Shares of cloud infrastructure provider DigitalOcean (DOCN 3.30%) tanked more than 24% following the company's second-quarter earnings call. Investors were reacting to news that it would have to restate previously reported earnings results, and that wasn't all. Management also had to walk back its total revenue outlook for the year.
It seems the market started hammering the stock before digging into recent disclosures to see just how damaging they might be. Let's look under the hood to see whether this stock could be a smart buy on the dip.
Earnings restatement
While preparing second-quarter results, DigitalOcean noticed errors in accounting for income tax expenses related to capitalized research expenditures. As a result, it will restate earnings from the first quarter, and that's not all. The issue goes back to 2022, so the independent accounting firm that audited last year's results will revise its statements and issue an adverse opinion regarding internal controls.
Weak internal control over financial reporting is generally disastrous news for publicly traded companies. In this case, though, it's probably nothing to get alarmed about. The company overstated income tax expenses by about $18 million in the first quarter. That means the correction should reduce its net loss.
The company had to withhold earnings guidance due to the error. It will continue withholding earnings guidance until it has time to restate results from the tail end of 2022 and the first quarter of 2023.
Bottoming out?
In addition to the news that it had to restate earnings, DigitalOcean told investors that growth was decelerating faster than anticipated. In May, management told investors it expected 2023 revenue to reach $710 million at the midpoint of its guided range.
Last week, management reduced its full-year revenue estimate to between $680 million and $685 million. This is more than a little disappointing because revenue growth has been decelerating since 2022, and investors had hoped the top line would return to rapid growth.
| Period | Q3 2022 | Q4 2022 | Q1 2023 | Q2 2023 |
|---|---|---|---|---|
| Revenue | $152.1 million | $163 million | $165 million | $170 million |
| Year-over-year change | 37% | 36% | 30% | 27% |
| Quarter-over-quarter change | 14% | 7% | 1% | 3% |
Data source: DigitalOcean Holdings.
DigitalOcean said it had to lower its revenue outlook due to moderating growth across its diverse customer base. The deceleration is expected to continue through the second half.
Revenue for this cloud service provider isn't rising as fast as before, but it's still outpacing industry giants. For example, second-quarter Amazon Web Services revenue grew just 12% year over year.
Controlling costs
There isn't a lot DigitalOcean can do about a general deceleration for the overall cloud service industry. In the second quarter, though, management showed us it can control costs. Investors should feel fairly encouraged by second-quarter sales and marketing expenses that declined by 12% year over year to $16 million. That works out to less than 10% of topline revenue.
DigitalOcean can't tell us how much it will earn this year according to generally accepted accounting practices (GAAP), but I'm not sure I'd let that dissuade me from buying the stock right now. Management hasn't wavered from the impressive non-GAAP profitability metrics it predicted in February. The company still expects adjusted free cash flow to come in at between 21% and 22% of total revenue.
Image source: Getty Images.
Looking ahead
Investors can think of free cash flow as profits a company can use to reward shareholders, pay down debt, or acquire new sources of growth. In a roundabout way, DigitalOcean is doing all three.
The company has reduced its share count by about 5% this year. And, in July, it acquired Paperspace, a cloud infrastructure company with heaps of graphics processing units used for artificial intelligence (AI) applications.
In late 2021, DigitalOcean raised around $1.5 billion through the sale of zero-interest convertible notes that mature in 2026. At the end of June, it still had about $1.5 billion in debt, but investors probably don't need to worry about the upcoming conversion of debt to new shares of its stock.
DigitalOcean's stock price has fallen around 80% from the initial conversion rate on its outstanding notes. This means repurchasing shares now will have a similar effect to buying dollar bills for $0.20 a piece, assuming the notes are allowed to convert in 2026.
A bad news buy?
After its post-earnings knockdown, shares of DigitalOcean are trading for just 20.9 times Wall Street's forward-looking earnings estimates. This is a very reasonable multiple to pay for a company that just grew revenue by 27% year over year.
In fact, it's a reasonable multiple for stocks growing at less than half this pace. Putting some shares in a diversified portfolio now gives investors a great chance to outperform the broad market over the long run.
