2023-04-21 05:30:36 ET
Summary
- DigitalOcean is the only pure-play cloud computing provider stock.
- Management has finally pulled back revenue growth guidance but expects accelerated free cash flow margin expansion.
- Management has outlined an aggressive share repurchase program, which it is implementing right now.
- DOCN stock trades cheaply with substantial upside.
DigitalOcean ( DOCN ) has finally adjusted its medium-term growth guidance in light of the tough macro environment, but investors seemed to have shrugged it off. Perhaps that had something to do with the fact that management also outlined plans to accelerate its free cash flow margin expansion, making DOCN a cash flow machine earlier than expected. With direct exposure to the growth of cloud computing, DOCN stands to benefit from the long-term secular trends of digital transformation with the potential for accelerated growth upon an economic recovery. DOCN stock remains too cheap in light of the coming focus on cash flow generation.
DOCN Stock Price
As the only pure-play cloud computing stock, DOCN was unsurprisingly pulled into the tech bubble in late 2021 as well as the subsequent crash.
I last covered DOCN in February where I compared DOCN to a cheaper albeit lower quality Amazon Web Services ( AMZN ). The stock is down a few percentage points since then despite the company's accelerated focus on profitability.
DOCN Stock Key Metrics
In its most recent quarter, DOCN delivered 36% YOY revenue growth and 400 bps of operating margin expansion to 16%. That growth was largely helped by the company's price increases in the 2022 year.
2022 Q4 Presentation
This is evidenced by the company seeing a dramatic step-up in larger customers in the third quarter, followed by only a mild increase in the fourth quarter.
2022 Q4 Presentation
DOCN has quickly ramped up cash flow generation since it came public in 2021, generating positive free cash flow in that year and seeing margins expand further in 2022.
2022 Q4 Presentation
DOCN has improved its net dollar retention rate on account of its improved product offerings, but much of that expansion over the past few quarters has been driven by the price increases.
2022 Q4 Presentation
On the conference call , management blamed the weakness in part due to the macro environment as existing customers slowed down their growth in spending and there was greater volatility in new customer additions. Management also noted their impact from the cryptocurrency crash, as blockchain customers represented 1.5% of revenues - down from 5% just 2 quarters ago. The Russia-Ukraine war has also had an impact, as customers from Russia and Ukraine totaled less than 2% of revenues - down from 3.5% just 3 quarters ago. Over the long term, these headwinds may turn into tailwinds as conditions improve.
DOCN has begun to breakout its customer types. As we can see below, DOCN derives the majority of its revenues from larger customers that it calls "scalers" and "builders," though it still retains a sizable number of "learners."
2022 Q4 Presentation
In the current environment, DOCN will have to rely on growth from its larger customers to drive overall growth.
Looking ahead, DOCN guided for up to $165 million in revenue in the first quarter and $720 million in revenue for the full year. That represents 29.6% YOY growth and 25% YOY growth, respectively. But this may be better off viewed sequentially, as first quarter guidance implies approximately 1% sequential growth with an acceleration to 5% sequential growth in the quarters thereafter.
2022 Q4 Presentation
That may imply that guidance is not de-risked, or may be a bullish signal if the company can deliver on accelerated growth.
That guidance did include free cash flow margin guidance of 22%, which would be one year ahead of the previous schedule to deliver margins of at least 20%. Management did unfortunately push out its guidance for $1 billion in revenue by 1 year to 2025. That said, management now expects to exit 2023 with free cash flow margins in the "high 20s" and has targeted cash flow margins of 30% or greater over the long term. Management has also retracted its previous guidance for 30% revenue growth over the medium and long term, as it is now "conservatively bracing ourselves for the potential that our growth rate will be in the low to mid-20s in the years ahead." While management stressed that they do not view this as a long term retraction, they also spent considerable time mentioning the improved cash flow profile, leading me to assume that this new guidance should be accepted as such.
The company has also approved an expansion of their share repurchase program to up to $500 million in 2023. Management has committed to purchasing at least $230 million in the year and anticipates repurchasing up to 125% of free cash flow in 2024. Management also unveiled their long-term target leverage ratio of 2.5x to 3x adjusted EBITDA. Net debt to adjusted EBITDA stood at around 3.3x as of the end of 2022 but I expect that ratio to decline this year as cash flows grow. Management was asked if they would exit the year "at or approaching the rule of 50" to which they agreed to the affirmative, implying an exit growth rate of around 20% heading into 2024.
Is DOCN Stock A Buy, Sell, or Hold?
DOCN is the only pure-play cloud computing provider stock in the market today. DOCN is not as well known as larger names like AWS or Azure ( MSFT ), but the company has found a niche catering to smaller companies which are seeking a simpler (and cheaper) solution.
2022 Q4 Presentation
That has had the financial benefit of lower sales & marketing spend - unlike many tech companies which spend more on S&M than R&D, DOCN has somehow sustained rapid revenue growth in spite of low S&M spend.
2022 Q4 Press Release
DOCN is highly attractive to smaller companies due to its "self-serve" funnel which makes it easy to test out the cloud computing services and get projects up and running.
At recent prices, DOCN was trading at just under 5x forward sales.
Seeking Alpha
But considering the company's rapid push for profitability, perhaps it may make more sense to value the stock on the basis of earnings - DOCN looks very reasonably valued as earnings ramp over the coming years.
Based on my estimates for 30% long term net margins, 20% growth, and a 1.5x price to earnings growth ratio ('PEG ratio'), I could see DOCN trading at 9x sales, implying over 85% upside over the next 12 months.
What are the key risks? It is unclear if Wall Street will give DOCN a premium multiple as it ramps up free cash flow, or if it will continue to discount the stock due to competitive threats from the mega-cap tech titans. The company may be able to take advantage of low stock prices through share repurchases, which become more meaningful as cash flows expand, but it is also possible that the company eventually loses its larger customers to that competition. In such a scenario, not only would DOCN see its growth story impaired, but its stock would undoubtedly trade at low valuation multiples - while not a perfect comparison, just look at what happened to Fastly ( FSLY ) stock. I continue to view a basket of undervalued tech stocks as my preferred way to position ahead of a recovery in tech stocks. DOCN fits perfectly in such a basket on account of its secular growth, low valuation, and expanding cash flow margins.
For further details see:
DigitalOcean: Cloud Computing With Soaring Free Cash Flows And Share Repurchases