For developers and small businesses looking to avoid the complexity of sprawling cloud computing platforms, DigitalOcean (DOCN 3.30%) is an attractive option.
While platforms like Amazon Web Services offer enormous lists of products, features, and services, there are some serious downsides. Costs can be hard to predict; learning curves are often steep; and tight integration between different services can make switching providers difficult.
DigitalOcean takes the opposite approach. While the company has expanded its menu of products, the platform remains heavily skewed toward the basics. DigitalOcean offers virtual servers, serverless functions, Kubernetes, managed databases, storage products, and some other odds and ends. Through the acquisitions of Cloudways and Paperspace, it's added managed hosting services and an AI platform.
Fighting through a rough patch
The average DigitalOcean customer spends $92.63 per month on the platform, a pittance compared to the enterprise-heavy cloud giants. While the ease of getting started on DigitalOcean brings in plenty of customers, churn is always going to be an issue, and doubly so in uncertain economic environments.
DigitalOcean is still growing, with revenue rising by 11% year over year in the fourth quarter. The picture doesn't look as bright under the surface. The net dollar retention rate, which measures the pace at which existing customers are expanding spending, dropped to 96% in the fourth quarter. Anything under 100% means that customers are pulling back on spending in aggregate.
There's clearly work to be done to sell existing customers on additional products and services. The good news is that DigitalOcean generates plenty of free cash flow to fuel investments in its platform. The company generated $156 million of free cash flow on $693 million of revenue in 2023, and it expects this metric to be similar this year.
Expanding the platform
DigitalOcean has been adding more ancillary services to its platform. These add-ons integrate with its other products and often provide an inexpensive alternative to third-party services.
One example: DigitalOcean offers a standard backup option like other cloud computing platforms, but the company's acquisition of SnapShooter last year gives its customers a far more robust backup solution. Notably, Snapshooter supports backups across multiple cloud providers. If a customer uses DigitalOcean in addition to other providers, Snapshooter can act as a one-stop shop for backups.
The company is also pushing to make cloud computing even easier for its customers. The recent launch of Cloudways Autonomous, a managed WordPress hosting service that automatically scales resources based on traffic, solves an expensive problem for customers.
A customer with a website prone to traffic spikes would normally need to pay for enough capacity to handle those spikes, with that extra capacity sitting idle most of the time. Autonomous plans are priced based on the total number of visits per month, with instances added and removed as traffic ebbs and flows.
Accelerating growth
Part of the slowdown in DigitalOcean's growth has been the result of the economic environment. However, the company still has plenty of room to add capabilities to its platform while maintaining the same ease of use that has drawn in hundreds of thousands of customers.
CEO Paddy Srinivasan, who took the helm earlier this year, has plans to improve the developer experience, add new products, and invest in AI. Cloudways Autonomous is a good example of the type of product that can generate new customers. Autonomous takes a real customer pain point and solves it in a simple and affordable way. WordPress hosting is a commodity, but managed WordPress hosting with automatic scaling and predictable costs offers a unique value proposition.
Shares of DigitalOcean have tumbled from their pandemic-era high, although they've bounced back a bit over the past few months. The stock is down nearly 70% from its peak, and the company's market capitalization sits at about $3.7 billion.
DigitalOcean stock trades for about 24 times free cash flow. The company's guidance calls for just 10% revenue growth in 2024, similar to its fourth-quarter growth rate. Many of the company's growth initiatives will take time to play out.
Even with sluggish growth set to continue this year, DigitalOcean's long-term opportunity remains enormous. Spending on public cloud infrastructure-as-a-service and platform-as-a-service among individuals and companies with fewer than 500 employees is expected to reach $114 billion this year and nearly double to $213 billion by 2027. A big chunk of that spending will be up for grabs as small businesses look for simpler and cheaper alternatives to the cloud giants.
Interest rates and inflation have led businesses to pull back on spending in some areas. DigitalOcean is feeling some pain, but this situation won't last forever. An improved spending environment coupled with new products and services should help accelerate the company's growth beyond 2024. With DigitalOcean's reasonable valuation relative to free cash flow, now is a good time to buy shares of this profitable cloud computing company.
