to APM and whatever else that category might entail as definitions become blurry. There’s a leap of faith required here to believe that a) APM has lots of room to grow and b) Datadog’s breadth will create stickiness and help them steal customers from their diverse set of competitors. While some useful metrics are lacking (ARR anyone?), there is enough data to gauge how well they’re upselling existing clients. Perhaps at the right valuation Datadog will make a compelling addition to our portfolio.