2022 brought about a sea change in the way technology companies do business. In the years prior, interest rates were near record lows, which meant capital was extremely cheap, so investors encouraged tech organizations to spend heavily on growth even if it meant they lost money at the bottom line.

But that changed last year as the U.S. Federal Reserve embarked on the most aggressive campaign to hike interest rates in its history in order to tame soaring inflation. Now, investors want to see companies generating a profit as opposed to outright growth. That led to much lower stock prices for most of the tech industry.

Cloud computing company DigitalOcean (DOCN) took the hint and successfully transitioned to profitability, but in the second quarter of 2023, it saw a deceleration in revenue growth that could be linked to its reduced investments in marketing and customer acquisition. Investors sent its stock price plunging 24% immediately following the report, and it’s now trading 72% below its all-time high.

DigitalOcean is building a business for the long term, and that long-term plan includes delivering advanced artificial intelligence (AI) tools to its customer base. Here’s why investors should take this share-price weakness as an opportunity to buy the stock right now.

DigitalOcean offers a unique value proposition, which now includes AI
In the past, businesses had to store their valuable data — and even host their websites — by purchasing expensive server hardware which would be stored on their premises. Cloud computing changed the game by allowing businesses to rent powerful infrastructure from providers like DigitalOcean at a fraction of the cost of doing it themselves. Now, they can run everything from their back-end operations to customer-facing sales channels online.

The cloud services industry is dominated by three main players: Amazon Web Services, Microsoft Azure, and Alphabet‘s Google Cloud, each of which is backed by a trillion-dollar parent company. DigitalOcean is technically in competition with all of them, and with a valuation of just $3.2 billion, it’s easy to assume the company is outgunned.

But DigitalOcean targets a niche, fast-growing segment of the cloud market: small to mid-sized businesses, typically with under 500 employees. It competes by offering them transparent pricing, a digital library filled with thousands of items of educational material, and highly personalized service that the larger cloud providers can’t match.

DigitalOcean is taking its services to the next level thanks to its recent acquisition of Paperspace, a cloud platform that helps over 500,000 developers build, train, and deploy artificial intelligence applications. Large language models and chatbots like ChatGPT have proven their ability to significantly boost productivity in the corporate world, so it’s important for DigitalOcean to have a presence in this segment for its small business customers.

Paperspace gels perfectly with DigitalOcean because it’s focused on serving customers at a low price point. In fact, its accelerated infrastructure — which runs on powerful Nvidia A100 GPU chips — is up to 70% cheaper to rent than comparable infrastructure managed by Microsoft Azure. Paperspace uses per-second billing and requires no long-term commitments from customers, which is how it achieves those savings.

DigitalOcean’s revenue growth slowed in Q2, but it was profitable
DigitalOcean generated $169.8 million in revenue during Q2, and while that was in line with its forecast, it represented year-over-year growth of just 27%, which was the slowest pace in the last four quarters. Even worse, the company’s outlook for the third quarter points to a growth rate of just 14% year over year, which is a key reason investors sent DigitalOcean stock plunging following the release of its Q2 report.

But there were positives. DigitalOcean had 616,000 customers at the end of Q2, and it puts them in three categories:

  1. Learners, who have just started their cloud journey and spend an average of $15 per month;
  2. Builders, who have an established business and spend an average of $136 per month; and
  3. Scalers, who are full-fledged business operators spending $1,933 per month on average.

The company had 150,100 builders and scalers on its platform at the end of Q2, up 42% year over year, which far outpaced the 12% growth of its overall customer base. This implies more small businesses are successfully leveling up using DigitalOcean, leading to more revenue despite the company investing less money in marketing and acquiring fewer customers overall.

As mentioned at the top, DigitalOcean achieved profitability. It trimmed its marketing costs and only grew its operating expenses by 10% in total in Q2, and since its revenue grew by 27%, more of that money flowed to the bottom line. As a result, the company delivered $3.9 million in net income for the quarter, which improved upon the $7.9 million net loss from the year-ago period.

Why DigitalOcean stock is a buy on the dip
While careful expense management is one reason DigitalOcean’s revenue growth slowed, management says the broader environment for the technology sector was also a factor. Businesses are simply spending less money on expanding their digital infrastructure right now because they’re uncertain how the economic climate will impact their operations in the short term.

The company said those headwinds could persist throughout the second half of 2023, and that peak growth deceleration was yet to come. Again, this outlook is the primary reason investors sent DigitalOcean stock plunging after the release of the Q2 report.

But that might be an opportunity for long-term investors, because the need for cloud services isn’t going away, and demand could actually grow from here thanks to new tools powered by AI. In fact, DigitalOcean estimates its addressable market will be worth $98 billion in 2023, but it could double to $195 billion by 2026. Since the company only has $682 million in annual recurring revenue today, it has barely scratched the surface of that opportunity.

Plus, a broader estimate of the value of AI for software companies suggests DigitalOcean could be playing in a $14 trillion market by 2030 thanks to its acquisition of Paperspace, according to Cathie Wood’s Ark Investment Management.

In any case, with DigitalOcean stock trading 72% below its all-time high, investors might wish they’d bought in when they look back on this moment five years from now.

— Anthony Di Pizio

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Source: The Motley Fool