DigitalOcean's growth challenges have created an attractive entry point in this niche cloud stock

2023 has been a great investing year for most, but not all public companies. While AI names are thriving, other companies serving small and midsized customers are facing challenges due to multidecade-high interest rates and inflationary pressures. Niche cloud player DigitalOcean ($DOCN) belongs in this category.

DOCN stock tumbled in early August after the company slashed its full-year growth outlook on persistent macro pressures. However, as you can see below, the stock has recently rebounded nicely. It’s now on track to outperform the market for the year, despite the selloff a few months ago.

The company may be facing growth headwinds in the near term, but its fundamentals and growth prospects remain strong, and profitability is at record highs. The current prices present an attractive entry point for long-term investors. Here’s why:

There Is A Market For DigitalOcean’s Offerings

DigitalOcean is a battleground stock that divides investors. This is because it essentially competes with cloud giants like AWS and Google Cloud. The naysayers believe that DOCN has no chance of winning in the cloud infrastructure space since it’s dominated by the cloud giants. To some degree, this is a solid argument. However, DigitalOcean has crafted its own niche where it dominates.

SMBs don’t have the resources and expertise to navigate the complex configurations and pricing models of larger cloud providers. This is where DigitalOcean comes into play. By focusing on simplicity and affordability, DigitalOcean has carved out a significant presence in the SMB market.

DOCN’s strategy is centered around user-friendly cloud services. Unlike its larger competitors who offer a wide array of complex and often overwhelming services, DigitalOcean provides a more streamlined and intuitive experience. This approach appeals to smaller businesses and individual developers who seek simplicity and cost-effectiveness over a broad suite of services.

One of the key advantages of DigitalOcean is its pricing model. The company offers transparent and predictable pricing, which is a stark contrast to the often complicated and opaque pricing structures of its competitors. This simplicity in pricing makes budgeting easier for SMBs, who usually operate with limited financial resources.

As of Q3, the SMB-friendly cloud platform boasted 154K customers paying more than $50 per month, up 9% y/y, and 633K in total. It’s the largest cloud infrastructure platform in the SMB space, and its large community creates a competitive advantage. By offering a wealth of resources, including comprehensive documentation, tutorials, and an active community forum, DigitalOcean has fostered a loyal user base.

However, some of its SMB customers grow over time and need more advanced cloud solutions. The company has successfully introduced some advanced offerings that generate incremental revenue and also reduce the possibility of big customers migrating to the leading cloud platforms. For instance, it has recently introduced premium-optimized droplets for more reliable performance. Also, earlier this year, it acquired Paperspace, an AI startup to offer GPU-powered infrastructure, which is required for the development of AI/ML cloud solutions. All these platform enhancements will help DigitalOcean remain competitive in the SMB space and continue to attract companies that value simplicity and transparency.

Challenging Macro Impacting The Top Line

DigitalOcean hasn’t been as resilient as other cloud names this year, due to its SMB customer base. While other publicly traded SaaS companies focus on enterprise customers, who have the resources to remain resilient during times of uncertainty, DigitalOcean serves individual developers and small startups that are typically cash-constrained. In the current high-interest rate environment, these customers are struggling to grow, and their weak performance is directly impacting DigitalOcean’s business.

In Q3, revenue grew by only 16.4% y/y, a sharp slowdown compared to the 37% growth in the year-ago quarter. During Q3, the Net Retention Rate fell to 96% from 118% in the same quarter last year, influenced by reduced spending from existing customers and challenging comparisons following a price increase last year.

On the bright side, DigitalOcean is more profitable than ever. Its efficient, organic growth strategy allows the company to keep its Sales and Marketing (S&M) expenses extremely low. In Q3, its S&M expenses accounted for just 10.7% of total revenue, down from 12.5% a year ago. This is an extremely low marketing spend, underscoring the company’s leading market positioning in the SMB space that drives organic growth.

The low marketing costs help DOCN deliver very high profits and cash flows. During the quarter, the company reported an adjusted operating margin of 43%, up from 40% a year ago, thanks to the operating leverage. It also doubled its free cash flow margin to 32% in Q3, which is a very strong performance amid an inflationary environment. DigitalOcean is a cash flow machine and uses its cash to reward investors via massive buybacks that are rare for SaaS firms. Year-to-date, it has spent $475 million buying back 13,888,704 shares. The company has been criticized for spending tons of money on buybacks, but given its organic growth strategy, increasing its marketing spending would probably result in lower marketing efficiency and lower profitability.

What About Valuation

DigitalOcean stock has nearly doubled in less than two months, but it’s still very reasonably valued. At current prices of around $37 per share, it trades at a PS ratio of 4.7, one of the cheapest multiples in the SaaS industry. If the company accelerates its revenue growth in 2024, the PS multiples could rise to between 6 and 8 due to the expected rate cuts that will benefit tech stocks next year.

What Else

DigitalOcean has struggled this year, but the rate cuts in 2024 could help it accelerate its growth rates. Its large community of developers and small businesses drives organic traffic allowing the company to deliver higher profit and cash flow margins than most SaaS firms. However, the company is facing execution risk as the CEO, Yancey Spruill, has stepped down and the search for a successor is ongoing. While Yancey will continue to serve as Chief Executive until a successor has been appointed, the transition may slow things down, and the company could potentially miss its targets. But despite the execution risks in the near term, the stock is attractive due to the company’s cheap valuation and deep profitability.

DIGITALOCEAN RATING

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