05/29/2024
DigitalOcean: High-Value Tech Stocks, Pure-Play Cloud Computing Provider
It might surprise investors to know that DigitalOcean Holdings, Inc. (NYSE: DOC), once a high-flying cloud computing stock, is now a value stock. The cloud computing industry has lost some of its luster over the past year and DOCN it is often viewed as an inferior player in the sector facing stiff competition from mega-cap tech titans. A challenging macroeconomic environment slowed customer expansion plans, but the company offset these headwinds through pricing initiatives.
Meanwhile, DigitalOcean is generating cash and buying back shares. It’s unclear how the rise of artificial intelligence, or AI, might affect the competitive cloud computing environment, but DOCN stock looks too cheap here — reiterating my strong buy judgment.
DOCN share price
DigitalOcean Holdings, Inc. is still trading at a fraction of its all-time high price, but it can be argued that the stock it never should have traded that high in the first place, despite being the only pure cloud computing stock on the market today.
YCharts data
I last covered DOCN in April where I priced the stock as a strong buy due to rising free cash flows. That thesis remains in play today, as management remains committed to driving profitability gains despite the challenging macro environment.
Key metrics of DOCN stocks
In the most recent quarter, DOCN reported 30% year-over-year revenue growth to $165.1 million and an Adjusted EBITDA margin of 34%.
DOCN has seen its net dollar retention rate drop significantly as the company has faced the same cloud optimization headwinds mentioned by other cloud computing vendors. DOCN was however able to continue to increase the average revenue per user thanks to the price increases implemented last year.
DOCN had already seen a big jump in its builders and scalers in the third quarter of last year due to the aforementioned price increase and has since seen sequential growth slow to near historic levels. Next quarter will be the last quarter that the company has times without price increases, and I expect top line growth to show material deceleration at that point, barring any improvement in the macro environment.
DOCN revealed that while testers and students make up the vast majority of its customer base, builders and scalers account for the majority of revenue.
DOCN ended the quarter with $613 million in cash and investments against $1.5 billion in debt. This net leverage position is somewhat atypical for a newer technology company and reflects the company’s history of mergers and acquisitions, including the recently closed acquisition of Cloudways.
Looking ahead, management guided for the second quarter to see up to $170.5 million in revenue, representing 27.3% year over year growth. However, management maintained its lead on $720 million in full-year revenue, representing 24.9% year-over-year growth. This implies that growth in the second half could slow to just 22%.
Note that DOCN is now guiding for shares outstanding at around 105 million, down from 116 million in previous guidance. The company repurchased 7.76 million shares for $266 million in the quarter, and management indicated on the conference call that it intends to put the remaining $175 million into its share repurchase program this year.
While management said it was uncertain when the macroeconomic headwinds would subside, it said it intended to offset any deceleration in growth rates with notable improvements in profitability. Management expects to exit 2023 with adjusted EBITDA margins around 40 years and free cash flow margins close to 30%. Management has outlined a resounding commitment to its buyback program, saying expectations for their share count will drop by 15% to 20% over the next few years.
Are DOCN shares a buy, sell or hold?
DOCN is a pure cloud computing platform that competes with the likes of Amazon (AMZN) AWS and Microsoft (MSFT) Azure. Despite near-term headwinds, cloud is expected to be one of the fastest growing sectors in the market with an estimated CAGR of 26% through 2026.
DOCN is a much smaller operator than the mega-cap tech titans, but believes it has found a niche that offers a simpler and more cost-effective solution for small to medium-sized businesses or SMEs.
That said, one has to wonder whether the growing enthusiasm for AI could pose a threat to DOCN, as its competitors are undoubtedly more advanced in that area. Management has stated that they have companies running AI-powered models and tasks on our platform today and have done for many years, but are of the opinion that AI could be a key differentiating offering for service providers. cloud computing moving forward. Later in the quarter, DOCN announced it was acquiring privately owned Paperspace for $111 million in cash “to augment its AI offerings.” It’s possible this acquisition could help address any competitive AI-related threats, but the true benefits of the acquisition remain to be seen. Meanwhile, this agreement aims to further increase the net debt position.
These competitive threats appear to be adequately priced in the share price. DOCN recently traded hands at less than 6x sales despite consensus estimates for about 18% growth going forward. I note that consensus estimates appear to cast substantial doubt on management’s claim that they can sustain about 30% growth over the long term.
I’m looking for Alpha
Due to the company’s strong drive towards profitability, the stock recently traded at about 27 times non-GAAP earnings.
I’m looking for Alpha
There aren’t many stocks that can grow their top line at an 18% rate while trading at just 27 times non-GAAP earnings. An argument can be made that DOCN deserves to trade at a hefty premium for being a cloud computing provider, but it’s hard to weigh that against competitive pressures. Based on long-term net margins of 30%, growth of 18%, and a 1.5x price/earnings growth ratio (PEG ratio), I could see DOCN trading at around 8.1x sales, which implies a significant upside. Competitive pressures may be holding back valuation, but management efforts to improve margins and share buybacks should help offset this.
What are the main risks? While the valuation appears somewhat risk-free, the primary risk is that of irrelevance to the competition. It is very difficult to determine if this is a secular growth story based on the long-term growth of cloud computing or if DOCN will eventually see high churn and be unable to compensate for the loss of customers with growth. DOCN appears to have boosted its growth rates with mergers and acquisitions in the past: given the net leveraged balance sheet and higher interest rate environment, I find it unlikely that the company could be that aggressive on the M&A front going forward. It is possible that growth rates will eventually crumble as management has to roll back from previous projections.
Even before the growing interest in AI, competitive threats were significant, but I’m increasingly concerned that tech titans may be able to steal market share thanks to superior AI offerings. Perhaps DOCN was able to thrive in the past due to simplicity and cheaper offerings, but it may not be able to do so in the future if customers aren’t willing to sacrifice AI capabilities. Given solid near-term growth and aggressive stock repurchase program, I continue to see the case for a significant multiple expansion ahead – I reiterate my buy assessment for DigitalOcean Holdings, Inc. stock.
