Goldman Sachs divides the rise of artificial intelligence (AI) into different phases. The first is all about a semiconductor company Nvidia. The second revolves around infrastructure companies such as Microsoft And Amazon. And the third revolves around software companies.
In a recent interview, Ben Snider of Goldman Sachs told CNBC that hedge fund managers started moving into AI software stocks in the third quarter. “The funds were shifting a little bit from the ‘Magnificent Seven’ stocks to software,” he said, “and this was really the first quarter where we saw that.”
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The phases will come and go, so there is plenty of time to invest in chipmakers and infrastructure companies. However, this is also a good time to build positions in AI software stocks. Data hound(NASDAQ:DDOG) checks that box and Wall Street is overwhelmingly bullish. Of the 45 analysts covering the company, 91% rate the stock as a buy.
Datadog specializes in observation software. The platform includes approximately twenty products that enable companies to monitor, analyze and resolve performance issues in their applications and infrastructure. These products are built on top of an artificial intelligence (AI) engine that helps resolve incidents by automating alerts, insights, and root cause analysis.
Datadog’s broad portfolio allows companies to consolidate spend through a single observability platform, which is easier than integrating tools from multiple vendors. That convenience has helped Datadog become a leader in observation software. But Forrester research has also recognized its leadership in AI for IT operations. “Datadog is at the forefront of data insights and visualizations,” analysts wrote.
Observability software helps businesses avoid problems and avoid costly IT outages, and the need for these tools increases as computing environments become more complex. That means cloud migration and the proliferation of AI are the tailwinds for Datadog. That’s why 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 reported solid financial results in the third quarter, beating expectations and raising full-year expectations. The company increased its customer base by 9% to 29,200, and average spend per existing customer increased by more than 10%. In turn, revenue rose 26% to $690 million, and non-GAAP (adjusted) earnings rose 27% to $0.46 per diluted share.
During the earnings call, CEO Olivier Pomel said, “We are seeing the first signs of growth for our LLM Observability product.” Also of note, CFO David Obstler said AI companies were responsible for 6% of annualized subscription revenue, up from 4% in the previous quarter and less than 3% in the previous year. This trend supports the case that Datadog could be a big winner as the AI boom unfolds.
Importantly, Datadog has recorded net revenue retention in the mid-110% range for five consecutive quarters, implying something between 111% and 119%. However, David Obstler provided additional context on the third quarter call, saying that revenue retention is consistently higher. That means existing customers are spending more at a faster pace, which bodes well for Datadog and its shareholders.
Looking ahead, the consensus estimate among Wall Street analysts is that Datadog’s adjusted earnings will grow 50% annually through 2026. Even in the context of that rapid growth, the current valuation of 150 times adjusted earnings seems expensive.
Patient investors can buy a very small position at the current price, provided they know the stock could fall 20% or more if Datadog fails to meet expectations or if the broader stock market undergoes a correction. However, if such a pullback occurs, investors should take the opportunity and buy more shares.
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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Trevor Jennevine has positions at Amazon and Nvidia. The Motley Fool holds positions in and recommends Amazon, Datadog, Goldman Sachs Group, Microsoft, and Nvidia. The Motley Fool recommends the following options: long January 2026 $395 calls to Microsoft and short January 2026 $405 calls to Microsoft. The Motley Fool has a disclosure policy.
Software Is the Next Big AI Opportunity: 1 AI Stock Wall Street Highly Recommends to Buy Now was originally published by The Motley Fool
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