Cloud computing providers big and small are facing a tougher environment compared to a few years ago. As economic uncertainty ramps up, companies are less eager to expand spending as they try to keep a lid on costs. Industry giant Amazon Web Services (AWS), for example, grew revenue by just 12% year over year in the third quarter.
DigitalOcean's (DOCN 3.30%) customer base doesn't have a ton of overlap with enterprise-heavy AWS, but the developer and small-business-focused cloud provider is still feeling some pain. DigitalOcean's revenue growth slowed down to 16% in the third quarter, and the company expects its growth rate to dip into the high single digits to finish out the year.
The company does expect to eke out double-digit growth in 2024, but just barely. The core business is expected to contribute 5% to the growth rate, managed hosting provider Cloudways is expected to contribute 3% to the growth rate, and AI acquisition Paperspace should deliver another 3% to the growth rate.
With DigitalOcean muddling through a difficult environment, is the stock worth buying?
Plenty of work to do
DigitalOcean has successfully used acquisitions to obtain bigger-spending customers. The company caters to individual developers and small businesses with relatively small cloud computing needs. Of DigitalOcean's 633,000 customers, about 479,000 spend less than $50 per month. Within that cohort, the average monthly revenue per customer is just $15.
While only 16,000 of DigitalOcean's customers spend at least $500 per month, that group accounts for more than half of the company's monthly revenue. It's also the fastest-growing group. During the third quarter, DigitalOcean grew the number of big spenders by 13% year over year. The company got a one-time boost last year when it acquired Cloudways, a managed hosting provider with much higher prices than DigitalOcean's platform.
DigitalOcean is still winning new customers, particularly bigger customers, but its existing customer base is clearly pulling back. The net dollar retention rate, a measure of how quickly existing customers are expanding spending, dipped to 96% in the third quarter. That's down from 118% in the same period last year. Anything below 100% means existing customers are, in aggregate, reducing their spending.
This is the core problem DigitalOcean must overcome to accelerate its growth. The company is hoping to get this metric back above 100% sometime in 2024, and it will detail a plan to do so when it reports its fourth-quarter results in February. Complicating the picture is the fact that DigitalOcean is actively looking for a new CEO. It's unlikely that the company will launch any big initiatives before it locks down a new leader.
The bottom line: DigitalOcean's revenue growth will hover around 10% next year, assuming conditions don't worsen, with the potential to improve in 2025 and beyond.
A focus on profits
The good news is that DigitalOcean is producing plenty of free cash flow despite the slowdown. The company expects to convert between 21% and 22% of revenue into free cash flow this year, which works out to roughly $150 million.
This free cash flow, along with a solid balance sheet, gives the company options. Paperspace, the AI infrastructure company DigitalOcean acquired this year, will require significant investment as it scales up. The company can easily fund that expansion, make additional acquisitions, and invest in new products, all of which will help boost the long-term growth rate.
In terms of valuation, DigitalOcean stock doesn't look all that expensive. Based on the full-year guidance, the stock trades for about 15 times free cash flow. That seems reasonable. The management shakeup is a wild card, and it's always possible that demand for cloud computing services will degrade next year if the U.S. economy falls into a recession. But if you take a long-term view, DigitalOcean looks like a solid investment.
