Shares of DigitalOcean (DOCN 0.95%), a cloud computing specialist for small and medium-sized businesses, have been rocketing higher in 2023. The stock is up 46% year to date, though it still has a long way to go to recapture its all-time highs from late 2021.
During its last quarterly update, DigitalOcean announced a restructuring plan that will reduce revenue growth this year, but should also help it achieve its targeted profitability metrics more quickly. The market has obviously been pleased and pricing in this new expectation for the small cloud infrastructure technologist. But after this year's sharp run-up, is DigitalOcean stock still a buy?
Expect some noisy earnings reports for a couple of quarters
There will be a growing disconnect between DigitalOcean's GAAP net income and free cash flow this year. The company briefly jumped into GAAP profitable territory in 2022 (during the third quarter specifically, before reporting a GAAP net loss in the fourth). GAAP net income is the metric typically used to calculate the price-to-earnings ratio, which is not currently meaningful for DigitalOcean since it reported a net loss for full-year 2022.
Expect more net losses to kick off 2023. That's because management announced a restructuring plan during its last earnings update. Charges totaling $25 million to $27 million will be incurred during first- and second-quarter 2023 -- charges that include employee cash severance payments and stock-based compensation.
On an annualized basis, DigitalOcean thinks this restructuring will save it about $60 million a year. Given that net losses were only $24.3 million in 2022, the cost savings from restructuring (plus the company's outlook for revenue growth of at least 22% this year, which should yield higher profit margins as well) means DigitalOcean could flip to GAAP profitability by the second half of 2023.
Meanwhile, free cash flow (which excludes non-cash expenses like employee stock-based compensation) profit margin is expected to expand to 21% to 22% in 2023, up from the 13.5% free cash flow margin in 2022. Based on the low end of guidance for 2023 revenue of $700 million, that means DigitalOcean could generate at least $147 million in free cash flow this year.
In other words, while DigitalOcean may appear to be a profitless stock still trading at a high valuation, under the surface the company has been putting in a lot of work to make itself appealing to the value investor crowd.
After the run-up in share price during Q1 2023, DigitalOcean still trades for less than 25 times the low end of free cash flow guidance for the current year. For a company that expects to grow its sales by over 20% during a year with plenty of economic challenges, I'd argue this is indeed a value stock.
Is stock-based compensation ruining the party?
But what about stock-based compensation, the issuance of new stock to employees that saves cash but dilutes existing shareholders? After all, DigitalOcean did issue $106 million worth of stock last year, or just shy of 3% of the current market cap.
I believe management has been addressing this issue too. DigitalOcean repurchased $600 million in stock in 2022, offsetting the value of stock-based compensation and then some. And for 2023, the company is committed to repurchasing at least another $230 million worth of stock, with the ability to opportunistically repurchase (buy the dips) an additional $270 million if it seems prudent to do so.
Again, that should more than offset any dilution from stock-based comp. So rather than dilute shareholders, DigitalOcean is boosting returns to shareholders by reducing share count (basically, making your slice of the pie bigger).
Additionally, the value of outstanding stock options that employees could exercise has also been aggressively reduced over the last year. For its 2022 outlook, DigitalOcean had said its fully diluted shares outstanding (which includes current stock shares issued, and those that could be issued if exercised by employees) was 128 million shares. For 2023, that number has been reduced to a range of 114 million to 116 million.
Simply put, DigitalOcean has turned itself into a shareholder-friendly business.
Is DigitalOcean a buy now?
There are risks to DigitalOcean's business. Rumblings of a recession could put a damper on growth for its small-business customer base. Its much larger cloud computing peers (Microsoft Azure and Amazon Web Services, to name just two massive rivals) are also experiencing sharp slowdowns in growth, and there's always the threat that these tech giants could go after small business customers more aggressively and hurt DigitalOcean's trajectory. Nevertheless, this has been a risk for years, and thus far DigitalOcean has managed to stave off the big tech steamroller.
DigitalOcean isn't as cheap as it was a few months ago. However, the stock could still be a great deal for investors looking to buy and hold for at least a few years, as this tiny cloud computing company makes waves in the small business world.
