Cloud service provider DigitalOcean (NYSE:DOCN) has been on a wild ride over the last few years. In late 2021, the stock briefly climbed to over $130 per share, reflecting the market enthusiasm for anything cloud-related at the time.
As with most technology stocks back then, DigitalOcean delivered a rude awakening to its shareholders when the market corrected going into 2022.
More recently, DigitalOcean shares have started to climb again. The stock is up 67.8% over the last 12 months, even though competition in the cloud computing market has become more fierce. Why are DOCN shares rising again, and will they keep their current trajectory?
DigitalOcean Staring Down Major Competitors
Amazon, Microsoft and Alphabet sit atop the cloud market and these three technology titans account for 67% of it globally.
The remaining one-third of the market is made up of many smaller companies, none of which breaks out of single-digit territory in terms of market share.
While a few major players clearly dominate cloud computing, the advent of generative AI has created a surge of demand for data storage and processing. By 2030, this trend is expected to send cloud computing sales to an annual total of about $2 trillion, roughly four times the total as of the end of 2023.
AI isn’t the only growth driver, though, as organic cloud spending also continues to increase for non-AI-related purposes.
Nonetheless, a really positive tailwinds is the positive trend, both in the number of customers and the average amount spent per customer which should certainly support margin improvement over the long haul.
Why Is DigitalOcean Stock Going Up?
DigitalOcean revenues have risen year-over-year for 12 quarters in a row, contributing to its share price going up 8% in the last month.
Though the giant cloud providers are the defaults when larger businesses invest in cloud computing for AI, DigitalOcean has focused on the developers who serve smaller businesses.
The company has especially focused on making access to the NVIDIA H100 GPU processor available through its Paperspace platform. This gives DigitalOcean the opportunity to compete with larger providers by focusing on an underserved segment of businesses.
Beyond investor enthusiasm for this AI opportunity, DigitalOcean has propelled its share prices higher by producing strong growth over the last year.
In Q2, revenue rose 13% year-over-year to $192 million. Net income totaled $19 million against just $1 million in the year-ago quarter. As of Q2, DigitalOcean’s net margin reached a record of 9.3%.
It’s also worth noting that revenue growth at DigitalOcean has been highly consistent. Quarterly revenues have now risen for 13 consecutive periods, a solid achievement in what has been a somewhat challenging macro landscape. In 2023, cloud growth slowed somewhat as businesses tightened their tech budgets. This trend, however, didn’t keep DigitalOcean from achieving respectable growth.
Another key metric for DigitalOcean is annual run-rate revenue, which increased 15% to $781 million at the end of Q2. Given the current trailing 12-month revenue total of $735 million, this ARR suggests that the company is still successfully driving additional revenue growth.
A final point in DigitalOcean’s favor is its financial health. The company is currently sitting on about $443 million in cash, up from $317 million at the end of last year. Current assets are more than double current liabilities, and the company’s profitability and ability to generate free cash flow will likely allow it to service its long-term debts with minimal difficulty.
Is DOCN Fairly Valued?
DigitalOcean carries rather a high price-to-sales ratio of 5.1x but other ratios are much more modest. For example, DOCN trades at 24.2x forward earnings, 1.7x earnings growth and 18.4x cash flow.
Given the fact that the company is already profitable and its earnings are growing respectably, these valuation metrics don’t seem out of line.
Wall Street also appears to believe that DOCN is fairly valued at its current price. The median 12-month target price from analysts for the stock is currently $38 per share, less than 2.5% below the current trading price of $38.95. While this view doesn’t leave room for near-term appreciation, it at least suggests that the stock isn’t actively overvalued.
Finally, it’s worth noting that DigitalOcean’s multiples have compressed enormously since its initial run in 2021. At its peak, the company was valued at over 15x sales. Though the stock was clearly overpriced at that level, the combination of lower multiples and steady growth is an encouraging sign that the market has repriced DOCN at a much more appropriate valuation.
Is Now the Time to Buy DigitalOcean?
Although DigitalOcean is making positive strides, the company’s record of profitability is still very short. Will DOCN deliver consistent and stable earnings over time or will they be choppy? That’s the big conundrum facing prospective buyers.
If the thesis of AI as a massive productivity multiplier does not come to fruition, DigitalOcean’s value proposition lies in a murkier state.
This has the potential to somewhat blunt its growth story, though the continued growth of cloud computing for purposes other than AI makes it likely that DigitalOcean will continue to post positive revenue growth.
The larger problem, however, is that DigitalOcean may not have a particularly strong moat if it can’t articulate and deliver a unique value proposition to the small businesses that rely on it. In a market already completely dominated by just three major vendors, the future of a smaller firm like DigitalOcean is largely a function of carving out a unique competitive advantage that so far is lacking.
Right now, DigitalOcean fares better as a Hold than a Buy. The stock has already moved upward a great deal and may be trading close enough to fair value to limit its upside potential. While future developments are likely to push DOCN share price higher, there doesn’t seem to be an immediate catalyst for a sharp upward trajectory.
Investors may want to watch DOCN for signs of additional growth, but right now the stock may not have enough potential to generate returns to justify buying it.
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