Down 59% in This Bear Market, Can Datadog Recover in 2023?

What happened

Shares of Datadog (DDOG 1.26%), a vendor of cloud-based observability software, have fallen 59% since Jan. 3, 2022, according to data from S&P Global Market Intelligence.

Datadog flew high during the pandemic, as cloud-based software-as-a-service (SaaS) stocks rocketed higher amid rapid digitization and the zero-interest-rate environment. However, the tide turned quickly against expensive growth stocks in 2022. As the Federal Reserve implemented aggressive interest-rate hikes last year, Datadog was never really able to mount a rebound, as rapidly rising rates and fears over a software slowdown continued to plague the stock.

Yet having drawn down nearly 60%, has Datadog suffered enough, and can this rising software star make a comeback?

So what

Even though Datadog’s stock continued to decline throughout the year, Datadog’s business actually delivered consistently solid earnings results. In fact, the company beat revenue and earnings expectations in every earnings release during the year. Still, these positives weren’t enough to overcome macroeconomic fears.

Datadog’s cloud-first platform is clearly catching on with developers and IT departments, who use it to protect and monitor the performance of their cloud-based software applications. With cloud computing still in its early stages and software complexity only increasing, Datadog looks to have a long growth path ahead.

Last quarter, when many of its software peers reported a slowdown, Datadog maintained a very strong 61% growth figure, and expanded gross margin by two percentage points over the prior-year quarter.

Another thing Datadog has going for it is that unlike a lot of other SaaS stocks, it actually operates very close to profitability under generally accepted accounting principles (GAAP) — even figuring in stock-based compensation. That makes it a candidate to potentially bounce back in 2023, whereas some of its more unprofitable peers may have a more difficult time, especially if interest rates stay higher for longer.

Overall, the questions about Datadog aren’t whether it has a competitive product, or whether it has a growing customer base with high retention and loyalty; it has all that in spades. The question is really one of valuation.

Considering Datadog still trades at a lofty 13 times sales, investors have to do a fair amount of guesswork about Datadog’s future growth and profitability to decide whether it’s a buy now. Moreover, they’ll likely need to assess whether interest rates will stop rising sometime soon. Unfortunately, as long as inflation remains high, it’s hard to get a handle on the appropriate discount rate to use for future earnings.

Interested investors should think about constructing their own discounted cash flow model to plug in various assumptions around all of these variables.

Now what

Looking at Datadog, it seems like it should be able to maintain high growth rates for a significant period of time. In my models — in which I try to be conservative on interest rates, decelerating growth, and slowly expanding margins — the stock looks to be fairly valued. That being said, it could be undervalued if we return to a low-rate environment, or if Datadog surprises to the upside on my assumptions about either revenue or terminal profit margin.

There aren’t many unprofitable SaaS stocks I would consider at the moment, but Datadog is one of them. Should inflation come down markedly and the Federal Reserve stop or even reverse its interest-rate hikes, the stock could very well bounce back this year.

For young investors looking to invest in growth stocks, this might be an opportunity to start a position in this A-list software name. Older investors may want to look at more profitable investments in companies that pay out dividends and buy back shares.

Billy Duberstein has no position in any of the stocks mentioned. His clients may own shares of the companies mentioned. The Motley Fool has positions in and recommends Datadog. The Motley Fool has a disclosure policy.