DigitalOcean (DOCN -0.54%) took investors on a wild ride after its initial public offering (IPO). The small-scale cloud infrastructure services provider went public at $47 on March 24, 2021, but its stock opened at just $41.50 before ending its first day at $42.50.
However, the subsequent buying frenzy in growth and meme stocks propelled DigitalOcean's stock to an all-time high of $130.26 on Nov. 16, 2021. At its peak, its enterprise value reached $13.6 billion -- or 24 times the revenue it would generate in 2022. That bubbly valuation was unsustainable and burst as rising rates crushed speculative growth stocks.
Image source: Getty Images.
Today, DigitalOcean trades at about $36 a share, with an enterprise value of $4.1 billion, or six times the revenue it expects to generate in 2023. Is it worth buying as a comeback play, or will it be forgotten as another burnt-out tech IPO?
What does DigitalOcean do?
DigitalOcean provides cloud infrastructure platform services to small- and medium-sized businesses (SMBs). Amazon's Web Services (AWS), Microsoft's Azure, and Alphabet's Google Cloud already dominate the cloud infrastructure market for larger organizations, but DigitalOcean serves up smaller "droplets" of servers to SMBs that require less computing power.
The bears will point out two glaring problems with DigitalOcean's business model. First, AWS, Azure, Google Cloud, and other larger cloud platforms have already been expanding into the SMB market with cheaper and smaller-scale services. In its S-1 filing, it readily admits those larger competitors have "substantial competitive advantages."
Second, it requires tremendous scale to turn a profit in the cloud infrastructure market. Of the three market leaders, AWS is still the only one that generates consistent profits. DigitalOcean is only growing its revenues at a comparable rate at those much larger infrastructure platforms, but it still isn't profitable on a generally accepted accounting principles (GAAP) basis yet.
How fast is DigitalOcean growing?
DigitalOcean is David in a market of Goliaths, but it's still growing. In 2022, its number of customers rose 11% to 677,000, its average revenue per user (ARPU) grew 25% to $75.19, and its net dollar retention (NDR) rate -- which gauges its year-over-year revenue growth per existing customer -- rose 2 percentage points to 115%.
Revenue rose 34% to $576 million. All of those growth rates either accelerated or held steady from 2021, so the company isn't being crushed by larger competitors just yet.
|
Metric |
2020 |
2021 |
2022 |
|---|---|---|---|
|
Customer growth |
6% |
6% |
11% |
|
ARPU growth |
19% |
25% |
25% |
|
NDR |
103% |
113% |
115% |
|
Revenue growth |
25% |
35% |
34% |
Data source: DigitalOcean.
In 2023, DigitalOcean expects revenue to rise 21%-25%. That outlook is stable, but the company is still struggling with three things:
- Slower acquisition of new customers in the tougher macroeconomic environment
- Loss of revenue from Bitcoin and blockchain-oriented businesses (which accounted for a peak of 5% of its revenue in the second quarter of 2022) as the crypto market collapsed
- Disruptions to its business in Russia and Ukraine
DigitalOcean originally expected to generate over $1 billion in annual revenue by 2024, but it pushed back that target to 2025 during its latest conference call. That reduction was disappointing but still implies the company can grow its revenue at a compound annual growth rate (CAGR) of at least 20% from 2022 to 2025.
Can DigitalOcean ever turn a profit?
The bears believed that DigitalOcean will struggle to expand its margins in the shadow of AWS, Azure, and Google Cloud. But on a non-GAAP basis, the company's gross, operating, adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA), and free cash flow (FCF) margins have all been expanding over the past three years.
|
Metric |
2020 |
2021 |
2022 |
|---|---|---|---|
|
Adjusted gross margin |
76% |
80% |
80% |
|
Adjusted operating margin |
4% |
12% |
18% |
|
Adjusted EBITDA margin |
30% |
32% |
34% |
|
FCF margin |
(18%) |
6% |
13% |
Data source: DigitalOcean.
In 2023, the company expects its adjusted EBITDA margin to rise to 38%-39% and its FCF margin to exceed 20% a year ahead of schedule. It attributes that expansion to its first-ever price hikes (which indicate it has pricing power in its niche), a decision to lay off 11% of its workforce, and the introduction of new ARPU-boosting features. It also expects its $350 million acquisition of Cloudways, which closed last September, to boost revenue and generate cost-cutting synergies.
On a GAAP basis, DigitalOcean's net loss narrowed from $43.6 million in 2020 to $19.5 million in 2021 but widened again to $24.3 million in 2022 as it acquired Cloudways. But on a non-GAAP basis, it turned profitable in 2021 and its net income jumped 141% to $104.7 million in 2022. If it reins in the stock-based compensation (which consumed 18% of its revenue in 2022), it might eventually turn a GAAP profit in the near future.
It might deserve a higher valuation
DigitalOcean looks more reasonably valued (but not cheap), relative to its growth prospects than it did in 2021. A lot of green flags are appearing, and it might be worth nibbling on this stock before more investors notice its stable growth, rising margins, and the surprising resilience of its niche market.
