DigitalOcean Holdings Stock: Potential Difficulties Ahead (NYSE:DOCN)

Thesis

DigitalOcean Holdings (NYSE:DOCN) reported strong operating results for their fourth quarter and is executing well on their strategic plans. The recent failure of SVB and concerns about the regional banking system may slow the development of startups and small businesses. While the valuation continues to look reasonable, investors may want to wait for the release of Q1 results and management’s commentary before buying shares.

You can read our initial writeup on DigitalOcean here.

Strong Fourth Quarter and 2022

For their fourth quarter DigitalOcean reported revenue of $163.0 million which was an increase of 36% year-over-year. Their ARPU grew by a healthy 24%. It’s good that their revenue growth was not fueled entirely by growth in ARPU, and investors should continue to monitor this for the foreseeable future. As long as DigitalOcean is able to add new customers while increasing ARPU they will be able to withstand the competitive pressure from the cloud hyperscalers.

DigitalOcean has a strong history of ARR growth, and this growth has accelerated in recent quarters. This is due to an updated pricing model that you can read about here.

DigitalOcean has done a good job growing their free cash flow margin without compromising revenue growth. As their business achieves additional scale it’s likely they will continue to activate additional operating leverage and improve the efficiency of their operations.

Non-GAAP operating margin has been increasing by 6% annually over the past two years. DigitalOcean still has a long way to go before achieving hyperscaler margins, and we believe they can eventually reach 30% Non-GAAP operating margins. This will require them to continue to meet the needs of their customers better than the hyperscalers. Some bullish investors may believe that DigitalOcean can achieve Non-GAAP operating margins that are even higher than 30% but we would caution that DigitalOcean is unlikely to achieve the scale necessary for that. Additionally, in order to compete effectively with the hyperscalers DigitalOcean will be limited on how far they can push pricing.

Net dollar retention rate continues to increase modestly, but is likely going to hit a wall very soon. As long as DigitalOcean can maintain a net dollar retention rate of around 115% they should be fine as far as this metric is concerned.

DigitalOcean has not only been executing well financially, they have also been executing well strategically.

Continued Strategic Execution

DigitalOcean’s strategy is to be the number one cloud provider for startups and small businesses. This means that DigitalOcean needs to grow with their client base and continually create more value for their customers. We can see this working through their growth in customers classified as “Scalers” and “Builders”. These customer groups grew healthily in both number and ARR.

Their graduation rates have been growing over time and likely have much more runway ahead of them. Investors should keep an eye on their % of builders to scalers graduation rate as these are the most valuable customers for DigitalOcean. They are also the customers who will shape the future offerings that DigitalOcean develops as the company seeks to retain them over the long-term.

While it is important for the Learner pool to continue to grow, it is much more important that the Builder and Scaler pools grow. These pools have shown strong growth over the past couple of years and this growth has accelerated recently (some of that is due to the pricing change).

Their growth in customers paying more than $50 a month got a nice bump from their pricing model update, but this metric is a bit arbitrary. Investors would do well to focus more on ARPU than any “customers paying more than $X a month” metric that the company puts forward.

Potential Issues Ahead

DigitalOcean gave reasonable guidance for Q1 and full year 2023. That being said, this guidance was given before all of the regional banking issues. The collapse of SVB could have a chilling impact on the startup ecosystem. If regional banks run into significant issues and slow down lending activities it could negatively impact the ability of small businesses to grow. If startups and small businesses cut back on their spending it would negatively impact DigitalOcean as these are their key customer groups.

For this reason it seems prudent for investors to wait until Q1 earnings come out and management gives their commentary before buying additional shares. We like the story over the long-term but there are too many unknowns in the short-term to make the risk/reward particularly attractive at these levels.

Price Action

DigitalOcean is well off their all-time highs and is trading below their IPO price of $47. We believe that investors who are highly bullish on DigitalOcean’s future can use this dip to buy shares, as long as they understand the potential risks.

DOCN stock has done well this year and if they can continue to operate well in a difficult environment investors will likely continue to be rewarded over the course of 2023.

Valuation

DigitalOcean appears reasonably valued on a PS basis relative to their history. This valuation could be considered a bit rich by some, but it’s important to note that DigitalOcean remains a cloud computing pure-play. This is a scarcity in public markets and investors are willing to pay a premium for it.

Their valuation on a free cash flow basis has been rapidly improving as the company has begun to take advantage of their scale. This metric will likely continue to improve and we view a long-term price to free cash flow multiple of 25 as being reasonable.

The valuation here looks decent, and if investors are super bullish on DigitalOcean’s prospects these current prices probably look like a bargain. We think it makes sense to wait for Q1 results and management’s commentary before buying shares.

Risks

Some upside risks include:

The ability for DigitalOcean to continue to grow ARPU and attract new customers despite the difficult macroeconomic environment.

The potential for the company to continue to operate more efficiently and expand their free cash flow margins.

Some downside risks include:

The potential for startups and small businesses to dramatically cut cloud spending.

The potential for DigitalOcean to lose customers to the cloud hyperscalers.

The biggest threat to DigitalOcean’s long-term success is competition from the cloud hyperscalers. This competition is what bullish long-term investors in the stock should pay the most attention to.

We view the risk/reward as being average.

Key Takeaway

While DigitalOcean has executed well in the past, the recent failure of SVB and challenges in the regional banking system complicate the story. We believe that investors can wait for Q1 earnings and management’s commentary before buying shares. We like the company and this is definitely one to keep an eye on.