DigitalOcean (NYSE:DOCN) Q4: Beats On Revenue But Guidance Underwhelms

Cloud computing provider DigitalOcean (NYSE: DOCN) reported Q4 FY2022 results that beat analyst expectations, with revenue up 36.2% year on year to $163 million. However, guidance for the next quarter was less impressive, coming in at $164 million at the midpoint, being 2.71% below analyst estimates. DigitalOcean made a GAAP loss of $10.1 million, improving on its loss of $12.1 million, in the 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.

Data is the lifeblood of the internet and software in general, and the amount of data created is growing at an accelerating pace. Likewise, the importance of storing the data in scalable and efficient formats continues to rise, especially as the diversity of the data and associated use cases expand from analyzing simple, structured data to high-scale processing of unstructured data, images, audio and video.

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 two years, growing from quarterly revenue of $87.5 million in Q4 FY2020, to $163 million.

And unsurprisingly, this was another great quarter for DigitalOcean with revenue up 36.2% year on year. But the growth did slow down compared to last quarter, as the revenue increased by just $10.9 million in Q4, compared to $18.2 million in Q3 2022. We'd like to see revenue increase by a greater amount each quarter, but a one-off fluctuation is usually not concerning.

Guidance for the next quarter indicates DigitalOcean is expecting revenue to grow 28.8% year on year to $164 million, slowing down from the 35.9% year-over-year increase in revenue the company had recorded in the same quarter last year. For the upcoming financial year management expects revenue to be $710 million at the midpoint, growing 23.2% compared to 34.5% increase in FY2022.

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'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 112% in Q4. That means even if they didn't win any new customers, DigitalOcean would have grown its revenue 12% year on year. Despite the recent drop this is still 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 61.1% in Q4.

That means that for every $1 in revenue the company had $0.61 left to spend on developing new products, marketing & sales and the general administrative overhead. This would be considered a low gross margin for a SaaS company and it has dropped significantly from the previous quarter, which is probably the opposite of what shareholders would like it to do.

Cash Is King

If you have followed StockStory for a while, you know that we put an emphasis on cash flow. Why, you ask? We believe that in the end cash is king, as you can't use accounting profits to pay the bills. DigitalOcean's free cash flow came in at $34.2 million in Q4, up year on year.

DigitalOcean has generated $84.2 million in free cash flow over the last twelve months, a solid 14.6% of revenues. This strong FCF margin is a result of DigitalOcean asset lite business model and provides it plenty of cash to invest in the business.

Key Takeaways from DigitalOcean's Q4 Results

With a market capitalization of $3.18 billion DigitalOcean is among smaller companies, but its more than $864.2 million in cash and positive free cash flow over the last twelve months put it in a very strong position to invest in growth.

We enjoyed seeing DigitalOcean’s impressive revenue growth this quarter. On the other hand, it was unfortunate to see that DigitalOcean's revenue guidance for the full year missed analysts' expectations and it indicates a slight slowdown. Overall, it seems to us that this was a mixed quarter for DigitalOcean. The company is up 4.63% in the pre-market and currently trades at $34.55 per share.

Is Now The Time?

DigitalOcean may have had a bad quarter, but investors should also consider its valuation and business qualities, when assessing the investment opportunity. We think DigitalOcean is a solid business. We would expect growth rates to moderate from here, but its revenue growth has been strong, over the last two years. 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 customers spend noticeably more each year, which is great to see.

DigitalOcean's price to sales ratio based on the next twelve months is 4.3x, suggesting that the market is expecting more steady growth, relative to the hottest tech stocks. There are definitely things to like about DigitalOcean and looking at the tech landscape right now, it seems that the company trades at a pretty interesting price point.

The Wall St analysts covering the company had a one year price target of $36.2 per share right before these results, implying that they saw upside in buying DigitalOcean even in the short term.

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