DigitalOcean Stock: A Compelling Valuation Heading Into Q3 Earnings (NYSE:DOCN)

Investment thesis

DigitalOcean (NYSE:DOCN) is a cloud computing platform that specializes in infrastructure and platform tools, with a focus on serving small and medium-sized businesses (also known as SMBs). This SMB segment has been largely ignored by the cloud behemoths of Amazon (AMZN), Microsoft (MSFT), and Google (GOOGLE), which offer enterprise solutions that are too complex and opaque for smaller companies.

This is where DigitalOcean differentiates itself by offering cloud infrastructure and platform technology that can be implemented quickly, intuitively and independently – with extremely affordable and transparent pricing.

Unfortunately, the focus on smaller businesses has made DigitalOcean much more susceptible to the macroeconomic headwinds the economy is currently facing. Enterprise-sized businesses have a whole host of costs that can be cut when times are tough, but they are so dependent on their cloud providers that these costs won’t be touched.

When it comes to smaller companies, there are significantly fewer costs to cut – and in a recession, the goal is simply to survive. As a result, DigitalOcean may well experience more churn than its larger peers; partly caused by SMBs cutting back on spending with DigitalOcean, but more so due to these smaller companies going out of business.

While I see a bright future for this company (as detailed in a previous article), it is undeniably facing more headwinds than most businesses in the same industry. That goes some way to explaining why it missed analysts’ estimates for second-quarter revenue.

But investing is a forward-looking game, and I believe that much of this headwind has been factored into DigitalOcean’s current share price, meaning that a successful quarterly earnings report could reward shareholders in a big way. So what should investors look for from DigitalOcean’s Q3 results?

Latest expectations

DigitalOcean will report its earnings for Q3’22 on Thursday, the 3rd^rd November, and there are several key items investors should keep their eyes on.

Starting with headline numbers, analysts expect third-quarter revenue of ~$147 million, representing ~32% year-over-year growth. This figure is at the top end of management’s $146-147 million guidance, so it would appear that analysts are feeling slightly more optimistic now than management was in August.

Looking ahead to Q4, and I took the implied management guidance (FY23 guidance minus Q3 guidance minus Q1 and Q2 actuals) of $157-160m. Analysts expect a bit more again, at $161m, which would represent Q4 YoY growth of ~35%.

Turning to full-year revenue guidance, analysts’ latest estimates are for $570 million. This was up from their expectations of $566 million in the second quarter, when DigitalOcean’s management team maintained its full-year guidance of $564-568 million.

Judging by these numbers, it would appear that analysts feel positive about DigitalOcean’s ability to beat its latest guidance in terms of revenue, and still achieve more than 30% year-over-year growth. This is a positive sign – analysts get more time than you or I to really dive into industries, so raising expectations could mean analysts find DigitalOcean more resilient than expected in Q3; yet there is another possible reason for this optimism which I will touch on later.

Moving down to earnings, this is where DigitalOcean had success in Q2. The company’s EPS came in at $0.20, significantly beating analysts’ estimates of $0.10, with strong guidance for the rest of the year.

Before the second-quarter results were released, analysts had expected full-year EPS of $0.66; after the release of Q2 results, and management’s updated FY22 EPS guidance of $0.74-0.75, analysts raised their expectations to $0.76.

While DigitalOcean is definitely more of a growth story than an earnings story, seeing a significant EPS improvement was a real bright spot in its Q2 earnings. This was partly due to an improvement in margins, but also due to $550 million in share buybacks at an average price of $43.83.

While the second quarter results looked solid, I’m intrigued to see whether or not analysts’ apparent optimism for the third quarter is merited. There was another piece of news about the quarter that I will look for more information on.

Cloudways Acquisition

DigitalOcean announced in August that it would acquire Cloudways, a leading managed cloud hosting and SaaS provider for SMBs. It will do so by paying $350 million in cash, with a substantial amount to be paid over a 30-month period following the closing of this acquisition (which closed on 8^st September).

I guess that goes some way to explaining analysts’ apparent optimism about DigitalOcean’s revenue numbers; management expects this deal to contribute between $13-15 million in revenue in FY22 – so ironically, I think analysts are currently underestimating DigitalOcean’s full-year revenue figures.

The difficulty here is knowing whether the figures on Investing.com take into account the impact of this acquisition or not; For example, Seeking Alpha sees the consensus estimate for FY22 revenue at ~$581m compared to Investing.com’s ~$570m – something for investors to consider when analyzing Q3 earnings and comparing results and guidance to analysts’ estimates.

Back to Cloudways, and I personally hate big acquisitions or “mergers”, but I’m a big fan of smaller bolt-on acquisitions like this. This is made even better by the fact that DigitalOcean and Cloudways have been working together for 8 years, as stated in the acquisition press release:

DigitalOcean and Cloudways have been close partners since 2014 – Cloudways currently relies on DigitalOcean infrastructure to power approximately 50% of its customers. Cloudways serves an international and growing customer base with an industry-leading NPS score of 71. Together, DigitalOcean and Cloudways will serve more than 124,000 customers paying more than $50 per month, representing approximately 84% of the company’s pro forma total revenue .

It’s also worth noting that Cloudways should help drive DigitalOcean’s revenue growth rate regardless, as it’s expected to generate more than $52 million in FY22 revenue, representing a CAGR of more than 50%. It’s also not going to negatively impact margins, which is great to see.

In fact, it feels like a smart and clever acquisition; Just beware that when looking at third quarter earnings, some of the numbers will be skewed by Cloudways – and there’s no telling exactly how much management will break out between organic and inorganic growth.

An attractive valuation

As with all high growth, disruptive companies, valuation is difficult. I believe my approach will give me an idea of ​​whether DigitalOcean is wildly over- or undervalued, but valuation is the last thing I look at – the quality of the business itself is much more important in the long run.

I kept all assumptions the same as in my previous article, just updated any items that changed, such as market cap. I’m not including the impact of the Cloudways acquisitions for now; however, I expect it to be attractive to DigitalOcean in the long run.

Put it all together, and I can see DigitalOcean stock achieving a CAGR through 2026 of 6%, 20%, and 50% in my respective bear, base, and bull case scenarios.

Bottom line

It’s a business that has continued to perform well despite a slew of headwinds, and I think it will emerge from these difficult macroeconomic times even stronger than before. Q3 earnings will give investors a chance to see just how much pressure is being placed on DigitalOcean, and I’m sure management will also talk about the integration of Cloudways.

In my view, DigitalOcean remains a compelling long-term investment with multiple secular headwinds. Once it rides out this storm, I believe the opportunity is enormous, with a current valuation offering an attractive risk/reward scenario.

Given all this, I would reiterate my previous ‘Strong Buy’ rating on DigitalOcean.