With a market valuation of less than $3 billion, DigitalOcean (DOCN -1.29%) is one of the smaller players in the cloud-computing space. It's a good business with plenty of customers, steady revenue growth, and strong margins, but not everything is going according to plan.
In June 2022, management set financial goals for 2024: revenue of $1 billion, revenue growth of greater than 30%, and a free-cash-flow margin of 20%. However, those goals have come way down.
As of the first quarter of 2024, DigitalOcean is calling for full-year revenue of just $775 million at the high end of its range, which would represent just 12% growth. That said, it does expect to deliver an adjusted free-cash-flow margin of 19% to 21% this year.
Even the best management team can't necessarily create demand, and demand may be the problem investors should be aware of looking ahead to the next five years.
What are realistic five-year expectations?
There's plenty of upside potential for DigitalOcean.
The company targets small businesses with fewer than 500 employees. And it offers what it calls Infrastructure-as-a-Service (IaaS) and Platform-as-a-Service (PaaS) through its cloud-computing platform. This will be a $213 billion opportunity in 2027, growing at a 23% compound annual rate from 2024, according to management.
In other words, such a massive opportunity means the company has tapped into less than 1% of its market.
Data by YCharts.
Another intriguing aspect of DigitalOcean's business is its customer composition. The company has 637,000 customers as of Q1. Of them, 75% are considered "learners" -- they're getting to know the platform. Learners account for just 11% of revenue. By contrast, less than 3% of its customers are considered "scalers," but they account for 56% of revenue.
In other words, most of DigitalOcean's revenue comes from a really small base of customers. If just a fraction of its base of learners grow and scale on the platform, it can have a profound impact on the company's financials. And that's just from its current customer base, to say nothing of securing business from new ones.
The Rule of 72 says if DigitalOcean's revenue is going to double over the next five years, it needs revenue to expand at a compound annual growth rate of about 14.5%. It only expects 12% growth this year. But given ongoing growth in the industry and the upside presented by its large customer base, doubling its revenue in five years seems attainable.
Then again, DigitalOcean's growth has failed to keep up with the industry in recent years. Even smaller businesses may prefer to use the cloud-computing platforms from the tech giants. This competitive risk is something to keep in mind.
What about an AI boom?
Some investors believe improved growth is almost assured for DigitalOcean going forward, thanks to strong demand for artificial intelligence (AI). The company's management has pointed out that AI demand on its platform is really strong.
That said, AI is a catch-22 for infrastructure companies such as DigitalOcean. Companies like Nvidia might be making money hand over fist, but the situation is different here.
If enterprises increasingly demand AI tools, then all cloud-computing platforms will have to offer it -- it won't be a differentiator. And offering AI tools requires investment since infrastructure companies have to buy what they need to offer the tools, particularly graphic processing units.
Profit margins for infrastructure companies are already taking a hit because of investments to support AI growth -- Snowflake is a good example of this. And in its Q1 report, DigitalOcean's management made soft comments about this. CFO Matt Steinfort said its gross margin will "moderate somewhat" because of its AI investments. Moreover, he went on to say that as the company tries to accelerate AI revenue growth, it "may result in reductions to our free cash flow margins."
So, where will DigitalOcean stock be in five years? Well, that will largely depend on its revenue growth and profit margins. It's possible profitability takes a hit as AI investments ramp up. In terms of revenue, there's certainly opportunity for growth, but the company is admittedly behind schedule in the context of the guidance it served up just a few years ago. While the stock could certainly climb from here, I wouldn't say it's my strongest bet to outperform the S&P 500 over the next five years.
