Nvidia shares have rocketed 255% over the past year, propelled higher by the enthusiasm surrounding artificial intelligence (AI). However, the company currently earns most of its revenue from AI hardware, a market that Ark Invest believes will be 21 times smaller than AI software. That estimate seems plausible, given that businesses buy chips and other data center hardware infrequently, but those products can power numerous applications for several years before they must be replaced.
Building on that, Sanjit Singh at Morgan Stanley sees Datadog (DDOG 0.07%) as one of the software companies best-positioned to benefit from generative AI. Alex Zukin at Wolfe Research expressed even more conviction in a note to clients last year. He said generative AI tailwinds could make Datadog the “fastest growing software company.” If that prediction comes true, Datadog would arguably be the single best AI software stock to buy.
Of course, investors shouldn’t put all their chips on any single company. The best strategy is to buy a basket of AI stocks, and Datadog deserves a place in such a basket.
Datadog is a leader in observability software
Datadog sells observability software for development, operations, and security teams. Its platform includes 19 modules that provide real-time visibility into IT infrastructure, helping businesses resolve performance and security issues that impact their systems, applications, and services. The platform is supported by an artificial intelligence engine called Watchdog, which continuously analyzes billions of data points to surface proactive alerts, automate root cause analysis, and accelerate incident remediation.
Datadog has received high praise from industry analysts. Most notably, Forrester Research ranked the company as a leader in AI for IT operations, and Gartner recognized the company as a leader in application performance monitoring. Beyond that, peer reviews accessed through G2 paint Datadog as a strong contender in several other observability markets, including cloud infrastructure monitoring, server monitoring, and database monitoring.
Going forward, growing demand for AI software should be a tailwind. Datadog has added integrations that support performance monitoring at every layer of the AI stack, from graphics processing units to machine learning models. It also launched LLM Observability, a performance monitoring solution built purposely for large language models.
The company also introduced a generative AI copilot called Bits AI, which helps businesses investigate and respond to incidents more quickly.
Datadog reported encouraging financial fourth-quarter results
Datadog looked strong in the fourth quarter. Customers climbed 17% to 27,300, and the company reported a net retention rate in the mid-110% range. This means the average existing customer spent at least 10% more.
In turn, revenue increased 26% to $590 million and non-GAAP net income soared 112% to $156 million. Management said its platform strategy — the fact that Datadog integrates nearly two dozen products — continued to be an important growth driver.
Also noteworthy, the remaining performance obligation (RPO) increased 74% to $1.8 billion. RPO measures sales pipeline momentum, and the rapid expansion seen in the fourth quarter indicates that revenue growth could accelerate in the future. On that topic, JPMorgan Chase analysts said Datadog grew RPO at its fastest pace in two years and called it the best inflection in bookings across their software-coverage universe.
That is only one data point but supports the idea that Datadog could be the fastest-growing software vendor as the AI boom unfolds. The company is certainly building momentum in that area. CEO Olivier Pomel said AI native companies accounted for 3% of annual recurring revenue in the fourth quarter, up from 2.5% in the third quarter. Additionally, the use of AI integrations increased 75% sequentially in the fourth quarter.
Datadog has big tailwinds at its back and the stock trades at a tolerable price
To summarize, Datadog has a strong presence in several observability software markets, including AI for IT operations and application performance monitoring. The company is also leaning into demand for AI with new products and integrations that accelerate incident investigation and support AI performance monitoring.
More broadly, Datadog has powerful tailwinds behind its business in cloud migration and digital transformation. Any technology that makes corporate IT environments more complex, including artificial intelligence, should boost demand for observability software. Datadog is well-positioned to capitalize on that, given its brand authority and broad portfolio.
The company ranked No. 2 on the Fortune Future 50 list for 2023, an annual assessment of more than 1,700 companies based on their capacity for long-term growth. Additionally, Wall Street analysts expect Datadog to grow sales at 25% annually over the next five years. That consensus estimate makes the company’s current valuation of 20.6 times sales look tolerable, though I wouldn’t call it cheap.
Could Datadog become the fastest-growing software company? Sure, but it matters very little whether that happens or not.
What actually matters is that Datadog should be a major beneficiary as businesses invest in digital transformation and AI, which could drive above-average returns for shareholders. Now is a good time for patient investors to buy a small position in this software stock, especially as part of an AI basket.
