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DigitalOcean (NASDAQ:DOCN) Surprises With Q3 Sales, Gross Margin Improves


Full Report / November 04, 2021
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Cloud computing provider DigitalOcean (NYSE: DOCN) announced better-than-expected results in the Q3 FY2021 quarter, with revenue up 37.2% year on year to $111.4 million. The company expects that next quarter's revenue would be around $118 million, which is the midpoint of the guidance range. That was in roughly line with analyst expectations. DigitalOcean made a GAAP loss of $1.85 million, down on its profit of $2.5 million, in the same quarter last year.

DigitalOcean (DOCN) Q3 FY2021 Highlights:

  • Revenue: $111.4 million vs analyst estimates of $108.8 million (2.38% beat)
  • EPS (non-GAAP): $0.12 vs analyst estimates of $0.07 ($0.05 beat)
  • Revenue guidance for Q4 2021 is $118 million at the midpoint, roughly in line with what analysts were expecting
  • Free cash flow of $19.1 million, up 46.6% from previous quarter
  • Net Revenue Retention Rate: 116%, up from 113% previous quarter
  • Customers: 598,000, down from 602,000 in previous quarter
  • Gross Margin (GAAP): 60.9%, up from 54.6% same quarter last year

Started by brothers Ben and Moisey Uretsky, DigitalOcean (NYSE: DOCN) provides a simple, low-cost platform that allows developers and small and medium sized businesses to host applications and data in the cloud.

DigitalOcean offers a range of cloud computing options for developers and small businesses. Hyperscalers Amazon Web Services, Microsoft Azure, and Google Cloud Platform are the dominant providers of the cloud infrastructure that has become the standard for companies today.

For individual developers and small and medium businesses, the large cloud platforms present some hurdles to adoption: the actual onboarding and implementation processes can be difficult, pricing models can be complex and at times unpredictable, and there is a relatively low level of support for SMBs, as the cloud giants are focused on serving enterprise customers.

DigitalOcean focuses mainly on less application and website hosting use cases and differentiates itself from the hyperscale platforms through the intuitive simplicity of its user interface, which allows customers to spin up “Droplets” (their term for a virtual machine) in under a minute. The company offers a high level of live-person customer support regardless of spend levels, and utilizes open source software to keep costs low. For context, DigitalOcean’s bandwidth prices are a fraction of its hyperscale rivals.

Digital Ocean is a beneficiary of trends supportive of cloud computing. Cloud’s benefits are multiple: greater flexibility, scalability, and reliability than old school on-premise data centers. Virtually every business is undergoing some degree of digital transformation, which is reliant on cloud’s benefits to accelerate their pace of innovation. But cloud has also reduced the barriers to starting new businesses, generating a proliferation of developer-led start-ups and SMBs.

Digital Ocean’s main competitors are the hyperscale cloud providers: Amazon (NASDAQ:AMZN), Microsoft (NASDAQ: MSFT), and Alphabet’s Google Cloud Platform (NASDAQ: GOOGL). IBM (NYSE:IBM) and Oracle (NYSE:ORCL) round out the larger players. A second set of rivals are niche cloud providers that target certain verticals or geographies such as OVH, Vultr, Linode, and Heroku, which is owned by Salesforce.com (NYSE:CRM).

Sales Growth

As you can see below, DigitalOcean's revenue growth has been very strong over the last year, growing from quarterly revenue of $81.2 million, to $111.4 million.

DigitalOcean Total Revenue

And unsurprisingly, this was another great quarter for DigitalOcean with revenue up an absolutely stunning 37.2% year on year. But the growth did slow down compared to last quarter, as the revenue increased by just $7.61 million in Q3, compared to $10.1 million in Q2 2021. We'd like to see revenue increase by a greater amount each quarter, but a one-off fluctuation is usually not concerning.

Analysts covering the company are expecting the revenues to grow 30.5% over the next twelve months, although estimates are likely to change post earnings.

Customer Growth

You can see below that DigitalOcean reported 598,000 customers at the end of the quarter, a decrease of 4,000 compared to the last quarter. That is suggesting that the customer acquisition momentum is slowing a little bit. That is a bit slower customer growth than what we are used to seeing lately, suggesting that the customer acquisition momentum is slowing a little bit.

DigitalOcean Customers

Product Success

One of the best things about software as a service businesses (and a reason why they trade at such high multiples) is that customers tend to spend more with the company over time.

DigitalOcean Net Revenue Retention Rate

DigitalOcean's net revenue retention rate, an important measure of how much customers from a year ago were spending at the end of the quarter, was at 116% in Q3. That means even if they didn't win any new customers, DigitalOcean would have grown its revenue 16% year on year. Significantly up from the last quarter, this a good retention rate and a proof that DigitalOcean's customers are satisfied with their software and are getting more value from it over time. That is good to see.

Profitability

What makes the software as a service business so attractive is that once the software is developed, it typically shouldn't cost much to provide it as an ongoing service to customers. DigitalOcean's gross profit margin, an important metric measuring how much money there is left after paying for servers, licenses, technical support and other necessary running expenses was at 60.9% in Q3.

DigitalOcean Gross Margin (GAAP)

That means that for every $1 in revenue the company had $0.60 left to spend on developing new products, marketing & sales and the general administrative overhead. While it improved significantly from the previous quarter this would still be considered a low gross margin for a SaaS company and we would like to see the improvements continue.

Key Takeaways from DigitalOcean's Q3 Results

Sporting a market capitalization of $10.1 billion, more than $589.7 million in cash and with positive free cash flow over the last twelve months, we're confident that DigitalOcean has the resources it needs to pursue a high growth business strategy.

We were very impressed by the strong improvements in DigitalOcean’s gross margin this quarter. And we were also excited to see the really strong revenue growth. On the other hand, it was unfortunate to see the slowdown in customer growth. Overall, this quarter's results seemed pretty positive and shareholders can feel optimistic. But the market was likely expecting more and the company is down 3.3% on the results and currently trades at $91.5 per share.

Is Now The Time?

When considering DigitalOcean, investors should take into account its valuation and business qualities, as well as what happened in the latest quarter. We think DigitalOcean is a solid business. Its revenue growth has been strong, and analysts believe that sort of growth is sustainable for now. And while its gross margins show its business model is much less lucrative than the best software businesses, the good news is its very efficient customer acquisition hints at the potential for strong profitability, and its strong free cash flow generation gives it re-investment options.

The market is certainly expecting long term growth from DigitalOcean given its price to sales ratio based on the next twelve months is 19.8x. There are definitely things to like about DigitalOcean and there's no doubt it is a bit of a market darling, at least for some. But when considering the company against the backdrop of the tech stock landscape, it seems that there is a lot of optimism already priced in and we are wondering whether there might be better opportunities elsewhere right now.

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