The bears could be burned by the small-scale cloud platform provider.
Following its initial public offering, DigitalOcean (DOCN 1.75%) took investors on a rollercoaster ride (IPO). On March 24, 2021, the small-scale cloud infrastructure services provider went public at a price of $47, but its stock only opened at $41.50 and ended the day at $42.50.
But on November 16, 2021, the stock price of DigitalOcean reached an all-time high of $130.26 thanks to the subsequent buying frenzy in growth and meme stocks. Its enterprise value peaked at $13.6 billion, or 24 times the amount of money it would make in 2022. That valuation bubble burst as rising rates crushed speculative growth stocks because it was unsustainable.
Currently trading at around $36 per share, DigitalOcean has an enterprise value of $4.1 billion, which is six times the amount of money it expects to make in 2023. Is it a good investment for a comeback or will people just forget about it as another failed tech IPO?
What is DigitalOcean’s function?
Small and medium-sized businesses can use the cloud infrastructure platform services provided by DigitalOcean (SMBs). For larger organizations, Amazon Web Services (AWS), Microsoft Azure, and Alphabet’s Google Cloud already dominate the market for cloud infrastructure, but DigitalOcean offers smaller “droplets” of servers to SMBs that need less processing power.
The bears will highlight two obvious flaws in DigitalOcean’s business strategy. First, larger cloud platforms like AWS, Azure, Google Cloud, and others have already begun to enter the SMB market with more affordable and scaled-down services. It freely acknowledges in its S-1 filing that those larger competitors “possess substantial competitive advantages.”
Second, the cloud infrastructure market requires enormous scale in order to be profitable. AWS continues to be the only market leader that consistently makes money out of the three. Even though DigitalOcean’s revenues are expanding at a similar rate across those much larger infrastructure platforms, the company is still not yet GAAP-compliantly profitable.
What is the growth rate of DigitalOcean?
Although it is a Goliath in a market of Davids, DigitalOcean is still expanding. The company’s total customer base increased by 11% to 677,000 in 2022, its average revenue per user (ARPU) increased by 25% to $75.19, and its net dollar retention (NDR) rate, which measures the revenue growth per existing customer over the previous year, increased by 2 percentage points to 115%.
Up 34% to $576 million, revenue. The company isn’t yet being annihilated by more powerful rivals because all of those growth rates either increased or remained constant from 2021.
DigitalOcean anticipates a revenue increase of 21% to 25% in 2023. Although the outlook is stable, the business continues to face three challenges:
slower customer growth in the more challenging macroeconomic environment
loss of revenue due to the collapse of the cryptocurrency market from Bitcoin and blockchain-related businesses, which peaked at 5% of its revenue in the second quarter of 2022.
Business disruptions in Russia and Ukraine
During its most recent conference call, DigitalOcean announced that it had revised its target date from 2024 to 2025, when it had originally anticipated making over $1 billion in annual revenue. This reduction was disappointing, but it still suggests that the company can increase its revenue from 2022 to 2025 at a compound annual growth rate (CAGR) of at least 20%.
Will DigitalOcean ever be profitable?
The bears anticipated that, in the shadow of AWS, Azure, and Google Cloud, DigitalOcean would find it difficult to increase its margins. But on a non-GAAP basis, the company’s operating, gross, adjusted EBITDA, and free cash flow (FCF) margins have all been rising over the previous three years.
The company anticipates that in 2023, its adjusted EBITDA margin will increase to 38% to 39% and its FCF margin will surpass 20% a year ahead of schedule. It attributes that growth to the implementation of new ARPU-boosting features, its first-ever price increases (which show it has pricing power in its niche), and a decision to let go of 11% of its workforce. It also anticipates that the $350 million acquisition of Cloudways, which was completed in September, will increase sales and produce cost-saving synergies.
According to GAAP, DigitalOcean’s net loss shrunk from $43.6 million in 2020 to $19.5 million in 2021 before increasing once more to $24.3 million in 2022 as a result of the Cloudways acquisition. On a non-GAAP basis, however, it started to turn a profit in 2021, and by 2022, its net income had increased by 141% to $104.7 million. It might eventually make a GAAP profit in the near future if it controls the stock-based compensation (which accounted for 18% of its revenue in 2022).
It might merit a higher price.
Compared to its growth prospects, DigitalOcean appears more fairly valued (although still not inexpensive) than it did in 2021. There are a lot of encouraging signs, therefore it would be wise to take a small position in this stock before more investors take notice of its steady growth, increasing margins, and the unexpected tenacity of its niche market.
