2023-10-20 16:21:55 ET
Summary
- DigitalOcean Holdings, Inc. offers an intuitive cloud computing platform tailored for startups and small and medium-sized businesses, enabling quick application deployment and scalability.
- I'm concerned about its upcoming Q4 revenue outlook and the potential impact on the company's growth momentum and market valuation.
- The company carries around 50% of its market cap as net debt.
Investment Thesis
DigitalOcean Holdings, Inc. ( DOCN ) is a company that provides an easy-to-use cloud computing platform for small and medium-sized businesses. They help these businesses quickly set up and manage their software and applications without worrying about complex technical details.
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 ( expected post-market November 2nd), 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.
Digital Ocean's Near-Term Prospects
In the first instance, I'll discuss DigitalOcean's attractive narrative and discuss its value proposition, then, I'll explain why I'm bearish on the stock. I hope you'll find this analysis balanced enough to help you form your own opinions. Let's get to it.
DigitalOcean is a leading cloud computing platform that offers a comprehensive suite of Infrastructure-as-a-Service, Platform-as-a-Service (PaaS), and Software-as-a-Service solutions tailored for startups and small to medium-sized businesses ("SMBs").
By providing a user-friendly and intuitive interface, DigitalOcean enables its customers to swiftly deploy and scale applications, facilitating innovation and driving business growth.
The platform's key features include simplified pricing, robust customer support, and utilization of open-source technology, thereby empowering them to focus on tasks that contribute to their digital journey.
In the near term, DigitalOcean is determined to capitalize on its recent acquisition of Paperspace, strategically positioning itself in the rapidly growing market for artificial intelligence and machine learning application development.
DigitalOcean aims to expand its capabilities to cater to a broader range of customers, from individual developers to emerging growth SMBs, providing even simpler pricing plans and cost-effective solutions without the constraints of long-term contracts.
One area in which DigitalOcean performs notably strongly is with its customer onboarding user experience. DigitalOcean believes that by identifying higher-growth potential customers early in their lifecycle, they may boost customers' average revenue per user. Furthermore, the company's efforts to build out direct sales and partner channels are expected to serve as vital growth levers in the future.
Now, let's get to the bearish aspects to think about.
Revenue Growth Rates Moderate
DOCN revenue growth rates
DigitalOcean faces several challenges as it navigates through a dynamic and competitive market.
Despite its efforts to stabilize its growth metrics, the company continues to grapple with decelerating expansion rates, signaling potential difficulties in retaining and upselling customers.
Furthermore, the broader slowdown in the technology market has further contributed to slower growth across its diversified customer base, highlighting the susceptibility of the industry to macroeconomic fluctuations.
Moreover, in the cloud infrastructure space, DigitalOcean's competitors include other major cloud providers such as AWS ( AMZN ), Microsoft Azure ( MSFT ), and Google Cloud Platform ( GOOG , GOOGL ).
These competitors offer a broader range of cloud services, including infrastructure as a service, platform as a service, and software as a service (SaaS), targeting both small businesses and large enterprises. While DigitalOcean has a strong focus on simplicity and developer-friendly features, these larger competitors provide a more comprehensive set of cloud solutions tailored to various business needs and scales.
Additionally, the pressure to maintain customer satisfaction and retention remains critical, particularly with the need to address changes in customer cloud usage patterns, as users increasingly adopt a more disciplined approach to managing their cloud resources.
Accordingly, this is my contention. As it stands right now, DigitalOcean will update investors on its Q4 revenues in less than 2 weeks' time. If DigitalOcean doesn't upwards revise its Q4 outlook, this would tell me that this company has now become ex-growth and that investors should brace themselves for it to grow at 10% to 15% CAGR into 2024 . And if that's the case, this stock will not re-rate higher, which leads us to discuss its valuation, next.
A Question of Valuation
DigitalOcean is highly free cash flow generative. And this allowed its balance sheet to carry $1 billion of net debt, without it being a consequential concern to investors. But with slowing revenue growth rates, and $1 billion of net debt, when the company's market cap is $2 billion?
Let's continue and discuss its valuation. For 2023, DigitalOcean is expecting around $150 million. If we presume that 2024 sees DigitalOcean's free cash flow increase by 20% y/y, which is a tough feat in and of itself, this would see DigitalOcean's free cash flow reach around $180 million in 2024. Note, this free cash flow figure is an aggressive assumption.
Altogether, this would put this stock with significant competition and slowing growth rates, plus 50% of its market cap made up of net debt is priced at 11x.
The Bottom Line
My evaluation of DigitalOcean underscores the company's compelling offerings tailored to small and medium-sized businesses within the cloud computing industry.
I also emphasize the platform's ease of use and rapid deployment of applications. Despite these strengths, I highlight its sluggish revenue growth rates and heightened competition from leading cloud providers such as AWS, Microsoft Azure, and Google Cloud Platform.
Further, DigitalOcean encounters challenges in retaining and upselling customers, exacerbated by the broader slowdown in the technology market.
Anticipating the upcoming Q4 revenue outlook, my sentiments toward DigitalOcean Holdings, Inc. lean towards pessimism, suggesting a potential lack of growth momentum. While my valuation analysis acknowledges DigitalOcean's robust free cash flow generation, I'm concerned about its slowing growth rates.
Indeed, should DigitalOcean fall short of revising its Q4 outlook upward, the stock will probably end up selling off further.
For further details see:
DigitalOcean's Cloudy Forecast: Q4 Guidance Is Crucial