DigitalOcean Holdings (DOCN 3.30%) is a cloud computing company that provides Infrastructure-as-a-Service (IaaS) and Platform-as-a-Service (PaaS) solutions. IaaS gives users computing, storage, and networking resources, while PaaS provides a platform for developers to build and deploy applications.
The company designs its cloud services to be easy to use and affordable for small developer teams and small and medium-size businesses (SMBs). Therefore, its business is highly dependent on the financial health of companies of this size.
And it uses a consumption-based business model, which means that its customers only pay for the services they use. This model can be risky during a downturn in the economy as developers and SMBs might use fewer services to conserve cash, hurting DigitalOcean's financial performance. Investors feared these factors would significantly dent its revenue growth in 2022, contributing heavily to the company's stock price decline last year.
Since the global economy is not out of the woods yet, many of the concerns that hurt the stock in 2022 persist in 2023. But growth investors should consider buying the stock at current prices despite these concerns. Here's why.
It targets high-value customers
One of the company's principal objectives is to increase its average revenue per user (ARPU), a crucial profitability metric that investors use to value companies. Its primary strategy to achieve this goal is to continuously launch new features and bundles designed explicitly for customers willing to pay more to meet their needs.
For example, one new capability DigitalOcean launched within the last year was managed cloud hosting when it acquired Cloudways in 2022, giving customers a more powerful, reliable, and secure way to host their applications and websites.
Managed cloud hosting is a service that leases and manages dedicated servers and hardware for a single client. It offers increased reliability, scalability, security, and support. It's a good option for businesses that lack the resources or expertise to manage their websites or want to avoid the hassle of managing their own cloud infrastructure.
Another example is that it recently branched into supporting artificial intelligence (AI) needs by buying Paperspace, a platform capable of running AI applications requiring large amounts of processing power. Ever since OpenAI introduced ChatGPT, virtually every business, from large to small, wants in on the generative AI chatbot revolution, and now DigitalOcean can offer those services -- potentially a huge revenue generator.
By constantly expanding its premium offerings, it can increase revenue without increasing the prices of its base products, an intelligent way to grow its business. The company can appeal to a broader range of customers and capture premium revenue from those that need more-sophisticated solutions.
And at the same time, it will still attract new customers looking for affordable cloud computing without the need for many bells and whistles. This strategy is likely to continue to be successful for DigitalOcean in the future.
Why the stock scares off some investors
The debt-to-equity (D/E) ratio of DigitalOcean is a negative 675% due to total debt of $1.47 billion and negative shareholder equity of $217.7 million. This ratio measures a company's financial leverage. You can calculate it by dividing the company's total debt by shareholder equity. When a company shows a negative D/E ratio, its liabilities exceed its assets -- a sign of potential problems.
DOCN shareholders equity (quarterly) data by YCharts.
On the one hand, the company has high debt. On the other hand, it also has positive cash flow, meaning it generates enough cash from its day-to-day business to repay debt or invest in growth.
DOCN Free Cash Flow (Quarterly) data by YCharts.
The company's future revenue growth and profitability will likely significantly impact its balance sheet. If DigitalOcean can continue growing its business and cash flow, its debt levels will become less of a concern. But if the company's growth slows or its profitability declines, its debt levels could become a significant problem.
Investors should carefully monitor DigitalOcean's financial performance. The company's balance sheet is a risk factor, but not necessarily a deal breaker. If it can continue to execute its growth strategy, its debt levels should be acceptable.
It has great fundamentals
Despite some questions about the balance sheet, there are many other things to like. The company has maintained excellent double-digit revenue growth since it went public in March 2021, as seen in the chart below.
DOCN revenue (annual YoY growth) data by YCharts; YoY = year over year.
The company also generated more cash than management had forecast for its first-quarter 2023 earnings, as it successfully reduced costs. That success is evident in the chart below, which shows that the company's expenses as a percentage of revenue have decreased over the prior year.
DOCN R&D to revenue (TTM) data by YCharts; TTM = trailing 12 months.
DigialOcean's first-quarter 2023 margin for adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA), a measure of profitability, was 34%, up from 29% in the same quarter last year. This increase is a positive sign, indicating that the company is generating more operating cash flow for each dollar of revenue earned. It also suggests that the company can control operating costs and improve efficiency. A rising EBITDA margin can also make a company more attractive to investors.
If you are a growth investor with a high tolerance for risk, this stock should be at the top of your buy list. It has all the makings of a multi-bagger, with a strong management team, a rapidly growing business, and a favorable industry outlook.
