DigitalOcean's (DOCN 3.30%) stock price surged 17% on Nov. 3 after the cloud infrastructure company posted its third-quarter report. Revenue rose 16% year over year to $177 million and exceeded analysts' estimates by $4 million. Adjusted earnings per share grew 22% to $0.44 and also cleared the consensus forecast by $0.22.
DigitalOcean's headline numbers seemed stable, but the stock has still declined more than 20% over the past 12 months and remains nearly 50% below its initial public offering (IPO) price. Let's see why DigitalOcean's stock slumped -- and where it might end up in a year.
Image source: Getty Images.
What does DigitalOcean do?
The cloud infrastructure market is already dominated by tech giants like Amazon, Microsoft, and Alphabet's Google. However, Amazon Web Services (AWS), Microsoft Azure, and Google Cloud Platform (GCP) mainly target larger enterprise customers.
It usually isn't economical for smaller companies to sign up for those large services. To fill that gap, DigitalOcean carves out tiny "droplets" of individual servers for smaller customers at lower prices. It also recently acquired the cloud start-up Paperspace to add GPU-powered artificial intelligence (AI) processing capabilities to its servers.
Why did DigitalOcean drop below its IPO price?
When DigitalOcean went public on March 24, 2021, the stock sank below its IPO price of $47 on the first trade and ended its first day at $42.50. The bears were convinced it was only a matter of time before AWS, Azure, and GCP rendered DigitalOcean obsolete with their own cloud offerings for smaller businesses.
Yet DigitalOcean silenced its critics as its revenue growth accelerated in 2021 and 2022. It continued to gain more customers, its average revenue per user (ARPU) grew, and its net dollar retention rate expanded. As a result, DigitalOcean's stock skyrocketed to an all-time high of $130.26 at the peak of the growth stock rally on Nov. 16, 2021.
But today, it trades at around $25. The stock tumbled again over the past year as its growth in customers, ARPU, net dollar retention rates, and total revenue cooled off. Rising interest rates also compressed its valuations.
|
Metric |
2020 |
2021 |
2022 |
Q1 2023 |
Q2 2023 |
Q3 2023 |
|---|---|---|---|---|---|---|
|
Customer growth (YOY) |
6% |
6% |
11% |
12% |
12% |
2% |
|
ARPU growth (YOY) |
19% |
25% |
25% |
16% |
14% |
6% |
|
Net dollar retention |
103% |
113% |
115% |
107% |
104% |
96% |
|
Revenue growth (YOY) |
25% |
35% |
34% |
30% |
27% |
16% |
Data source: DigitalOcean. YOY = year over year.
Like many of its larger peers, DigitalOcean attributed its slowdown to the macro headwinds that forced companies to rein in their cloud spending. However, DigitalOcean is now growing at a slower rate than most of its larger rivals.
AWS' revenue only rose 12% year over year in its latest quarter, but Microsoft's "Azure and other cloud services" revenue increased 29% and GCP's revenue grew 22%. Azure was also the only leading cloud platform to generate accelerating growth in its latest quarter. It's generally a red flag when the underdog is growing slower than the market leaders.
DigitalOcean has also been acquiring more companies -- including Nimbella, Cloudways, Snapshooter, and Paperspace in 2023 -- over the past three years. Those acquisitions suggest it could be running out of room to grow organically.
For the fourth quarter, DigitalOcean expects its revenue to only rise 9% year over year. But for the full year, it expects its revenue to grow 20%. That's a bit higher than its previous outlook for 18%-19% revenue growth, but it's still well below the 21%-25% growth it had originally forecast in the first quarter of the year.
But its margins have been expanding
DigitalOcean's revenue growth is cooling off, but its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) and free-cash-flow (FCF) margins have both expanded significantly since its IPO. That ongoing expansion implies the company still has plenty of pricing power in its niche market.
|
Metric |
2020 |
2021 |
2022 |
Q1 2023 |
Q2 2023 |
Q3 2023 |
|---|---|---|---|---|---|---|
|
Adjusted EBITDA margin |
30% |
32% |
34% |
34% |
43% |
43% |
|
Adjusted FCF margin |
(18%) |
6% |
13% |
16% |
27% |
32% |
Data source: DigitalOcean.
For the fourth quarter, it expects its adjusted EBITDA to expand 5 to 6 percentage points year over year to 36%-37%. For the full year, it expects its adjusted EBITDA margin to grow to 38%-39% as its adjusted FCF margin rises to 21%-22%.
Where will DigitalOcean stock be in a year?
With an enterprise value of $3.2 billion, DigitalOcean trades at less than 5 times this year's sales and 12 times its adjusted EBITDA. Those are reasonable valuations for a pure-play cloud infrastructure company that could see its revenue growth accelerate again as the macro environment stabilizes.
But its growth is still decelerating, it isn't consistently profitable on a generally accepted accounting principles (GAAP) basis, and it's still shouldering $1.5 billion in long-term debt. Those flaws could drive away the bulls as long as interest rates stay elevated. Therefore, DigitalOcean might remain a resilient underdog in the crowded cloud market over the long term -- but the stock will likely remain far below its IPO price for the next 12 months.
