Businesses large and small are looking for ways to rein in costs as a tough economy creates uncertainty. An easy target for these cost savings is cloud computing. The mega-cloud platforms like Amazon Web Services (AWS) and Microsoft Azure has already suffered a sharp slowdown as customers optimize consumption. AWS grew 12% year-over-year in the second quarter, while Azure grew 26%.
DigitalOcean (DOCN 2.23%) focuses on serving developers and small businesses. While this makes its customer base more fickle than the enterprise-heavy cloud giants, customers likely have less fat to cut from their cloud computing bill. An enterprise customer spending millions every year with cloud resources spread across dozens of teams is more likely to have let cloud spending get away with it than a small business putting off $90 a month.
Still, DigitalOcean is now starting to feel pain. The company’s revenue grew 27% year over year in the second quarter, but the real story was its guidance. DigitalOcean sees growth slowing significantly in the third quarter, and it cut its full-year guidance to reflect weaker demand for cloud computing services.
A broad deceleration
DigitalOcean expects to generate between $172.5 million and $174.0 million in the third quarter, up from $170 million in the second quarter. On an annual basis, this guidance represents a growth rate of just 13%.
For the full year, the company cut its revenue forecast to a range of $680 million to $685 million. Previously, DigitalOcean expected revenue to come in between $700 million and $720 million. The new guidance range represents 18% growth at the 2022 midpoint.
DigitalOcean is experiencing slow growth in all regions and almost all industries. Expansion is the biggest problem for the company. Customers are increasingly reluctant to increase spending, and this shows in DigitalOcean’s net dollar retention rate (NDR). NDR was only 104% in the second quarter, down from 112% in the same period last year.
Decline in customer spending also acts as a headwind, although the company noted that the decline stabilized in the second quarter. This may mean that the impact of customers optimizing their cloud spending is largely a thing of the past, although the decline remains elevated from before the downturn in the cloud computing market began.
One good news was the churn. DigitalOcean’s churn rate, which will naturally be higher than the major cloud platforms due to its lack of sticky enterprise customers, is holding steady around the same level as before the downturn. While customers optimize consumption and are reluctant to expand, they are not abandoning DigitalOcean.
Impressive cash flow
DigitalOcean is making lemonade out of lemons, using the downturn as an opportunity to reduce its costs and increase free-cash-flow generation. The company produced free cash flow of $45 million in the second quarter, good for a free cash flow margin of 26%.
The free cash flow margin will come down to a range of 21% to 22% for the full year, in part because the company will invest heavily in Paperspace, its recent artificial intelligence (AI) acquisition. Paperspace, which offers an easy-to-use platform for training and deploying AI models, is expected to contribute at least 3 percentage points to DigitalOcean’s growth rate in 2024, but this will require significant investment. Paperspace is expected to reduce free cash flow this year by as much as $20 million as DigitalOcean acquires graphics processing units (GPUs) and expands its AI capabilities.
Shares of DigitalOcean are up in 2023, although the stock took a big hit on Friday after the disappointing second-quarter report. Despite the slowdown, DigitalOcean’s long-term growth prospects still look bright.
The company sees its total addressable market growing to $195 billion by 2026, and the acquisition of Paperspace will help boost growth in 2024 and beyond. The company remains well positioned to be the cloud leader for small businesses, and the stock still looks like a solid long-term investment.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Timothy Green has positions in DigitalOcean. The Motley Fool has positions in and recommends Amazon.com, DigitalOcean and Microsoft. The Motley Fool has a non-disclosure policy.
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