1 Impressive Metric Shows How Well DigitalOcean Is Doing -- Is the Stock a Buy?

Many expected DigitalOcean (DOCN -0.90%) to disappoint in the second half of 2022. With global economic conditions worsening, this small cloud computing infrastructure service could easily have shrunk back. After all, it focuses on small businesses -- which many investors view as getting hit hardest by a deteriorating economy (versus larger and slower-moving big businesses). And DigitalOcean's high rate of international revenue was never going to help either, not with the U.S. dollar on a record run-up (which lowers the value of overseas sales).

Instead, DigitalOcean surprised the naysayers during its Q3 2022 report and showed it is more than keeping up with its cloud titan peers. In fact, this one metric shows just how well it's doing right now.

What economic slowdown?

DigitalOcean reported total revenue growth of 37% in Q3 2022, or 33% on an organic basis (excluding the acquisition of cloud hosting service Cloudways back in September). What's impressive about the 33% rise is that it was an acceleration from 29% in Q2. That stands in contrast to the cloud titans Amazon (AMZN -1.14%) Web Services and Microsoft (MSFT -1.84%) Azure, both of which decelerated in the third quarter of the calendar year compared to earlier in the year. Alphabet's (GOOGL 0.35%) (GOOG 0.37%) Google Cloud, also far smaller than AWS and Azure, also notched a healthy acceleration in cloud infrastructure growth in Q3.

Notes: *DigitalOcean results exclude Cloudways revenue of $4.1 million in Q3. **All quarters on a calendar year basis (Microsoft's Q1 2023 corresponds with Q3 calendar year 2022). ***Total Intelligent Cloud and Server revenue was $20.3 billion. YOY = year over year. Data sources: DigitalOcean, Amazon, Microsoft, and Alphabet.

Of course, this is just one quarter of results. DigitalOcean could see weakness in its financials going forward, especially if the U.S. dollar continues to take a heavy toll on revenue from outside the U.S. But as of right now, DigitalOcean is looking incredibly resilient. The outlook for the final quarter of 2022 implies year-over-year revenue growth of 34% at the midpoint of guidance -- hardly a picture of a business struggling against uncertain economic conditions.

Is DigitalOcean stock a buy?

DigitalOcean CEO Yancey Spruill noted on the earnings call that it's too soon to say when weakness in the global economy will ease. However, the fact business is holding up well in spite of various issues is notable. As Spruill pointed out, many investors view small and medium-sized businesses (or "SMBs," companies with under 500 employees) as being particularly vulnerable to economic downturns. 

Thus far, DigitalOcean's revenue growth would prove otherwise. SMBs are nimble, and in the face of uncertainty can quickly pivot. Moving operations to the cloud is a way to save money, and clearly many SMBs are choosing DigitalOcean to cater to their digital needs. 

To capture expected demand in the coming years, DigitalOcean is working on new specific use cases for its platform (like upping its game in data storage). It's also expanding its geographic footprint, like the recent opening of a new data center in Australia. All the while DigitalOcean is still able to maintain robust profitability. Free cash flow was $22.4 million in Q3, or just shy of a 15% profit margin.  

After the last earnings update, DigitalOcean stock trades for over 85 times trailing 12-month free cash flow. That's a steep premium, especially in these market conditions that have put profitability under a microscope. Nevertheless, if you think DigitalOcean can continue to grow sales at about a 30% pace, and continue to increase its profit margins along the way, this is a quality cloud computing platform to invest in for the long-term. I continue to nibble on this stock, building a larger position over time as I expect the cloud industry to continue expanding at a rapid pace for the rest of the 2020s.