2023-11-24 11:06:40 ET
Summary
- DigitalOcean, a two-billion-dollar plus market cap company, focuses on serving developers and small and medium-sized businesses in the cloud industry.
- It has faced challenges due to reduced cloud growth in 2022-2023 as interest rates increased.
- However, the company's business prospects should strengthen with a global economy that economists expect to improve in 2025.
DigitalOcean Holdings, Inc. ( DOCN ), a $2.45 Billion market cap company, has carved out a niche for itself in the cloud industry by serving developers and small and medium-sized businesses ("SMBs"). The company's stock price fell from its peak in late 2021 as small-cap, high-growth, unprofitable companies like DigitalOcean fell out of favor in a high-inflation environment. Additionally, like its much larger cloud brethren, Amazon.com, Inc.'s ( AMZN ) AWS, Microsoft Corporation's ( MSFT ) Azure, and Alphabet Inc.'s ( GOOGL ) ( GOOG ) Google Cloud Platform, customers have reduced spending on cloud services in an uncertain economic environment. Consequently, DigitalOcean's quarterly year-over-year revenue growth dived from 36% in the fourth quarter of 2022 to 16% in the third quarter of 2023. Today, the stock sits at $28.59, well below its initial public offering price of $47 .
However, the news is not all bad. Regarding revenue growth, the company's Chief Executive Officer ("CEO"), Yancey Spruill, said during the company's third-quarter earnings call that he sees "stabilizing revenue trends." He added that DigitalOcean "continued to deliver significant free cash flow," which is a good thing at a time when investors want to see profitability and free cash flow ("FCF") in this uncertain economy.
Management has also made numerous investments since 2021 to increase its product offerings, reach a more comprehensive range of customers, and improve its overall competitive position. These investments will potentially be beneficial in future years as it seeks to re-establish revenue growth. Last, the stock trades at a reasonable valuation after selling off from its 52-week high hit on July 19, 2023. Once the demand for cloud service returns, investors should value DigitalOcean's cash flows much higher. If you are an aggressive growth investor looking for a worthwhile investment while waiting in anticipation of an eventual global economic rebound, consider investing in this cloud company.
A promising investment in Artificial Intelligence
Since OpenAI introduced ChatGPT to the market in late 2022, generative Artificial Intelligence ("AI") has become all the rage. DigitalOcean's management has likely noticed companies' high adoption rates of generative AI and the race among all the major cloud providers to add various AI capabilities to their platforms. It needed to offer generative AI solutions to remain competitive in attracting developers and SMBs to its cloud platform in the long term. Thus, DigitalOcean dove deeper into the high-performance computing and generative AI space when it acquired Paperspace on July 6, 2023.
Paperspace and NVIDIA Corporation ( NVDA ) have been partners for the last several years, and the company announced it had reached NVIDIA's Cloud Service Provider partner program's highest tier earlier this year. The news release stated, "This program will enable Paperspace to offer its customers access to state-of-the-art NVIDIA GPUs, including the recently announced NVIDIA H100 Tensor Core GPU, through the Gradient ML platform." CEO Spruill said during the company's third-quarter earnings call that Paperspace's solutions are seeing "very strong" demand, and he gave a use case example from a new customer named Nomic:
To date, Nomic has released two products, an open-source AI model GPT for all, which is which is the third fastest-growing repository in GitHub history, and Atlas, a tool that allows users to visualize unstructured data sets used to build large language models. Nomic selected DigitalOcean to access High Performance Compute along with our intuitive software, customer support, and reliability. Their Co-Founder was quoted as saying, "Our team loves Paperspace. It's far more intuitive than other compute providers. It allows us to spend less time managing infrastructure and more time building great products for our customers."
Source: DigitalOcean Third Quarter Earnings Call.
DigitalOcean's management believes that the Paperwork acquisition will boost its revenue growth starting in 2024. On November 21, 2023, Oppenheimer analysts upgraded the stock based on the potential benefits of the company's Paperspace acquisition. Analysts Timothy Horan and Edward Yang believe AI could be a "burgeoning opportunity" for the company.
Increasing profitability and free cash flow
DigitalOcean hired a new Chief Financial Officer ("CFO"), Matt Steinfort, in November 2022, with a start date in early January 2023. CEO Spruill said about the hire, "His expertise in scaling and leading early-stage, as well as multi-billion dollar revenue businesses, is exactly the right fit for DigitalOcean as we scale towards $1+ billion revenue and 20%+ free cash margin targets in the coming years."
If you consider the economic growth forecasts looked bleak entering 2023, there was little wonder management shifted to a business model emphasizing more profitability at the start of the year. On the fourth quarter 2022 earnings call , new CFO Steinfort said
Given the reality of the near-term macroeconomic environment, in conjunction with the maturation of our business model, we are conservatively bracing ourselves for the potential that our growth rate will be in the low to mid-20s in the years ahead. In light of this growth profile, we are taking immediate actions that will both boost our margins in 2023 and position us to generate annual free cash flow margins of 30% plus in the coming years. Our continued revenue growth and increasing cash flow margins, combined with our sizable cash balance, will result in our building significant cash in the coming years.
Source: DigitalOcean Fourth Quarter 2022 Earnings Call.
The "immediate actions" the company's Board of Directors took was approving a restructuring plan on January 27, 2023, that laid off 200 workers or 11% of its workforce. Additionally, on February 14, 2023, the company's board approved an up to $500 million expansion of its share repurchase program in 2023. These actions positively affected DigitalOcean's bottom line in the third quarter. Between the company's buyback program reducing its diluted weighted average shares outstanding from 104.9 million in the third quarter of 2022 to 102.7 million in the third quarter of 2023 and increased profit margins, it recorded generally accepted accounting principles ("GAAP") diluted earnings-per-share ("EPS") of $0.20, up 150% from the $0.08 diluted EPS in the previous year's comparable quarter. Non-GAAP earnings per share were $0.44, a 22% year-over-year increase from $0.36.
Management considers FCF the company's "Northstar" metric or a vital measure of its financial performance and long-term growth potential. On CFO Steinfort's first earnings call with the company, he said the following about FCF:
We will use this cash to both fund ongoing investments in our products and platform and pursue additional accretive M&A [mergers and acquisitions]. But even after those investments, we are projecting to have material excess cash given our strong cash flow generation. Our plan is to return a meaningful portion of this excess cash through a regular share repurchase program. We believe an ongoing buyback program creates a compelling investor thesis for DigitalOcean when combined with our focus on driving operational excellence and profitable growth, and together, will drive total shareholder return.
Source: DigitalOcean Fourth Quarter 2022 Earnings Call.
So, let's look at FCF. The company generated $56 million of FCF in the third quarter with margins of 32%, a significant improvement from the previous year's third quarter of 15%. The company expects FCF margins in the fourth quarter of 2023 to be lower than in the third quarter due to one-time working capital factors and an investment in expanding Paperspace's GPU capacity. However, the CFO believes DigitalOcean will still hit its full-year FCF margin projections of 21% to 22%. The chart below shows a significant improvement in the annual FCF margin every year since 2021 if it reaches its 2023 estimate.
DigitalOcean
Next, DigitalOcean recorded robust third-quarter core operational profitability of $75.8 million adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), a 43% margin for the second quarter in a row -- outstanding numbers. The chart below shows management projects the adjusted EBITDA margin from 38% to 39% for 2023.
DigitalOcean
Investors should also monitor the Average Revenue Per User ("ARPU"), a measure of the company's ability to monetize users. Ideally, we want to see ARPU rise as that would indicate it is either attracting higher-value customers or finding ways to increase revenue from existing customers. DigitalOcean recorded an ARPU of $67.65, $86.64, and $92.06 in the third quarter of 2021, 2022, and 2023, respectively -- an excellent sign for the business.
Last, despite considerable headwinds in the cloud business this year, management still projects 20% revenue growth for the full year 2023, which gives it a nice mix of growth and profitability.
Debt could eventually be a problem
DigitalOcean ended the September quarter with $384 million in cash and short-term investments and $1.47 billion in long-term debt. Disturbingly, it has -358.8 million in shareholders equity. Dividing the $1.47 in debt by shareholders' equity of -358.8 million equals a debt-to-equity (D/E) ratio of -409%, a potential red flag. A negative D/E ratio indicates a company with more debt than assets, which is far from ideal.
The company is not distressed because it has a growing FCF, allowing it to pay its debt over time, buy back stock, and reinvest in its business. As long as the company executes and grows FCF, it can manage current debt levels. However, if DigitalOcean's FCF ever falters and rapidly deteriorates, the company could face significant problems.
Additional risks
Wall Street analysts expect revenue growth to slow considerably next year. The chart below shows that annual growth will sink to 11% in 2024 before recovering slightly in 2025 and returning to around 20% growth in 2026. The following estimates assume that global economic conditions don't worsen.
Seeking Alpha
Year-over-year growth in "Customers Paying More Than $50 per Month" slowed to 9% in the third quarter of 2023 from 50% in the third quarter of 2022. Additionally, the company reported an ugly net dollar retention rate ("NDR") of 96% in the third quarter, significantly down from the previous year's NDR of 118%. When a NDR sinks below 100%, existing users are pulling back from spending money on the platform. The combination of slow new customer growth and less money from existing customers is an ominous sign for future revenue growth.
The good news is that management reported that NDR's rate of decline decreased in the third quarter, and the company expects the number to improve moving forward. If NDR does improve in future quarters, it would indicate spending on the platform by existing customers is increasing. While there is no guarantee, a rising NDR could portend a reacceleration of revenue growth. The CFO said in the earnings call, "We expect NDR to improve in Q4 and early 2024, driven in part by the continued strength of the Cloudways business and more favorable year-over-year comparisons." The Cloudways business is a managed cloud hosting platform that helps companies deploy, manage, and scale their cloud applications. DigitalOcean acquired the Cloudways business in September of 2022.
DigitalOcean has acquired multiple businesses over the last several years, which brings up another risk. Although acquisitions like Paperspace and Cloudways have the potential to impact revenue growth significantly, one has to wonder if the company is using its four acquisitions since 2021 to mask a maturing core business that needs more organic growth. Investors are typically more interested in companies growing organically than businesses that consistently engage in M&A to produce revenue growth. If DigitalOcean fails to grow its core business, attracting new investors and raising capital could become more complex .
Complicating matters was the company announcing on August 24, 2023, that Yancey Spruill plans to step down after serving as DigitalOcean's CEO for four years. That announcement came on the heels of the company telling investors in its second-quarter earnings report released on August 3 that growth was decelerating faster than anticipated. Since the company didn't give a reason for the CEO's departure, some might view the timing as suspicious. Additionally, a new CEO presents an unknown risk to investors, as there is no guarantee the future CEO will utilize a similar game plan to the current one.
Last, there is competition. DigitalOcean is a David fighting multiple Goliaths in AWS, Azure, Google Cloud, and Oracle Corporation's ( ORCL ) cloud. Although the larger cloud companies may not try to compete for their smaller customers, as DigitalOcean competes for the business of larger companies, it will start competing more directly with the big boys, which have considerably more resources. The company's current customer base primarily consists of SMBs, but it needs to attract larger companies to achieve long-term, sustainable growth. Whether it can do so remains a mystery.
Should you buy it?
Investors grew extraordinarily pessimistic about DigitalOcean as its price-to-FCF (P/FCF) hovered above 40 earlier in the year. There were legitimate reasons to dislike the stock at such high valuations. The chart below shows the percentage of float short rose above 24% in April, which is exceptionally high.
As DigitalOcean's valuation dived over the last several months due to investors selling off the stock, the percentage of float short has decreased by more than 50%, suggesting that investors have become much more bullish about the company's prospects at a lower valuation. Investors were also satisfied with the third-quarter earnings report, which exceeded expectations . After the company's third-quarter earnings report, a Seeking Alpha article cited Canaccord Genuity analyst Kingsley Crane, who said:
Shares have "found a foothold" and the third-quarter results are "instrumental" to show there is still a lot to like about the company's prospects...As trends improve, we see more urgency to begin building a position even as we await more clarity on the CEO seat.
Source: Seeking Alpha
However, some investors may remain unexcited about investing in a stock that, according to the chart below, trades at a 2024 forward price-to-earnings (P/E) ratio of 17.53 when analysts' revenue estimate only calls for 11% growth and the EPS estimate calls for 7.65% growth next year.
Seeking Alpha
If you are a short-term investor, DigitalOcean might be a terrible stock to invest in over the next one or two years. In a slow-growth economy, SMBs generally take it on the chin, as historically, smaller businesses do worse than larger businesses. While the U.S. muddles along, Europe still fears a recession . Since most of this company's client base is SMBs and close to two-thirds of its revenue is generated from customers outside the U.S., don't expect the company to recover until the global economy rebounds, which doesn't look like it will happen anytime soon.
The Conference Board, a global, nonprofit think tank, expects global growth to slow further in 2024. Financial company Allianz agrees with that view and states, "A trough in global economic activity is expected at the turn of the year followed by below-trend growth in 2024-25. Consumer demand will remain soft amid negative wealth effects and increasing precautionary savings." As the worldwide economy bottoms out, some expect little upside from the stock over the next year. The chart below shows Wall Street analysts' consensus one-year price target for DigitalOcean of $31.20, up 8.00% from the closing price of $28.89 on November 22, 2023.
Seeking Alpha
Wall Street analysts expect DigitalOcean's revenue and earnings growth to hit its lowest point in 2024, improve in 2025, and return to above 20% growth in 2026. Now, you might wonder if DigitalOcean's growth will resume in 2025 or 2026, why buy the stock now? The answer is that economists don't have a perfect record of predicting the growth rates of the global economy. Global growth could improve above expectations in 2024, which is what Goldman Sachs analysts predict . If Goldman's assessment holds, the stock could rebound more than expected next year, and investors waiting for the "all clear" signal may miss the beginning of a bull market in DigitalOcean's shares.
If you are a patient investor with three to five years, the potential combination of long-term high-teen revenue growth and robust cash flow generation is enticing. I rate the stock as a modest BUY.
For further details see:
DigitalOcean: A Long-Term Buy In The Cloud Computing Industry