2023-11-21 07:39:39 ET
Summary
- Positive aspects include DigitalOcean's profitability and robust cash flow generation.
- However, concerns arise over its stock valuation, trading at 17x forward EPS with guided decelerating growth rates.
- Q3 guidance revision was optimistic, but a dip in net dollar retention raises customer retention concerns.
Investment Thesis
DigitalOcean (DOCN) provides cloud infrastructure solutions, offering scalable computing resources, meaning a consumption-based business model (more on this soon). Their platform enables users to deploy and manage applications seamlessly, emphasizing simplicity and efficiency in navigating the complexities of the cloud.
Even though the business is highly profitable and cash flow generative, I don't find its stock particularly cheap, given its underlying growth rates for 2024.
Consequently, I'm sticking to the sidelines here for now, but leave myself the opportunity to revisit my thesis if I see that its growth prospects meaningfully improve.
Quick Recap,
In my previous neutral analysis , I said,
Undoubtedly, there's a lot to like about DigitalOcean. Not only is its corporate narrative compelling but also, the business oozes free cash flow, two matters that are clearly bullish.
But the problem I have is that there are countless competitors offering largely the same service. And throughout the sector, I consistently find one refrain. Customers are being more restrained with their IT expenditure.
As we look out for Q3 earnings in less than 2 weeks, I expect to see DigitalOcean upwards-revising its revenue outlook for Q4. If it doesn't improve its guidance, I'll revisit this stock with a sell rating.
Q3 2023 results are in, and DigitialOcean did upwards revise its guidance. So, this is bullish, right? Well, not so fast, as you'll soon see.
I'll first discuss the bull case for investors and then I'll discuss some detractions that keep me on the sidelines.
DigitalOcean's Near-Term Prospects
DigitalOcean operates as a cloud infrastructure provider, serving as a virtual platform where businesses and developers can rent computing resources to run websites and applications efficiently. One of its central offerings, known as a droplet, functions as a high-performance computing unit, simplifying the process for users to build and expand their online projects.
DigitalOcean's key products, such as Managed Kafka, premium features for general-purpose droplets, and scalable storage for managed databases, underscores the company's commitment to meeting evolving customer needs and enhancing platform capabilities.
The integration of Paperspace's AI/ML capabilities has garnered strong demand, presenting the potential for an expanded market opportunity. As DigitalOcean continues to navigate the complexities of the cloud market, customer-centric simplicity remains foundational to its value proposition.
All that being said, without getting too caught up in details, DigitalOcean faces the challenge of successfully navigating the CEO transition and ensuring a smooth leadership change.
However, perhaps most critical of all, is the following trend that we can see in the following two graphs.
Above we see DigitalOcean's net dollar retention for DigitalOcean's previous 3 years. In each of its calendar years, DigitalOcean saw a positive increase in net dollar retention figures.
However, Q3 results saw its figures dip to less than 100%. This implies that not only is DigitalOcean not succeeding in increasing its sales from customers, but that it's actually losing its ability to retain its customer base.
I've often stated, that consumption-based business models work well in certain market environments, but that high-quality businesses don't put themselves on the opposite side of the table to their customers.
Rather, they set up their businesses to maximize consumption, not to maximize revenues. The short-term tactic of seeking to maximize revenues only works positively for so long, before customers seek out alternative products.
Revenue Growth Rates Guided for 2024
DigitalOcean provided investors with unofficial 2024 revenue guidance during its earnings call. Essentially, the way the guidance was framed gave investors the impression that DigitalOcean could perhaps reach 12% CAGR in 2024.
Indeed, since DigitalOcean gave investors that guidance, the share price has been moving higher. Why?
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I argue that analysts and investors had become too bearish on DigitalOcean's revenue growth rates and that the stock is re-rating higher off that high level of pessimism that the stock was pricing in.
However, I assert that this doesn't detract from my straightforward contention that this business is delivering decelerating revenue growth rates. And that investors will not reward this stock with a high premium, if DigitalOcean ends up delivering around 10% to 15% CAGR in 2024 and possibly less in 2025.
DOCN Stock Valuation -- Fully Priced
DigitalOcean guides for about $1.55 of EPS in 2023. If we look out to 2024 and expect its EPS to grow by approximately 15%, this would mean that its EPS would reach approximately $1.75 in 2024.
This means that DigitalOcean is priced at approximately 17x forward EPS. That's not an expensive valuation by any measure, but it's far from exciting when its business is growing at around the low-double digits.
The Bottom Line
While DigitalOcean presents some positive aspects, such as its profitability, cash flow generation, and appealing narrative, I remain cautious about its stock valuation.
Paying 17x next year's EPS for a business guiding for decelerating growth rates around 12% CAGR doesn't appear to be an asymmetrical bet.
The competitive landscape and customers' restrained IT expenditure poses challenges, and despite an optimistic Q3 guidance revision, concerns about net dollar retention slipping below 100% raise questions about the company's ability to retain its customer base.
As DigitalOcean navigates a CEO transition and integrates Paperspace's capabilities, the business is at a critical juncture. I'll continue to monitor its growth prospects closely, but for now, I find the risk-reward ratio unappetizing.
For further details see:
DigitalOcean's 2024 Revenue Growth Rates And Prospects