Datadog, Inc. (DDOG): What Made Goldman Sachs Give this SaaS Stock a Buy Rating?

We recently compiled a list of the 10 Best SaaS Stocks To Buy Now. In this article, we are going to take a look at where Datadog, Inc. (NASDAQ:DDOG) stands against the other SaaS stocks.

SaaS, also known as software as a service, is one of the biggest and most important industries in today's high technology era. SaaS evolved along with personal computing, and initially, it allowed businesses to make use of software to manage their supply chains, manufacturing, and other business operations.

Software as a service means that a SaaS customer simply needs access to a computer and the internet to use the service. Since the post broadband internet revolution, internet speed and bandwidth have increased to such an extent that consumers can easily stream high definition videos from the comfort of their homes. Simultaneously, businesses are also able to use third party software for functions such as payroll and human resource management. Relying on SaaS for entertainment or business management allows users to access a portfolio of specialized and customized services to suit their requirements without having to invest heavily in equipment or resources.

Additionally, the boom of artificial intelligence products means that SaaS is right at the front of the technological revolution. AI is, after all, software, and most AI users are unlikely to invest in expensive GPUs or hardware to run their models. Therefore, it's only natural that AI becomes an extension of SaaS, with models such as ChatGPT providing users globally with a novel software tool that they can use as they please.

The popularity of Software as a Service (SaaS) stocks has surged in recent years, driven by the widespread adoption of cloud-based solutions across industries. Products like Zoom have become essential tools for businesses, enhancing productivity, scalability, and cost-efficiency. This trend reflects the broader digital transformation that has been accelerated by the global shift to remote work and online services.

Marc Andreessen's influential essay, "Why Software Is Eating the World," published in 2011, foresaw this shift. Andreessen argued that software companies would revolutionize traditional industries by leveraging the internet's power to deliver innovative and scalable solutions. He predicted that every company would eventually become a software company, driven by the need to adapt to the digital age. Andreessen's vision has proven prescient as we witness the dominance of SaaS companies in the stock market. These firms offer subscription-based models that provide continuous revenue streams and foster long-term customer relationships. This business model has attracted investors due to its predictability and growth potential.

The ability of SaaS firms and stocks to benefit from the Internet also means that the sector is quite lucrative. Market research shows that the global SaaS market was worth $276 billion in 2022. From then until 2032, the sector is expected to grow at a compounded annual growth rate (CAGR) of 13.9% to be worth $1 trillion by the end of the forecast period. Individual SaaS stocks, like their broader technology peers, have also seen investors react to AI announcements. Those who have convinced Wall Street of their ability to blend AI into their product portfolios have flourished while others have floundered.

Finally, and before we head to our list of the best SaaS stocks that hedge funds are buying, it's also important to understand how these stocks differ from others. Since SaaS is a high growth industry which prioritizes growth over profitability. Many SaaS businesses follow a "land and expand" strategy. This means acquiring a large customer base initially, even if it means sacrificing short-term profits. The idea is that once they have a sizable customer base, they can focus on increasing revenue from existing customers through upselling and cross-selling additional services. In certain competitive SaaS niches, achieving a dominant market share early on can also be crucial. By prioritizing rapid growth and user acquisition, SaaS companies can establish themselves as the leading player in their niche. This can create network effects, where the value of the platform increases as more users join, making it even more attractive to new customers. As a result, investors typically analyze SaaS firms through their revenue and enterprise value as opposed to their profitability. The enterprise value of a firm is an extension of its market value of equity as it adds the value of net debt that the firm has taken on. Net debt is total debt minus cash and equivalents, and for SaaS investors, one key metric is dividing the EV by the revenue. Generally, a higher EV/Revenue multiple suggests a more valuable company.

This multiple is also affected by interest rates. When interest rates rise, the discount rate used to value future cash flows also increases. This discount rate reflects the time value of money and the potential return investors could earn elsewhere. For high-growth stocks like SaaS companies, a large portion of their value is derived from the expectation of significant future earnings. A higher discount rate makes those future earnings less valuable in today's dollars, leading to a lower present value for the stock. When the interest rates were reduced to historically low levels during the pandemic, SaaS companies took off and traded at median EV/Revenue multiples of nearly 20 in 2021. Before the pandemic, the media EV/Revenue multiple for the publicly traded SaaS stocks was around 11.

After the Fed increased short term interest rates to above 5% in 2022 and 2023, SaaS companies' EV/Revenue multiples contracted sharply. For the last 18 months, the median multiple is hovering around 7. Fed's interest rate policy shift is one reason for this decline; however, declining growth rates is another. SaaS companies used to grow their revenues by around 30% before the pandemic and this figure increased to 33% in 2021. However, we observed a sharp contraction in growth rates since then. Currently, the median revenue growth rate for publicly traded SaaS companies is around 17%.

It isn't just a coincidence that the growth rates of SaaS companies went down as the Fed increased interest rates. Higher interest rates make cost of capital expensive, and this leads to lower demand for capital spending. Higher interest rates also force unprofitable companies into cost cutting because they can't easily raise capital anymore. As a result, most SaaS companies, especially the ones that burn cash at high rates, switch from prioritizing growth to prioritizing profitability.

We believe we are at the end of the "SaaS winter" as the market expects the Fed to start cutting interest rates later in 2024. This means the dynamics that led to lower valuation multiples and lower growth rates for publicly traded SaaS stocks will reverse and we will see higher stock prices for SaaS stocks. The average return of hedge funds' favorite 10 SaaS stocks is -10% in 2024 and underperformed the market by nearly 25 percentage points so far this year. We don't know when the perfect time to buy these SaaS stocks is, but we believe this is a good time to establish entry positions in these stocks as these stocks will start to recover their losses after the Fed starts to cut interest rates.

So, with these details in mind, let's take a look at the best SaaS stocks to buy now according to hedge funds.

Our Methodology

To make our list of the best SaaS stocks, we first made a list of the top 30 SaaS stocks in the US by their market capitalization. They were then ranked by the number of hedge funds that had bought the shares in Q1 2024, and the top SaaS stocks were selected. Why do we care about what hedge funds do? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points (see more details here).

A close-up of a laptop with a software engineer coding on the monitor.

Datadog, Inc. (NASDAQ:DDOG)

Number of Hedge Fund Investors In Q1 2024: 77

YTD Return: -2.9%

Datadog, Inc. (NASDAQ:DDOG) is a diversified enterprise SaaS company that enables customers to monitor their systems performance, threat logs, and other aspects. The firm's shares slipped by 11% in May after its latest earnings report presented a mixed bag of results. It saw Datadog, Inc. (NASDAQ:DDOG) beat analyst EPS estimates of $0.34 by posting $0.44 and revenue estimates of $590 million by posting $611 million. However, investors were disappointed as billings of $618 million missed estimates of $623 million and it announced a leadership transition in the form of a new president. Goldman Sachs kept a $143 share price target and a Buy rating in June 2024, after it was impressed by CEO Olivier Pomel's belief that Datadog, Inc. (NASDAQ:DDOG) stands to benefit from AI due to increasing IT complexity which can drive a 20% long term growth rate.

The average of 34 one year analyst share price targets for Datadog, Inc. (NASDAQ:DDOG) is $147.34. This marks an upside of 25% over the recent closing price of $117.84. The three year annualized revenue growth rate is 52.22%. Baron Funds mentioned Datadog, Inc. (NASDAQ:DDOG) in its Q4 2023 investor letter where it shared:

Many of our companies have been reporting on customer consolidation trends and rising win rates against competitors. In its their most recent quarterly conference call, Datadog described a customer who replaced seven different tool providers with the Datadog platform and another one who replaced a dozen different tools and moved to Datadog.

Overall DDOG ranks 6th on our list of the best SaaS stocks to buy. You can visit 10 Best SaaS Stocks To Buy Now to see the other SaaS stocks that are on hedge funds’ radar. While we acknowledge the potential of DDOG as an investment, our conviction lies in the belief that AI stocks hold greater promise for delivering higher returns, and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than DDOG but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.

 

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Disclosure: None. This article is originally published at Insider Monkey.