DataDog (DDOG) stock popped yesterday on the rumor that Salesforce (CRM) was considering acquiring the company in an all-stock deal. "But wait" said everyone. "This makes no sense". (Whilst at the same time bidding up DDOG). We don't know if the rumor is true. And certainly the numbers are hard to wrap your mind around. But we could see why CRM might want to acquire DDOG. We expand on this below.
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Monopolizing The Plumbing
In the dim and distant past, enterprise customers used a plethora of old-line software, some purchased from vendors, many penned in-house, to handle the plumbing that lies beneath the applications that users actually interact with. Usually lumped together under the monikers of transaction processing, messaging, middleware, systems monitoring, you name it. All kinds of boring names. The companies that provide these kinds of software systems have typically not been household names. Mercury Interactive, AT&T Tuxedo (yes, that AT&T), Compuware, Tibco, BMC, the list goes on.
All very tedious stuff. Except for one thing. The maintenance stream of cash flowing from the enterprise to those vendors. Because once you commit this kind of code to your environment, you're unlikely to unpick it any time soon. And that means you are going to be sending money to your software vendor of choice from here until the end of time. That's why so many of these kinds of software providers end up in private equity ownership - it's because they can support and pay down very sizeable leverage indeed. The customer environment doesn't change very quickly, so new product R&D isn't as pressing an issue as is the case for, say, security software. And the sheer difficulty and risk of replacing one vendor with another means that for the most part, enterprise customers pick a platform and stick with it for years - many, many years. Taken together, this means lower R&D costs as a percentage of revenue, larger cashflow margins, and a greater ability to increase annual pricing, than for the average software company. All of which translates into gushers of cash which can pay down those leveraged loans very quickly and soon start to grow equity value.
As is always the case in software, what shakes up this kind of ossified market landscape is a shift in network architecture. As cloud has grown to become the orthodox choice, client-server the legacy, the functionality required of the plumbing has changed. Today there are a lot of cloud applications in use at any given enterprise. That's a function of the youth of the cloud sector and therefore the relative absence of consolidation between cloud vendors. A recent Forbes article estimated that "companies with more than 250 employees use an average of 124 SaaS applications". Read that again. One hundred and twenty-four cloud apps. Let's say the estimate is wrong by a factor of two. No matter. That would be sixty-two cloud apps. In addition to all the other non-cloud applications still running in client-server, mainframe and no doubt the odd AS/400 still lying around the place under a desk somewhere. Now, all this spaghetti has to be connected somewhere by something. If you ask any one of those old-line providers to do so, they'll tell you that yes, they can integrate cloud, client-server, mainframe, mini and anything else your close-to-retirement IT guy can throw at them. And no doubt they can. But as with any shift in network architecture, if you want to be truly top in the new world, you have to be born of the new world.
You know who wants to own a lot of the plumbing now? Amazon (AMZN). Look within AWS and you will find all kinds of trinkets allowing you to connect this and monitor that. This isn't their leading pitch, but the more compute services you buy from AMZN the easier it is going to be for you to have them handle all the difficult boring plumbing stuff too. And at least you already know it is likely to scale. Now, what with Big Tech's proclivity to seek out monopoly positions wheresoever it can, you can bet that AMZN has designs on owning a lot more of the plumbing than they do today. But the game isn't over yet - there is probably five, maybe ten years of consolidation in cloud software ahead. So there is room yet for multiple big consolidators.
Enter Salesforce (CRM). It's not new news that CRM has designs on something other than front-office applications. Back in the early 2000s, CRM was developing Force.com as a platform for other application vendors to use their then-unique-at-scale multitenanted database instances. Fast forward nearly two decades to 2018 and you have the company digging deep to pay $6.5bn in cash and stock for Mulesoft (MULE), a company with just shy of $300m of prior year revenue. The reason CRM acquired MULE was to build up their ownership of the plumbing. We think that the newly-refreshed CRM, with founder Benioff back at the sole helm, tweeting less, and seemingly more focused than during the co-CEO years, has designs on being a major part of the next-generation plumbing alongside AMZN. And in that context we see another major systems monitoring / systems management acquisition making perfect strategic sense. As for the price of DDOG, which as everyone knows is absurd at 50x TTM revenue - well, CRM paid just shy of 22x TTM revenue for MULE, and thanks to the Fed's ongoing supply of free money, 50x today isn't that much more odd than 22x was two years back. Also, and this is a topic for a different day, CRM is actually very good at big acquisitions. The market always hammers CRM stock in the short term when they spend big; but so far those big deals have been great for the stock long term.
So. We don't know whether CRM/DDOG is just a rumor drummed up by bored M&A folk sat at home, or whether it's taking up real time at the Salesforce Tower. But we believe it might be a real thing. And if it does happen, we think it could work out very well for CRM. Even at what will presumably be a premium to that 50x.
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