What a fantastic six months it’s been for DigitalOcean. Shares of the company have skyrocketed 81.6%, hitting $78.24. This run-up might have investors contemplating their next move.
Is now the time to buy DigitalOcean, or should you be careful about including it in your portfolio? See what our analysts have to say in our full research report, it’s free.
Why Is DigitalOcean Not Exciting?
We’re glad investors have benefited from the price increase, but we're sitting this one out for now. Here are three reasons why DOCN doesn't excite us and a stock we'd rather own.
1. Customer Churn Hurts Long-Term Outlook
One of the best parts about the software-as-a-service business model (and a reason why they trade at 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 99.8% in Q4. This means DigitalOcean would’ve grown its revenue by -0.2% even if it didn’t win any new customers over the last 12 months.
DigitalOcean has an adequate net retention rate, showing us that it generally keeps customers but lags behind the best SaaS businesses, which routinely post net retention rates of 120%+.
2. Low Gross Margin Reveals Weak Structural Profitability
For software companies like DigitalOcean, gross profit tells us how much money remains after paying for the base cost of products and services (typically servers, licenses, and certain personnel). These costs are usually low as a percentage of revenue, explaining why software is more lucrative than other sectors.
DigitalOcean’s gross margin is substantially worse than most software businesses, signaling it has relatively high infrastructure costs compared to asset-lite businesses like ServiceNow. As you can see below, it averaged a 59.9% gross margin over the last year. Said differently, DigitalOcean had to pay a chunky $40.14 to its service providers for every $100 in revenue.
The market not only cares about gross margin levels but also how they change over time because expansion creates firepower for profitability and free cash generation. DigitalOcean has seen gross margins improve by 2.5 percentage points over the last 2 year, which is very good in the software space.
3. Operating Margin Rising, Profits Up
Many software businesses adjust their profits for stock-based compensation (SBC), but we prioritize GAAP operating margin because SBC is a real expense used to attract and retain engineering and sales talent. This is one of the best measures of profitability because it shows how much money a company takes home after developing, marketing, and selling its products.
Analyzing the trend in its profitability, DigitalOcean’s operating margin rose by 5.8 percentage points over the last two years, as its sales growth gave it operating leverage. Its operating margin for the trailing 12 months was 17.4%.
Final Judgment
DigitalOcean isn’t a terrible business, but it doesn’t pass our bar. Following the recent rally, the stock trades at 7.5× forward price-to-sales (or $78.24 per share). While this valuation is reasonable, we don’t really see a big opportunity at the moment. We're pretty confident there are superior stocks to buy right now. Let us point you toward a safe-and-steady industrials business benefiting from an upgrade cycle.
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