DigitalOcean (DOCN 0.95%) is aiming to be a disruptive force in the cloud infrastructure market by tailoring its services to individual developers, start-ups, and small businesses. The company had its initial public offering in March 2021, and the stock has seen some volatile swings across its relatively short history as a publicly traded company.
Amid turbulence for the broader market and investors pivoting away from growth stocks, the company's share price has slid roughly 56% year to date and is down about 73% from its lifetime high. The stock is also down roughly 16% from where it closed on the day of its IPO. Should investors pounce on this beaten-down cloud stock, or are its shares still too richly valued? There are always at least two sides to every story. Read on for a look at some of the bullish and bearish catalysts that could shape the stock's performance.
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Bull case: DigitalOcean leads a niche with huge long-term potential
While leading cloud infrastructure providers, including Amazon, Microsoft, and Alphabet, will likely continue to dominate the overall category, DigitalOcean could continue to have success with its specialized market approach. The giants of the industry focus on large customers, but DigitalOcean is providing services and pricing tiers to better meet the needs of small businesses and developers. It's an underserved market, and the company could deliver strong performance if it shores up lasting leadership in the niche.
DigitalOcean's revenue climbed roughly 29% year over year in the second quarter to reach $133.9 million, and the business's average revenue per user also jumped 24% year over year to reach $71.76 in the quarter. The company has the potential to continue growing alongside its customers and generate more revenue as they scale and ramp up their usage of its cloud infrastructure services.
The company's margins are also improving. DigitalOcean posted a 65% gross margin in Q2, representing a substantial increase from the 58% it posted in the prior-year period. While sales growth has decelerated this year, the company has managed to increase revenue at a healthy clip, and it has a large addressable market to expand into. The business is also already posting positive free cash flow (FCF).
DigitalOcean estimates that it will have a $145 billion addressable market in 2025, up from an estimate of $72 billion this year. The cloud infrastructure specialist also expects that it will be able to reach $1 billion in revenue in 2024 and post a 20% free cash flow margin in the period, up from its midpoint guidance for sales of $566 million and a free cash flow margin of 9.5% this year. Hitting those targets would be impressive, but the company would still be just scratching the surface of its addressable market, and the stock could deliver market-crushing returns if DigitalOcean can capitalize on opportunities in its corner of the cloud infrastructure space.
Bear case: The growth-dependent valuation creates risk
Like many cloud software stocks, DigitalOcean's valuation has seen a dramatic pullback this year. But even after some big sell-offs for the stock, the company still has a growth-dependent valuation. DigitalOcean now has a market capitalization of roughly $3.5 billion and is valued at approximately six times this year's expected sales and 48 times estimated adjusted earnings, which could set the stage for more big sell-offs if volatility continues to roil the broader market or business performance comes in weaker than anticipated.
With continued economic uncertainty on the horizon, it's possible that the company's growth targets will prove to be overly optimistic. Inflation, rising interest rates, or a prolonged recession could prompt developers and small businesses to cut back on spending and lead to slower sales growth or weaker margins for DigitalOcean.
While the company has been seeing impressive results when it comes to scaling spending from existing customers, it will have to prove it can continue to attract new customers as well. The number of customers paying at least $50 each month rose 16% to reach roughly 105,000 at the end of Q2, but overall customer growth has lagged behind that pace, and a tougher macroeconomic backdrop could significantly weaken customer acquisitions.
The long-term demand outlook for cloud infrastructure services remains very promising, but some strong performance is already priced into DigitalOcean's valuation, and shares could underperform if the business falls short of expectations or investors continue shifting away from growth stocks.
Is DigitalOcean stock a buy today?
For risk-tolerant investors, I think that DigitalOcean stock is a worthwhile buy with strong potential to significantly outperform the broader market over the next five years. The company's growth-dependent valuation comes with the risk of outsized sell-offs if the broader market continues to struggle, but the cloud infrastructure provider's share price has already come down a lot, and the business's long-term growth potential is intriguing.
