The cloud infrastructure market is cooling off after years of rapid-fire growth. Amazon's (AMZN 3.43%) market-leading Amazon Web Services (AWS) grew revenue by just 12% year over year in the second quarter, and profits tumbled as customers started to take hard looks at their cloud bills. The same trends are playing out across the industry.
DigitalOcean (DOCN 3.30%), a cloud provider focused on developers and small businesses, still grew revenue by 27% in the second quarter. But the company's guidance was subpar. For the third quarter, DigitalOcean expects revenue to grow by just 14%. That guidance includes the contributions from recent acquisitions, notably from managed cloud provider Cloudways.
While DigitalOcean has little control over how its customers react to a tough economy, there could be deeper problems at the company. It announced on Thursday that CEO Yancey Spruill will step down once a successor has been found.
Spruill has been leading the company since 2019 and successfully guided it through its initial public offering in 2021. There was no specific reason given for the change, beyond the fact that now is the right time for the "next phase of leadership."
Acquisitions may be masking a deeper downturn
Under Spruill's leadership, DigitalOcean has made a series of acquisitions in two areas: content and cloud services. In total, the company has shelled out nearly $500 million on these deals.
The company's main customer acquisition channel leverages a trove of helpful and informative content across multiple websites to draw in prospective customers. It's a cost-effective way to win new customers, with the company spending less than 10% of its revenue on sales and marketing in the second quarter. Notable content acquisitions include CSS-Tricks, a website with thousands of articles focused on front-end web development.
Outside of content, DigitalOcean paid $350 million for Cloudways, $111 million for AI infrastructure provider Paperspace, and undisclosed amounts for server-less platform Nimbella and backup solutions provider SnapShooter. In all cases, DigitalOcean's non-content acquisitions fit in with the company's strategy of keeping its cloud platform simple.
Both Cloudways and Paperspace are growing "substantially faster" than DigitalOcean's core business, according to Spruill. Given that the third quarter this year will include a full contribution from Cloudways and a partial contribution from Paperspace, whereas the third quarter last year included only a few weeks of Cloudways revenue, DigitalOcean's core business may be running into serious trouble.
Its organic revenue growth, which excludes the impact of acquisitions and is not disclosed by the company, will certainly be far slower than the company's guidance for total revenue growth. While it's unclear why Spruill is stepping down, a deterioration in the core business could be one reason.
Assuming DigitalOcean achieves its third-quarter guidance, its full-year guidance implies a year-over-year revenue growth rate of just 7% for the fourth quarter.
Buy on the dip?
Shares of DigitalOcean tanked following its second-quarter report and tanked again on Friday after news of the CEO transition was released. As of early Friday afternoon, the stock was down more than 40% from recent highs.
The CEO change is likely a signal that something is going wrong with DigitalOcean's strategy. The company isn't losing customers at an elevated rate -- churn is about where it was prior to the downturn.
But customers are reluctant to expand spending and, in some cases, are cutting spending as they optimize their cloud bills. DigitalOcean seems to be getting hit harder by this phenomenon than its larger rivals.
I'm a DigitalOcean shareholder, and I'll be holding on to my shares for now. The company's long-term story still looks good, but the core business is clearly having issues in a tough environment. Its market capitalization has slid to about $2.5 billion, or about 17 times its implied full-year guidance for free cash flow.
That's a reasonable price to pay given DigitalOcean's long-term growth potential, but it's going to be a rough ride for investors as the company works through its issues.
