DigitalOcean Holdings (DOCN 3.30%) may not be a popular name in the cloud computing space when compared to the likes of Microsoft and Amazon, and that's not surprising as it is currently in its early phases of growth.
Founded in 2012, DigitalOcean isn't a cloud service provider in the mold of its more illustrious peers. The company is known for providing an on-demand cloud computing platform that's used by small businesses, developers, and start-ups, and it has been struggling in the past year because of weak cloud spending. This explains why DigitalOcean stock has gained just 15% in the past year, which is well below the Nasdaq Composite index's 42% gains.
However, a closer look at the company's prospects and its attractive valuation suggests that it could indeed step on the gas in the future. Let's see why that may be the case.
DigitalOcean is facing challenges, but investors should focus on the bigger picture
DigitalOcean released its fourth-quarter 2023 earnings report on Feb. 21. The company's annual revenue increased 20% year over year to $693 million, while adjusted earnings were up an impressive 75% to $1.59 per share. However, a look at DigitalOcean's Q4 results suggests that the company is struggling due to tight spending by customers.
The company's fourth-quarter revenue was up just 11% year over year to $181 million. Its average revenue per user (ARPU) increased only 6% from the year-ago period. Also, DigitalOcean's net dollar retention rate of 96% suggests that existing customers reduced spending on its offerings. This metric was down from a reading of 112% in the year-ago quarter.
The net dollar retention rate compares the spending from its customers in the year-ago period to the spending by the same customer cohort at the end of the current period. So, a reading of less than 100% suggests that spending contracted.
CEO Paddy Srinivasan admitted on the company's latest earnings conference call that DigitalOcean "begins 2024 having weathered a challenging macro demand environment where, like many large platform providers, top-line growth slowed from historical highs." This explains why the company's outlook for 2024 points toward a slowdown.
DigitalOcean expects $765 million in revenue this year, which would be an increase of just over 10% from 2023 levels. It expects earnings to land at $1.64 per share at the midpoint, which would be a big drop in growth from last year. DigitalOcean management, however, is focusing on the long-term growth opportunity available in the market it serves.
The company aims to win a bigger share of customers' wallets by improving customer engagement and integrating new solutions such as artificial intelligence (AI) and machine learning (ML) into its cloud computing platform.
DigitalOcean's acquisition of Paperspace last year could help the company revive customer spending and bring new customers into its fold. Paperspace gives users access to cloud infrastructure accelerated by graphics processing units (GPUs) so that they can train, test, and deploy AI/ML applications. DigitalOcean claims that Paperspace will help its customers access "AI and machine learning-centric cloud applications that harness the power of GPUs in ways that have been predominantly available only to large enterprises."
It is worth noting that the AI-as-a-service market is currently in its early phases and generated $11.3 billion in revenue last year, according to Grand View Research. The researcher expects this market to generate a whopping $105 billion in revenue by 2030. Investors, therefore, can expect DigitalOcean to regain its mojo in the future. The good part is that analysts are anticipating an acceleration in the company's revenue growth from 2025.
DOCN Revenue Estimates for Current Fiscal Year data by YCharts
The stock could step on the gas
Once DigitalOcean's growth starts improving, it won't be surprising to see the stock get a shot in the arm and deliver healthy gains to investors in the long run. As seen in the previous chart, analysts have raised their revenue expectations for DigitalOcean this year and expect its top line to get close to $1 billion in 2026.
The stock is trading at 5.3 times sales, which seems attractive relative to the revenue growth it has been clocking.
DOCN Revenue (TTM) data by YCharts
The market may reward DigitalOcean with a higher sales multiple if its growth indeed accelerates. But even if it trades at its current sales multiple after three years and generates $1 billion in revenue, the company's market cap could increase to $5 billion -- a 43% jump. That's why investors looking to buy a cloud stock that could deliver healthy long-term gains may want to take a closer look at DigitalOcean before it starts heading north.
