Shareholders of DigitalOcean would probably like to forget the past six months even happened. The stock dropped 25.7% and now trades at $28.78. This may have investors wondering how to approach the situation.
Is there a buying opportunity in DigitalOcean, or does it present a risk to your portfolio? Get the full stock story straight from our expert analysts, it’s free.
Why Is DigitalOcean Not Exciting?
Despite the more favorable entry price, we're swiping left on DigitalOcean for now. Here are two reasons why we avoid DOCN and a stock we'd rather own.
1. 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 98.2% in Q1. This means DigitalOcean’s revenue would’ve decreased by 1.8% over the last 12 months if it didn’t win any new customers.
Despite trending up over the last year, DigitalOcean still has a weak net retention rate, signaling that some customers aren’t satisfied with its products, leading to lost contracts and revenue streams.
2. 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 59.9% gross margin over the last year. That means DigitalOcean paid its providers a lot of money ($40.08 for every $100 in revenue) to run its business. 
Final Judgment
DigitalOcean isn’t a terrible business, but it doesn’t pass our bar. Following the recent decline, the stock trades at 3.2× forward price-to-sales (or $28.78 per share). This valuation is reasonable, but the company’s shakier fundamentals present too much downside risk. We're fairly confident there are better stocks to buy right now. Let us point you toward one of our top digital advertising picks.
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