DigitalOcean Holdings (DOCN 1.27%), the cloud platform for small businesses and start-ups, just announced another acquisition. The company said it plans to acquire managed hosting service provider Cloudways for $350 million in cash. This purchase is a little different from what DigitalOcean's focus has been in the past, but it could make a lot of sense -- especially for the clients DigitalOcean serves.
Striking the deal was somewhat expensive for DigitalOcean and it represents a completely new business for the infrastructure company. Is the company up to the task of making the deal work and, more importantly, does it make this stock still a buy?
Help for the cash- and digital resource-strapped small businesses
Before delving into the acquisition itself, let's recap what DigitalOcean and Cloudways do. DigitalOcean is a cloud infrastructure business. Developers and small businesses can "rent" computing hardware that is housed in a data center and access that hardware via an internet connection. This computing hardware can be used to build applications, like a business website or a mobile app.
But getting a new digital tool up and running is one thing, and managing it is another. That's where Cloudways comes in. The company offers a managed cloud hosting service for small businesses. This can free up time and resources for a tiny operation and allow it to focus on the day-to-day running of the business instead of spending time making sure a website or app is functioning properly.
Cloudways doesn't offer any infrastructure itself, but instead partners with cloud providers like DigitalOcean. In fact, according to details of the acquisition, about half of Cloudways' customers utilize DigitalOcean for hosting. The other half use services like DigitalOcean competitor Linode, as well as public cloud giants Amazon Web Services and Alphabet's Google Cloud. For cybersecurity, Cloudways has a partnership with fellow small business tech provider Cloudflare.
DigitalOcean management explained in a recent interview that Cloudways will continue operating as a stand-alone business once the acquisition is complete. The other cloud infrastructure providers available for Cloudways' hosting service might be reexamined at some point in the future, but there are no immediate plans for any changes there. However, DigitalOcean has always aimed to be open source so that it works in a multi-cloud environment (i.e., it plays well with other cloud infrastructure services), and that goal would remain unchanged as Cloudways is integrated.
Help for DigitalOcean as it keeps up with the cloud giants
Hosting services are a new foray for DigitalOcean, but acquiring Cloudways is an interesting move. Making cloud IT as easy as possible for small businesses and start-ups is key for DigitalOcean's growth, but in recent quarters, onboarding new customers has slowed a bit. Of course, much of this can be attributed to tightening global economic conditions in 2022, but making onboarding and ongoing management easier would certainly help DigitalOcean maintain its pace of growth.
That's why Cloudways is an interesting move. The acquisition could help keep DigitalOcean's stream of new user acquisitions flowing. It also provides a more seamless path for existing customers to scale up their usage of DigitalOcean's infrastructure as they need it -- which shows up in metrics like net dollar-based expansion. Net dollar retention was 112% in the second quarter of 2022, meaning that for every $1 the average customer spent with DigitalOcean last year it's spending $1.12 this year. That implies net dollar-based expansion has plenty of room for improvement.
Cloudways could thus help DigitalOcean increase its head of steam. This is particularly important right now since many small businesses are feeling the pressure of slowing economic growth this year, dragging down DigitalOcean's revenue growth rate as a result (revenue was up 29% in Q2 2022, compared to a 36% pace in the first quarter). Public cloud giants AWS and Google Cloud -- partners of the Cloudways service -- grew sales by 35% and 36% respectively in Q2.
Could Cloudways help DigitalOcean pull a coup in the small business cloud infrastructure department? Perhaps it could. But it will set DigitalOcean back $350 million in cash. The company reported having nearly $1.17 billion in cash and investments at the end of June 2022, offset by debt of nearly $1.47 billion, so it isn't a stretch to make the purchase. The good news is that DigitalOcean is profitable on a free cash flow basis, and Cloudways is reportedly a profitable business, so the deal should immediately boost the bottom line for DigitalOcean.
In all, Cloudways looks like a good use of money for DigitalOcean if it can help the company onboard more customers or help existing users scale up. Shares look like a solid buy at just over seven times current-year expected sales, and just over 140 times enterprise value to free cash flow. The valuation assumes DigitalOcean can sustain double-digit percentage revenue growth for at least the next few years, and that profit margins rise from about 8% to 10% today to 20% or higher. With the cloud industry on an unstoppable path higher, DigitalOcean stock is a buy in my book if you plan to hold for the next decade.