3 Reasons to Sell DOCN and 1 Stock to Buy Instead

What a fantastic six months it’s been for DigitalOcean. Shares of the company have skyrocketed 69.1%, hitting $48.31. This was partly due to its solid quarterly results, and the run-up might have investors contemplating their next move.

Is there a buying opportunity in DigitalOcean, or does it present a risk to your portfolio? Check out our in-depth research report to see what our analysts have to say, it’s free for active Edge members.

Why Is DigitalOcean Not Exciting?

We’re glad investors have benefited from the price increase, but we're swiping left on DigitalOcean for now. Here are three reasons you should be careful with DOCN and a stock we'd rather own.

1. Weak ARR Points to Soft Demand

While reported revenue for a software company can include low-margin items like implementation fees, annual recurring revenue (ARR) is a sum of the next 12 months of contracted revenue purely from software subscriptions, or the high-margin, predictable revenue streams that make SaaS businesses so valuable.

DigitalOcean’s ARR came in at $919 million in Q3, and over the last four quarters, its year-on-year growth averaged 14.2%. This performance slightly lagged the sector and suggests that increasing competition is causing challenges in securing longer-term commitments.

2. Customer Churn Hurts Long-Term Outlook

One of the best parts about the software-as-a-service business model (and a reason why they trade at high valuation multiples) is that customers typically spend more on a company’s products and services over time.

DigitalOcean’s net revenue retention rate, a key performance metric measuring how much money existing customers from a year ago are spending today, was 99.2% in Q3. This means DigitalOcean would’ve grown its revenue by -0.8% even if it didn’t win any new customers over the last 12 months.

DigitalOcean has an adequate net retention rate, showing us that it generally keeps customers but lags behind the best SaaS businesses, which routinely post net retention rates of 120%+.

3. Low Gross Margin Reveals Weak Structural Profitability

For software companies like DigitalOcean, gross profit tells us how much money remains after paying for the base cost of products and services (typically servers, licenses, and certain personnel). These costs are usually low as a percentage of revenue, explaining why software is more lucrative than other sectors.

DigitalOcean’s gross margin is substantially worse than most software businesses, signaling it has relatively high infrastructure costs compared to asset-lite businesses like ServiceNow. As you can see below, it averaged a 59.5% gross margin over the last year. That means DigitalOcean paid its providers a lot of money ($40.46 for every $100 in revenue) to run its business.

The market not only cares about gross margin levels but also how they change over time because expansion creates firepower for profitability and free cash generation. DigitalOcean has seen gross margins decline by 0.5 percentage points over the last 2 year, which is slightly worse than average for software.

Final Judgment

DigitalOcean isn’t a terrible business, but it doesn’t pass our bar. Following the recent rally, the stock trades at 5.1× forward price-to-sales (or $48.31 per share). This valuation multiple is fair, but we don’t have much faith in the company. We're pretty confident there are superior stocks to buy right now. We’d recommend looking at a dominant Aerospace business that has perfected its M&A strategy.

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