Datadog (DDOG) is one of the most recent names to debut in the IPO space, and those investors jumping in on its first trading day are now down between 10 to 20%. While there have been a few names that have broken the mold and are trading above their IPO opens, many more prominent names this year have struggled. This has left most IPO investors with buyer's remorse. This shouldn't be all that surprising, given the valuations that many of these names are debuting at.
Datadog is in a league of its own, given its incredible growth rates, but the valuation is hardly palatable, even at current levels. Despite the 20% drop from its opening price, the company is still trading at valuations comparable to where many tech names sat in Q2 1999 of the tech bubble. Based on this, I see the company as high-risk and high-reward at current levels. While a run back to the prior highs is possible, I believe this would be an opportunity to take profits if it occurs before the year-end.
It's been a busy year in the IPO space, with more than 125 IPOs thus far this year. While it's likely that we'll see a drop in IPOs year over year from the 190 we saw debut in 2018, we've seen a record amount of money raised for unprofitable companies in 2019 thus far. The fact that IPO listings are down more than 40% from the 275 names that debuted in 2014, and 70% below 1999 levels would suggest that we are nowhere near frothy levels.
However, looking at dollar amounts raised for unprofitable companies, there's certainly a case to be made that things are a little frothy in the IPO space. Nearly $30 billion has been raised thus far for unprofitable companies in 2019, above the levels of 1999 and 2000. Of note, we still have three months to go, and will likely eclipse this prior record by over 30%. This does not mean that the music has to stop, but it does mean that one has to be more careful if their main arena to invest in is the IPO space.
If we use an inflation-adjusted basis, we are also on track to pass this level. As the below image suggests, $25 billion in 2000 is $37.3 billion in 2019, and the amount raised for IPOs with three months left is just above $30 billion. Therefore, the argument that less money has been raised in the equivalent of 2000 dollars is untrue. So how is any of this relevant to Datadog? We know we're in a hot IPO market with record money flowing towards unprofitable companies, and Datadog is yet another unprofitable large-cap to debut this year. While the company's growth metrics would make even the most influential growth companies jealous, the valuation is still frothy. Despite the 20% correction, we're still sitting at elevated levels. For this reason, it's essential to keep this in mind before chasing the stock. Before digging into the valuation, let's take a look at the company's growth metrics:
(Source: Company Website)
Datadog is a cloud software company that focuses on monitoring services for cloud-scale applications. The company's products provide monitoring of servers, databases, tools, and services through their data analytics platform, Datadog. The company is certainly doing something right, with some of the most impressive revenue-growth rates in the industry. Quarterly revenue growth for the past four quarters has averaged 83%, with revenue in the most recent quarter jumping to $83.2 million, from $45.7 million in the prior-year quarter. Even more impressive, the company has grown revenue on a double-digit basis sequentially for the past three quarters in a row. While sky-high revenue growth rates above 50% are astonishing, sequential growth in the double-digit range is even more impressive.
While these growth rates are outstanding, the issue is that we see some minor deceleration. Revenue growth rates peaked at 116% in Q1 2018, and have since slipped to 82% year-over-year in the most recent quarter. This is entirely normal as no company can sustain triple-digit growth rates forever. However, this deceleration can weigh on a stock if it's priced for near perfection from a valuation standpoint. The blue line in the below chart represents the quarterly growth rate, while the white line represents the two-quarter average. I like to use a two-quarter average for revenue growth rates as it helps to smooth out any lumpy quarters and better dictates the overall trend. As we can see, both are trending down.
(Source: YCharts.com, Author's Chart)
Datadog's Q2 2019 revenues came in at 82% year-over-year with $83.2 million, and this was a positive sign as it suggested the deceleration might have come to an end. However, looking forward to Q3 2019 estimates, this may not be the case. Q3 2019 revenue estimates are currently sitting at $85.1 million, and this is only 66% year-over-year growth from the $51.1 million reported in Q3 2018. If the company cannot beat these numbers by a massive amount, this will translate to deceleration of over 1500 basis points from the Q2 2019 revenue growth rate of 82%.
This would also put a dent in the two-quarter average revenue growth rate, and knock it down 500 basis points from 79% to 74%. Estimates are not set in stone, and there is no guarantee at all they come in at $85.1 million, but the bar is set quite high to avoid deceleration. For Datadog to avoid material deceleration, it is going to need to report $90.4 million or higher in Q3 revenues. This is more than $5 million above the current estimates. While this is possible, as anything is, it won't be an easy feat to accomplish.
Looking at sequential revenue growth, the growth rates have been exceptional, with 20% growth in Q4 2018, 19% growth in Q1 2019, and 18% growth in Q2 2019, respectively. Anything above double-digit growth rates on a sequential basis is astounding, and Datadog has managed to hit these metrics in every quarter since Q3 2017, with 15% growth or higher in four of the past five quarters. However, looking forward to Q3 2019, this sequential revenue growth is expected to grind to a halt.
Based on Q3 2019 estimates, sequential revenue growth looks like it will come in at low-double digits, at $85.1 million, up from $83.2 million in Q2 2019. Even if Datadog were to report $90 million in revenues for Q2 2019, this would still be a more than 1000 basis point deceleration from the 19% in Q2, and high single-digit sequential revenue growth. While still impressive, this is clear deceleration.
(Source: YCharts.com, Author's Chart)
Based on the above growth metrics, Datadog is a hyper-growth company in a greenfield space, and there is a lot of things to like about the company. The issue, unfortunately, is that quarterly revenue growth rates are decelerating on a year-over-year and sequential basis, and this can be a problem for a company's stock when this occurs. This is especially true when the deceleration in quarterly growth rates is showing up at a time when the company is trading at a lofty valuation.
Unless Datadog can somehow report $91 million or better for Q3 2019, we are going to see material deceleration on a year-over-year and sequential basis. For these reasons, investors in Datadog should realize that the bar is set at sky-high levels going into this report. Any miss on the current estimate of $85 million is likely to push the stock to new lows, and this is the risk one takes at this valuation. Unfortunately, the company's prior quarter and year comps are so high that it's created a short-term headwind for the stock.
So why do I think the company is trading at lofty levels? One simple look at current leaders and leaders from the past can give us some clues. Looking at the below table I've built of companies from the 1999 tech-bubble, we can examine prior price to sales ratios to see what was considered as lofty in the past.
(Source: Author's Table, The Internet Bubble)
As we can see, the average price to sales ratio of large-caps as of the end of Q2 1999 leading up to the bubble peak was 86.7x. I believe this number to be less useful than the median, as it is distorted by a couple of names like Priceline (PCLN) and eBay (EBAY) trading at triple-digit price to sales ratios. If we use a median instead, the number is 46.6x price to sales. At Datadog's IPO highs, the company was trading at over 36.5x price to sales, just 20% shy of the median price to sales ratio during the tech bubble. After the 20% correction, the stock is still trading at 31.1x price to sales, above the valuations of America Online, Amazon.com (AMZN), and E-Trade (ETFC) during the lead-up to the tech bubble. On a comparative basis, it's easy to see that the upside is limited, and the stock is close to fully valued even after this fall from its IPO highs.
How about a comparison to recent IPOs in the past two years?
If we compare the company to Slack (WORK), Coupa Software (COUP), and CrowdStrike (OTC:CRWD), the stock is also trading at the highest price to sales ratio among its peers. CrowdStrike peaked at 50x price to sales, Coupa Software has had difficulty breaching the 30x price to sales level, and Slack topped at 36x price to sales. Datadog saw its IPO debut at 36x price to sales and has since slid to 31.1x. As can be seen, there is an invisible ceiling at a 30x price to sales ratio for many tech stocks. Brief trades above this level are opportunities to get out while the going is good. While CrowdStrike lived above this ceiling for two weeks and defied gravity, it didn't last. The stock is now at new lows and 50% off of its August highs.
While Datadog has a great product and incredible revenue growth rates, the valuation leaves the stock as high-risk and high-reward. The fact that Q3 estimates of $85.1 million are forecasting a material deceleration in both sequential and year-over-year revenue growth is not ideal. To thwart this deceleration, the company will need to report $90.4 million or better for Q3 revenues. A miss on the $85.1 million mark would likely see the stock head to new lows below $30.00. For this reason, I see the stock as an avoid at current levels, and a sell into new highs if they occur before year-end. There's certainly a possibility that Datadog has upside long-term, but short term, valuation remains a headwind. Every dog has its day, but it's unlikely 2019 will be Datadog's year as it needs time to grow into its semi-lofty valuation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.