The past six months have been brutal for the stock market, and the Federal Reserve's decision to raise interest rates has convinced even more investors to flee. But that indiscriminate sell-off has cerated some enticing bargains. One such company that's selling at a bargain right now is DigitalOcean (DOCN 0.92%).
This cloud computing company caters specifically to small- and medium-sized businesses, but overlooking DigitalOcean because of its size may be a missed opportunity for long-term investors. Let's see why.
Strong business fundamentals
Cloud computing has been pivotal to digital transformation. With the cloud, businesses can build and scale their operations faster than ever. Amazon's AWS, Microsoft's Azure, and Alphabet's Google Cloud are all platforms that offer cloud-based services to massive companies, but often these platforms are too expensive for small developer teams to afford.
DigitalOcean addresses this gap, simplifying cloud computing for smaller businesses. With its vast knowledge resources, convenient onboarding, relatively easy-to-implement products, and affordable pricing, young upstarts with limited resources are excited to partner with DigitalOcean.
During the company's first quarter earnings call on May 4, DigitalOcean reported that its total customer base grew to 623,000, a 6.5% increase year over year. The higher-value cohort, which constitutes customers who pay over $50 per month, grew even faster, improving 20% year-over-year to hit over 102,000.
Average revenue per customer jumped 28% to $68.90. Strong cadence with customers led to a 36% increase in quarterly revenue, bringing in more than $127 million and marking the company's fourth consecutive quarter of 35%-plus revenue growth. DigitalOcean generated $5 million in free cash flow, which was 4% of revenue.
Time horizon matters
All in all, DigitalOcean had a very good first quarter of the year, although that likely wouldn't be the immediate impression if one looked solely at the company's stock price. Shares took a tumble after the earnings announcement, shedding over 16% in a single day. This brought the company's stock price down an eye-popping 76% from its all-time high of about $130 in November 2021.
What likely triggered the post-earnings sell-off was that DigitalOcean missed average analyst expectations on certain metrics. Although the company beat analysts' revenue estimates, it fell short on an earnings per share (EPS) basis, reporting $0.07 per share in comparison to analyst expectations of $0.12. But missing analyst estimates for one quarter is really a non-event. The sell-off seems to me to be more a product of investors' short-term fears around the broader market and macroeconomic headwinds rather than DigitalOcean's business fundamentals.
Management forecasts $566 million in full-year 2022 revenue, which would represent year-over-year growth of 32%. DigitalOcean also anticipates the expansion of its free cash flow margin from 6% in 2021 to 9% in 2022, another indication of strong business momentum for the company. For long-term investors, the reaction to DigitalOcean's share price is a mere blip on the radar.
Making all the right moves
Historically, DigitalOcean's primary means of customer acquisition has been its self-service sales model, in which prospects visit DigitalOcean's website and sign-up for its services. Because of this, increasing web traffic is key. The company has been successful in this regard, increasing traffic among unique visitors by a whopping 70% year-over-year during the first quarter.
That increase came before DigitalOcean acquired CSS Tricks, a learning site with 6,500 articles, videos, guides, and other content focused on website and cloud development. The addition of that valuable content will help in boosting the pipeline of prospects even further.
The company is also complementing its self-service sales model by building a sales force to attract larger customers. These larger customers will have a starting spend of $5,000 to $6,000, as opposed to self-service customers, who start at $15 to $20 per month.
Finally, the company is expanding its product suite and serving more and more of its clients' needs. This will allow a steady uptick in the average spend of existing customers, which currently sits at about $827 per year. That said, one current customer spends as much as $2 million annually with the company. Even a relatively modest increase in per-customer spend could greatly expand the revenue potential of the existing customer base. Growing its products further enhances the company's chances of tapping that growth opportunity.
Adulting at a young age
DigitalOcean's strategy is to attract and cultivate a large universe of developers and early-stage businesses without worrying about customers' initially low spending. As those companies flourish using DigitalOcean's services, the platform will reap rewards over the long term. Successful execution of this strategy is already driving steady growth for the company.
But DigitalOcean is holding itself to a high standard and wants to grow responsibly. It's steadfastly focused on improving free cash flow, or how much cash is left over after paying its bills. The company turned cash flow positive in 2021 and expects to improve its free cash flow margin from 6% in 2021 to 9% in 2022.
It's also striving to ensure that shareholder equity isn't diluted. DigitalOcean repurchased $150 million worth of its own shares in the first quarter. It expects to buy the same amount over the remainder of 2022 to compensate for the equity awarded to executives and employees, ultimately avoiding dilution for shareholders.
The company's fiscally responsible behavior at such a young age is extremely rare to see. This should give investors the confidence that the company is in great hands.
Bringing it all together
Shares of DigitalOcean may continue to be volatile. However, the company is acting deftly to overcome macro headwinds and drive profitable growth. According to DigitalOcean, spending by small- and medium-sized businesses on cloud computing is expected to more than double from $72 billion in 2022 to $145 billion in 2025. With just $566 million in projected revenue for 2022, the company has a long runway ahead.
Looking at the company's prospects, its current price-to-sales valuation of about 7.3, as of this writing, doesn't seem too rich. For patient investors, now may be a great opportunity to take a small position in DigitalOcean.