Cloud computing provider DigitalOcean (NYSE: DOCN) reported Q3 FY2023 results exceeding Wall Street analysts' expectations, with revenue up 16.4% year on year to $177.1 million. Guidance for next quarter's revenue was also better than expected at $178 million at the midpoint, 1.63% above analysts' estimates. Turning to EPS, DigitalOcean made a GAAP profit of $0.20 per share, improving from its profit of $0.10 per share in the same quarter last year.
DigitalOcean (DOCN) Q3 FY2023 Highlights:
- Revenue: $177.1 million vs analyst estimates of $173.4 million (2.14% beat)
- EPS (non-GAAP): $0.44 vs analyst estimates of $0.35 (24.5% beat)
- Revenue Guidance for Q4 2023 is $178 million at the midpoint, above analyst estimates of $175.2 million
- Free Cash Flow of $32.6 million, down 19.7% from the previous quarter
- Net Revenue Retention Rate: 96%, down from 104% in the previous quarter
- Gross Margin (GAAP): 60.3%, down from 64.1% 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 accelerating. As a result, the importance of storing the data in scalable and efficient formats continues to rise, especially as its diversity and associated use cases expand from analyzing simple, structured datasets to high-scale processing of unstructured data such as 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 $111.4 million in Q3 FY2021 to $177.1 million this quarter.
This quarter, DigitalOcean's quarterly revenue was once again up 16.4% year on year. We can see that DigitalOcean's revenue increased by $7.25 million quarter on quarter, which is a solid improvement from the $4.68 million increase in Q2 2023. Shareholders should applaud the re-acceleration of growth.
Next quarter's guidance suggests that DigitalOcean is expecting revenue to grow 9.2% year on year to $178 million, slowing down from the 36.2% year-on-year increase it recorded in the same quarter last year. Looking ahead, analysts covering the company were expecting sales to grow 8.7% over the next 12 months before the earnings results announcement.
One of the best parts about the software-as-a-service business model (and a reason why SaaS companies trade at such high valuation multiples) is that customers typically spend more on a company's products and services over time.
DigitalOcean's net revenue retention rate, a key performance metric measuring how much money existing customers from a year ago are spending today, was 96% in Q3. This means DigitalOcean's revenue would've decreased by 4% over the last 12 months if it didn't win any new customers.
DigitalOcean's already weak net retention rate has been dropping the last year, signaling that some customers aren't satisfied with its products, leading to lost contracts and revenue streams.
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's left after paying for servers, licenses, technical support, and other necessary running expenses, was 60.3% in Q3.
That means that for every $1 in revenue the company had $0.60 left to spend on developing new products, sales and marketing, and general administrative overhead. DigitalOcean's gross margin is poor for a SaaS business and it's deteriorated even further over the last year. This is probably the opposite direction that shareholders would like to see it go.
Cash Is King
If you've followed StockStory for a while, you know that we emphasize free cash flow. Why, you ask? We believe that in the end, cash is king, and you can't use accounting profits to pay the bills. DigitalOcean's free cash flow came in at $32.6 million in Q3, up 32.3% year on year.
DigitalOcean has generated $120.8 million in free cash flow over the last 12 months, an impressive 17.9% of revenue. This high FCF margin stems from its asset-lite business model and strong competitive positioning, giving it the option to return capital to shareholders or reinvest in its business while maintaining a cash cushion.
Key Takeaways from DigitalOcean's Q3 Results
With a market capitalization of $1.76 billion, DigitalOcean is among smaller companies, but its $384.1 million cash balance and positive free cash flow over the last 12 months give us confidence that it has the resources needed to pursue a high-growth business strategy.
It was good to see DigitalOcean's strong revenue guidance for next quarter, which topped analysts' expectations. We were also glad it outperformed Wall Street's estimates this quarter. On the other hand, its net revenue retention fell. Zooming out, we think this was still a good quarter, showing that the company is staying on track. The stock is up 14.3% after reporting and currently trades at $24.25 per share.
Is Now The Time?
When considering an investment in DigitalOcean, investors should take into account its valuation and business qualities as well as what's happened in the latest quarter.
We cheer for everyone who's making the lives of others easier through technology, but in case of DigitalOcean, we'll be cheering from the sidelines. Its revenue growth has been strong over the last two years, though we don't expect it to maintain that historical pace. And while its bountiful generation of free cash flow empowers it to invest in growth initiatives, 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 12 months is 3.0x, suggesting that the market does have lower expectations of the business, relative to the high growth tech stocks. While we have no doubt one can find things to like about the company, and the price is not completely unreasonable, we think that at the moment there might be better opportunities in the market.
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