DigitalOcean Stock: The Only Pure Digital Computing Stock

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Digital Ocean (NYSE: DOCN) continues to report strong growth rates despite severe macro headwinds, even though share price valuations remain discounted.While the company appears to be using pricing to maintain near-term growth rates In the long run, this remains a rare pure investment opportunity in cloud computing. The company’s announcement that it will acquire Cloudways illustrates another way the company can accelerate future growth. This is a cash-flowing company whose stock trades at a compelling valuation — I reiterate my Buy rating.

DOCN stock price

Before this tech crash, DOCN had peaked above $130 per share, but was still more than 70% below its all-time high.

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Data provided by YCharts

I last cover DOCN discussed the takeaways from the company’s Investor Day in July. The stock has since fallen about 13%, but I expect more upside for long-term investors.

DOCN Stock Key Indicators

In the most recent quarter, DOCN reported strong revenue growth of 29% and an adjusted EBITDA margin of 34.4%.

The company’s customers paying more than $50,000 a month grew 16% and accounted for 85% of total revenue.

customer growth

Q2 2022 Presentation

In addition to strong customer growth, DOCN reported a net dollar retention rate of 112%.

net dollar retention

Q2 2022 Presentation

Looking ahead, the company expects third-quarter revenue of up to $147 million (up 32%) and full-year revenue of $568 million (up about 32%). DOCN also guided for free cash flow of $54 million with a 9.5% margin.

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Q2 2022 Presentation

On the conference call, management said they will be “very cautious in adding new spending and will prioritize delivering strong margins and free cash flow” until they have a clearer picture of the growth outlook.

In an environment where many companies are taking advantage of macro uncertainty to cut guidance, DOCN’s continued strong performance is a clear positive. That being said, management was asked on the conference call how much of their projected growth was due to their price increases. I didn’t find their answer satisfactory as they seem to be deliberately trying to avoid answering the question (suggesting that much of the recent growth may be due to price increases, which are not sustainable in the long term). One could argue that I’m just nitpicking, considering the company still looks set to generate strong growth rates, even if it’s driven by leverage in the near term.

On August 23, DOCN announced the acquisition of managed hosting service Cloudways. You can think of Cloudways as offering value-added services on top of cloud providers like DOCN. Cloudways is very popular as a hosting provider for WordPress.

Acquired by Cloud Road

Cloud Road Infographic

The deal, which will cost $350 million in cash, isn’t expected to have an impact on margins, but it will boost growth rates.

Financial terms

Cloud Road Infographic

DOCN ended the quarter with $1.2 billion in cash and investments and $1.5 billion in debt. Since the company is cash flow positive, I have no hesitation in the company’s decision to spend $350 million in cash for M&A. Quite the contrary, in fact, the technology collapse provides exactly the type of environment I would like companies to be somewhat aggressive in their mergers and acquisitions.

Is DOCN stock a buy, sell or hold?

DOCN continues to guide revenue of about $1 billion through 2024. Looking back, we can see the revenue and margin targets given at an investor day earlier this year:

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Investor Day 2022

Investors should expect some bumps in the road to $1 billion due to management’s lack of clarity on the impact of pricing on near-term growth rates. Although because DOCN is a cloud computing provider, this is a long-term growth story that should grow with the development of the Internet. Net retention rates are likely to improve over time as DOCN continues to expand its product offering to make it more competitive with alternatives. Consensus estimates call for DOCN to miss its $1 billion goal and projected exit growth rate of 30%.

consensus estimate

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Even assuming DOCN misses its target and hits consensus estimates, the stock looks cheap here. I can see DOCN achieve a 30% net profit margin in the long term. Using a 1.5x price-to-earnings growth rate (“PEG ratio”), DOCN could trade at 10x sales by the end of 2024, implying a share price of $96 per share or about 35% annual upside over the next 2.5 years.

If DOCN does hit its target, it could have more upside – I could see the stock trading at 13.5x by the end of 2024, which would imply a share price of $139 per share, or at the next 2.5 years of annual increases of more than 50%.

I wouldn’t be surprised if DOCN ends up commanding a huge valuation premium due to its entry into the cloud computing space – Amazon’s AWS (AMZN) and Microsoft’s Azure (MSFT) are often considered the crown jewels of these companies. This could make the return potential even more exciting as it could prove to be front-weighted.

The main risk here is mainly because DOCN is competing with formidable competitors in AWS, Azure and Alphabet (GOOG) (GOOGL). Cloud giants may eventually seek price-based competition, which would eliminate DOCN’s main advantage. Although DOCN is a cloud computing provider, this threat may also prevent DOCN from trading at a premium.

At these prices, the thesis work doesn’t take much. Even accounting for the acquisition of Cloudways, the company has a lot of cash on its balance sheet and is running free cash flow. DOCN will be a great addition to a diversified basket of growth stocks — a strategy I’ve discussed with Best of Breed Growth Stocks subscribers. I consider the stock a Strong Buy due to its high potential for a recent re-rating.

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