Investor sentiment toward cloud infrastructure provider DigitalOcean (DOCN -1.76%) has recently gone from bad to worse amid concerns about Morgan Stanley and Goldman Sachs analysts lowering the company's price targets and downgrading the stock to a "sell" rating. With investors becoming more concerned about a possible recession, you might wonder whether now is a good time to invest in DigitalOcean.
Here are two Reasons DigitalOcean should be on your investing radar.
Image source: Getty Images.
1. Strong growth, positive free cash flow, and profitability
Despite the turbulent market, DigitalOcean grew its first quarter 2022 revenue by 36% year over year; its fourth consecutive quarter of revenue growth greater than 35% kept the company on pace to reach a revenue goal of $1 billion annually by 2024.
However, a company needs more than revenue growth to survive this terrible market. Investors want to see profitability, and the most critical profitability measurement is free cash flow (FCF), as it shows how well a company converts sales into cash.
DigitalOcean started improving its FCF last year by cutting its capital expenditure (CapEx) costs, which is the money spent on acquiring, upgrading, and maintaining physical assets like data center infrastructure, office buildings, and technology. After management lowered the CapEx from 38% of revenue in 2020 to 26% in 2021, FCF grew from negative $58 million with negative 18% FCF margins in 2020 to 2021 FCF of $24 million with FCF margins of 6% -- a substantial improvement. Management's ultimate goal is to reach 20% or better FCF margins by 2024. This is a great end goal, as most investors generally consider an FCF margin of 10%-15% above average.
Image source: DigitalOcean.
Next, some investors consider GAAP (generally accepted accounting principles) net income as a significant profitability measurement. And while DigitalOcean is not yet profitable (it recorded a GAAP net loss of $18 million in the first quarter) it's within striking distance of breakeven, unlike many of its cloud peers.
DOCN Net Income (Quarterly) data by YCharts.
Moreover, the consensus opinion of 11 analysts who follow the company is that it will turn a GAAP profit in mid-2023. If that holds, DigitalOcean would be one of the few cloud companies growing revenue by 30%-plus while having positive FCF and GAAP profitability.
2. Small businesses need to modernize
DigitalOcean's platform primarily serves the needs of developers working independently, at start-ups, and within small and medium-sized businesses (SMBs) -- a market that CEO Yancey Spruill says is a multibillion-dollar opportunity for the company.
Image source: DigitalOcean.
The global market intelligence firm IDC estimates DigitalOcean's market opportunity will grow at a 27% compound annual growth rate from 2022 to 2025 from a $72 billion base. Since DigitalOcean has maintained a 30%-plus revenue growth rate since its IPO, it is growing faster than its overall market opportunity.
What drives this rapid growth?
The answer is that to survive the pandemic, business leaders started incorporating the latest technology such as collaboration software, e-commerce software, and other advanced tools into every area of their business to overcome shelter-in-place limitations. Digital transformation is the name industry experts gave to this process of embedding the latest computing technology into every part of a business.
In a recent Salesforce report, a survey of SMB leaders worldwide found that 71% of growing SMBs said their business survived the pandemic only because of digitization. Additionally, many of these growing SMBs are accelerating technology investments -- great for DigitalOcean, as the cloud services and tools it offers have become critical services that support digitization. And digitization has now become more than just surviving the pandemic; it is now necessary for a business to remain competitive.
Long-term investors should consider a buy
The company currently has a price-to-sales (P/S) ratio of 8.55, which bearish investors might think is high considering that the P/S ratio for the Nasdaq Composite is 4.57. Also, demand for DigitalOcean services could drop in a recession, resulting in a further stock decline.
Alternatively, DigitalOcean is selling near its lowest valuation since becoming a public company. Considering the company's solid fundamentals and high upside, bullish investors might consider the stock undervalued over the long term.
If you are a long-term investor willing to withstand short-term downside, it is a great time to start accumulating a few shares.
