Summary
- DigitalOcean's stock is down a staggering 75% from highs.
- DigitalOcean is one of the only pure-play cloud computing vendor stocks in the market today.
- The company has sustained 30+% revenue growth, helped by increases in pricing.
- The company continues to guide for $1 billion in revenues and 20% free cash flow margins by 2024.
- Priced at just 5x sales, this stock is too cheap and has explosive upside potential ahead.
DigitalOcean ( DOCN ) is one of the only, if not the only, pure-play cloud computing vendor stocks in the market today, but that distinction has not helped the stock avoid the brutal beatdown of the past year. While DOCN has seen some macro-impact due to its focus on small- and medium-sized businesses, the company has nonetheless still sustained rapid growth rates and continues to guide for robust growth next year as well. The company has plenty of cash on its balance sheet and is generating positive free cash flow. With the stock trading just like any generic tech stock, I see substantial upside potential as Wall Street re-rates this stock to higher levels.
DOCN Stock Price
DOCN peaked near $130 per share in late 2021 just prior to the bursting of the tech bubble. The stock has since slid 75% and is now trading well below its IPO price.
I last covered DOCN in October where I rated the stock a strong buy on account of the attractive combination of robust growth, solid margins, and a clear-cut secular growth story. A strong earnings report and acquisition since then have only solidified that thesis.
DOCN Stock Key Metrics
The latest quarter saw DOCN deliver 37% YOY revenue growth to $152.1 million (33% excluding contribution from Cloudways). DOCN had previously been guiding to $147 million in revenue, meaning that this represented a small beat.
2022 Q3 Presentation
DOCN continued to see strong growth in its larger customers, with outsized sequential growth in the latest quarter.
2022 Q3 Presentation
As disclosed on the conference call , their increase in pricing generated a 1,200 basis point benefit to the growth rate in the quarter. That may have spooked investors as it implies only 21% growth excluding the price increase (and excluding Cloudways' contribution).
But for now, the price increase has also helped to drive significant margin expansion for both gross and operating margins. Management noted that they are seeing less customer churn than projected from the price increase.
2022 Q3 Presentation
Meanwhile, the 118% net dollar retention rate remained respectable but reflected lower growth in usage after adjusting for the price increases. On the call, management noted that less than a quarter of their customer base cited the price increase as being the cause of their reduced usage, as the reason was more macro-driven.
2022 Q3 Presentation
Looking ahead, DOCN expects $162 million in revenue in the fourth quarter, representing 35.3% growth. Excluding the projected $12 million contribution from Cloudways, that reflects 25.3% YOY growth.
2022 Q3 Presentation
Management noted that these results should be taken in the context of numerous headwinds, including "a global economic slowdown, high inflation, US dollar strength, the Russia-Ukraine war, and the decline in blockchain." Management estimates that these headwinds resulted in a 900 basis point impact to their prior goals of 30% growth. Management is still seeing weakness persist and expects the near term to continue to be impacted by macro issues.
Nonetheless, management is still committed to their long-term targets of 30% annual revenue growth, free cash flow margins of 20% or better, and $1 billion in annual revenue by 2024.
DOCN ended the quarter with $824 million of cash versus $1.5 billion of debt. That already includes the cash paid to finance the Cloudways acquisition. That net debt position is atypical in a tech sector full of net cash balance sheets, but DOCN is generating free cash flow with what appears to be a mission-critical product.
Is DOCN Stock A Buy, Sell, Or Hold?
DOCN remains a compelling proposition as a pure-play cloud computing vendor. Unlike tech titans Amazon Web Services ( AMZN ) or Microsoft Azure ( MSFT ), DOCN focuses on small- and medium-sized businesses. In DOCN's view, SMBs can be intimidated by the complexity and pricing of the tech titan cloud offerings.
2022 Q3 Presentation
In contrast, DOCN offers a much simpler product specifically tailored for SMBs at a lower price point. Management estimates that its prices are roughly half that of the tech titans.
2022 Q3 Presentation
At recent prices, DOCN was priced at only 5x sales. That multiple seems too low considering the strong projected forward growth and what is arguably an attractive secular growth story in cloud computing. While DOCN trades like a distressed tech stock, a clear argument could be made for it to trade more in line with tech darlings like Snowflake ( SNOW ) or CrowdStrike ( CRWD ) given the attractive story, robust growth, and cash flow generation.
Consensus estimates see DOCN falling short of its $1 billion 2024 revenue target, expecting only $938 million in revenue. The stock is trading at just 3x that number. Assuming just 20% revenue growth (recall DOCN is guiding for 30% long-term growth), 20% long-term net margins, and a 1.5x price to earnings growth ratio ('PEG ratio'), I could see DOCN trading at 6x sales by the end of 2024, representing a stock price of $60 per share. That represents 40% potential compounded annual upside over the next two years, and I'd argue that the underlying assumptions incorporate a great deal of conservatism.
What are the long-term growth catalysts? Besides cloud computing being a direct play on the growth of data, DOCN can also benefit from its closed acquisition of Cloudways. Recall that Cloudways is a market leader in managed cloud hosting.
2022 Q3 Presentation
DOCN acquired Cloudways for $350 million and views the acquisition as transformational for its business. DOCN has historically catered to SMBs with a self-serve onboarding model, but Cloudways enables DOCN to cater to SMBs who want a more managed experience. This has a significant impact on the financials - management estimates that Cloudways generates roughly 2x the pricing than their typical offering.
DOCN's low pricing structure and potential to increase ARPU make it a similar investment proposition as a Snapchat ( SNAP ) or Pinterest ( PINS ) is to Meta Platforms ( META ) in social networking. But that also means that it carries similar risks - DOCN may not sustain the same resilient growth rates seen at tech titan competitors AWS or Azure. In fact, a real risk is that as DOCN customers grow larger and larger in terms of their cloud usage, they might switch over to a more robust cloud offering. I'd argue that this risk is priced into the valuation, but it definitely should be emphasized that the risk does exist. Another risk is that of the potential to withdraw long-term guidance. Short interest stands at around 16% , potentially highlighting expectations that DOCN is still being too aggressive in guiding for 30% long-term growth. Many other tech peers like Twilio ( TWLO ) and Okta ( OKTA ) have already withdrawn their long-term guidance and DOCN might be next. While the valuation arguably already reflects any drawdown in guidance, I wouldn't be surprised if the stock took a hit on any such announcement anyways, as this isn't the most tech-friendly market. As discussed with subscribers to Best of Breed Growth Stocks, a diversified basket of quality undervalued tech stocks is my preferred way to take advantage of the crash in tech stocks . DOCN fits right into such a basket, offering high secular growth at compelling valuations.
For further details see:
DigitalOcean: Like Cloud Computing AWS, But Much Cheaper