Is DigitalOcean the Best Cloud Stock to Buy for 2023?

After getting clobbered by the bear market last year, shares of DigitalOcean (DOCN -3.30%) have been on fire in 2023. The stock is up nearly 30% on the year, despite another pullback as of late. The cloud provider for small and mid-sized businesses (SMBs) is actually continuing to put up great growth numbers, even as its tech titan peers slow.

With that said, is this a top cloud stock to buy for 2023 and beyond? 

DigitalOcean is growing despite big challenges

After more than a decade of fast and consistent expansion, the public cloud market (primarily Amazon Web Services, Microsoft Azure, and Alphabet's Google Cloud) is facing some serious challenges. At best, the economy is expected to slow dramatically this year (or fall into recession at worst).

Inflation is hurting too, as many companies find that the money-saving merits of the cloud have their limits. Data centers are power-hungry, which means that rising energy prices the last couple years equate to cloud operating costs going up.

Yet, even with mass migration to cloud-based IT (seemingly) on hold, small fish in the big pond DigitalOcean suddenly finds itself dramatically outperforming its heavyweight peers in terms of year-over-year revenue performance.

All quarters refer to calendar year 2022 and 2023 growth, as Microsoft's fiscal year ends at the end of June every year. Data source: DigitalOcean, Amazon, Microsoft, and Alphabet.

DigitalOcean's Q1 2023 revenue was just $165 million, so one might assume its tiny size accounts for faster growth than AWS, Azure, and Google Cloud. But CEO Yancey Spruill has said in the past that it's due to the resiliency of the SMBs DigitalOcean serves. In the aggregate, even small businesses can get hit by a downturn, but individually, a small enterprise has far more flexibility in dealing with economic woes than a giant business with countless moving parts.

That's one explanation for DigitalOcean's outperformance last quarter. But one could also say DigitalOcean is growing faster than peers, because the big cloud providers are helping their customers with "cost optimization" -- basically, moving customers to lower-tier offerings to help them save money. But DigitalOcean is doing that too, by recently introducing flexible pricing models to its customers.

Of course, DigitalOcean is also getting a little extra momentum from the purchase of Cloudways in 2022. However, the big public cloud providers make acquisitions too. At any rate, unfair growth-rate comparison for DigitalOcean versus the cloud giants or not, I call it savvy capital allocation.

Basically, don't take too much away from DigitalOcean here. This company is rolling with macroeconomic punches and intensifying competition, and getting more resilient with each blow.

Financial excellence in all the right places

Revenue growth is all fine and well, but profitability is what the market really wants to see these days. On this front, DigitalOcean is putting up exceptional progress. Free cash flow was $12.6 million in Q1 (a 7.6% free cash flow profit margin), or $25.7 million (a 16% profit margin) when excluding one-time cash expenses related to employee severance and restructuring implemented in the quarter. 

Management continues to expect an adjusted free cash flow margin of 21% to 22% for full-year 2023, on revenue of $700 million to $720 million. Additionally, $266 million in share repurchases were made in the quarter to more than offset dilution from stock-based compensation. This did eat into the balance sheet a bit, but the company is still doing OK in this department. It had $613 million in cash and short-term investments on hand at the end of March, offset by debt of $1.47 billion. 

DigitalOcean stock currently trades for 21 times expected 2023 adjusted free cash flow. As I've mentioned in recent months, this doesn't look like the "steal of a deal" it was at the end of 2022, but there could still be plenty of value in this tiny cloud stock. If you're looking for a pure-play on cloud infrastructure, DigitalOcean could indeed still be a best buy now if you're eyeing the company's potential over the long term.