DigitalOcean (DOCN -1.76%) just released its earnings report for the first quarter of 2022, and the results sent the stock to record lows. The New York-based cloud infrastructure provider has experienced a drop of more than 70% since achieving a record high about six months ago.
Unfortunately, timing is not my strong suit when it comes to investing, and it showed with my investment in DigitalOcean. I bought the stock in early November, right before it peaked. While I was happy when I saw it at the record high of $133 last November, that joy turned to pain soon after in the tech sell-off. But despite that deep disappointment, I plan to keep my stock and ride this out for three key reasons.
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1. DigitalOcean's industry is only getting started
DigitalOcean provides cloud services to small and medium-sized businesses (SMBs). The cloud allows users to access the functionality and data of a given system without having to store such systems on their computers. This saves enterprises money and allows for better mobility, flexibility, quality control, and other benefits without sacrificing speed or security.
Moreover, both DigitalOcean and its peers have barely scratched the surface of this opportunity. According to Grand View Research, the cloud had grown into a $369 billion industry as of 2021. DigitalOcean made up only a tiny fraction of that with its $429 million in revenue that year. Still, by 2030, Grand View expects the industry to grow to $1.55 trillion, a compound annual growth rate (CAGR) of 16%.
Additionally, the outlook improves further when considering the cloud market for companies of 500 employees or less, which is DigitalOcean's target market. That CAGR rises to 27% on an addressable market of $145 billion by 2025, according to IDC. This market is about $72 billion today.
2. DigitalOcean's competitive moat is solid
Within that market, DigitalOcean could beat its competition. Large providers such as Amazon Web Services and Microsoft's Azure tend to cater to larger enterprises that need more services and have lower cost sensitivity. In contrast, DigitalOcean provides low-cost and easy-to-understand cloud offerings. This means that businesses can manage costs.
However, the most compelling advantage lies in DigitalOcean's community. This community connects businesses with other DigitalOcean clients and provides a library of information they can consult to resolve issues. This especially helps those who run one-person IT departments or business owners who must manage multiple functions.
Furthermore, much like Etsy's community in the e-commerce realm, communities are primarily built with effort rather than money, meaning large players cannot easily copy this model through spending. So far, this community consists of more than 623,000 clients in 185 countries.
3. Company growth is attractive
These clients helped the company generate about $127 million in revenue in Q1 2022. This increased 36% year over year and slightly exceeded the 2021 revenue growth rate of 35%. Additionally, DigitalOcean reported 117% net dollar retention, meaning the average client who has been on the platform for over a year spent 17% more on services than last year.
This led to a non-GAAP net income of $9.4 million, a 168% rise versus Q1 2021. Still, the company reported a GAAP loss due to over $27 million in adjustments, $26 million of which was stock-based compensation.
However, the company predicts revenue between $564 million and $568 million in 2022. Since this represents a 32% increase, the growth rate should only show mild slowing.
The falling stock price has taken the price-to-sales (P/S) ratio down to eight. From one standpoint, this mortifies me since I paid 26 times sales, but I think that an eight P/S ratio is an attractive valuation for such a growth story.
Making sense of DigitalOcean as an investment
As strange as it is to say, I am glad I bought DigitalOcean, given the potential for both the company and its industry. While I wish I had held out for a much lower valuation, even the most well-known investors cannot consistently time markets. Moreover, I felt like DigitalOcean's potential to bring SMBs into the cloud would lead to outsized returns, and I have not changed that viewpoint. I would feel better if this cloud stock recovered sooner rather than later, though.
