Cloud computing provider DigitalOcean (NYSE: DOCN) reported results in line with analyst expectations in Q1 FY2023 quarter, with revenue up 29.7% year on year to $165.1 million. The company expects that next quarter's revenue would be around $170 million, which is the midpoint of the guidance range. That was roughly in line with analyst expectations. DigitalOcean made a GAAP loss of $34.9 million, down on its loss of $18.1 million, in the same quarter last year.
DigitalOcean (DOCN) Q1 FY2023 Highlights:
- Revenue: $165.1 million vs analyst estimates of $164.1 million (small beat)
- EPS (non-GAAP): $0.28 vs analyst expectations of $0.29 (2.87% miss)
- Revenue guidance for Q2 2023 is $170 million at the midpoint, roughly in line with what analysts were expecting
- The company reconfirmed revenue guidance for the full year, at $710 million at the midpoint
- Free cash flow of $11.1 million, down 69.5% from previous quarter
- Net Revenue Retention Rate: 107%, down from 112% previous quarter
- Gross Margin (GAAP): 56.5%, down from 63.3% 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).
As you can see below, DigitalOcean's revenue growth has been very strong over the last two years, growing from quarterly revenue of $93.7 million in Q1 FY2021, to $165.1 million.
This quarter, DigitalOcean's quarterly revenue was once again up a very solid 29.7% year on year. But the growth did slow down compared to last quarter, as the revenue increased by just $2.14 million in Q1, compared to $10.9 million in Q4 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 27% year on year to $170 million, in line with the 29% year-over-year increase in revenue the company had recorded in the same quarter last year. Ahead of the earnings results the analysts covering the company were estimating sales to grow 19.5% over the next twelve months.
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 107% in Q1. That means even if they didn't win any new customers, DigitalOcean would have grown its revenue 7% year on year. Despite it going down over the last year this is still a decent retention rate and it shows us that not only DigitalOcean's customers stick around but at least some of them get increasing value from its software over time.
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 56.5% in Q1.
That means that for every $1 in revenue the company had $0.56 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 $11.1 million in Q1, up 121% year on year.
DigitalOcean has generated $92.6 million in free cash flow over the last twelve months, a solid 15.1% 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 Q1 Results
With a market capitalization of $2.96 billion DigitalOcean is among smaller companies, but its more than $612.6 million in cash and positive free cash flow over the last twelve months put it in a very strong position to invest in growth.
It was good to see DigitalOcean revenue guidance for the full year, exceed market's expectations even if just slightly That feature of these results really stood out as a positive. On the other hand, it was less good to see the pretty significant deterioration in gross margin and the revenue retention rate deteriorated. Overall, this quarter's results ok and mostly in line with expectations. The company is flat on the results and currently trades at $33.22 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. Although DigitalOcean is not a bad business, it probably wouldn't be one of our picks. Its revenue growth has been strong, though we don't expect it to maintain historical growth rates. But while its strong free cash flow generation gives it re-investment options, unfortunately its gross margins show its business model is much less lucrative than the best software businesses.
DigitalOcean's price to sales ratio based on the next twelve months is 4.3x, suggesting that the market has lower expectations of the business, relative to the high growth tech stocks. We don't really see a big opportunity in the stock at the moment, but in the end beauty is in the eye of the beholder. And if you like the company, it seems that DigitalOcean doesn't trade at a completely unreasonable price point.
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