Goldman Sachs divides the artificial intelligence (AI) boom into several different phases. The first centers entirely around semiconductor company Nvidia. The second centers around infrastructure companies like Microsoft and Amazon. And the third centers around software companies.
In a recent interview, Ben Snider at Goldman Sachs told CNBC that hedge fund managers began transitioning toward AI software stocks in the third quarter. "Funds shifted a little bit away from "Magnificent Seven" stocks and toward software," he said, "and this was really the first quarter where we saw that."
The phases will ebb and flow, so there is plenty of time to invest in chipmakers and infrastructure companies. However, now is also a good time to start building positions in AI software stocks. Datadog (DDOG -1.06%) checks that box, and Wall Street is overwhelmingly bullish. Of the 45 analysts following the company, 91% rate the stock a buy.
Datadog is a leader in observability software
Datadog specializes in observability software. Its platform includes roughly two dozen products that help businesses monitor, analyze, and resolve performance problems across their applications and infrastructure. Those products are built atop an artificial intelligence (AI) engine that helps with incident resolution by automating alerts, insights, and root cause analysis.
Datadog's broad portfolio lets businesses consolidate spending through a single observability platform, which is easier than integrating tools from multiple vendors. That convenience has helped make Datadog a leader in observability software. But Forrester Research has also recognized its leadership in AI for IT operations. "Datadog leads the pack in data insights and visualizations," analysts wrote.
Observability software helps businesses prevent issues and avoid costly IT outages, and the need for those tools increases as computing environments become more complex. That means cloud migration and the proliferation of AI are tailwinds for Datadog. So, earlier this year, the company introduced LLM Observability, a suite of performance monitoring tools for infrastructure and large language models that power generative AI applications.
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Datadog sees early traction with its LLM Observability software
Datadog reported solid financial results in the third quarter, beating estimates and raising full-year guidance. The company increased its customer count 9% to 29,200, and the average spend per existing customer rose more than 10%. In turn, revenue increased 26% to $690 million, and non-GAAP (adjusted) earnings jumped 27% to $0.46 per diluted share.
On the earnings call, CEO Olivier Pomel said, "We are seeing initial signs of traction for our LLM Observability product." Also noteworthy, CFO David Obstler said that AI companies accounted for 6% of annualized subscription revenue, up from 4% in the previous quarter and less than 3% in the previous year. That trend supports the thesis that Datadog could be a major winner as the AI boom unfolds.
Importantly, Datadog has listed its net revenue retention as being in the mid-110% range for five straight quarters, which implies anything between 111% and 119%. However, David Obstler provided additional context on the third-quarter call, saying revenue retention has been trending higher. That means existing customers are spending more at a faster pace, which bodes well for Datadog and its shareholders.
Datadog stock trades at a premium valuation
Looking ahead, the consensus estimate among Wall Street analysts is that Datadog's adjusted earnings will increase at 50% annually through 2026. Even contextualized by that rapid growth, the current valuation of 150 times adjusted earnings looks expensive.
Patient investors can buy a very small position at the current price, provided they know the stock could decline 20% or more if Datadog fails to meet expectations or the broader stock market suffers a correction. However, if such a pullback occurs, investors should lean into the opportunity and buy more shares.
