News

Aug 21, 2023

DigitalOcean Seeks To Become AI Solution For SMBs (NYSE:DOCN)

Just_Super Digital Ocean (NYSE:DOCN) is a quality company that has had a mixed year so far. On the one hand, they are in a challenging situation where some metrics have deteriorated, but on the other

Just_Super

Digital Ocean (NYSE:DOCN) is a quality company that has had a mixed year so far. On the one hand, they are in a challenging situation where some metrics have deteriorated, but on the other hand, they also made an important acquisition that could shape the future of the company.

And I think the reaction to the earnings call a few days ago, where it is now down 28%, is not justified. But this is the current state of the market, where the reactions seem to be too extreme, creating excellent opportunities for long-term investors.

DigitalOcean's pre-earnings valuation was expensive, and the DOCN stock was expected to fall a bit if results or guidance were worse than assumed. However, if we look at the results, we see that the company still delivered respectable numbers, with revenue up 27% year over year and gross profit up 19% year over year. The 25% year-on-year increase in ARR and the 230% increase in FCF were also strong results. Especially when capex is now lower year-on-year despite the company's strong growth. For the quarterly results in 2022, the capex was 27 million and now it is only 24 million. This is a positive signal for me.

But not all metrics were good, as NDR fell from 107% to 104%, and on the earnings call they warned that it will likely fall to the mid 90s later this year before rebounding to triple digits. However, one of the 2 biggest impacts was probably the tax expense error, which is something that looks unprofessional as they could not give net earnings per share numbers due to this and need to correct the ones for Q1 2023. But on the positive side, it looks like they overstated the tax expense by $18 million, so net income per share should be higher in Q1. Still, this should not happen to a company of this quality and size.

The second major impact was the 3% to 5% reduction in full year guidance due to the challenging macro environment in the SMB space and slowing growth in the cloud industry. However, this could be temporary and 20%+ revenue growth rates could be possible again in the future if the SMB market environment changes and becomes more positive.

Another area where DigitalOcean has deteriorated is its balance sheet. At the end of 2022, they had $140 million in cash and $723 million in marketable securities, compared to long-term debt of $1.47 billion. As of June 30, they had only $120 million in cash and $430 million in marketable securities, compared to long-term debt of $1.474 billion. As a result, the balance sheet has deteriorated this year and risk has increased.

But FCF increased to $45 million, and if we subtract the SBC costs of $36 million, their real FCF is $9 million, which is a good result for a technology company in the stadium that DOCN is in. Especially compared to last year's FCF of $13 million and SBC of $28 million, which was a result of -$15 million, this year's results were a strong improvement, considering that management's goal was to increase FCF in 2023, and they achieved that.

The long term outlook for DigitalOcean could be really interesting, due to the Paperspace acquisition they could become an AI play in the future. Paperspace is likely to see triple-digit revenue growth and could be a large part of DigitalOcean's revenue in the near future.

Cloudways, their most recent major acquisition, is also posting revenue growth numbers that are well ahead of DOCN's traditional cloud business. They were up 45% year over year in Q2 2023.

Paperspace, with its 12,000 paying customers and cross-selling opportunities, will be the key growth driver going forward. However, the AI market is going to be very competitive, and I see competitors that are more advanced even in the SMB space right now. And it is often a red flag when a company is transforming or making a lot of acquisitions instead of growing organically. The odds of success are often lower than thought.

Initially, DOCN had found a good niche for itself, differentiating itself from AWS (AMZN) and other players by focusing on SMBs. They have maintained this focus, but with new products in a highly competitive AI market. It will be interesting to see if they can keep their developers first and simplify the user experience approach in the new space.

In addition, I am not sure that using capital to buy back shares is the most efficient allocation of capital at this time. Over the past 2 years, DOCN has repurchased $1.3 billion in shares, and shareholders may have been better served by investing that money in growth.

For me, it is important to see whether shareholders' interests are aligned with management's performance measures. And in the last proxy statement we can see that the performance measure for the long-term packages is a combination of revenue growth plus FCF margin.

The three levels are 44%, 47% and 57%. Since the LT FCF margin target is between 25% and 30% according to the earnings call, management needs to achieve revenue growth of about 20% to 30% to meet the targets. If management lowers these targets in the next proxy statement, I would take it as a bad sign.

I am holding my small position for now as I want to see how the next few quarters play out. In general, I think it will be difficult to gain a competitive advantage in the AI industry, and that DigitalOcean does not currently have pricing power or significant barriers to entry that would protect it.

However, I like the fact that they are FCF positive even if we subtract SBC and could grow 20%+ going forward as SMBs recover.

Compared to other popular growth companies, DOCN also trades at a much lower price-to-sales valuation, although some have much higher growth rates or stronger competitive advantages that somehow justify their valuation.

However, I think the earnings reaction was too extreme and therefore DOCN should still be an attractive pick to beat the market over the next 5 years.

In summary, I think DOCN has made a big step by achieving positive FCF - SBC and I think they will most likely increase their FCF going forward which would leave them with a lot of money that they could invest and here comes the tricky part. Right now I am not 100% sure that they are using their capital in the most efficient way.

In the long run, the capital allocation skills of the management team will be the most important factor, along with the return they earn on their capital. But from my perspective, it is unusual to use so much for share buybacks at this stage.

Personally, I am holding my small position as I want to see how Paperspace and Cloudways perform over the next few quarters as I still think DigitalOcean is a good company in a niche where they can generate strong FCF going forward that they can then return to shareholders.

This article was written by

Analyst’s Disclosure: I/we have a beneficial long position in the shares of DOCN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.