Summary
- DigitalOcean is a cloud computing platform focused on serving small and medium-sized businesses.
- The company just reported Q4 earnings and beat analysts' expectations on both revenue and EPS.
- Investors should be more excited by the free cash flow guidance offered up by management for 2023.
- They expect margins to expand from 13% in 2022 to a whopping ~21% in 2023.
- Combine these margins with the long-term growth prospects, and I think DigitalOcean's shares look incredibly attractive right now.
Investment Thesis
DigitalOcean (DOCN) is a cloud computing platform specialising in infrastructure and platform tools, with a focus on serving small and medium-sized businesses (aka SMBs). This SMB segment has been largely ignored by the cloud behemoths of Amazon ( AMZN ), Microsoft ( MSFT ), and Google ( GOOGL ), who offer enterprise-focused solutions that are overly complex and too opaque for smaller companies.
This is where DigitalOcean differentiates itself, by offering cloud infrastructure and platform technologies that can be implemented quickly, intuitively, and independently - with extremely affordable and transparent prices.
I outlined my detailed investment thesis for DigitalOcean in a previous article , but the short version is this: DigitalOcean is targeting an under-served segment of the market when it comes to cloud services, and it's doing this successfully. Cloud adoption is even more nascent in SMBs, giving DigitalOcean a huge runway and the ability to scale alongside its customers. Basically, it just needs to keep capturing the opportunity in front of it.
The company just reported its Q4 results, and whilst the revenue outlook for 2023 was slightly disappointing, the free cash flow expectations certainly made a splash on Wall Street.
Let's take a look through the highlights from DigitalOcean's results to see exactly why the market rewarded investors with an 8% jump in the share price.
DigitalOcean's Q4 Earnings Overview
Starting from the top, DigitalOcean's Q4 revenue grew 36.2% YoY to $163m, coming in comfortably ahead of analysts' $157-$160m estimates.
It's worth highlighting here that DigitalOcean recently acquired Cloudways for $350m, and this acquisition will boost DigitalOcean's results and YoY comparisons from Q3'22 onwards. I personally think this was a good acquisition, and touched on it in a recent article .
Looking ahead to Q1'23, management guided for revenue of $163-$165m. Despite this representing an impressive YoY growth rate of 28.8% in a tough macroeconomic environment, it came in below analysts' estimates of $169m.
The weaker-than-expected performance on revenues was carried through to DigitalOcean's full year guidance for 2023. Management expects revenue of $700-$720m for FY23, representing YoY growth of 23.2% and coming in below analysts' expectations of $740m.
However, Wall Street didn't seem to mind, and the next couple of graphs will allude as to why.
Moving down the income statement, DigitalOcean delivered adjusted EPS in Q4 of $0.28, coming in comfortably ahead of analysts' $0.19 expectations.
Looking ahead to Q1'23, management guided for adjusted EPS of $0.28-$0.29, which also came in ahead of the $0.24 analysts were expecting despite revenue coming in light. What does that mean? It means DigitalOcean is going to be far more profitable than expected, given that it's churning out a higher profit with less revenue.
This is reflected when we look ahead to the full year for 2023, as management guided for EPS of $1.65-$1.69 with analysts' expecting $1.16.
This is a huge ramp up in profitability for DigitalOcean and was one of the reasons that shares rallied after this earnings report.
These results can be summed up simply: over the next few years, DigitalOcean is going to grow at a slower rate than expected, but it will be far more profitable than expected.
Customer Growth and Soaring Free Cash Flow
One metric I always track with DigitalOcean is its growth of large customers and its dollar-based net retention rate, with the below graph summarising them nicely.
The growth in large customers has clearly slowed down, with DigitalOcean only adding ~2,100 customers into this bucket during Q4. That's no surprise given the macroeconomic uncertainty; however, I'm still pleased with these numbers. I had expected the SMBs that DigitalOcean serves to be more heavily impacted by an economic slowdown, but so far this company (and by extension its customers) has coped well and continues to grow at a healthy rate.
It probably helps that these 'large' customers (defined as customers spending more than $50 per month, which really isn't that large) make up 86% of DigitalOcean's revenue. The larger the business, the more likely it is to cope with these economic shocks, so this is a good sign for DigitalOcean and is yet another reason why it continues to deliver strong results.
But the most exciting aspect of these results for shareholders is DigitalOcean's margins, and in particular the company's free cash flow.
Management stunned Wall Street by forecasting free cash flow margins of 21-22% in 2023, up from 13% in the year just finished and just 6% in 2021. CFO Matt Steinfort implied on the earnings call that this was only the beginning, and that DigitalOcean would head into 2024 with free cash flow margins approaching 30%:
On the back of the strong performance in 2022 and our announced cost reduction initiatives, we have confidence in our plans to pull forward our longer-term free cash flow target and exit 2023 with free cash flow margins in the high 20s.
This should get shareholders excited, and value investors should also be paying attention. DigitalOcean is starting to become a free cash flow machine, and given that a company is theoretically worth the present value of all future cash flows, these increasing margins should have a very positive impact on DigitalOcean's intrinsic valuation.
Quick Take: DigitalOcean's Financial Trends
I won't talk too much on the below table, but I think it's useful to see exactly what's going on with DigitalOcean's financials.
The free cash flow continues to be improving rapidly, the stock-based compensation continues to be impacted by (one-off) performance-based awards granted to CEO Yancey Spruill, and the balance sheet has deteriorated primarily due to the acquisition of Cloudways.
DigitalOcean remains a financially strong business, and it plans to use some of the cash it's generating to buy back shares at what I believe to be very cheap prices.
Normally I'd prefer a company to rightsize its balance sheet if debt > cash, however the debt is 0% convertible notes and the share price is incredibly cheap in my view… so, surprisingly, I don't mind the choice to spend cash on share repurchases.
DOCN Stock Valuation
As with all high growth, innovative companies, valuation is tough. I believe that my approach will give me an idea about whether DigitalOcean is insanely overvalued or undervalued, but valuation is the final thing I look at - the quality of the business itself is far more important in the long run.
The assumptions in my model are fairly similar to my previous article , however I've started to incorporate analysts' estimates into my base case scenario and use the bear and bull case scenarios for my own assumptions. I'm also now able to include the impact of DigitalOcean's Cloudways acquisition, which I wasn't able to do previously.
Putting this all together, I can see shares of DigitalOcean achieving a CAGR through to 2027 of 10%, 27%, and 50% in my respective bear, base, and bull case scenarios. In my eyes, it's very difficult to call this current price anything but enticing for long-term investors.
Bottom Line
Whilst we are seeing a slowdown, and management did push back it's $1 billion annual revenue target from 2024 to 2025, I believe this is largely macro-induced and that DigitalOcean is continuing to perform swimmingly.
The speed with which this company has been able to improve its free cash flow margins has been staggering, and with revenue still expected to grow at a healthy rate despite the recessionary environment, combined will the secular tailwinds in DigitalOcean's back, I think this company is only going one way over the next decade.
Take all that, and add in a share price that I believe is truly undervalued, and it's no surprise that I'll be reiterating my previous 'Strong Buy' recommendation on DigitalOcean.
For further details see:
DigitalOcean Q4 Earnings: A Free Cash Flow Machine