Cloud-computing platform DigitalOcean (DOCN -1.29%) reported financial results for the second quarter of 2024 on Aug. 8 and investors celebrated the report by sending the stock higher.
To be sure, DigitalOcean's Q2 results were strong in key areas. For example, the company's revenue grew 13% year over year, which represents its second consecutive quarter of accelerating growth. Moreover, its had adjusted free cash flow (a key measure of profitability) of $37 million. This number may have been down from the prior year. But it's still a strong 19% margin.
DigitalOcean stock rose following the report, which would seem to suggest that things are good for the business and its outlook. However, investors are prone to overreaction. Therefore, there's more digging to do when trying to determine whether or not DigitalOcean stock is a buy.
One concerning trend
I believe DigitalOcean is losing customers at a troubling rate, as I'll explain.
In Q2, DigitalOcean's net dollar retention rate was 97%, which was its fourth consecutive quarter below 100%. This metric measures spending for its customer base from one year to the next. A retention rate over 100% indicates that last year's customer base is spending more this year as a whole. A retention rate below 100% indicates it's spending less.
This is an important yet complex metric to grasp. But keep in mind that new customers in the past year don't contribute to this metric. By contrast, new customers do contribute to average revenue per customer. For DigitalOcean, its average revenue per customer was $99.45 in Q2, which was up 9% year over year and up 25% from two years ago.
Also important to this discussion is DigitalOcean's overall customer count. It ended Q2 with 638,000 customers, which was up 3% year over year.
Putting these three metrics together, investors can see that DigitalOcean has more customers than ever before and customers are spending more on average. But many of these customers are new and it's lost longer-time customers, as evidenced by its declining retention rate. And this is a concerning trend.
Why this could be a problem
DigitalOcean's retention rate jumped in 2022 after it increased the prices for its cloud-computing services -- higher prices naturally lend themselves to higher spending. But the retention rate dipped below 100% a year after the price increases. This means that it lost customers with the pricing changes.
DigitalOcean is going up against some of the biggest names in the technology space including Amazon, Alphabet, and Microsoft. The company has carved out a niche with counter-positioning -- it caters to small and medium-sized businesses that are likely too small to be worth the efforts of the larger players.
When parsing out the numbers, DigitalOcean has been losing customers that are spending $50 or less per month. In other words, it would appear that platform changes have inched the company away from the smaller end of the market, bringing it closer to direct competition with the bigger tech giants. Competition could consequently intensify.
Why DigitalOcean stock might be a buy anyway
The investment thesis for DigitalOcean stock was that the platform would attract small users overlooked by bigger cloud-computing platforms. And as the platform enabled the success of these small users, they would grow and increase their spending.
However, DigitalOcean is losing smaller users and making up the difference by attracting newer customers that spend more on average. This changes a facet of the thesis and brings it in closer competition with bigger rivals. But it may still be a good investment despite this risk.
DigitalOcean's revenue growth is accelerating, which is encouraging. Management attributes its growth partly to the release of 24 new products in Q2 alone -- product velocity is surging. And yet, research and development expenses fell 11% in the first half of 2024 compared to the first half of 2023. One would have expected an increase with the sheer volume of new products.
This illustrates something that's been true of DigitalOcean for some time: The company has grown while demonstrating fiscal restraint. For this reason, it does regularly generate positive free cash flow, as the chart below shows.
DOCN Revenue Per Share (TTM) data by YCharts
Granted, DigitalOcean's management expects profit margins to take a hit as it invests more in artificial intelligence. But the long-term trend shows that the company is focused on profitable growth, which should serve it well over the long term. And trading at about 4 times sales, the stock is a decent value.
Because of the concerning trend that I highlighted, I wouldn't say that DigitalOcean stock is a no-brainer today -- it's not my best bet for strong stock returns. But for some investors, it has enough promise that it could warrant a place in a diversified portfolio.
