Is It Too Late to Buy DigitalOcean Stock?

DigitalOcean's (DOCN 3.30%) stock plunged 25% on Aug. 4, after the cloud infrastructure services provider posted a messy second-quarter earnings report. Its revenue rose 27% year over year to $170 million, while its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) grew 59% to $72 million.

Its revenue matched its own guidance, and its adjusted EBITDA margin of 43% easily surpassed its prior outlook of 37%-38%. However, two issues triggered DigitalOcean's ugly post-earnings sell-off: accounting errors that prevented it from reporting its net income and earnings per share by generally accepted accounting principles (GAAP) and non-GAAP terms, and a big reduction to its 2023 guidance. Let's review those red flags and see if it's too late to buy DigitalOcean's stock.

Image source: Getty Images.

Another quarter of resilient growth

The world's top cloud infrastructure platform providers -- Amazon (AMZN 3.43%) Web Services (AWS), Microsoft (MSFT 1.82%) Azure, and Alphabet's (GOOG 9.96%) (GOOGL 10.22%) Google Cloud Platform (GCP) -- mainly provide their computing and data storage services to large enterprise customers.

However, those plans aren't ideal for individual developers or smaller startups that need only a small amount of computing power. To reach those customers, DigitalOcean provides its cloud services through smaller "droplets" of individual servers.

When DigitalOcean went public in 2021, its critics claimed Amazon, Microsoft, and Google would eventually render it obsolete by providing similar services. But if we look back at its growth in customers, average revenue per user (ARPU), net dollar retention rate (which gauges its year-over-year revenue growth per existing customer), and total revenue over the past three and a half years, we'll see it's still growing rapidly in the looming shadows of those cloud giants. 

Data source: DigitalOcean. YOY = Year over year.

DigitalOcean's revenue growth decelerated in the first half of 2023 as its net dollar retention rate declined, but that wasn't surprising since the macro headwinds had caused many companies to rein in their software spending over the past year.

An unexpected reduction to its full-year guidance

DigitalOcean has also been growing at a comparable rate to its larger peers. In their latest quarters, Amazon's AWS sales rose 12% year over year, Microsoft's "Azure and Other Cloud Services" revenue grew 26%, and Google Cloud's sales climbed 28%.

But looking ahead, DigitalOcean expects its revenue to rise only 13%-14% year over year in the third quarter and 18%-19% for the full year. That marked a significant reduction from its previous full-year outlook for 21%-25% growth. It also warned that its net dollar retention rate would slip to the mid-90s in the third quarter.

DigitalOcean attributed that slowdown to the persistent macro headwinds, but its recent acquisition of the cloud startup Paperspace, which adds GPU-powered AI processing capabilities to its servers, also suggests it's running out of room to grow organically.

Its accounting issues are overshadowing its expanding margins

On the bright side, DigitalOcean's adjusted EBITDA and adjusted free cash flow (FCF) margins have consistently expanded since its IPO as it gradually reined in its spending. Those expanding margins suggest it still had plenty of pricing power in its niche market, and that economies of scale might gradually drive it toward stable GAAP profits.

Data source: DigitalOcean.

DigitalOcean expects its adjusted EBITDA margin to slip sequentially to 38%-39% in the third quarter, but it reiterated its full-year margin outlook of 38%-39%. It also expects its adjusted FCF margin to expand to 21%-22% for the full year.

Unfortunately, a lot of that progress was overshadowed by the aforementioned tax-expense accounting errors that prevented it from reporting its net income and earnings per share by GAAP or non-GAAP measures for the quarter.

DigitalOcean will need to restate its Q1 numbers and spend more time finalizing its Q2 numbers to rectify those mistakes. It claims its revised non-GAAP EPS for the second quarter will probably surpass its prior outlook for $0.40-$0.41 per share, but the accounting errors rattled investors who were already disappointed in its full-year revenue outlook.

Is it too late to buy DigitalOcean's stock?

DigitalOcean's double whammy of bad news crushed its stock, but this could still be a good buying opportunity for investors who can tune out the near-term noise. With an enterprise value of $5.4 billion, DigitalOcean isn't a screaming bargain at eight times this year's sales, but it also isn't terribly expensive if it can keep growing its revenue by more than 20% annually after the macro environment improves. This tiny cloud infrastructure company could also still be a great takeover target for Amazon, Microsoft, and Google -- which could all use its platform as an on-ramp to their other cloud-based services.