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Motley Fool Issues Rare “All In” Buy Alert
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Since bottoming out a few months ago, shares of small cloud-computing platform DigitalOcean (DOCN -4.51%) have been on a tear. The stock is up some 50% since mid-May, rallying along with other tech stocks and the market overall on hopes that the bear market of 2022 might be nearing an end.
DigitalOcean’s second-quarter earnings report certainly helped with this rally, too. Business isn’t perfect right now as the global economy slows and the risk of a recession still looms, but DigitalOcean is proving it’s a resilient operation even in difficult times. Is it too late to buy the stock after the last few months’ rally?
DigitalOcean’s Q2 revenue growth came in at a 29% year-over-year pace to $134 million, the midpoint of guidance provided three months ago. It was a cool-off from the 36% rate of top-line growth reported in the first quarter. Like just about everyone else, DigitalOcean is being affected by a slowing economy, customers scaling back slightly on their spending as they deal with inflation, and the U.S. dollar’s record run-up against most other foreign currencies.
Additionally, DigitalOcean CEO Yancey Spruill also reported on the earnings call that some of the largest customers are cryptocurrency firms, which were deeply impacted by evaporating crypto prices in Q2. Nevertheless, spending among other small and mid-sized businesses remained healthy and handily offset these issues. Just as the cloud computing titans like Amazon‘s AWS and Microsoft Azure have been saying, the cloud is still in growth mode despite headwinds. Cloud computing helps organizations become more efficient, so businesses aren’t likely to cut spending on cloud services as they might on other line items if a recession does eventually strike.
Nevertheless, faced with slowdowns during the quarter, DigitalOcean did decide to cut costs to focus on an essential few growth initiatives. The result was an adjusted operating profit margin of 17%, up from just 11% in Q1. So far this year, DigitalOcean has generated $23 million in free cash flow, or just shy of 9% of revenue. It expects to reach a 9% to 10% free cash flow margin for the full-year period, on its way to scaling to 20% or better free cash flow margins over the longer term.
DigitalOcean isn’t the fastest-growing cloud platform out there. For reference, AWS grew 33% in Q2, Azure grew 40%, and Alphabet‘s Google Cloud grew 36%. Spruill pointed out on the earnings call that, based on Q1 marketing spend and Q2 net new annualized revenue, DigitalOcean is getting positive returns on its customer acquisition expenses within about six months. One could argue that DigitalOcean thus needs to spend more right now to maximize its potential. But Spruill and company run a tight ship, and maintaining profitable growth is the name of the game for the company.
Over time, growth and higher profitability should be a winning combination.
But time will be a key ingredient for this stock. Though shares remain down well over 40% so far this year, DigitalOcean stock trades for 155 times enterprise value to trailing-12-month free cash flow. On a price-to-sales basis, the stock is valued at just under nine times current full-year expected sales. Suffice to say, the market expects DigitalOcean to continue delivering double-digit percentage growth for at least a few years.
The good news is that Spruill and the top team expect just that. The company still sees a path to reaching $1 billion in annual sales within the next few years — implying revenue growth of about 25% to 30% through 2025. It’s a lofty goal but not unreasonable, given that the cloud industry overall should grow around this same rate on its way to $1 trillion in annual spending within the next decade or so (researcher Gartner sees the cloud market hitting $500 billion in 2022).
If DigitalOcean can sustain this pace and, more importantly, scale up its operation to reach 20% free cash flow margins or better, it’s certainly not too late to own a piece of this small business. Patience will be required, though, and not every investor may want to jump aboard right now. Here’s a checklist of general guidelines for owning a stock like DigitalOcean:
In spite of economic difficulties, DigitalOcean’s Q2 2022 update was rock solid. The small cloud platform is holding its own and building a solid base of small and medium-sized customers and start-ups. Given the uncertain economic situation for many of these small businesses, it’s encouraging to see their vote of confidence in what DigitalOcean can do for them. I remain a buyer right now.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Nicholas Rossolillo has positions in Alphabet (C shares), Amazon, and DigitalOcean Holdings, Inc. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Amazon, DigitalOcean Holdings, Inc., and Microsoft. The Motley Fool recommends Gartner. The Motley Fool has a disclosure policy.
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