Cloud computing platform DigitalOcean (Document 5.87%) released its second quarter 2024 financial results on August 8, and investors celebrated the report by driving up the stock price.

Certainly, DigitalOcean’s second-quarter results were strong in key areas. For example, the company’s revenue grew 13% year over year, marking the second consecutive quarter of accelerating growth. In addition, the company had adjusted free cash flow (a key measure of profitability) of $37 million. That number may be lower year over year, but it’s still a strong 19% margin.

DigitalOcean stock rose after the report, suggesting that the company and its prospects are doing well. However, investors tend to overreact, so you need to take a closer look to find out if DigitalOcean stock is worth buying.

A worrying trend

I am convinced that DigitalOcean is losing customers at an alarming rate, as I will explain.

In the second quarter, DigitalOcean’s net dollar retention rate was 97%, which was the fourth consecutive quarter below 100%. This metric measures spending on a customer base from one year to the next. A retention rate below 100% indicates a decline in revenue due to customer churn and downgrades and is a warning sign.

This is an important but complex metric to understand. However, keep in mind that new customers do not contribute to this metric in the past year. In contrast, new customers contribute to average revenue per customer. At DigitalOcean, average revenue per customer in Q2 was $99.45, up 9% year over year and 25% year over year.

Also important to this discussion is DigitalOcean’s total customer count. The company ended the second quarter with 638,000 customers, up 3% year over year.

Looking at these three metrics together, investors can see that DigitalOcean has more customers than ever before and that customers are spending more on average. However, many of those customers are new and the company has lost long-standing customers, as evidenced by the declining customer retention rate. And that’s a worrying trend.

Why this could be a problem

DigitalOcean’s customer retention rate jumped in 2022 after the company raised prices for its cloud computing services—higher prices naturally lead to higher spending. However, a year after the price increases, the customer retention rate fell below 100%, meaning the company lost customers due to the pricing changes.

DigitalOcean competes against some of the biggest names in technology, including Amazon, alphabetAnd MicrosoftThe company has carved out a niche for itself by positioning itself counter to small and medium-sized businesses that are likely too small to be worth the effort of the larger players.

Looking more closely at the numbers, DigitalOcean has lost customers who spend $50 or less per month. In other words, it seems that the platform changes have taken the company away from the smaller market segment and brought it closer to direct competition from the larger tech giants. Competition could therefore intensify.

Why DigitalOcean could still be a buy

The investment thesis for DigitalOcean stock was that the platform would attract small users overlooked by larger cloud computing platforms. And as the platform enabled the success of these small users, they would grow and increase their spending.

However, DigitalOcean is losing smaller users and making up the difference by attracting new customers who spend more on average. This changes one facet of the thesis and puts the company in more competition with larger rivals. But despite this risk, it can still be a good investment.

DigitalOcean’s revenue growth is accelerating, which is encouraging. Management attributes the growth in part to the release of 24 new products in the second quarter alone – product velocity is increasing rapidly. And yet, research and development expenses fell 11% in the first half of 2024 compared to the first half of 2023. Given the sheer volume of new products, one would have expected an increase.

This illustrates something that has been true for DigitalOcean for some time: the company has grown while maintaining financial restraint, which is why it regularly generates positive free cash flow.

DOCN Revenue per Share (TTM) data by YCharts

Admittedly, DigitalOcean’s management expects profit margins to fall as it invests more in artificial intelligence. But the long-term trend shows that the company is geared toward profitable growth, which should benefit it in the long run. And with a price-to-earnings ratio of about four times sales, the stock is a good value.

Because of the troubling trend I’ve highlighted, I wouldn’t say DigitalOcean stock is a sure thing today — it’s not my top pick for strong stock returns. But for some investors, it’s promising enough to warrant a place in a diversified portfolio.