DigitalOcean Stock Is Down in the Dumps Again, but Could a Rebound Be Coming?

Small- and midsized business cloud computing infrastructure provider DigitalOcean (DOCN 3.30%) has been on one wild ride this year. Shares rallied the first half of the year, but investors started selling en masse again and erased all of those gains in recent months. The stock is currently near all-time lows, though there was a bit of a relief rally following the third-quarter 2023 financial update and an upgrade from some Wall Street analysts.

However, a number of important questions now need answering. If those answers are sufficient to assuage investor concerns, could a big DigitalOcean rebound be on the way?

DigitalOcean's last quarter was better than feared

First, those Q3 2023 numbers: Revenue was $177 million, up 16% year over year and a few million dollars better than the outlook management provided three months ago.

Profitability also exceeded guidance. Generally accepted accounting principles (GAAP) net income was $19 million, an 11% net margin. And free cash flow (FCF) remains on track to meet the 21% to 22% profit margin target for full-year 2023. Through the first nine months of the year, FCF was $83 million, up 80% from the same period in 2022 and an FCF profit margin of 16%.

Global woes for the economy are clearly taking their toll on DigitalOcean's small customers, though. Full-year revenue guidance was bumped up to an expected $690 million ($680 million to $685 million before). But the Q4 sales outlook implies just 9% year-over-year growth. That's far below DigitalOcean's mega-cap peers Amazon AWS, Microsoft Azure, and Alphabet Google Cloud, which also reported slowdowns in cloud infrastructure spending, but nonetheless are overall now growing far faster than DigitalOcean.

Data source: DigitalOcean, Amazon, Microsoft, and Google.

Two big questions to ponder on DigitalOcean

At this point, who will be the next CEO of DigitalOcean is the big overhang of uncertainty for this stock. The company reported some errors in calculating tax liability over the summer, and shortly thereafter it was announced that current CEO Yancey Spruill would be leaving. Spruill reported on the last call that the board of directors is in advanced talks with several candidates with extensive cloud infrastructure experience.

And second, investors want to know when the deceleration in revenue growth will stabilize. Spruill said signs are emerging again that the bottom could be near. Several new product launches occurred in recent months to great customer feedback, and average revenue per user chugged higher as a result. The Paperspace acquisition is also complete, providing Nvidia GPUs and related AI use cases to DigitalOcean's computing capabilities.

Nevertheless, the net dollar retention (NDR) rate -- which measures changes in recurring subscription revenue less customer downgrades and cancellations -- fell to 96% in Q3, down from 104% the previous quarter. DigitalOcean still has work to do in retaining and growing its customer base.

At any rate, the business overall could be poised to return to more robust growth in 2024, and management has done a great job getting this tiny cloud infrastructure platform in profitable territory. Shares trade for 27 times enterprise value (EV) to trailing-12-month free cash flow, and about 22 times EV to expected full-year 2023 free cash flow. I still see plenty of value in this small cloud stock and remain cautiously optimistic about DigitalOcean.