The Sky Is Falling: 3 Cloud Stocks To Buy (NASDAQ:DDOG)

The past year has been rocky if you are a cloud software investor. To illustrate, the WisdomTree Cloud Computing ETF (WCLD) is down almost 40% from its previous high. That compares to 13% for the Nasdaq (QQQ) and 7% for the S&P 500 (SPY).

We are wired to believe that recent returns indicate what will happen in the near term. In this context, most investors would rather avoid cloud software stocks.

According to AAII’s sentiment survey published every week since 1987, only 23% of investors are bullish at the moment. Such a low number is well below the historical averages and a rarity, as pointed out recently by Michael Batnick in his post Nobody’s Bullish.

While I can’t speak for where the market is going (I don’t know), such a bearish sentiment has created better entry points for many outstanding businesses that used to trade at astronomical valuations last year.

• Do they have more room to fall? Absolutely.
• Are they looking increasingly attractive for long-term investors? Certainly.

I don’t waste my time trying to time the market. Members of App Economy Portfolio are familiar with the four simple rules I follow to protect my portfolio.

1. My investments are staged over time (fixed amount every month).
2. I avoid throwing too much at my highest convictions (max allocation).
3. I don’t let myself pile up on my losers.
4. I hold onto my winners for years, letting them take over my portfolio.

I add the equivalent of 1% of my portfolio’s value from new savings every month, usually spread between four to five stocks. So, for example, I bought at the top in February 2021 and at the bottom in March 2020. Over a lifetime of investing, I expect this approach to yield great returns.

While the macro environment is causing a lot of uncertainty, the migration to the cloud has continued its march forward, unabated. As a result, US cloud computing alone is expected to grow at +18% CAGR, illustrating the growth potential ahead for the leaders in these categories.

The three companies I’m discussing today benefit from the increasing scale of data being consumed, growing exponentially. They serve a wide range of use-cases across observability, security, search, and data management.

They just had outstanding quarters with an accelerating transition to the cloud. Meanwhile, they are the most investable they have been in years amid the current market sell-off.

In a world where most businesses are shifting their operations to the cloud, the need for development, operations, and security teams to work together seamlessly has become more critical than ever. Yet, it has historically not been the case. What Datadog wants to achieve is for all departments to see the same problems as they arise and to work together to fix them.

Datadog (NASDAQ:DDOG)

In a world where most businesses are shifting their operations to the cloud, the need for development, operations, and security teams to work together seamlessly has become more critical than ever. Yet, it has historically not been the case. What Datadog wants to achieve is for all departments to see the same problems as they arise and to work together to fix them.

Datadog’s approach is called product-led growth. It’s a business methodology in which the product is the most significant driver of growth (as opposed to sales and marketing). The acquisition, retention, and monetization are all driven by the product experience. The product “sells itself,” if you will.

Datadog prioritizes significant investments in innovation as the go-to-market strategy. At its core, Datadog wants to reduce complexity. This approach applies to many areas, allowing the platforms to expand.

The company has designed products that are easy to adopt. Later on, customers expand their usage or start adopting other products available on the platform. As a result, Datadog has a best-in-class dollar-based net retention, above 130% in the past 18 quarters.

Customers increase their spending on the platform over time. As a result, Datadog can grow its revenue significantly even without adding new customers. Below is a graph that breaks down Datadog’s customer cohorts by year. It’s my favorite way to appreciate how a high dollar-based net retention can compound over time. Each annual cohort of customers is yielding higher revenue over time. It can lead to sustainable growth for a very long time. Twilio (TWLO) has a similar profile.

Datadog Customer Cohort Analysis (ARR, in $ million)

At the end of the most recent quarter, Datadog had:

• 18,800 customers (+32% Y/Y).
• 2,010 customers with more than $100K in ARR (+63% Y/Y).
• 216 customers with more than $1M in ARR (+114% Y/Y).

The success of the company’s platform strategy shows in the number of customers adopting more products over time:

• 78% of customers used two or more products (+6pp Y/Y).
• 33% of customers used four or more products (+11pp Y/Y).
• 10% of customers used six or more products (+7pp Y/Y)

Datadog’s management regularly updated the CAC Payback Period of the company. It’s been around 5-to-7 months. It means that it takes about two quarters for Datadog to recoup its sales & marketing costs via new gross profit generated.

Most public SaaS businesses have a CAC Payback period of more than two years, as illustrated below with Q3 2021 data.

Q4 FY21 Highlights:

• Revenue was $326M (+84% Y/Y, vs. guidance of +64%)
• GAAP operating margin was 3% (+8pp Y/Y).
• Non-GAAP operating margin was 22% (+12pp Y/Y), vs. guidance of 13%.
• Operating cash flow was $116M (+391%), a 35% OCF margin.
• Free cash flow was $107M (+541% Y/Y), a 33% FCF margin.
• Cash and investments on the balance sheet were $1.6B.
• Long-term debt was $0.8B.

Guidance:

• Q1 FY22: Revenue ~$336M (+70% Y/Y).
• FY22: Revenue $1.52B (+48% Y/Y).
• Non-GAAP operating margin 11%.

We have a few important things to unpack.

At this rate, Q1 FY23 might see even more revenue growth acceleration and stay in the mid-80s range (though there is no guarantee). Guidance for Q1 FY22 implies a +6pp acceleration compared to the guidance provided for Q4 FY21.

Let’s put the past year in context:

• FY21 Guidance (February 2021): Revenue $830M and adj. op. margin 5%.
• FY21 Actual: Revenue $1.03B (+$0.2B) and adj. op. margin 16% (+11pp).

Management has a history of underpromising and overdelivering. That makes the strong FY22 guidance even more compelling.

It’s been now three consecutive quarters of revenue growth acceleration. That puts Datadog in rare air. Yet, Wall Street keeps assuming that the company’s revenue will normalize to 30% in the next two years.

If we look at the margin trends, they are exceptional. The gross margin and operating margin improved steadily. In addition, the company is spending less on sales & marketing over time, showing how efficient the go-to-market strategy is.

• Gross margin is improving, at 79%.
• Sales & marketing costs are falling, at 27% of revenue.
• Operating margin is improving steadily, now at 3%.

Datadog spent $164M on stock-based compensation in FY21 (+120% Y/Y). That’s the main difference between GAAP and non-GAAP margins and about 16% of the revenue. The company had an excellent operating cash flow margin in FY21 (28%, +10pp Y/Y). This margin profile is similar to Atlassian (TEAM).

We can summarize the recent results as follows:

• Accelerating revenue growth at +84% Y/Y – showing strength.
• Very high gross margin at 79% – showing long-term potential.
• Falling sales & marketing costs, at 27% – showing scalability.
• Improving adjusted operating margin – showing operating leverage.
• Positive net cash position on the balance sheet and positive cash flow from operations – showing sustainability.

Since the IPO, DDOG has always been an expensive stock if we look at the valuation spectrum. If we exclude the few weeks around the March 2020 bottom related to the market meltdown due to COVID, DDOG has always traded between 30 and 70 times trailing sales.

Despite improving KPIs and the potential for further accelerating growth, DDOG is now trading in the middle of its valuation spectrum, at about 44 times trailing sales. If we focus on forward-sales multiples, DDOG is on the low end of the range of the past two years. Let me be clear: it’s not a cheap stock-quite the opposite. My only point here is that it was never cheap since the company is public.

More context on Datadog’s valuation:

• 43 times FY21 revenue (past 12 months).
• 29 times FY22 revenue estimates.
• 21 times FY23 revenue estimates.

As you can see, even assuming the company merely meets Wall Street’s expectations moving forward, it will “grow into” its valuation multiple pretty quickly. Moreover, given the company’s stellar track record of beating expectations, the company’s revenue estimates for FY22 and beyond are likely conservative.

We could see a continued re-rating of high-multiple stocks in the current macro environment. As a result, DDOG has more room to fall. The best way to alleviate this concern is to adapt position sizing and build a position very slowly over several quarters or even years.

Datadog beat Wall Street’s consensus by 10% on average in the ten quarters since going public.

Datadog has received many awards in recent years and is celebrated as one of the best employers in America.

MongoDB (NASDAQ:MDB)

MongoDB is a top 3 holding in the App Economy Portfolio and almost a 7-bagger since I started my position in 2018. I discussed the company previously on Seeking Alpha.

For decades, relational databases, also called SQL for “structured query language” have been the status quo. SQL was first introduced as a commercial database system in 1979 by Oracle (ORCL).

While the world’s data is changing, with more granularity and complexity than ever before, so does the need for efficient and flexible databases.

MongoDB co-founder Eliot Horowitz explained:

A relational database is fundamentally Microsoft Excel on steroids. Both are made of rows and columns organized into tables or sheets. […] MongoDB takes an entirely different approach. Data is stored in the documents and just like physical medical records, one patient’s document can have 3 phone numbers, two addresses and, 20 prescriptions and can live right next to another patient document that only has one phone number one address and no prescriptions

Since its first release in 2009, MongoDB has offered a new approach to database design, freeing developers from the constraints of legacy SQL databases. It is faster, more flexible, and easier to scale.

The company follows a land-and-expand strategy. Its software is free to download, letting developers learn, use, and build on the platform with limited storage. MongoDB then sells more storage and services as its relationship with customers matures.

The MongoDB database platform reached over 210 million downloads, and there have been more than 1.5 million MongoDB University registrations.

CEO Dev Ittycheria explained in the most recent call:

The core reason for our success is that in an era where there is an urgency to build compelling modern applications, MongoDB reduces the friction and cost of working with data, which is the biggest challenge developers face.

MongoDB has a radically different approach to reduce complexity for developers:

1. The document model is aligned to the way how developers think and code.
2. The architecture is designed to address most use cases through a unified, seamless developer experience.
3. It meets the most demanding requirements for performance and scale.

The evidence that the platform is resonating in the marketplace shows in the customer metrics at the end of Q4 FY22:

• 33,000 customers (+33% Y/Y).
• 31,500 Atlas customers (+35% Y/Y).
• 1,307 are spending $100K+ annually (+34% Y/Y).
• 164 are spending $1M+ annually (+70% Y/Y).

As illustrated by its dollar-based expansion rate above 120%, the strategy is successful. MongoDB makes more money out of the same cohort of customers over time. The company crossed over the $1B mark in annualized revenue run rate only five years after crossing $100M.

MongoDB has remained extremely popular with developers over the past few months, as illustrated by its stable ranking on DB-engines.

MongoDB Atlas, the company’s cloud solution, is its growth engine. It grew +85% Y/Y in the most recent quarter (accelerating), representing 58% of the top line.

More context on MongoDB’s valuation:

• 30 times FY22 revenue (past 12 months).
• 22 times FY23 revenue estimates.
• 18 times FY24 revenue estimates.

As you can see, even assuming the company merely meets Wall Street’s expectations moving forward, it will “grow into” its valuation multiple pretty quickly. Since going public, the company has a stellar track record, beating expectations by 9% on average over 16 quarters.

MongoDB CEO Dev Ittycheria is highly praised by his employees with an approval rating of 98%. The company is regularly featured as a Best Place To Work.

Elastic (NYSE:ESTC)

The search company was the Stock Idea of January 2019 on App Economy Portfolio. At the time, I was cautious about starting a position and wanted to see continued strong execution, which has been the case ever since. As a result, I have slowly built up a ~1% position over several quarters.

You might not be familiar with Elastic, but its real-time search and analytics engine Elasticsearch is very popular with developers. It’s ranked #8 out of 383 database management systems on DB-engines ranking and is a leader in Enterprise Search Software, according to G2 Grid.

Like MongoDB, Elastic is built on a heritage of open source. In 2021, Elastic started a partnership with Confluent (CFLT) (another company built on another open-source software called Apache Kafka) to jointly develop and deliver an enhanced product integration.

Elastic made several big announcements in January 2022:

• Ash Kulkarni (CPO since January 2021) was promoted to CEO.
• Shay Banon (founder) will step down and reassumes his previous CTO role.
• Chetan Puttagunta (partner at Benchmark) becomes Chairman.

Founder Shay Bannon explained:

Elastic is my life’s work, and in my role as CTO, I’ll be laser-focused on innovation and product, and people and culture — where my greatest passions lie.

I’m glad to see Shay Banon stay on board as a CTO, which is his background and probably where he can contribute the most. Elastic Cloud has been on a roll in the past year, and it sounds like Ash Kulkarni had an essential contribution to this success. I’m also glad to see Chetan Puttagunta stepping up in the Chairman role.

If you have missed it, here is a fantastic interview of Chetan Puttagunta on open-source software by Patrick O’Shaughnessy. The podcast breaks down how the few open-source software businesses that succeed turn into tremendous companies. Chetan is an early investor in Elastic and MongoDB.

The resiliency of Elastic’s business momentum throughout the pandemic is proof that Elastic’s stack is a need, not a luxury, for the businesses it serves. More importantly, the rapid rise of Elastic Cloud is giving Elastic a profile similar to MongoDB a few years ago. As a result, I would expect Elastic Cloud to grow in % of the top line, potentially accelerating revenue growth in the quarters ahead.

Among the traits I particularly like when looking at Elastic:

• High insider ownership > 5%.
• Impressive gross margin at 73%.
• Fast revenue growth with previous re-acceleration.
• A path to profitability with signs of operating leverage.
• Capital efficient, with a positive net cash position on the balance sheet.

In its most recent quarter, Elastic has been firing on all cylinders.

The company is on track to cross $1B+ in revenue in FY23 (FY22 ends in April 2022) and expects Elastic Cloud to exceed 50% of the revenue in the next three years.

• 17,900 customers (+30% Y/Y, showing no slowdown vs. Q2).
• 890 are spending $100K+ annually (+33% Y/Y).
• Net Expansion rate was slightly below 130% (slightly above Q2).

Q3 FY22 Highlights:

• Revenue grew +43% Y/Y to $206M (vs. +42% Y/Y in Q2).
• Elastic Cloud revenue grew +79% to $80M (vs. +84% Y/Y in Q2), +16% sequentially, also a sequential acceleration. Cloud is 36% of the revenue (+4pp Y/Y).
• Gross margin was 73% (flat Y/Y)
• Operating margin was -20% (+1.4pp Y/Y).
• Non-GAAP operating margin was 0% (flat Y/Y)
• Operating cash flow was $5M (vs. $19M in Q3 FY21).
• Cash on the balance sheet was $0.9B.
• Long-term debt was $0.6B.

Guidance:

• FY22 Guidance raised to $854M (vs. $829M previously).

The rapid pace of customer additions combined with a steady margin expansion illustrates Elastic’s solid trajectory.

The margin trends have been positive:

• Gross margin has been stable, at 73%.
• Sales & marketing costs are very high but trending down, at 47%.
• Operating margin is still negative but improving, at -20%.

Elastic spent $98M on stock-based compensation so far in FY22 (+49% Y/Y). That’s the main difference between GAAP and non-GAAP margins. The company turned cash flow positive in 2021 and is starting to show some operating leverage.

Q3 FY22 can be summarized as follows:

• Strong top-line growth (+43%) – showing strength.
• High gross margin at 73% – showing long-term potential.
• Stable sales & marketing costs.
• Improving operating margin, showing operating leverage.
• Positive net cash position on the balance sheet and positive operating cash flow margin in the trailing 12 months – showing sustainability

Let’s put the recent growth of Elastic Cloud in context:

Source: Company filings

Elastic is now trading at ~9 times forward sales, which is at the very low end of its valuation spectrum since going public. There was only a short period when Elastic had such a low valuation, during the market meltdown in spring 2020. At the time, the S&P 500 fell by more than 30%.

More context on Elastic’s valuation:

• 10 times past 12 months revenue.
• 9 times next 12 months revenue estimates.
• 6 times FY24 revenue estimates.

I have previously drawn a comparison to how Splunk (SPLK) looked in 2014. Like Elastic, Splunk invested close to 50% of its revenue in Sales & Marketing efforts and was still loss-making. If Elastic continues to follow Splunk’s trajectory, which already assumes a slowdown in revenue growth, the company could double or triple in size in the years ahead. But you will need to give it time and let the story play out.

Of note, Splunk is currently going through a challenging shift in its revenue model, making the comparison in 2020 and beyond less relevant.

Let’s look at other companies involved in the observability space, which goes beyond search and includes security and monitoring.

Elastic is not alone. The observability market includes companies like Datadog, Dynatrace (DT), and more. However, not all these companies are direct competitors, and there is some competition. For example, Datadog uses Elasticsearch as part of its infrastructure.

I think there is nothing wrong with owning both companies in a diversified portfolio. For context, both Datadog and Elastic are loved by the community.

I expect Elastic to see revenue growth re-acceleration via the rise of Elastic Cloud and its continued customer growth (though I could be wrong). Since going public (14 quarters), the company has delivered an 8% average revenue surprise.

Elastic’s multiple already implies that growth will normalize, allowing for surprise and outperformance if revenue re-accelerates.

Elastic has a unique culture and leadership. So far, employees seem to be happy with the leadership change, though the jury is still out.

Hyper-growth and the execution risk

These three businesses demonstrate exceptional growth north of 70% for their cloud segment or overall revenue. But eventually, this revenue growth will decelerate. The Wall Street consensus implies a steep deceleration.

LTM = Last 12 months. NTM = Next 12 months.

The execution risk is more significant for companies currently trading at a large premium. To use a recent example, when DocuSign (DOCU) saw revenue growth acceleration, it benefited from a sizeable multiple expansion from mid-2020 to late 2021. As bookings growth normalized in recent quarters, the multiple dropped to an all-time low.

I would not invest in these companies without a multi-year time horizon. Revenue growth will have fits and starts with deceleration and re-acceleration. Success is not linear, and some quarters will be higher or lower than expectations.

Since there is no way to predict the exact trajectory of these businesses, I believe the best way to invest in them is by controlling three factors:

• Slowly building positions (over several quarters to factor uncertainty).
• Position sizing (an allocation that doesn’t keep you awake at night).
• Time horizon (at least five years to give them time to tell their story).

A high multiple already assumes that a company will have stellar execution for the next few quarters. However, some companies may continue to live up to expectations and more than justify their high premium. We’ll have to see.

We could see a continued re-rating of high-multiple stocks in the current macro environment.

Bottom Line

The sky is falling, with most cloud software stocks trading more than 50% below their previous high.

While most investors are looking the other way, many great businesses in this category are currently offering better entry points for long-term investors willing to build up their position in the face of negative sentiment.

What about you?

• Are you cautiously accumulating shares of great businesses during this sell-off?
• Are you avoiding high-growth companies given the uncertainty of the macro-environment?

Let me know in the comments!