2023-07-06 11:36:48 ET
Summary
- DigitalOcean, a cloud computing provider, saw its stock value surge and then decline sharply after its IPO in May 2021.
- Despite a 30% YoY increase in revenue in Q1 2023, the company's cost of revenues rose by 52%, which is a concern for us.
- The company repurchased $266 million of its shares in the first quarter.
Background
Building and servicing a high-volume website can be difficult. Aside from the required know-how, a lot of behind the scenes work goes into development, maintenance, and infrastructure. Developing a website from scratch, then, can be a daunting task, and many companies would rather outsource the work of finding server space and other issues to someone else. Enter DigitalOcean (DOCN), a cloud computing provider with platform-as-a-service [PAAS], infrastructure-as-a-service [IAAS], and software-as-a-service offerings [SAAS].
Armed with the tools offered by DigitalOcean, companies and their development teams can create, manage, refine, and expand their online presence through myriad options.
The company has only been public since May 2021, but of course, since that time things have been... eventful for high-growth tech companies.
After surging more than 200% from its IPO levels, the company rapidly shed value through the back half of 2021 and 2022, no doubt exacerbated by rising interest rates and investors' sudden distaste for tech companies promising future profits while posting losses today.
2023, however, has been more kind to the company, with the stock rallying more than 50% so far this year. The question now is whether or not the company can sustain this upward momentum - let's dive in.
Financials
In the first quarter of 2023 DigitalOcean posted a net loss which was a bit wider than its previous Q1, though this was in part due to a restructuring plan the company announced in February of this year, which the company expects to have completed by the third quarter of 2023.
In the earnings press release , management highlighted the fact that revenue had increased 30% year over year. This is great news, of course. Less great, however, is the fact that the company's cost of revenues rose by 52% year over year. This is concerning because the costs included in this line item are the company's costs associated with the infrastructure needed to provide customer services--fees for third-party co-location facilities, personnel costs associated therein, and so on. According to DigitalOcean's quarterly filing , this figure contains about $392,000 in stock based compensation and a little over $500,000 in impairment for software no longer in use, but removing these figures does little to make the overall cost of revenue number palatable.
This precipitous rise in revenue costs is no surprise. Data center costs have been rising for some time, and are likely to continue to rise in the future. From increasing wages to employees who work there, to rising power and construction costs (not to mention semiconductor supply chain issues), data centers are just more expensive to utilize today than they used to be .
Management, however, appears to feel that these increased costs are somewhat transitory. CFO Matt Steinfort said in regard to data center costs on the most recent conference call that "[d]ata center expansion is a key element of our growth strategy as we increase our footprint to meet growing customer demand. While margins are initially impacted with these expansions, we will grow into the new capacity over the coming quarters, improving their utilization and margin profile."
This is a curious point, however, since investments in data center expansion are generally treated as capital expenditures and therefore do not typically impact gross margins but are recorded over time under depreciation and amortization. DigitalOcean, though, does not have a stand-alone depreciation and amortization line (as you can see in the P&L pictured above). Instead, it opts to include its depreciation and amortization expense within its cost of revenues.
Let's pull on that string a little bit. According to the quarterly filing, DigitalOcean incurred $28.9 million of D&A costs in Q1 2023, and $23.9 million in Q1 2022. Subtracting those figures from the two cost of revenue numbers leaves us with $42.9 million for Q1 2023, and $23.2 million for Q1 2022--an increase of 85% year over year.
We also remind readers that D&A is calculated cost for long-term investment already made. New property & equipment capital expenditures (which are generally associated with new, long-term purchases) for the quarter totaled $23.3 million, which will have to be depreciated over time as well.
We are left, then, to conclude that higher data center costs associated with the general operation of the business are likely playing a significant role in the growth of DigitalOcean's cost of revenue.
Share Repurchases
Interestingly, DigitalOcean bucks a particular trend when it comes to high-growth software companies in that its share count isn't rising. While the company does post more stock-based compensation than we'd like to see ($31.5 million for the first quarter of 2023), the company has actually engaged in share repurchases.
In the first quarter alone, the company repurchased $266 million of its shared, bringing the current total of outstanding shares to around 88 million.
While stock buybacks are not bad in and of themselves, and while we like to see a high-growth company with a falling share count, we are unsure as to whether or not buying back stock for a company that is currently unprofitable is the best move. Further, while the company still retains a comfortable amount of liquidity, with total current assets of $698 million at the end of the first quarter, the company also has a not insignificant amount of debt. As of the end of the first quarter, the company's balance sheet shows a negative stockholders' equity of $217 million.
The Bottom Line
While DigitalOcean conducts a much needed function in an increasingly cloud-based world, the rising costs associated with the business as well as capital allocation moves that we find curious currently keep us away. Management, however, stated in the most recent conference call that some of the margin pressure headwinds experienced in the first quarter are likely to recede as the rest of 2023 plays out. For us, we will wait and see.
For further details see:
DigitalOcean: Sinking Or Swimming?