For investors eyeing the prospects of the emerging cloud computing player, DigitalOcean (NYSE: DOCN), an interesting narrative unfolds with not one but two chances to capitalize on a significant market downturn. After hitting a low point at the tail end of 2022 during a bear market, the stock saw a remarkable upswing in the first half of 2023. However, fresh all-time lows were reached later in the year, fueled by slowing revenue growth, the revelation of past accounting errors, and a shake-up at the CEO level.
Fast forward to the present, and DigitalOcean (referred to as DO going forward) is staging a recovery, witnessing a doubling in value over the past four months. The latest earnings update for 2023 and the outlook for 2024 have reinstilled confidence in the cloud business among investors. The question arises: Is it too late to join the buying frenzy?
A new CEO with a technical background
DO had a reasonably solid performance last year, navigating through its fair share of drama. Specializing in providing remote data center computing power for startups and small to mid-sized businesses (SMBs), DO operates in a high-growth industry that weathered the challenges of the recent bear market.
As we step into 2024, it’s crucial to address the CEO transition that took place in the latter part of the previous year. Yancey Spruill, who steered the ship through significant milestones such as the DO IPO in early 2021 and strategic acquisitions like Cloudways in 2022 and Paperspace in the last year, bid farewell. Notably, he orchestrated the repurchase of nearly $1.1 billion of stock, effectively offsetting the impacts of stock-based compensation over the last two years.
Under Spruill’s leadership, DO thrived in growth mode, holding its ground against tech titans and achieving profitability by all measures. Closing 2023 with a GAAP net income margin of 2.8% (including a robust 8.8% net margin in Q4 2023) and a full-year free cash flow (FCF) of $110 million (a FCF margin of 15.9%), DO demonstrated resilience.
However, with the bear market behind us and investors currently content with the balance between growth and profitability, the board of directors seemingly recognized the need for a change. This is where the new CEO, Paddy Srinivasan, enters the scene. With a background in software engineering, Srinivasan brings diverse experience from roles at Amazon, Oracle, and Microsoft. He was also the founder and CEO of a cloud monitoring startup acquired by Microsoft in 2012, and most recently, he led IT software service company GoTo (formerly LogMeIn).
The shift in leadership appears to signal DO’s intention to reposition itself on the offensive in the continually growing cloud computing trend. Introducing a fresh perspective with a strong technical background could potentially fuel the development of new services, attracting a broader clientele of developers and SMBs.
Is DigitalOcean gearing up for another run higher?
The resurgence of DO stock is notable, likely fueled by its compelling affordability a few months back. Despite a doubling in price, the current trading valuation stands at approximately 33 times trailing-12-month free cash flow (FCF) as of the latest update.
The looming question: Is DO poised for further ascension? The answer hinges on execution. According to tech researcher Gartner, cloud computing spending is projected to surge by over 20% in 2024, with cloud infrastructure and related app development services (DO’s specialty) leading the growth charge.
However, the initial 2024 outlook from CEO Srinivasan and the leadership team suggests a more conservative estimate, with revenue expected to increase by just 10% at the midpoint of guidance, reaching $765 million. Several factors could contribute to this apparent underperformance, including economic challenges impacting DO’s predominantly SMB customer base. Alternatively, the company might be adopting a cautious approach as Srinivasan familiarizes himself with the intricacies of the business.
In my investment strategy, I prefer to back smaller businesses that outpace their respective industries. Despite the uncertainties, DO anticipates maintaining FCF profitability in the current year as it channels investments into new growth initiatives. The journey with DO has been turbulent, requiring a rebuilding of trust. While the stock may not be the value it was a few months ago, I’m inclined to hold onto my stake. I’ll be closely observing DigitalOcean and its new CEO for at least a few quarters before making any conclusive decisions.
