Earnings Review - November 5, 2022
Brief market commentary, portfolio company earnings results, and a deeper dive into Datadog (DDOG)
October brought a sigh of relief to the markets, with the three major indices climbing between 5 and 15%.
November, however, has already taken a turn in the other direction.
Big tech has taken a big hit, as large cap technology companies sell off after earnings.
Any company with a weak outlook is being punished by the market with a large drop.
The strong dollar is having a significant impact on top and bottom lines.
Cloud growth was not as strong as expected, as companies are reducing excess usage to optimize their spending. Q3 results are shown below.
The Fed raised rates by another 0.75% at the November 2nd FOMC meeting. The benchmark federal-funds rate is now between 3.75% and 4%.
The market is forward-looking and prices in everything it can today. On the other hand, it takes time for the rate increase to ripple through the economy. There are signs it is beginning to have an effect.
While the median new home price has still been climbing, up 14% y/y to $470,600, new home sales decreased by 11% in September. It takes time for sellers to accept lower prices, as mortgage rates have climbed to above 7%. The first step is fewer deals closing.
The payroll report on November 4th showed unemployment ticked up to 3.7% in October, compared to 3.5% in September. The hot jobs market may be easing up.
While the 0.75% increase was expected, Powell’s commentary came in much more hawkish than expected. Powell suggested the Fed will need to move to higher rates for longer, even though future increases might be smaller.
It is important to recognize that the Fed needs to take a firm stance. The market will react to any glimpse of a potential pivot, which would undermine the entire effort. Powell needs to keep a firm tone up until the moment he switches. It is unlikely to be gradual.
In June 2021, the Fed predicted they would set rates at 0.6% in 2023. Today the rate is 3.75%-4%.
After the first 0.75% hike in May 2022, the Fed mentioned that it wouldn’t be the norm. There have been 4 0.75% hikes in a row in 2022.
The Fed’s hawkish tone is necessary to manage expectations. It doesn’t necessarily paint a clear picture about how things will unfold.
CY Q3 2022 Results
Over the last two weeks, 16 portfolio companies reported earnings.
The weakness in big tech is evident in the earnings results. Companies that beat earnings were not necessarily safe. The market reaction was in large part driven by outlook and cash generation (i.e. free cash flow margins).
Company Spotlight: Datadog (DDOG)
Founded in 2010, Datadog defines themselves as “the monitoring and security platform for cloud applications.”
They provide a software platform that helps software teams monitor their own software applications, bridging the gap between development, security, and operations (“DevSecOps”).
At essence, their software collects a lot of data and makes it easy for people to see what is going on. Examples of types of data includes:
the various workflows required to get code released into production – to help identify any issues (slow builds, failing tests, security concerns, etc)
the software application running in production – to help understand traffic patterns, response times, identify issues (slow pages, bugs, etc)
the machines the software runs on (typically AWS, Azure, or Google Cloud) – to help understand CPU usage and memory usage so that the software doesn’t go down; can be used to optimize resources
… and much more
This visibility is critical to ensure uptime (the application is up and running), satisfaction (things are working quickly and correctly), security (identify and address threats early), and more.
The way software is built, deployed, and monitored is constantly evolving, moving towards more granular independent pieces, faster release cycles, more flexibility, and more oversight.
The more pieces, systems, and people, the more difficult it is to get a meaningful picture.
Datadog helps wrangle in this complexity.
Datadog makes money by selling their software as a service (SaaS). Pricing is transparent and publicly available online.
Their pricing is structured by consumption, allowing Datadog to grow with their customers.
Datadog has been able to consistently deliver new products over time. This ability to continually innovate is key, as it enables them to “land-and-expand” – sell more solutions to their existing customer base.
Their strategy seems to be working.
From the financials:
Revenue growth has been consistently high, ranging from 51-84% y/y growth
Gross margins have been steady in the 78-80%
Investment in R&D makes up a significant portion of the operating expenses. While the elevated level could be worrisome, the fact they have delivered on products is reassuring.
Adjusted EBITDA margins have been expanding over time, doubling from ~10% to ~20+%
Total capital has been maintained. Coupled with the high revenue growth and strong margins, FCF return on invested capital has expanded to low 30’s.
Dilution due to SBC has been measured. 2% dilution in exchange for sticky, durable revenue growth of 60%+ seems digestible.
The following graph visualizes the total capital, revenue, and FCF over time.
Datadog has not only been consistent, but has also exceeded expectations. Ever since their IPO in Sept. 2019, Datadog has beat revenue expectations.
While there is likely some art in managing expectations, the fact they are able to consistently exceed speaks to the predictability of the business. Management is able to forecast effectively.
Datadog has a very clear opportunity for continued growth. The cloud hyperscalers are growing fast off a large base.
Amazon’s AWS is growing 28% with a $82b run rate
Microsoft’s Azure is growing 42% with a $50b run rate
Google Cloud Platform is growing 38% with a $27b run rate
All of the applications running on these platforms are prime candidates for Datadog.
The fact the cloud platforms are growing at such a fast pace off of a large base is promising for Datadog. It is fair to assume Datadog may have 5-10% market share. The opportunity to expand market share in a market growing 30% is attractive.
The driver behind the trend is the fact that everything is running on software. Every company is becoming a tech company. Chipotle, a quick service restaurant, has invested heavily in their mobile app – digital orders now make up 37% of their sales. Starbucks has 17 million members in their rewards program, and mobile ordering made up 44% of their sales. Everything seems to be moving digital – from groceries (ex. Instacart, Safeway), to home appliances and automation (ex. Google Home), to cars (ex. Tesla), and much more.
Alongside other high growth companies, the macro environment has led to multiple compression. Datadog is trading at its lowest multiples ever, 10.4x EV/S and 59x EV/EBITDA.
For a different perspective, the following table shows a set of possible outcomes over the next 5 years.
If Datadog is able to…
Grow revenue 20% per year and trade at a 8x multiple, that would yield a 15.7% CAGR return
Grow revenue 30% per year and trade at a 10x multiple, that would yield a 31% CAGR return
Grow revenue 40% per year and trade at a 12x multiple, that would yield a 46% CAGR return
While it is impossible to predict the future, this framework also seems to imply the shares are attractively valued.
The investment scene has been challenging this year. It can be hard to stay the course.
For me, it is always helpful to remember that equities, i.e. companies, are the primary driver behind forward progress. Companies pay interest so that they can use that money to generate higher returns. Equities, although volatile, outperform over the long-term. That is why I focus my time on understanding company-level performance.
This market is starting to offer some attractive return opportunities.
Torre Financial is an independent investment advisory firm focused on emerging and established compounders.
Disclaimer: This post and the information presented are intended for informational purposes only. The views expressed herein are the author’s alone and do not constitute an offer to sell, or a recommendation to purchase, or a solicitation of an offer to buy, any security, nor a recommendation for any investment product or service. While certain information contained herein has been obtained from sources believed to be reliable, neither the author nor any of his employers or their affiliates have independently verified this information, and its accuracy and completeness cannot be guaranteed. Accordingly, no representation or warranty, express or implied, is made as to, and no reliance should be placed on, the fairness, accuracy, timeliness or completeness of this information. The author and all employers and their affiliated persons assume no liability for this information and no obligation to update the information or analysis contained herein in the future.