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DigitalOcean (NYSE:DOCN) Exceeds Q3 Expectations But Guidance Underwhelms


Full Report / November 07, 2022
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Cloud computing provider DigitalOcean (NYSE: DOCN) reported Q3 FY2022 results that beat analyst expectations, with revenue up 36.5% year on year to $152.1 million. However, guidance for the next quarter was less impressive, coming in at $161 million at the midpoint, being 4.14% below analyst estimates. DigitalOcean made a GAAP profit of $10 million, improving on its loss of $1.85 million, in the same quarter last year.

DigitalOcean (DOCN) Q3 FY2022 Highlights:

  • Revenue: $152.1 million vs analyst estimates of $147.7 million (2.95% beat)
  • EPS (non-GAAP): $0.38 vs analyst estimates of $0.23 ($0.15 beat)
  • Revenue guidance for Q4 2022 is $161 million at the midpoint, below analyst estimates of $167.9 million
  • Free cash flow of $22.4 million, up 10.4% from previous quarter
  • Net Revenue Retention Rate: 118%, up from 112% previous quarter
  • Gross Margin (GAAP): 64.1%, up from 60.9% 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 $81.1 million in Q3 FY2020, to $152.1 million.

DigitalOcean Total Revenue

And unsurprisingly, this was another great quarter for DigitalOcean with revenue up 36.5% year on year. On top of that, revenue increased $18.2 million quarter on quarter, a very strong improvement on the $6.55 million increase in Q2 2022, and a sign of acceleration of growth.

Guidance for the next quarter indicates DigitalOcean is expecting revenue to grow 34.5% year on year to $161 million, in line with the 36.7% 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 37.7% over the next twelve months.

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 118% in Q3. That means even if they didn't win any new customers, DigitalOcean would have grown its revenue 18% 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 64.1% in Q3.

DigitalOcean Gross Margin (GAAP)

That means that for every $1 in revenue the company had $0.64 left to spend on developing new products, marketing & sales and the general administrative overhead. Despite it trending up over the last year this would still be considered low gross margin for a SaaS company and we have no doubt shareholders would like to see the improvements continue.

Cash Is King

If you follow 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 $22.4 million in Q3, up 8.11% year on year.

DigitalOcean Free Cash Flow

DigitalOcean has generated $49.8 million in free cash flow over the last twelve months, a solid 9.36% 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 Q3 Results

With a market capitalization of $2.95 billion DigitalOcean is among smaller companies, but its more than $824.6 million in cash and positive free cash flow over the last twelve months give us confidence 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 revenue retention rate. And we were also excited to see the really strong revenue growth. On the other hand, it was unfortunate to see that the revenue guidance missed expectations. Overall, it seems to us that this was a complicated quarter for DigitalOcean. The company is up 3.83% on the results and currently trades at $30.6 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. There are a number of reasons why we think DigitalOcean is a great business. First, its revenue growth has been strong. 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 are increasing their spending quite quickly, suggesting that they love the product.

DigitalOcean's price to sales ratio based on the next twelve months is 4.2x, suggesting that the market is expecting more measured growth, relative to the hottest tech stocks. Looking at the tech landscape today, DigitalOcean's qualities as a business really stand out and we do like the look of the company at current prices.

The Wall St analysts covering the company had a one year price target of $51.3 per share right before these results, implying that they saw upside in buying DigitalOcean even in the short term.

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