Datadog (DDOG) Fell 19% After Q2 Beat and Guidance Raise - The AI Customer Cut Spooked the Market

Datadog’s Q2 was reported as a decent quarter with a 36% increase in revenue, a positive surprise of $0.07 on the EPS, 38% increased billings to $1.18B, a 43% increase in RPO to $3.47B, and a reported free cash flow positive of $279M, in addition to an increase in full year guidance. Expectations and evaluations were part of the problem. DDOG had roughly doubled year-to-date, and with a P/E over 700, the market had little tolerance for reduced growth. 

There were two major concerns. First, Datadog indicated its largest AI-native customer would reduce usage starting Q3. That revived the concern of major customers dealing with AI optimizing workloads and reducing observability expenditures. 

The second issue with the selloff was Datadog’s guidance indicated Q3 growth was expected to slow with revenues of $1.135B – $1.145B, indicating a slow growth rate of 28% to 29% annually from the reported 36% growth in Q2. This guidance and the anticipated slow growth was of greater concern to the market than the reported earnings.

Datadog’s decline in earnings was a more concentrated issue in the decline of the software earnings that were reported as an overall decline. This was primarily due to the questions of how AI implementations will affect pricing, and how AI will effect the Rabatt and usage-based revenue models.

One major concern is that as AI tools become more advanced, companies will lose incentive to invest in observability tools. To counter this, Datadog is integrating AI into their own products - Bits Code, Bits Chat, Bits Agent Builder - and over 100 AI features.

AI-native customers are unpredictable, but compared to Datadog’s enterprise clientele, they are far more volatile. Datadog’s 33,400 clientele includes 4,720 who have an ARR greater than $100,000 and increased by 23%. If budget cuts to observability tools are limited, the sell off will be unwarranted. If other large AI customers act similarly, Datadog will experience a significant decline in growth.

Currently, DDOG is trading at $236.81 after a significant breakdown from the $290 range. This has caused DDOG to break the long-term ascending trendline and become a bearish trend after falling below the 50-period and the 100-period EMAs, currently at $262.87 and $257.71, respectively. The RSI has recently dropped to 24, indicating that DDOG is strongly in an oversold condition and therefore has an increasing probability of a rebound in the short term.

DDOG Price Chart - Source: Tradingview

Currently, DDOG is trading above the important support level of $225.23. If DDOG does rebound and trade above $241 DDOG is likely to target $256.89, as that level is where the trendline and the moving averages create stronger resistance. Weaker resistance identifies that the broader market is likely to push prices below $256.89. If this support level fails DDOG is likely to push prices downward to $212.05 and $196.52.

DDOG pushed earnings for both revenue and EPS above expectations and pushed the full year guidance, yet prices fell 19%. The primary concern was the outlook. DDOG’s management stated that the largest AI-Native customer would begin to decrease usage in Q3. Q3 guidance was also given that stated DDOG would likely push revenue with year on year growth at 28-29% vs. 36% in Q2.

The slowdown did impact pricing as DDOG had pushed nearly a 100% gain YTD, and with a trailing P/E above 700, expectations were for growth to continue. The earnings push did not support the concerns of one of the largest customer segments.

Datadog mentions the expected cut from the largest AI client has already been factored into guidance. Should this reduction affect only one customer, the rest of the business segments seem to be operating at a fair level of functionality. Datadog has about 4,720 customers, 23% more than the previous year, and more than $100,000 in ARR from other segments.

The main concern is how many other AI companies will cut observability in their infrastructure. Given this, Datadog would need to reduce the expected growth. Q3 and Q4 results will shed more light on the situation

Investors knew the outlook for Datadog was strong in Q2. That was not the reason for the -17% drop. The revenue was more than $1.12 billion, EPS were positive, and the guidance for the year was raised. Investors were more worried about AI customer usage, which has declined, and the awaited slower growth for Q3. 

Currently, $225.23 is the support level. If the stock price is greater than $241, the outlook for Datadog will improve in the short term, while $256.89 is the key level for a price recovery. The test is easy. If more than one AI customer indicates weakness, Datadog will have to defend a lower stock price. Otherwise, the August drop was likely much larger than the deterioration in the business.