Datadog, Inc. (DDOG) Earnings Call Transcript & Summary

Thanks, David. Hi. So by way of introduction, my name is Kamil Mielczarek, and I'm the Research Analyst Here at William Blair & Company, covering the data and analytics software space. For a complete list of research disclosures or potential conflicts of interest, please visit our website at williamblair.com. We have with us today the Chief Financial Officer of Datadog, David Obstler, joining us virtually; and the Head of Investor Relations, Yuka Broderick. Thank you both for joining us today. Datadog is a leading provider of observability solutions with one of the most efficient sales models in all software and [indiscernible] tech. We see Datadog as a long-term winner and one of the rapidly growing and largely greenfield market today.

So David, for those new to the Datadog story, can you provide an overview of what the company does and what differentiates you from others in the marketplace?

Yes, thanks, and thanks for having us. Datadog provides an integrated observability platform for modern DevOps and cloud environments. The targeted customer base is the DevOp functions for real-time client-facing applications. That platform includes leading products in infrastructure monitoring, in application monitoring, APM and in logs. In subsequent years, we've expanded the platform to include security analytics for DevSecOps and some analytics for the CI/CD world as well. The differentiation of Datadog is that it is a tightly-integrated single pane of glass with the data infrastructure that unites all the data. It is easy to implement. Clients can download their data in a very short period of time and see their metrics, traces and logs in real time. It has industry-leading [indiscernible] integrations, and it also is able to be used in a very ubiquitous way by DevOps, business users and other related parties. The platform has been -- has evolved from its early stages in infrastructure to the 14 SKUs, and keeps expanding from there to benefit the clients.

That's great, David. And following up on that, so when you think about the platform as a whole, can you talk about how it compares to competitive solutions? What does that environment look like? And what is it about Datadog's functionality that allows it to grow at 80% and with 30% free cash flow margin in what is otherwise a tough software environment?

Yes. So Datadog is designed to monitor applications delivered in public and hybrid clouds, and it's used to handle the complexity of modern DevOps. And by that, I mean containers orchestrated by Kubernetes, microservices, et cetera. So that's what its use case is for. It was built for that. And some of the reasons why it's been able to be adopted so frictionlessly is the way the product was designed means that clients can import their data, use our integrations and can be up and live with reports very quickly, so no professional services. It's used and priced on an infrastructure or data model rather than the seat model, so it generally can be used by everybody in the function and related functions. It is a multi-tenant pure SaaS, so all incremental functionality is uploaded and the clients benefit from that. And we go to market with a fairly frictionless bottoms-up where the DevOps customers can be on and using the product, seeing reports and then downloading additional capacity and functionality themselves, which results in very frictionless bottoms-up adoption that has facilitated our growth.

And then maybe we could double click on that pace of adoption. Can you walk us through the go-to-market playbook and the sales motion, and where you're making some of these newer investments?

Yes. In terms of go-to-market, we have essentially 3 sales teams. For our SMB and mid-market clients under 5,000 employees, we have a inside sales land group, supplemented by the second very important group, which is customer success. Customer success takes that new logo and tries to help scale the customer in terms of its use of the product and cross-sell. We also have a traditional enterprise selling group for customers over 5,000. They own the customer relationship, and their mandate is to land with enterprises in the use case I mentioned and then cross-sell products and divisions. On top of that, we have product management, technical solution management, sales engineers that help the client to understand the product and adopt it. In terms of cross-selling, because the product is united, knitted together, and clients can use the products right away, they're able to play with it, experiment it and use their data in it, and therefore, we've had -- as we've given the metrics, very strong upsell metrics. Right now, 75% of our clients who land purchase more than one product and north of that use more than one, and the other metrics in terms of cross-sell are strong and growing.

That's great. And if we think about some of the secular drivers leading to this high level of adoption, we're seeing digitization of businesses, continued strong moves to the cloud, adoption microservices, Kubernetes, et cetera. What inning are we in some of these secular drivers, especially as we think about the sustainability of Datadog's growth and the TAM you're addressing?

Yes, definitely. You're right. You said it right that essentially, at the very core, it's migration to the cloud as well as the development of applications in modern development techniques. And if you look at it, very, very small percentage of workloads today are on the cloud. It's growing quite rapidly. There's disclosure from the hyperscalers indicating this as well, and most applications are not monitored. So we feel we're in very early innings in terms of the deployment of workloads to the cloud. And as you mentioned, digitalization, cloud migration and modern DevOps as drivers of Datadog's growth.

Got it. And you talked about this at your conference that TAM is expanding, growing, I think, to more than $50 billion in the next few years. When you think about your 14 modules -- how should we think about the opportunity in the context of that larger TAM? And you've been able to reach over $100 million revenue within 5 years for some of the longer modules. Like how -- what should the time line look like for the remainder of the business? What's the outlook based on the market?

Yes. We have a history over -- now we've been in existence over 10 years, and we can monitor the cohorts. And one of the great things about the business is that the cohorts, meaning, the analysis of company's net retention, clients net retention over a long period, has stayed upwardly sloping and for a very long period of time. So -- and why? At the core of it, it's workloads on the cloud, which have been growing in terms of new workloads and migration of workloads, and our land is centered around infrastructure. And on top of that, in order to see what's going on, makes sense, understand the performance of applications, research problems, remediate, you need to see the logs and the APM altogether. So essentially, what we've seen is both in terms of existing customers growing their workloads, their hosts, and buy more of the product as well as new customers landing and starting on the journey, we've seen tremendous legs in both of them. And that's produced the net retention, which has been over 130% from -- before the company was public and continues to be very solid, evidencing growth in both use and in products by our customer base over a long period of time.

So coming back to competition, when you think about that market, how much of your new customers are greenfield versus competitive pack-offs? And how has that changed in recent years? Are you seeing a different set of competitors or has it been relatively stable?

Where we are, which is we'd be in real-time customer-facing, modern DevOps applications, we see most of that being greenfield. With new workloads, the largest competition for us is open source, do-it-yourself, and that continues to be a viable source. I think we've seen over time as our platform has expanded that workloads are flowing towards us and our managed platform, and so we very rarely see RFPs. We're not a rip and replace. We're essentially a land and then expand the use case as the workloads develop. And we've been investing in and sticking to our niche, which I mentioned, which is a very large and growing one, which is modern developed workloads in the cloud. And in that area, in that, we see some of the companies that are -- your audience is familiar with as competitors. But really, they all have their own niche. For instance, someone may be more of an on-premise. Someone may be more an APM specialist. But when it comes to the full platform, backed out with full capacity, we think that we've had product leadership and continue to invest to [ dismiss ] that product leadership from competition.

Got it. You've seen a number of competitors over the last few years change their pricing models to maybe better adapt it to the environment workload-based pricing, credit-based pricing, but your ARPU has continued to expand. How do you think about your pricing model going forward? And does the macro environment kind of ? You active thoughts in any way?

Yes. As competitors have changed their pricing model, we've [ stopped ] because our pricing model, and the reason is that works in clients like us. First of all, we don't bundle. We have a very clear set of pricing on our website. Clients can see it. We give them reports, they can understand how they're using it. And they like that and that gives us a lot of information. In addition, we've always designed our products to align with value given to clients. For instance, in our logging product, from day 1, we innovated by not having the majority of the pricing based on ingestion but on usage, on indexing. And that's proven to be very popular with clients and allowed them, again, to associate their cost of the contract to their actually usage. And we help them to understand how they're using it so they can be partners with us in growing that relationship.

Got it. . So when you think about your largest module infrastructure monitoring, I think last quarter, it was close to half of revenue. How should we think about the potential there, the sustainability of growth and maybe the risk of that larger business now decelerating? And then the more necessity for some of the smaller modules to accelerate -- to sustain some of our growth rates going forward?

It's been both. If you look at our -- the piece together the information we've been given, our infrastructure business has been growing very fast. And that is related to the growth of the cloud, the workloads I mentioned and the complexity of the workloads in terms of containers and microservices. So that's been growing at or in excess to the growth of the cloud for some time. Again, I go back to what I said upfront, which is a very small percentage of workloads that are in the cloud, and we see we're in very early innings. So we think that is going to be -- there's a lot of runway when early on. And we've been able to do, as you know from and I just referred to, is we've come up with new modules. We weren't in APM, the logs 5 years ago. And I think with the metrics that we've given of in that period of time between them being over $500 million, that was over a quarter ago. In hyper growth, you're seeing the adoption of those incremental metrics. So I would say both. Why? Because it's a single knit together platform, and our clients really view this as one product with a different functionality. So therefore, there's a lot of synergies in adopting the products together.

Yes. It's great to see the product growth, and you've recently introduced new functionality around security. How should we think about the opportunity there? How do you compare relative to some of the existing security features and that a lot of companies use?

Yes. Most of the security market, as investors know it, is in the areas of endpoint e-mail and network. And that's not where we are, we're in cloud security and application. And so when you look at that sort of spectrum, we're trying to add value to DevOps and provide additional monitoring signals related to security topics, cybersecurity. And so that's where we're focused. We're not looking into their markets. We're focused on our market. What are our assets we have there? We have a group of users in DevOps who are in our platform every day. Secondly, we have the data. We have the metrics, the logs and the traces, and so we see a significant opportunity for us to turn that into additional signals as we're seeing DevOps take on more and more security responsibilities. So that's where we're competing. To date, as we've been building the platform, we've been -- our clients who are most progressive in DevSecOps have been adopting this again in a fairly frictionless way, and that is now in the thousands of customers. And we see some real traction that as we continue to build out the functionality and as the market and demand for security within DevOps grows, we'll be there to add that service to our observability suite.

Great. So given the traction you're seeing, how early are you in investing in the go-to-market strategy and security? What are some of the next steps? And how should we think about the pace of the ramp and pace of investment over the next few years?

Yes. I mean, we're early in terms of the product build and the go-to-market. When you think about it, we weren't in APM. We invested in over 4, 5 years, and the same thing is happening in security. In terms of go-to-market, we have essentially -- because we're right now selling to the same group, the DevOps, we're essentially adopting the same go-to-market. Now, we're learning along the way. We'll have to see. Is this going to require other influences, the CISO or otherwise that might -- that we may need to develop overlay or specialist or product management there? We're learning about that, and we told everybody is we'll let them know, we'll let us -- them know. Certainly based on our efficiency and go-to-market and how we've been able to get adoption, we think there's a tremendous opportunity for increased investment. We just don't know how much that will be required. For instance, if DevSecOps takes the same path quickly as DevOps, and DevOps is using this in a frictionless way. It will be less over left. And if it's a longer burn, it will be more over left.

Got it. Turning to the topic a little bit more top of mind for investors, the macroeconomic environment. We've seen a number of companies report weakness in specific pockets, whether it's Europe or some internet exposure or other kind of industries that benefited from the pandemic. I know you're not giving an update, but maybe you could talk about the downturn in 2020, and how Datadog was resilient where you saw weakness in prior recessions?

Yes. I will say up sort of front, we said at the time of the last earnings release that in the first quarter, we didn't see -- we saw the very effect we didn't -- we had very similar to the first quarter. I would say, to clarify, we service a wide range of industry. So we were not what you call a coded beneficiary, meaning, we have clients who are offering products that were remote work or [ really ] that were COVID beneficiaries, but we're very diversified. So back -- what happened in the second quarter is that our -- some of our products are linked to host, linked into the amount of host purchased in the cloud. And we always have our clients going through optimization as they roll out applications and looking at their cloud environment and figuring out can they consolidate, et cetera, that happens all the time. We do it as well. What we saw in the second quarter is more of our clients do it at the same time, and that resulted in our host-based products, a flattening of the usage. It didn't go down but we had a less of a growth rate of clients using that, and so that's what we saw in that period of time. It was also, we said, concentrated in some of our larger users who were most rapidly developing applications into the cloud, and so that's what happened last time. Again, too early to know and -- this time, but that's what happened in COVID. We quickly recovered from that, and I think we said by Q3 and Q4 that we were seeing more normal usage. And we did have very strong new client adoption throughout, and then you saw what happened last year and into the early part of this year with the acceleration of the growth.

Got it. And to your last point, you're growing at 80% plus for the last 2 quarters now, free cash flor margin is increasing. And despite the macro concerns, you're now increasing your investments in sales and marketing. I think they're up over 50% in the most recent quarter. Why is now the right time to invest? And how should we think about those incremental investments layering into the growth rate over the next few years ?

Good question. We -- I think we said this in COVID, and it's similar. We think there's just a huge market, and we're still not fully deployed in go-to-market. And so throughout the whole period, we've been attempting to invest. We think there's a great return pretty aggressively, and this has been our sort of target type of investment. We think there's tremendous payback. I think what we've gotten better at is how to do it. How to scale, how to invest in recruiting, how to sort of scale up the type of hiring. So we've always invested within our means. You can tell that from our cash flow and our EBIT. We've always been an investment company who has seen very high return in R&D and sales and marketing. And I think over the past couple of years, as we scale, we've got better at doing that. So we intend to layer that in as we have been in recent quarters in the areas which don't have full coverage, or in the enterprise areas where we may have a lot more leverage in narrowing accounts and having our enterprise salespeople concentrate on upselling in certain accounts, or in geographies where we just scratched the surface or an alliance. So there's still a lot of investment here that we think will have a very strong payoff. And don't forget, we think there's a very large opportunity and a long opportunity. So we think that long term, these investments will pay off.

Got it. And then David, you mentioned strong R&D investments as well. I think that organization has done a better job of keeping up with the revenue growth, which I know is tough at 80%. But how do you think about prioritizing investments across the existing platform, the 14 modules and developing new modules at the same time?

Yes. Both. I think that you're right. We have been a strong hirer and retainer. We have a very strong culture in R&D, a lot of interesting projects. We also, I think, have supplemented that R&D head count with acqui-hires, where we're able to bring in teams to supplement our growth, maybe quicken some product functionality. And we essentially want to do both. We want to basically invest in our platform. Many of the things that you're seeing coming out that are making the APMs, with the log suite so strong have been incremental investments that we've been making. At the same time, we see huge opportunities to expand in security in ITSM and the platform itself in CI/CD. So we're doing both. And I think each quarter, we sit down in OKRs and we prioritize as to what we're seeing in the client base. We get very good feedback, what we're seeing in the market, and make those choices on the next areas to expand, and we've been really good at being able to fit in both, again, back to the platform because of the efficiency of adding additional functionality to the platform.

Right. And given the large market, the large opportunity to gain share, how do you think about balancing revenue growth and margins going forward? And how should investors think about the long-term margin opportunity and the path to getting there?

Yes. We gave mid-term guidance or mid long-term guidance at the time of the IPO of 20% to 25% EBIT, and you can see we're pretty much there. That has to do with the top line growth and the way the business is efficient, et cetera. We've -- what we said is we are a prudent investor. We think there's a big opportunity, and our limitation on investment is our ability to execute it, really. So we're going to continue to push that limit. I would say there are some factors that we noted in the earnings call in terms of things that we maybe didn't have last year that might filter in, which might be office expenses and travel and trade, so if we gave the 300 to 400 basis point type of thing. And we still want to reserve the right, and we think we've been pretty good at making those investments to maintain and grow product leadership. But at the core of this, we have a very efficient model and a management team that's been very prudent in living within our means, which has resulted in the type of margin and cash flow that we have.

Right. And when you think about making some of these investments internationally, I think your business outside the U.S. actually accelerated in 2021. What drove that strong growth? And how do you invest to capitalize further on the broader opportunity?

Yes, it's 2 things, and they're both related. The trends towards cloud migrations and DevOps, and we're a little behind in some regions of the world, and we're investing behind. We can't produce that. We follow those trends. And so we've seen the rest of the world catch up a bit, and we've been successful in scaling and building our teams. Our teams were much smaller internationally than they were in North America because we were fitting into the business trend. So we see a lot of growth there. I think we have more growth to do. We're still not mature in terms of deployment of our resources internationally, and see it as a big opportunity in the future.

All right. And you mentioned M&A as a source of potential acceleration and expansion of the product road map. Can you remind us how you balance the decision to buy versus build? And how does the movement to security and the pullback in valuations affect that decision going forward?

Yes. So far, we've -- our decision has largely been around technology talent and the ability to acquire capabilities to accelerate the product road map. We also look at how the team can fit into Datadog, whether they want to be equified and continue on. Many of our leaders in R&D have come from those acqui-hires, and we've been very successful at it, so we look at the people. We essentially tend to go in places where there's additional functionality that, maybe it's a little later in our road map, but we think it's important to deliver to clients. And then immediately, we build that on our unified platform in order to try to maintain the integrity. I would say that we're not adverse to doing a larger acquisition. We certainly -- but it all goes back to the product, the technology and the ability to add to the platform. We're not looking to have multiple -- necessarily to have multiple tangent platforms. Maybe that will be in the case at some point in the future, but it's not at the very center of the M&A. There will be more opportunities probably in the shake out from all of this, but we are pretty -- we have a pretty high bar in terms of the product, the code, the technology and the fit.

That makes a lot of sense. We have just a few minutes left, maybe we can take a few questions from the audience? While you think those over, maybe I can throw one more, David, just more broadly about capital allocation. You have close to $2 billion of cash. What are some of the other uses of cash going forward? Is there a potential -- you talked about maybe a more transformative acquisition. I mean, what are some of the metrics you look at? And how do you think about the bar for valuation? What would drive Datadog to make a more transformative acquisition?

What we said is we want to have the flexibility with our balance sheet, and it's a great time to say that right now. So we don't have to make short-term decisions. We can make investment decisions, whether that be investment in the business or in acquisitions. So we feel good about being able to have that flexibility. Yes, that may have more firepower in this market, so we look at it as flexibility and sort of a dry powder to make acquisitions. We think, again, there are so many opportunities out there that we're glad we have that flexibility to take advantage of.

Got it. And then one maybe on the federal side, can you update us on the status of Datadog trying to penetrate that market? What are some of the next milestones we need to look out for? And how does your FedRAMP status -- how do you expect it to change over the next 1 to 2 years?

Yes. We're mid. It took a long time. It's a long burn. We have a separate instance. We have a sales team in place. We're starting to win business. We mentioned one of them on the earnings call. We'll continue to up -- when the metrics are, are we winning the business? Do we have the right go-to-market right people and the right technology? We think we do. We'll keep everybody informed as that happens. I think that a next step along the way. It could be high impact, that opens it up to other agencies that are more related to intelligence, defense, et cetera. We think there's a big market even where we are, and we're working on it. I think we're beyond the whole thing of sort of we're going to get a customer to and we're now in the go-to-market phase, try to win some contracts.

Got it. And just in a last minute, it's a high-level question. As you think about Datadog over the next 5-plus years, what's going to be most different about the business? What do you think investors most underappreciate about the model?

Well, one thing I think is when we talk about the other areas we're going into in security, which could be very important, but there is a huge market and a very rapidly growing market in observability. When you think about the amount of workloads that could go to the cloud, this is a very large opportunity that we're in earlier innings of. So I think that that's one thing. Everybody likes the shiny new penny, but -- or nickel or a quarter or have -- whatever. But we -- this business, that's one thing. And I know everybody appreciates the fact that we've expanded our SKUs and grown that. But underneath of that, there's a whole lot of functionality that's being launched to clients every month. So this is an ongoing thing to maintain this leadership and grow it. Takes the kind of R&D group we have and the fact that we are a product-centric customer-led type of company, I think, is a very strong place to be in this market. So those are some of the things that I know people know, but to remind them of.

That's a great place to end it. Thank you so much, David. Thank you, Yuka, for joining us, and thanks to all the clients for supporting William Blair. As a reminder, we do have a breakout session in the Richardson room upstairs, so looking forward to seeing all of you. Thanks again..

Thank you for having us. Thank you. Appreciate it.