Artificial Intelligence (AI) Is Set to Drive Sizzling Growth in This Market: Here's 1 Stock That Could Win Big From This Emerging Opportunity

The proliferation of artificial intelligence (AI) is having a positive effect on multiple industries, and cloud computing is one of the markets where the adoption of this technology is helping companies mint a lot of money.

From hardware suppliers such as Nvidia, whose chips are being used by cloud service providers (CSPs) to train AI models, to Oracle, whose infrastructure is being rented by companies to train models and deploy AI applications, several tech companies have seen a nice lift in their revenue because of this technology. However, there is another area within the cloud computing niche where the adoption of AI is expected to grow at a healthy rate in the future.

According to market research provider Market.us, the adoption of AI in the observability space is set to increase at a compound annual rate of 22.5% through 2033, generating close to $11 billion in revenue at the end of the forecast period. Observability refers to the process of monitoring and analyzing the output, performance, and logs of a system. It is important because this process helps improve the reliability, security, and performance of applications.

The research provider further adds that 69% of observability solutions are cloud-based, thanks to their flexibility and scalability. Investors looking to tap this emerging AI-related niche can consider taking a closer look at Datadog (NASDAQ: DDOG). This company has been making a name for itself in the cloud observability space and has started integrating AI within its offerings, a move that could help accelerate its growth.

Datadog could clock healthy growth for years to come

Datadog is already operating in a market that's set to become quite big in the future. The company points out that the overall observability market was worth an estimated $51 billion in 2023, and it could clock an annual growth rate of 11% through 2027. The adoption of AI within this space should ideally boost this market's growth in the long run.

The good part is that Datadog is already benefiting from the observability opportunity on offer. The company's revenue in the third quarter of 2024 increased 26% year over year to $690 million. Non-GAAP net income increased nearly 28% from the same quarter last year to $0.46 per share. The company's top and bottom lines exceeded Wall Street's expectations of $0.40 per share in earnings on $665 million in revenue.

However, the stock was down following the release of its Q3 earnings on Nov. 7. That's because the company's guidance of $711 million in revenue for the current quarter was in line with consensus estimates. But investors would do well to focus on the bigger picture, as the company has raised its 2024 guidance. It now expects just under $2.66 billion in revenue this year, along with $1.76 per share in earnings.

It was earlier anticipating $1.64 per share in earnings, and the updated revenue guidance is also ahead of analysts' expectations of $2.63 billion. Datadog's updated forecast means that its revenue is on track to increase by 25% in 2024, while the bottom line would increase by 33% from last year. Even better, analysts have raised their earnings estimates for the next couple of years as well.

DDOG EPS Estimates for Next Fiscal Year data by YCharts.

However, don't be surprised to see Datadog clocking faster growth than what analysts are expecting. We have already seen that the company is scratching the surface of a huge end-market opportunity, and the good part is that its AI-specific offerings are now gaining traction among customers.

Datadog CEO Olivier Pomel remarked on the recent earnings conference call that around 3,000 of its customers were using its AI-specific offerings at the end of the third quarter to monitor their usage of machine learning, large language models (LLMs), and AI applications. Pomel went on to add that the initial batch of customers paying for the company's AI observability solutions has "cut the time spent investigating LLM latency, errors, and quality from days or hours to just minutes."

It's worth noting that Datadog ended Q3 with just over 29,200 customers, up from 26,800 in the same quarter last year. The company launched its AI-specific observability solutions in August last year, indicating that its AI solutions have gained good traction with more than 10% of its customer base already using them.

This also means that a large chunk of its customer base is yet to adopt its AI solutions, suggesting that there is still a lot of opportunity for the company to cross-sell its new offerings. As it turns out, Datadog customers have been spending more money on its platform and are adopting more of its services.

For instance, the number of customers using four or more Datadog products increased by three percentage points year over year last quarter to 49%. Those using more than six products jumped by five percentage points to 26%. Again, 12% of its customers are now using 8 or more products, compared to 8% last year.

This improved adoption of its products helped Datadog increase its remaining performance obligations (RPO) by 26% on a year-over-year basis to $1.82 billion last quarter. RPO is the total value of the company's contracts that are yet to be fulfilled, so the strong jump in this metric is an indicator that it is on track to sustain its robust growth going forward.

The size of the company's addressable market and the growing adoption of its AI-specific offerings should help it maintain strong levels of growth in the future.

Is the stock a buy right now?

Datadog is growing at an impressive pace and also has a lot of room for growth going forward, as the discussion above indicates, but its valuation is on the expensive side. The stock currently commands a price-to-sales ratio of almost 19, while its forward earnings multiple is just under 60. The tech-laden Nasdaq-100 index, on the other hand, has a forward earnings multiple of 31.

So, Datadog will have to consistently deliver strong growth quarter after quarter to justify its expensive valuation. The good part is that Datadog seems capable of doing that, thanks to the huge market it serves and the growing adoption of AI in the observability space. This probably explains why Datadog has a price/earnings-to-growth ratio (PEG ratio) of 0.80, according to Yahoo! Finance.

A PEG ratio of less than 1 suggests that a stock is undervalued with respect to the growth that it is forecast to deliver. So, investors who are looking to buy a growth stock and are willing to pay a premium valuation for one can consider adding Datadog to their portfolios, as it could deliver healthy stock price gains in the long run.

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Harsh Chauhan has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Datadog, Nvidia, and Oracle. The Motley Fool has a disclosure policy.