When discussing cloud infrastructure companies, it's common to think about the three giants: Amazon Web Service (AWS), Microsoft Azure, and Alphabet's Google Cloud. However, these companies only focus on the largest customers, as they provide the largest contracts. But what about the little guy?
DigitalOcean (DOCN -1.76%) is that company. It is specifically tailored to help "developers, start-ups, and small and medium-sized businesses (SMBs) rapidly build, deploy, and scale applications." By focusing on small businesses, DigitalOcean has a massive market in front of it; but is the stock a buy?
DigitalOcean is much cheaper than the bigger companies
Fledgling businesses usually focus on surviving, meaning every expense should be optimized. On-premise computing is expensive and is often outdated within years of purchase. By running applications on the cloud, developers can avoid this expense while simultaneously gaining the ability to access powerful computational power.
DigitalOcean's cloud offering is also much cheaper than the cloud computing giants. For a system with four CPUs, 8 GB of memory, 160 GB of storage, and 5,000 GB of bandwidth, the monthly cost is:
| Provider | Monthly Cost Without Bandwidth | Monthly Cost With Bandwidth |
|---|---|---|
| DigitalOcean | $48.00 | $48.00 |
| Google Cloud | $55.09 | $480.09 |
| Amazon Web Services | $60.74 | $521.54 |
| Microsoft Azure | $60.74 | $452.74 |
Chart by Author. Source: DigitalOcean.
DigtialOcean's product is quite the deal if you include bandwidth in the calculation. However, once customers require massive computing power, DigitalOcean's offering starts to fall behind the more prominent competitors.
But that's according to plan. Remember, it's focused on small and medium-sized businesses. Still, this doesn't mean it's a second-rate offering, as GitLab (a development ops platform) uses DigitalOcean. If a company of software developers making products for developers uses DigitalOcean, it's probably a great offering.
To back it up, DigitalOcean has a 4.5 out of five-star average product rating with over 350 reviews on G2, with customers praising its pricing and customer service.
The business model and implementation check out, but how about the financials?
Management has high hopes for the business
DigitalOcean's third-quarter results were impressive; revenue was up 37% year over year to $152 million, with annual recurring revenue rising 41% to $641 million. The rise in revenue was spurred on by increasing average revenue per user (ARPU), with the average customer spending about $79.22 with DigitalOcean, up 28% over the prior year.
However, DigitalOcean has its eyes on a bigger revenue target: $1 billion in revenue in 2024. Additionally, in 2024, management wants free-cash-flow margins of 20% or greater.
DigitalOcean isn't too far off from its free-cash-flow goal, as it posted a 15% margin this quarter. Yet, management's full-year free-cash-flow margin estimates are about 10.5%.
The Q3 metric does come with an asterisk: If you add stock-based compensation back, it returns to a cash-burn state. Yes, stock-based compensation is technically a non-cash expense. Still, if you don't account for it, you may be tricked into thinking a company is producing massive amounts of cash while aggressively expanding the share count. Still, free cash flow was $22.4 million in Q3, while stock-based compensation was $23.6 million, so DigitalOcean doesn't have a huge gap to close.
With the stock only trading for under six times sales, it's also not terribly expensive.
DOCN PS Ratio data by YCharts.
So with the company rapidly growing, a stock that isn't outrageously expensive, and a management team that believes it can grow its revenue at a 30% pace sustainably, DigitalOcean seems like it checks all of the boxes. The cloud computing market is massive, and DigitalOcean has found its niche in smaller businesses while the more prominent providers go after larger companies. I think DigitalOcean is a strong buy here, and I will likely initiate a position in the stock myself shortly.
