The market has not been kind to DigitalOcean (DOCN +5.34%) in 2022. While the Nasdaq Composite index has dropped 28% year to date, DigitalOcean has plummeted 57%.
Smart investors know that it could get worse from here because of the company's focus on a select consumer demographic. However, this specific focus has its benefits, and creates a competitive advantage that few rivals have been able to replicate. Smart investors also know that DigitalOcean has made cash flow a priority, which will be critical during an economic downturn. Let's examine these factors to see how DigitalOcean could perform over the short and long term.
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1. DigitalOcean focuses on small businesses
DigitalOcean's cloud platform caters to individual developers and small and medium-sized businesses (SMBs) that aren't cloud experts. The company realized that developing cloud infrastructure can be difficult for SMBs, especially when they are inexperienced and forced to use large platforms like Amazon (AMZN +0.53%) Web Services. Those platforms can be complex given their overwhelmingly large product offerings and minimal customer support.
Therefore, DigitalOcean created a simple platform with core products and little else. The company has also focused on creating best-in-class customer support, including a community where developers can learn how to operate on the cloud.
There have been a few benefits to this niche focus. First, DigitalOcean has become known for serving this niche customer cohort, which has helped it gain a brand reputation -- as well as $524 million in annual run-rate revenue (ARR). DigitalOcean's brand reputation is also paying off in other ways: In Q1 2022, the company only spent 15% of revenue on sales and marketing. Comparatively, Snowflake (SNOW 1.61%) spent almost 58% of revenue on marketing in its recent fiscal quarter.
Additionally, with more than 623,000 customers, investors don't need to worry about customer concentration.
However, this niche focus has drawbacks, too. Mainly, these small businesses are just that: small. Out of the company's 623,000 customers, only 102,000 spend more than $50 per month. Therefore, rather than attracting a couple of million-dollar customers, DigitalOcean's expansion strategy lies in gaining lots of small customers and having them increase their spending. Luckily for DigitalOcean, it is doing just that. In Q1, the company's net retention rate was 117%, and for those spending over $50 per month it was 118%. There are also 100 million SMBs globally today, leaving plenty of room for this company to grow.
NYSE: DOCN
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2. The second quarter could be rough sailing
However, there are more drawbacks to focusing on SMBs. This cohort typically has tighter budgets than large, billion-dollar enterprises, so they are more sensitive to economic downturns. With a potential recession on the horizon, DigitalOcean could see higher churn and stagnant average revenue per user growth. Wall Street analysts haven't been afraid to point this out.
The company also recently announced price hikes on some of its products. For the same reason SMBs are more sensitive to economic downturns, price hikes can hurt them too. With both of these impacting customers simultaneously, Q2 or Q3 could be underwhelming for DigitalOcean investors.
3. DigitalOcean has been focused on cash flow
Many tech stocks haven't focused on cash flows and profitability until recession fears arose, which has come back to bite them now. DigitalOcean, however, has made cash flow generation a priority. In Q1, the company achieved a free cash flow margin of 4%, and management expects this to improve throughout the year, reaching 9% for the full year.
The company has the same views about its operating profitability. Q1's operating margin slumped, but for the full year, DigitalOcean foresees a 14% non-GAAP operating margin.
This focus could help the company stay afloat during an economic downturn. In a recession, this business would likely get hurt more than most enterprise rivals, but its financials are in good shape. This business isn't burning cash, and with over $1.5 billion in cash and securities on the balance sheet, it has the resources to withstand a rough storm.
Is DigitalOcean worth buying now?
It's safe to assume there could be some pain in store over the coming quarters, but at eight times sales -- its lowest valuation as a public company -- some of this pain seems to be priced in already.
Additionally, with DigitalOcean's healthy balance sheet and optimistic outlook for this year's profitability, the company looks strong enough to weather this downturn. DigitalOcean still serves an underserved group of customers, and those SMBs will still desire cloud infrastructure. While the amount they demand might change over the coming months, the long-term adoption from these smaller customers is unlikely to waver. As a top dog in this niche space, DigitalOcean could capitalize on it over the long haul.
