DigitalOcean (DOCN -2.72%) just offered investors an impressive third-quarter 2022 report that shows the cloud-computing platform is more than holding its own in the face of an economic slowdown. Revenue in Q3 was up 37% year over year, or up 33% when excluding the recent takeover of hosted cloud-services company Cloudways. The company was able to maintain a healthy balance of profitability along the way, generating a free-cash-flow profit margin of nearly 15%.
However, as the U.S. Federal Reserve's escalated interest-rate hikes this year are only beginning to take effect, DigitalOcean could face its toughest challenge yet. Annualized revenue sat at just $640 million last quarter, but CEO Yancey Spruill still has the $1 billion-a-year revenue milestone by 2024 in his sights -- which would represent an average compound growth rate of about 25% in each of the next two years. How will DigitalOcean pull it off?
Bravo to the job done so far by DigitalOcean
Let's first give credit where credit is due before picking apart Spruill and the company's plan going forward. In Q3 2022, the CEO celebrated his three-year anniversary. As pointed out on the earnings call, when Spruill took the reins a few years ago (before the early 2021 IPO), DigitalOcean was growing revenue at a low- to mid-20% rate and was putting up negative 25% free-cash-flow margins. As other CEOs have done when taking over tech start-ups, Spruill righted the ship by "focusing on the most impactful opportunities" that DigitalOcean had ahead of it.
DigitalOcean fared for the better since then, as evidenced by its recent performance. And as we near 2023, Spruill sees recent momentum carrying over.
The early expectation is for revenue to grow at least another 30% next year and get free-cash-flow profit margins to 20% or higher by 2024. A $70 billion-and-growing market for small and mid-sized business (SMB) cloud services will certainly help, but DigitalOcean isn't taking that for granted. After all, it has hefty competition from some of the most successful organizations of all time in Amazon's AWS, Microsoft, and Alphabet's Google Cloud.
Four ways DigitalOcean plans to grow
Spruill said some of the strategies of the last three years will shift slightly to get DigitalOcean to the next level. As outlined on the last earnings call, the four growth "levers" the company will pull are as follows:
1. Product enhancements that address big markets: DigitalOcean is a tiny cloud infrastructure platform, compared to its peers, but it already has a robust list of capabilities that address complex SMB needs. Still, improvements can be made -- either internally or via acquisition (like what was done with Cloudways). Data storage is one example Spruill pointed to. Data storage services represent just a single-digit percentage of total sales, but housing data is big business for other cloud platforms. With some improvements, management believes it can double its data storage revenue as a percentage of total revenue mix in the coming years.
2. Change product and service bundle pricing: This is a step that already paid off handsomely for DigitalOcean. Back in July, the company introduced a new and cheaper starter tier at just $4 a month. Meanwhile, its previous starter tier was increased to $6 a month to reflect the fuller set of features it comes with today. These pricing changes are, in part, what helped DigitalOcean reaccelerate its growth rate in Q3. However, Spruill said there are other opportunities to refine pricing and put together other service packages that help address some of the specific needs of customers (like offering online security as an add-on). If recent results can be repeated, this could be a huge boost for the company.
3. Expand the sales and marketing department: When Spruill took over in 2019, direct sales were practically non-existent at DigitalOcean. The company relied on its extensive database of free-to-use cloud development tutorials that drive traffic to its site, and in turn, drive sales. However, there was clearly an opportunity to introduce some extra marketing efforts. So far so good, as DigitalOcean's sales efforts raised revenue by 5%, compared to 0% a few years ago. New programs like the recently introduced "Partner Pod" program that arms developers, consultants, and other tech providers with training and co-marketing should help DigitalOcean continue to ramp up its efforts.
4. Expand infrastructure to new locales: DigitalOcean is a cloud infrastructure business, so expanding its reach to customers is also important. That means building new data centers -- the basic computing unit of the cloud. A new data center in Australia will open for business in the final months of 2022, a key market for the tech industry. Additional locations are being planned to further expand into new regions. Not only could this open the door to cloud services for new customers, but it also improves the performance of the company's global network.
DigitalOcean stock trades at a premium
I like DigitalOcean's chances at reaching that $1 billion milepost. It has some momentum working in its favor right now, given the effects of global inflation. With basic expenses rising, the cloud can help SMBs get operationally flexible and save on costs. And now a robustly profitable business itself, DigitalOcean has some leeway in spending money on new growth initiatives.
This stock is still priced at a premium that assumes a fast pace of expansion and rising profit margins. DigitalOcean appears to be on track to deliver the goods after its last earnings update.