2023-05-31 16:00:24 ET
Summary
- DigitalOcean Holdings, Inc.'s outlook for Q4 2023 points to a substantial ramp in free cash flow margins.
- The integration of Cloudways has contributed to growth and is expected to generate improved free cash flow.
- According to my estimates, DigitalOcean stock is priced at 13x.
Investment Thesis
DigitalOcean Holdings, Inc. ( DOCN ) is an affordable and user-friendly cloud platform that allows businesses to host their applications.
There's a lot of nuance to this investment thesis. Not everything is positive when it comes to investing in DigitalOcean, but there are more positive aspects than negative, which now leads me to upgrade my DigitalOcean Holdings, Inc. stock rating to a buy from a hold.
Indeed, note that I concluded my previous analysis by saying:
I'm not openly bearish on DigitalOcean Holdings, Inc. But I'm not bullish either. Indeed, I'm happy to readjust my views in the next several months if I find that DOCN integration of Cloudways leads to higher sustainable free cash flows. (Emphasis added.)
And that's precisely what's happened here and why I'm now bullish on this stock.
Why DigitalOcean? Why Now?
DigitalOcean is a cloud platform offering on-demand computing for startups and small and medium-sized businesses, or SMBs.
During the earnings call , we heard an update on its integration of Cloudways and how Cloudways managed hosting capabilities are performing well and have contributed to growth.
That DigitalOcean plans to leverage its self-serve funnel to drive customer leads to Cloudways and sees significant synergies from this acquisition, which will lead to improved free cash flow at the end of this year.
In the next section, I'm going to highlight some negative aspects followed by some position elements.
Revenue Growth Rates Remain Enticing
The negative consideration is that DigitalOcean's revenue growth rates appear to be slowing down at a rapid rate. Case in point, last year, DigitalOcean could be counted on for plus 30% CAGR.
While in the current year, DigitalOcean's revenue growth rates are pointing towards no more than mid-20s% CAGR.
And before anyone articulates that DigitalOcean is being conservative with its guidance, consider these two matters, look below.
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In the first instance, we can see that DigitalOcean's consensus revenue beats have in the past 5 quarters been on average razor-thin.
Secondly, DigitalOcean reported its Q1 2023 results , and it didn't take the opportunity to upwards-revise its full-year outlook. Even though at the time of the results being reported, we are nearly halfway through 2023.
This means that what we see is pretty much all there is, a cloud company's revenue growth rates of mid-20s% CAGR.
Next, we'll turn to discuss some positive elements.
Capital Allocation Strategy
In my previous analysis, I made the argument that DOCN's capital allocation decisions left a lot to be desired. More specifically, I articulated that DigitalOcean was buying back its shares, but that this wasn't bringing down its total number of shares outstanding.
With that context in mind, consider the full-year guidance that DOCN provided together with its Q4 2022 results:
And now, consider DOCN's recently updated outlook provided together with its Q1 2023 results:
Clearly, this outlook points to a significant improvement.
However, the core reason why I'm upgrading DOCN to a buy is that I believe that its business model will see higher sustainable growth rates over the next several quarters, and here's why:
DOCN's free cash flow margin jumped from 4% in the prior year's quarter to 16%. Even though management didn't increase its free cash flow guidance for 2023, I now believe that once the restructuring costs from its recent acquisition of Cloudways get into the rearview mirror, there are even more synergies to surface.
What's more, the evidence backing my assertion for improving free cash flows can be found in management's commentary on the earnings call :
For the full year 2023, free cash flow will increase as a result of our improved profit margin and lower capital expenditures, driving 21% to 22% free cash flow margin. Excluding the one-time cost associated with our workforce reduction and transaction costs, like adjusted EBITDA, free cash flow will ramp throughout the year. And we expect free cash flow margin to approach 30% by the fourth quarter.
The Bottom Line
There are some positive and negative considerations. The integration of Cloudways, a managed hosting service, has contributed to growth and is expected to generate improved free cash flow.
However, there are concerns too about DigitalOcean's slowing revenue growth rates, which have dropped from over 30% to mid-20s% CAGR.
That being said, given that DigitalOcean Holdings, Inc.'s outlook for Q4 2023 points to 30% adjusted free cash flow margins, this means a meaningful ramp-up from the present 21% free cash flow in Q1 2023. For investors looking out to 2024, I suspect that DigitalOcean Holdings, Inc. investors are paying approximately 13x forward free cash flow, which is far from expensive for a cloud storage business.
For further details see:
DigitalOcean Holdings: Improving Prospects (Rating Upgrade)