DigitalOcean: Learnings From a Record Year for the IPO Market

2021 has been a record year for initial public offerings (IPOs) worldwide as 2,388 new companies listed their shares. In the U.S., the IPO market reached an all-time high with more than 900 companies going public, raising $300 billion in 2021. DigitalOcean Holdings (NYSE:DOCN) went public in late March 2021. DOCN Stock raised $775 million in its IPO at a price of $47 a share.

DigitalOcean is a cloud platform that is making cloud computing simpler for small and medium businesses. There are plenty of good, bad, and ugly key points you should know about DOCN stock. The prospects of cloud business may seem to be bright for DigitalOcean, but there is a key difference between a great company and a great stock. Do I consider DigitalOcean a great company?

I would say no, simply because as a newcomer to the stock market, the business expectations have changed dramatically. Expectations are much higher. Investors now desire strong financial performance and growth. It is too early for my analysis to be convinced of great status, but I consider it a very promising and exciting company to monitor.

What about its stock? I will begin with the good points first. For the readers on InvestorPlace that are anxious and want to get to the bottom-line quicker than usual, my thesis is that DOCN is not yet a hot stock. Plus, it is too pricey.

The Good Points for DOCN Stock

The third-quarter 2021 financial results were strong, reflecting an improvement in many key performance indicators.

On a year-over-year comparison, DigitalOcean reported revenue of $111 million, an increase of 37%. It reported a scaling annual recurring revenue (ARR) of $455 million, an increase of 36%, and customer growth of 7%, reaching 598,000 customers. The average revenue per user (ARPU) increased 28% to $61.97 and net dollar retention grew 1200 bps to 116%.

According to Seeking Alpha, the firm reported positive free cash flow of $13.5 million, which makes this the second consecutive quarter in 2021 it achieved this milestone. There is a growing market opportunity of $116 billion by the year 2024, growing at a compound annual growth rate (CAGR) of 27%. Compared to a market of $44 billion in 2020, this is another positive factor.

This market consists of platform as a service (PaaS) and infrastructure as a service (IaaS) cloud computing services, with IaaS as the dominant market share.

The Bad Points: Financial Results

The revenue growth, ARPU, and ARR improvements have not yet made DigitalOcean a profitable company. The net loss reported year-over-year for 2021’s third-quarter was $1.852 million compared to a net loss of $10.214 million in Q3 2020. Net losses have been also reported for Q1 and Q2.

There is a crucial tradeoff to consider between growth and value. Value is not supported, which I will address below.

Ugly Points: Focus Here

Going back to March 2021, DigitalOcean’s IPO price was set at $47 a share. On its trading debut, the stock closed at $42.50, losing about 10%. This loss was short-lived as DOCN stock has a 52-week range of $35.35 – $133.40 and its latest stock price at the close of the U.S. stock market was $79.24.

IPOs tend to be highly volatile and once expectations and early momentum are brought back to reality, selloffs occur. Being conservative is a virtue, following the “fear of missing out” effect is too risky. DigitalOcean was not an exception to this in 2021.

So what are the ugly points? It is not the volatility of its stock price. It is the fact that, according to this CNBC article, “at its $47 IPO price, DigitalOcean was valued at a price-to-sales multiple of 16 based on 2020 revenue, compared with 12 for Microsoft.”

Think about this for a moment. Its valuation from the beginning was rich, richer than a tech giant such as Microsoft (NASDAQ:MSFT). In its financial outlook, DigitalOcean estimated a 2021 fiscal year revenue of $426 million – $428 million.

With a market capitalization of $7.836 billion as of Dec. 17, the multiple of market capitalization to annual revenue stands at about 18.30x, which I consider too high. Simply Wall Street data shows that DOCN stock is relatively overvalued based on its price-to-book ratio of 8.9x. This is compared to the U.S. IT industry average of 4.5x.

Bottom Line on DOCN Stock

I consider DigitalOcean to be a company in the cloud business to monitor. If it continues to improve its key metrics, it may turn into a strong brand capable of delivering a good financial performance. Its stock, however, is currently pricey. And having announced a $1.3 billion convertible senior notes offering, stock dilution is another negative factor.

Growth stocks may face a hard 2022 with rising interest rates. It is prudent to see how DigitalOcean will face this challenge over the next quarters.

On the date of publication, Stavros Georgiadis, CFA  did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Stavros Georgiadis is a CFA charter holder, an Equity Research Analyst, and an Economist. He focuses on U.S. stocks and has his own stock market blog at thestockmarketontheinternet.com/. He has written in the past various articles for other publications and can be reached on Twitter and on LinkedIn.