2023-09-07 08:44:55 ET
Summary
- DigitalOcean is a cloud computing platform catering to SMBs, with 70% of its revenues coming from outside the U.S.
- The stock is currently fairly valued, with higher valuation multiples compared to the sector median.
- In the current harsh environment for SMBs, I believe that the stock price might fall well below my fair value estimates.
Investment thesis
Despite a substantial year-to-date rally in the technology sector, particularly the one demonstrated by First Trust Cloud Computing ETF ( SKYY ), DigitalOcean's (DOCN) stock has demonstrated almost no price growth since the beginning of 2023. The reasons for the underperformance are on the surface to me. Despite demonstrating solid revenue growth in the latest fiscal quarter, I think that multiple next quarters will be challenging for DOCN. The company targets to serve small and medium-sized businesses, which are the main victims of the current environment of the tight monetary policy in the developed economies. My valuation analysis suggests the stock is approximately fairly valued, but given the current challenging environment and vast competition risks, I think the stock might go well below the fair value. All in all, I assign the stock a "Hold" rating.
Company information
DigitalOcean is a cloud computing platform offering on-demand infrastructure and platform tools for startups and small and medium-sized businesses [SMBs].
The company's fiscal year ends on December 31 with a sole operating segment. According to the latest 10-K report , DOCN generates about 70% of its revenues outside the U.S.
Financials
DigitalOcean went public two years ago, so we have a short history of the company's financial performance. Over the past five years, revenue compounded at almost 30% annually, which is impressive. Despite being a young company, DOCN's operating margin is already close to turning profitable. The same is true of the free cash flow [FCF] margin ex-stock-based [ex-SBC] compensation, which looks very positive.
Having a wide, above 60% gross margin enables the company to invest heavily in innovation. The R&D to revenue ratio has been consistently above 20% over the last five years despite revenue more than doubled. I like the management's commitment to innovation, which can build long-term value for shareholders. Despite having robust revenue growth with expanding margins, the company is in a substantial net debt position. However, I do not see high risks here since this debt is long-term. It is also crucial to mention that the debt represents zero percent convertible senior notes due December 1, 2026, according to the company's 10-K report. The cash position of more than half a billion looks solid, and liquidity ratios are also in excellent shape.
Seeking Alpha
The latest quarterly earnings were released on August 3, when the company slightly missed consensus estimates. Revenue demonstrated a substantial 27% YoY growth, which looks impressive in the challenging environment. Despite a massive revenue growth, during the latest earnings call , the management downgraded its full-year revenue guidance by roughly 5%. This downgrade addresses the weaker-than-expected environment.
The upcoming quarter's earnings release is scheduled for November 3. Quarterly revenue is expected by consensus at $173 million, which indicates a 14% YoY growth. Looks like a significant growth deceleration, though 14% still looks strong amid the current environment. Despite revenue growth, the adjusted EPS is expected to decline YoY slightly, from $0.38 to $0.36.
I have mixed feelings about DigitalOcean. On the one hand, the company operates in a very promising cloud computing infrastructure market, which is expected to compound at 14% by 2030. On the other hand, being a cloud computing infrastructure company means competing with hyper-scale technology companies like Amazon ( AMZN ) with its AWS cloud solution or Microsoft's ( MSFT ) Azure. These large competitors possess substantially more resources and have much stronger brands than DOCN. That said, sustaining growth ahead of the industry looks unlikely over the long term.
The current environment also looks more challenging for DOCN than for its competitors. I think so because DigitalOcean works primarily with SMBs, and this category of business is the most vulnerable to economic downturns. SMBs enjoyed a decade of low interest rates and prospered, but the environment is different now. Due to the substantial costs and complexity of raising equity financing, it is not an option for small businesses. Therefore, SMBs rely heavily on debt financing. As a result, the current environment of high interest rates and the worsening credit crunch are unfavorable for SMBs. That said, the level of economic activity in the SMB segment is poised to decline, which will adversely affect DOCN's revenue growth profile over multiple quarters. Of course, large businesses also suffer from high interest rates, but these companies usually have more options to raise cheaper funds and stronger balance sheets are inherent to larger businesses more than to SMBs. DOCN bulls might say that the company generates only slightly above 30% of its sales in the U.S., but the same problems are now faced by Europe.
Valuation
The stock price appreciated by one percent year-to-date, significantly underperforming the broader U.S. market. Seeking Alpha Quant assigns the stock a "C+" valuation grade, meaning the stock is approximately fairly valued. On the other hand, most of the valuation multiples are substantially higher than the sector median.
Since DOCN is a growth company, the discounted cash flow [DCF] approach would be appropriate to proceed with my valuation analysis. I use an 11% WACC for discounting. Revenue consensus estimates project a 14% CAGR over the next decade, which I consider fair enough. I expect zero FCF margin for my base year but expect 150 basis points yearly expansion for the years beyond.
According to my DCF simulation, the business's fair value is close to the current market cap, meaning the current stock price is fair. Given the massive near-term headwinds and vast level of uncertainty, I cannot say that the stock is attractively valued.
Risks to consider
DigitalOcean is a relatively young company with a short history of publicly available earnings. The company has not yet achieved sustainable positive FCF, which adds vast uncertainty to the future performance.
As a growth company, DOCN faces significant risks to underperform the projected revenue growth and profitability metrics expansion. In case of even a slight underperformance against the guidance or temporary earnings downgrade revisions, the market can overreact significantly. This can result in a massive stock sell-off with a double-digit intraday price drop. That said, investors should be ready to tolerate significant volatility and wait for multiple quarters for the stock price to recover.
The company generates a substantial portion of its sales outside the U.S., making it vulnerable to fluctuations in the foreign exchange market. DOCN's earnings might be adversely affected by unfavorable shifts in foreign exchange rates. It is also crucial to mention that 30% of its sales the company generated in Europe, where most countries demonstrate weakness in the broader economy this year. Recent news suggests that the Eurozone is in a substantial economic downturn . In the U.S., the uncertainty regarding the Fed's further rate hikes also does not add optimism. American economy demonstrates strength despite the highest interest rates in two decades, meaning that more hikes are likely. A strong economy also means that a pivot in tight monetary policy can occur later than expected. High-interest rates will weigh on the valuations of growth companies.
Bottom line
To conclude, DOCN stock is a "Hold". While the long-term shift to cloud computing is a secular tailwind for the company, near-term prospects look ugly, especially for DigitalOcean's "target audience". SMBs are suffering from high-interest rates across all the developed economies, and I do not expect central banks to pivot their monetary policies soon. Despite being fairly valued at the moment, I believe the stock might go well below my fair value estimations due to the unlikeliness of positive catalysts in the near term.
For further details see:
DigitalOcean: Massive Headwinds And Unattractive Valuation