Home Web hosting DigitalOcean Makes a Splash With a Big Acquisition — Is the Stock a Buy?

DigitalOcean Makes a Splash With a Big Acquisition — Is the Stock a Buy?

by Lottar

DigitalOcean Holdings (DOCN -0.65%), the cloud platform for small businesses and startups, just announced another acquisition. The company said it plans to acquire managed hosting services provider Cloudways for $350 million in cash. This purchase is a bit different than what DigitalOcean’s focus has been in the past, but it could make a lot of sense – especially for the customers that DigitalOcean serves.

Entering into the deal was somewhat expensive for DigitalOcean and it represents an entirely new business for the infrastructure company. Is the company up to the task of making the deal work and, more importantly, does it still make this stock a buy?

Help for the cash and digital resource-strapped small businesses

Before we delve into the acquisition itself, let’s recap what DigitalOcean and Cloudways are doing. DigitalOcean is a cloud infrastructure company. Developers and small businesses can “rent” computer hardware housed in a data center and access that hardware via an Internet connection. This computer hardware can be used to build applications, such as a business website or a mobile application.

But getting a new digital tool up and running is one thing, and managing it is another. This is where Cloudways comes in. The company offers a managed cloud hosting service for small businesses. This can free up time and resources for a small operation and allow it to focus on the day-to-day running of the business instead of spending time making sure a website or app is functioning properly.

Cloudways does not provide any infrastructure itself, but rather works with cloud providers such as DigitalOcean. In fact, according to details of the acquisition, about half of Cloudways’ customers use DigitalOcean for hosting. The other half use services such as DigitalOcean competitor Linode, as well as public cloud giants Amazon Web Services and Alphabet‘s Google Cloud. For cybersecurity, Cloudways has partnered with fellow small business technology provider Cloud flame.

DigitalOcean management explained in a recent interview that Cloudways will continue to operate as a stand-alone business once the acquisition is complete. The other cloud infrastructure providers available for Cloudways’ hosting service may be reconsidered at some point in the future, but there are no immediate plans for any changes there. However, DigitalOcean has always aimed to be open source so that it works in a multi-cloud environment (that is, it plays well with other cloud infrastructure services), and that goal will remain unchanged as Cloudways is integrated.

Props to DigitalOcean for keeping up with the cloud giants

Hosting services is a new endeavor for DigitalOcean, but the acquisition of Cloudways is an interesting move. Making cloud IT as easy as possible for small businesses and startups is key to DigitalOcean’s growth, but in recent quarters, new customer onboarding has slowed a bit. Of course, much of this can be attributed to tightening global economic conditions in 2022, but making onboarding and ongoing management easier will certainly help DigitalOcean maintain its growth rate.

That’s why Cloudways is an interesting move. The acquisition could help keep DigitalOcean’s stream of new user acquisitions going. It also provides a more seamless path for existing customers to scale up their use of DigitalOcean’s infrastructure as they need it—which shows up in metrics like net dollar-based expansion. Net dollar retention was 112% in the second quarter of 2022, meaning that for every $1 the average customer spent at DigitalOcean last year, they spent $1.12 this year. This implies that net dollar-based expansion has much room for improvement.

So Cloudways can help DigitalOcean increase its head of steam. This is especially important right now as many small businesses are feeling the pressure of slowing economic growth this year, which is slowing DigitalOcean’s revenue growth rate as a result (revenues rose 29% in the second quarter of 2022, compared to a rate of 36 % in the first quarter ). Public cloud giants AWS and Google Cloud – partners of the Cloudways service – grew sales by 35% and 36% respectively in the second quarter.

Can Cloudways Help DigitalOcean Succeed in the Small Business Cloud Infrastructure Division? Maybe it can. But it will set DigitalOcean back $350 million in cash. The company reported having nearly $1.17 billion in cash and investments at the end of June 2022, offset by debt of nearly $1.47 billion, so it’s not a stretch to make the purchase. The good news is that DigitalOcean is profitable on a free cash flow basis, and Cloudways is said to be a profitable business, so the deal should immediately boost the bottom line for DigitalOcean.

All in all, Cloudways looks like a good use of money for DigitalOcean if it can help the company onboard more customers or help existing users scale up. Shares look like a solid buy at just over seven times current-year expected sales, and just over 140 times enterprise value to free cash flow. The valuation assumes that DigitalOcean can sustain double-digit percentage revenue growth for at least the next few years, and that profit margins rise from around 8% to 10% today to 20% or higher. With the cloud industry on an unstoppable path higher, DigitalOcean stock is a buy in my book if you plan to hold for the next decade.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Nicholas Rossolillo and his clients have positions in Alphabet (C shares), Amazon, Cloudflare, Inc., and DigitalOcean Holdings, Inc. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Cloudflare, Inc., and DigitalOcean Holdings, Inc. The Motley Fool has a disclosure policy.

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