26 BARRON’S July 12, 2021
TECH TRADER
Observability tools seek clues to network health
much as doctors diagnose illnesses by looking
for symptoms that point to internal issues.
TheNextTechTrend
Is Here—It’s Worth
Paying Attention
O
ne of the chal-
lenges of modern
enterprise com-
puting is keeping
track of what’s
going on inside
your network.
Cutting-edge information-technology
systems are a messy brew of public
clouds, private clouds, old-school data
centers, third-party apps, edge comput-
ing, and mobile workers. Keeping tabs
on what’s working—and what isn’t—is
a gigantic challenge. The good news for
investors is that the result is an enor-
mous emerging market.
Once blandly known as infrastruc-
ture management tools, the market for
this stuff now has a sexier, slightly
Orwellian name: “observability.” Com-
panies like Datadog (ticker: DDOG),
Dynatrace (DT), Elastic (ESTC), and
Splunk (SPLK) provide observability
tools to help IT departments monitor
their networks’ health. With enterprise
tech spending poised to accelerate com-
ing out of the pandemic, observability
players should be big beneficiaries.
In a research note last week, Citi
software analyst Tyler Radke laid out
a bullish case for the group generally—
and for Datadog, Dynatrace, and Elas-
tic in particular. “We see a positive out-
look for observability spending, with
signs it could reaccelerate as IT spend-
ing recovers and as digitization projects
pick up,” Radke writes.
While observability is a relatively
new buzzword, the concept has been
around for decades. “The term observ-
ability dates back over six decades to
1960 and has its roots in engineering
and mathematical applications,” he
explains. “Observability was defined
as a ‘measure of how well internal
states of a system can be inferred from
knowledge of its external outputs.’ ”
In other words, observability tools
seek clues to network health much as
doctors diagnose illnesses by looking
for symptoms that point to internal
issues. Radke notes the market has
three pillars: infrastructure monitoring
(why is the network so slow?);
application-performance management
(what’s up with my apps?); and log
management and telemetry (why are
we getting errors and service tickets?).
“Having visibility into these three com-
ponents allows organizations to iden-
tify service issues, and isolate them,
whether it is an infrastructure or appli-
cation issue, and remediate,” he writes.
In an interview, Radke says he has
been getting questions from the buy
side about whether the market is big
enough to support the heady growth
rates of leading players. He’s convinced
that the opportunity is substantial, at
an estimated $55 billion in 2025, about
triple the forecast from Gartner. He
thinks some estimates rely too heavily
on revenue from legacy on-premise
tools providers, rather than anticipat-
ing the growing adoption of cloud-
based applications.
Radke is particularly keen on Data-
dog, which provides both infrastruc-
turemanagement and application-
performance monitoring tools, ranking
it as one of his favorite overall enter-
prise software stocks. The stock isn’t
cheap. Datadog shares trade for 28
times estimated 2022 sales, and profits
are too small for the price/earnings
ratio to be meaningful. But he sees
“durable growth powered by continued
robust new customer additions, and
multiproduct strength,” and contends
that the premium valuation reflects a
combination of premium growth, im-
proving profitability, and potential for
upside to consensus estimates.
He also likes Dynatrace for its po-
sition in application monitoring for
large enterprises, and he’s keen on
Elastic’s combination of observability
tools and search software. He’s less
excited about Splunk, a company I’ve
written about that has been ham-
pered by an ongoing business-model
transition that is crimping financial
results. But all four will benefit if IT
spending follows the script and picks
up in the second half.
A
pple (AAPL) shares hit a re-
cord last week, pushing its mar-
ket cap to an astounding $2.4
trillion. It was the stock’s first
new high since January, reflecting grow-
ing anticipation of June-quarter financial
results, now two weeks away, and the fall
launch of iPhone 13.
In the March quarter, hardware
sparkled—sales were up 66% for
iPhones, 70% for Macs, and 79% for
iPads—overshadowing 27% growth in
services. That segment includes com-
missions generated from the App
Store, where it sells programs for
iPhones and other devices; revenue
from streaming services like Apple
Music and Apple TV+; and other
services like Apple Care and iCloud.
There’s growing risk to Apple’s role
as a gatekeeper and toll taker for app
distribution. Last week, a group of state
attorneys general sued Google over its
control of the Android Play Store. Sim-
ilar litigation against Apple seems inev-
itable. And as Cowen Washington Re-
search Group analyst Paul Gallant
asserts, new rules for app stores from
the Federal Trade Commission, now
led by Lina Khan, are likely.
How much risk is there? Services
were 16% of revenue in the latest six
months. Apple said recently that the
“app store ecosystem” generated $643
billion in revenue in 2020, about 90%
outside the store itself (booking rides
on Uber, say, or buying goods on
Amazon). That implies $64 billion
of activity via the store.
If you use the 30% maximum com-
mission, that’s some $20 billion in rev-
enue, a little over a third of the $57 bil-
lion in calendar-2020 services revenue.
That’s consistent with app tracker Sen-
sor Tower, which estimates Apple’s
2020 take from the store at $21.7 bil-
lion. (For Google, it says it’s $11.6 bil-
lion.) That means about 7% of Apple
revenue is at risk if the App Store is
regulated. But a reduced fee seems the
likeliest scenario, so the true risk is
probably smaller.
Apple’s vulnerability is real, but
modest. Investors seem unconcerned.B
By Eric J. Savitz
Apple seems increasingly likely to face
litigation over its App Store policies and its
dominant role in app distribution. The risk
to Apple’s revenue is real but modest.
Investors appear unconcerned.
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