Bernstein: Datadog (DDOG.US) and Cloudflare (NET.US) shares have been oversold; strong AI business growth is expected to drive Q3 results above expectations.

Bernstein: Datadog (DDOG.US) and Cloudflare (NET.US) shares have been oversold; strong AI business growth is expected to drive Q3 results above expectations. Wall Street research firm Bernstein said in a report released on Monday that the large-scale selloff in cloud infrastructure software stocks last Friday may have been an overreaction. Although the latest results from Amazon.com, Inc.'s cloud service (AWS) and Twilio (TWLO.US) triggered market concerns about slowing cloud computing demand, Bernstein believes that Datadog (DDOG.US) and Cloudflare (NET.US) are expected to show performance superior to the broader industry in their upcoming third-quarter earnings reports, driven by rapid growth in artificial intelligence (AI)-related businesses. Last Friday, American Software, Inc. Class A shares generally declined, with usage-based cloud infrastructure software companies falling particularly sharply, as most stocks dropped 5% to 10% or more. Cloudflare shares fell 9.5%, while Datadog dropped 11.5%. Bernstein analyst Peter Weed believes that this round of selling was largely affected by the performance of AWS and Twilio. Twilio's organic revenue growth slowed year over year, while although AWS's revenue growth accelerated, the pace of acceleration was below Wall Street expectations. In addition, both companies' comments on their fourth-quarter business outlook also fell short of market expectations, further intensifying investor concerns. Bernstein noted that the cloud computing industry is indeed facing some demand pressure in the near term. Previously, a surge in the use of AI coding tools briefly drove rapid growth in cloud service demand, but as related demand has pulled back from its peak, some companies may see temporary slowdowns in fourth-quarter revenue growth. However, the firm believes that the situation for Datadog and Cloudflare may be different. Although both companies' traditional customer businesses are also facing pressure from slowing growth, strong growth in AI-related businesses is expected to offset this impact and enable them to outperform other cloud infrastructure software companies. For Datadog, Bernstein is particularly optimistic about the growth opportunities brought by its AI-native customers. The firm estimates that Datadog's AI-native customer base may have added about US$200 million in annualized recurring revenue (ARR) in the third quarter, roughly US$200 million more than previously expected. This means the related business could bring in about US$50 million in additional revenue, but because Datadog uses a usage-based, billed-in-arrears model, there is still uncertainty over whether this portion of revenue will be recognized in the third quarter or the fourth quarter. Bernstein's current forecast model mainly incorporates this growth into the third quarter, implying that Datadog's revenue for the quarter could be about US$90 million above the company's previous guidance, roughly twice its historical maximum beat. However, the analyst also acknowledged that this forecast may be too optimistic. Even if part of the revenue is deferred to the fourth quarter, it could still drive the company to provide strong guidance for the next quarter. Bernstein expects that, driven by AI demand, Datadog's fourth-quarter revenue growth year over year could reach about 40%, although growth in its traditional customer business may slow from about 28% in the third quarter to around 25%. Cloudflare is also expected to benefit from rapid growth in demand for AI application development. Bernstein estimates that annualized recurring revenue for Cloudflare's developer platform Workers may have reached about US$500 million in the third quarter, roughly triple the level in the fourth quarter of 2025, meaning it expanded to three times its size at that time. The firm believes that AI coding agents are driving enterprises and developers to adopt new application development models, rapidly increasing demand for cloud services that do not require customers to manage their own servers. Currently, Bernstein views Cloudflare and Vercel as the two main competitors in this market. Related data show that so far this year, the scale of applications deployed through this type of technology has grown about twofold, while growth trends in early the fourth quarter indicate that related demand may further increase by about 25% quarter over quarter. Bernstein expects this growth could accelerate Cloudflare's third-quarter revenue growth by nearly 2 percentage points compared with the previous quarter and enable it to achieve its largest earnings beat so far this year. Although slowing demand for traditional cloud services may cause Cloudflare's fourth-quarter revenue growth year over year to decline somewhat, continued expansion of the Workers business is expected to support growth in 2027. Bernstein believes the company's revenue growth year over year in 2027 could reach more than 40%. In addition, the firm's preliminary network traffic data show that demand for cloud services has already rebounded in October, with growth trends similar to the strong performance in the fourth quarter of 2025. This means that the demand pressure recently faced by the industry may be only temporary, and both companies are expected to provide more optimistic 2027 business outlooks in the future. Despite being optimistic about the growth prospects of both companies, Bernstein still differentiates its investment ratings. The firm maintained its "Outperform" rating on Datadog with a target price of US$350; it maintained its "Market Perform" rating on Cloudflare with a target price of US$245, both unchanged. Based on the closing prices on October 30, Datadog was at US$235.27, implying about 48.8% upside to Bernstein's target price; Cloudflare was at US$280.70, and its target price is about 12.7% below the current share price. Bernstein noted that although the combined profitability performance of the two companies may be relatively similar, Cloudflare's valuation is significantly higher than Datadog's, making the latter more attractive at current price levels. However, the firm also believes that Cloudflare lacks an obvious near-term catalyst for a valuation downgrade. If the Workers business continues to grow rapidly and drives the company's 2027 revenue growth to more than 40%, its share price may still be supported.