On May 9, cloud-computing company DigitalOcean (DOCN -0.03%) reported financial results for the first quarter of 2023 and the market yawned in response. DigitalOcean stock has barely moved since reporting.
On the one hand, it's understandable. DigitalOcean's Q1 results were largely in line with expectations, and forward guidance remained mostly unchanged. However, there was one significant change to DigitalOcean's guidance that most investors missed. But as a shareholder, I'm ecstatic.
The crucial Q1 context
Before I share my excitement, I believe it's important to provide context regarding DigitalOcean's business and recent business results.
DigitalOcean targets small and medium-sized businesses as its primary customers. Management believes this demographic needs an efficient customer-acquisition strategy. It's why it's opted to use a self-serve onboarding process. Management also believes its onboarding process is simple enough for this self-serve strategy to succeed. And the numbers indeed support this belief.
DigitalOcean ended Q1 with 614,000 total customers, up an impressive 12% year over year. That's a large customer base for a small company, leading me to believe its self-serve strategy is working.
The great thing here is how relatively inexpensive it is to acquire customers this way. Sales and marketing is consistently the cheapest line item on DigitalOcean's statements of operations. For example, it spent less than 11% of revenue on sales-and-marketing expenses in Q1, which is fairly normal for this company.
DOCN Revenue (TTM) data by YCharts
By keeping what could be a huge operating expense under control, DigitalOcean has started unlocking impressive free cash flow. Here's a chart of the last eight quarters so that the trend is clearer.
| Quarter | Q2 2021 | Q3 2021 | Q4 2021 | Q1 2022 | Q2 2022 | Q3 2022 | Q4 2022 | *Q1 2023 |
|---|---|---|---|---|---|---|---|---|
| Revenue | $103.8 million | $111.4 million | $119.7 million | $127.3 million | $133.9 million | $152.1 million | $163.0 million | $165.1 million |
| Free cash flow | $10.4 million | $13.5 million | $173,000 | $5.2 million | $18.4 million | $22.4 million | $35.7 million | $25.7 million |
| Free cash flow margin | 5% | 12% | <1% | 4% | 7% | 15% | 22% | 16% |
Source: DigitalOcean's filings. Chart by author. *Q1 2023 adjusted for restructuring charges.
The results aren't completely smooth -- financial results never are. But there's an undeniable trend for DigitalOcean: Revenue is ticking higher, and its free-cash-flow margin is consistently expanding. Q1 was a continuation of the trend.
DigitalOcean is rewarding shareholders
Investors sometimes criticize companies like DigitalOcean for sharing free-cash-flow numbers. Often, companies compensate employees substantially with stock-based compensation. And since this isn't a cash expense, it artificially boosts free cash flow. But stock-based compensation can dilute shareholder value for free-cash-flow-positive companies nevertheless.
That's not the case with DigitalOcean's free cash flow. Whereas shares outstanding are increasing at some free-cash-flow-positive companies, DigitalOcean's share count is going down because it's repurchasing shares at a faster pace. As the chart below shows, the share count has dropped more than 5% in the past year.
DOCN Average Diluted Shares Outstanding (Quarterly) data by YCharts
And now we finally come to what has me excited about DigitalOcean right now. As I said, management largely maintained its financial guidance for 2023. But it did tweak one thing: its guidance for shares outstanding. Previously it believed it would have 114 million to 116 million fully diluted shares outstanding in 2023. Now it believes it will have 103 million to 105 million -- an 8% to 11% decline from its previous guidance.
Translation: Share repurchases are going better than expected.
Now, to be clear, DigitalOcean does pay stock-based compensation. And its guidance implies a slight uptick from its average share count of 101 million in 2022. Therefore, this isn't a complete non-issue for the company.
However, DigitalOcean expects to hit $1 billion in annual revenue in 2025, and it expects to hit a 30% free-cash-flow margin. Therefore, free cash flow should increase dramatically over the next few years, providing more ammunition for share repurchases. This is a big reason why management believes it can reduce its share count by 15% to 20% in coming years.
Referencing the table above, DigitalOcean has about $102 million in trailing-12-month free cash flow. But in 2025, it could have $300 million. That's a clean triple. But if it reduces its share count by 20% during this time, then its free-cash-flow per share will be closer to quadrupling.
As of this writing, DigitalOcean stock trades at about 28 times its trailing free cash flow -- a little pricey considering an average stock valuation would be closer to 15 times to 20 times free cash flow. However, if it can triple or quadruple its free cash flow per share in coming years, I believe DigitalOcean has a clear path to market-beating returns.
