DigitalOcean

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An Astronaut In The DigitalOcean
Let's talk about DigitalOcean (NYSE:DOCN). Starting with what the business does: DigitalOcean is a cloud computing services provider similar to AWS, GCP, or Azure that provides customers with IaaS (infrastructure as a service) and PaaS (platform a

aaS

IaaS is the bread and butter of DigitalOcean's business. For readers who don't understand the cloud or at least the IaaS portion of cloud computing, this is for you: IaaS is essentially a business model in which customers pay cloud providers (like DigitalOcean) a recurring fee to host their applications and websites on the providers' hardware.

 

Think of it in terms of an example: let's take a shoe store. A shoe store is looking to diversify outside of its brick-and-mortar locations and set up an effective eCommerce platform to sell shoes. Let's say that they build a website or an app. They have to host this platform somewhere, on a server somewhere. As of right now, this small business has two choices: host on the public cloud, or host it privately. Hosting privately has been the predominant method of small businesses for years, but there are some problems:

 

high upfront and maintenance CapEx

lack of understanding of how to program servers

difficultly troubleshooting issues as they arise (no customer support)

Let's take this point by point. Keep in mind, you are a shoe store. You spend your money and your time on shoes, not programming or building online platforms. This isn't your area of expertise. By privately hosting, however, you incur the capital expenditures of purchasing the servers themselves and the space to fit them. Servers aren't cheap and often aren't scalable. What if you are looking to address only your local neighborhood, not the entire US? Scalability issues and high capital expenditures come with purchasing servers outright.

 

Secondly, there is the knowledge gap of programming your servers to provide the functionality that may be required. Again, you aren't a computer programmer. You are selling shoes. This isn't your forte so in purchasing these servers you have to learn how to program them too.

 

And finally, you are on your own. Unlike with the public cloud, customer support for issues is incredibly limited when you are hosting privately. As issues arise, your website might go down and you might not know how to fix it. And again, why should you, you sell shoes.

 

Hosting privately has been the predominant way of doing things for SMBs looking for an online presence for one simple reason: they have had no other choice.

 

These are just three issues of many, many issues with private hosting that SMBs run into. Fortunately, the public cloud and IaaS providers offer a solution to these problems:

 

No upfront CapEx spend (IaaS providers own the hosting hardware)

servers are malleable and reprogrammable with ease

dedicated customer support teams

There is more to IaaS that I am leaving out and will cover later on. The bottom line is, the shift from private hosting to IaaS is coming because it needs to. SMBs need to get on the cloud because need to have a digital presence. The COVID era demonstrated that running a business without a digital presence is downright archaic.

 

What is IaaS (Infrastructure as a Service)? | The Iron.io Blog

(source)

 

Now, let's discuss PaaS, a smaller part of DigitalOcean's business, but a faster-growing part.

 

PaaS

What is PaaS? Well, simply put, PaaS is everything IaaS is (storage, servers, firewalls/security, etc.) and then some. PaaS platforms allow customers to lease platform building services on a pay-as-you-go basis. Such services include business analytics, app development tools, operating systems and database management tools. PaaS allows developers to worry less about specific operating system configurations or technical nitty-gritty details in building their app. For a fee, developers are given a framework to build, test, track, and deploy applications on the cloud. Additionally, using a PaaS-based model on a cloud platform allows developers to bypass spending money on purchasing large software licenses, as such licenses are often bundled into the PaaS model. Basically, an efficient PaaS model allows developers to scale up the development of their applications based on a framework created by the cloud provider. This reduces code times, smoothens out configuration bugs, allows development across platforms (mobile/desktop) and operating systems, among other things.

 

IaaS vs PaaS vs SaaS {Ultimate Comparison} | phoenixNAP Blog

(source)

 

Bull Case

Now that we somewhat understand the market that DigitalOcean operates in, let's break down their differentiation in this market, and the long-term bull case for the stock going forward.

 

Moat

In an often competitive and commoditized world of public cloud computing, what makes DigitalOcean stand out as a pure play relative to the big cloud hyperscalers? Well, there are three key factors that I can identify from a product perspective.

 

simplicity focused

culture community

transparent billing and pricing

There are more factors than just these three, but these three are the core factors that differentiate DigitalOcean from competitors. Starting with simplicity. Whether it be the user interface, the listed tools and offerings, or the pricing, it's just simple. In reading customer reviews, one of the highest touted features of DigitalOcean's model was the simplicity. Operating and building in DigitalOcean is like driving a car, whereas it often feels like using hyperscalers feels like flying a jumbo jet. These are two different products designed for two different target markets. Large hyperscalers have built their platforms centered around an appeal to enterprise customers, while DigitalOcean is focused on smaller businesses. Now, as growth stalls in enterprise, could hyperscalers pivot to move down market? Yes. But DO has already built in that customer loyalty for being a unique first-mover, while hyperscalers would have to pivot to accommodate the onboarding of SMBs.

 

The second factor that DigitalOcean has going for it is its culture. A culture of simplicity and community to help developers who aren't experienced or are struggling with some part of the platform. While the platform inherently is an easy-to-use platform (thanks mostly to self-serve), there are always going to be problems that devs will stumble upon. Having a library of thousands of videos and documents to fall back on and learn from is incredibly valuable, something that most other SMB-oriented cloud providers just don't have.

 

The third factor is DigitalOcean's transparency in billing and pricing. Buy what you need, nothing more, nothing less. With DigitalOcean, calculating how much you owe them isn't a nightmare, it's a simple process that you select based on what products you choose. Hyperscalers, particularly AWS, have failed in this regard. Pricing transparency, or lack thereof, is one of the biggest knocks clients have on AWS. In comparison, while seemingly quite the simple fix, DigitalOcean solves a complaint that most hyper scaling clients have: opaque and confusing pricing.

 

 

(source: DigitalOcean 2Q Investor Deck)

Large Market With Space For Many Players

Let's address DigitalOcean's market schematics. DigitalOcean operates in an addressable market of SMBs, so while some investors might be enthused to look at the global IaaS/PaaS market as a whole, we should skew DigitalOcean's TAM for SMBs specifically (businesses with 500 employees). That narrows it down a bit, but we're still looking at a massive market.

 

 

(source: IDC)

They operate in a $44 billion market that is projected to grow to at a CAGR of 27% to $116 billion by 2024. Market growth alone, not even market share gains can propel the growth story. This is a business operating in a massive market with a differentiated product. This, in theory, should lead to outsized market share growth too. DigitalOcean's 2020 revenue was 1% share of the 2020 addressable market. Keep in mind, this is a global TAM, but then again, DigitalOcean is a global platform. DigitalOcean is at very low TAM penetration right now. While I do expect many SMBs, tech startups, and cloud-native companies with experienced IT teams to continue to use hyperscale offerings, I would fully expect simplified solutions like DigitalOcean to reign supreme. Why? Again, the secular theme of moving off in-house and moving towards the public cloud is real. Any business that doesn't have some digital presence is strategically floundering. I would expect DigitalOcean's market share to increase as they have built out a differentiated cloud platform. DigitalOcean Is clearly gaining spending and mind share among the development community, as is evidenced by this statistic from Wiseman Capital on Twitter.

 

 

DigitalOcean is fifth when compared to the Big 3, and second when excluding the big 3. DigitalOcean's focus on simplicity, excellent customer support, and transparent pricing is paying off in terms of developer loyalty.

Also keep in mind, DigitalOcean's NPS (net promoter score) is 65, well above the "excellent" threshold of 50+ (per HubSpot), and above smaller cloud providers. Customers love the product generally, and the market is big enough for a player like DigitalOcean to pick up meaningful share long-term.

 

Strong Underlying KPIs Already

The business is already firing on all cylinders. Across almost every KPI, DigitalOcean is executing with strength. This isn't a stock where you buy now and reap the rewards of the financial success later. This is a business that is already executing.

 

ARR

Customer adds

accelerating revenue growth

EBITDA

decreasing capex

improving NDRR

increasing ARPU

Starting with ARR (annualized revenue rate), DigitalOcean has seen the highest ARR in company history in 2Q at $426M, up $38M (highest ARR increase ever) sequentially. Additionally, in spite of incredibly light marketing, DigitalOcean added 17k customers in 2Q and now has 602K, up 9% y/y. Keep in mind, this is with very light sales and marketing spend. Revenue growth has continued to accelerate, hitting 35% in 2Q after 1Q's 29% and 4Q's 26%. Revenue growth acceleration especially this late in a company's life cycle (post-startup phase) is an amazing indicator of how the business is performing.

 

EBITDA is already positive. DigitalOcean, for all intents and purposes, is already a profitable business. 2Q EBITDA hit $31.4M, a new record for the company. The high gross margin, low overhead structure of the business model has enabled this strength in EBITDA.

 

CapEx is decreasing as well. In an asset-heavy world of datacenter, reducing expansion and maintenance Capex relative to revenue is quite important. DigitalOcean hit 25% Capex as a percentage of revenue these last two quarters, down from 44% and 40% in 1Q and 2Q of last year. CapEx efficiency is important when it comes to long-term cash generation. Good to see DigitalOcean executing here.

 

One of the most important metrics in understanding customer relationships with the business is NDR. Net dollar retention basically balances out upgrades in spend from customers with downgrades/cancellations in spending. An NDR above 100% indicates that churn and downgrades are less than upgrades. Inversely, an NDR 100% indicates churn and downgrades are taking over. DigitalOcean has for a while been at around 100-105%. NDR jumped 600bps q/q to 113% in 2Q. Customers are developing loyalty to the platform and are net upgraders of spend. This is positive as it supports the bull thesis of sticky customer engagement.

 

And finally, there is monthly ARPU. How much is the average client spending per month with DigitalOcean. ARPU was up to another high of $58.07/month in 2Q, growing +25% y/y. As businesses scale operations on DigitalOcean or start to use new features, their spend will increase, leading to a rise in ARPU.

 

Conservative Street Estimates/Undercovered

The next part of the bull thesis is the company's coverage, or lack thereof. According to SA, DigitalOcean only has nine sell-side analysts providing estimates. This leaves big gaps between individual analysts that can skew the consensus. Management recently commented that they are targeting $1 billion in revenue by 2024 implying 30%+ CAGR. The Street is south of 30% for that time frame.

 

Additionally, the stock trades at low daily volume, meaning institutions haven't piled into this name yet. Lack of attention can often be an indicator for an arbitrage opportunity between the current share price and the fundamentals of the business.

 

All in all, I believe fundamental estimates for EPS and revenue are too low. Customer growth, increased spend, customer upgrades, and TAM should fuel multiple years of 30%+ revenue growth that the Street simply isn't modeling right now. I'll break it down more in the valuation model.

 

Low Marketing Spend

The next part of DigitalOcean's bull case is marketing. Or really, DigitalOcean's lack of marketing. The accelerating revenue growth achieved of late was done while spending just ~11.4% of total revenue on marketing. As Citron Research eloquently put it, past $100 in infrastructure credits and some Google ads, they don't really market. And that's kind of the point. This is a product that speaks for itself. They don't need marketing to drive customer growth because the developer community likes it enough to recommend via word of mouth. This low marketing spend is a big part of why the company is already successful on a bottom-line level. I think over time, if the industry becomes more commoditized, or if DigitalOcean pushes to aggressively add market share against that TAM, then maybe SM expenses as a % of revenue scales to the 15-20% range. But even then, that's okay. What DigitalOcean's recent results are proving is that it's a company with a very compelling product. So compelling that even with low levels of marketing, they are able to improve NDRR, increase customer count, and reduce churn. I love to see it when customers are as enthusiastic about a product as these customers seem to be with DigitalOcean.

 

Management's MA History + Incentives

Another piece of upside for the stock is the management team. Management is a critical piece of evaluating any business and its future. The TL;DR is that I really like the management team, specifically CEO Yancey Spruill. Yancey was the former CFO/COO of SendGrid. They were a CPaaS play native to the programmatic email space. They were bought out roughly two and a half years ago by Twilio (NYSE:TWLO). What I'm saying here, is that management has past experience in MA. If management saw fit to merge DigitalOcean with a larger scale cloud/tech company, I have no doubt they could pull it off. Over the long-term, I think an MA deal would be premature, and that the company shouldn't sell, but they have a CEO with past MA experience.

 

Secondly, management appears to be betting big on the company. Just look at Yancey Spruill's executive stock compensation structure. As Citron Research pointed out, the first tranche of his RSU package doesn't vest until the stock hits at least $93.50/share, with the final tranche vesting at $280.50. When management is incentivized to bet big on their own company's stock, usually it's a pretty good sign in terms of the ambition of the management team.

 

Bear Case

DigitalOcean is undoubtedly a risk on play, however, and investors need to keep a heavy bear case in mind. Let's break down the DigitalOcean bear case.

 

IaaS Commoditization

As time has passed, IaaS solutions have grown in propensity as money flows from self-hosting to public cloud. That said, the breadth of competition has as well. Not just in enterprise cloud, but across the board. DigitalOcean, while being a well-known and respected player in the public cloud, isn't the only one. Competitive moats are not as big in IaaS as they are in other software-driven industries. Commoditization is a real risk to DigitalOcean's pricing. As offerings become more available across the globe, pricing power and leverage will likely decrease. This might hurt unit economics or revenue, or both. Commoditization is a real risk that investors need to keep in the back of their minds.

 

SMB Churn Risk

The next risk is DigitalOcean's exposure to SMBs. While this is the predominant demographic of customer on DigitalOcean, it also is a risk. SMBs are more prone to economic downturn, and the vast majority of them fail. If a business fails and pulls spending with DigitalOcean, it can affect revenue and customer size. Additionally, switching costs aren't as high for SMBs as SMBs are generally more nimble than large enterprise customers. If another IaaS/PaaS offering comes along that is better priced or more efficient than DigitalOcean, SMB churn could be a real risk to revenue growth, customer count, and NDRR.

 

Competition From Large Small Providers

Tying back into the point made about commoditization, DigitalOcean faces real competition from large and small public cloud players. Additionally, they even admit that customers have less access to key tools than on enterprise cloud platforms like GCP, Azure, or AWS. If any of the Big 3 public cloud plays makes a legitimate push down market to compete with DigitalOcean, then the company could be in real trouble.

 

Inability to Innovate Iterate

DigitalOcean has done a great job over the last few years of transitioning and continuing to innovate forwards. Whether it was building out from base Droplets to a more comprehensive IaaS offering, or transitioning up the tech stack to PaaS, DigitalOcean has taken the appropriate steps to innovate and iterate. Future opportunities likely involve building out AI/ML tools in their PaaS service and adding GPUs to their infrastructure. That said, if DigitalOcean somehow fails to stay on the ball of evolving technology trends and giving clients/developers the right tools to expand, they could fall to obsolescence.

 

Potential CapEx Intensity

The final tenet of the bear case on DigitalOcean is an inability to convert positive EBITDA and net income into cash flow. Right now, that's because of capital expenditures. Since DigitalOcean is an IaaS provider, they upfront the cost of building and maintaining their 14 global datacenter. In the IaaS business, CapEx is high. If CapEx remains a high percentage of revenues long-term, transitioning the business to high levels of cash flow may be difficult.

 

Twilio/Shopify Comparison

Now let's break down the comparison to Twilio and Shopify (NYSE:SHOP). I want to be clear about something from the outset, however: I do not necessarily expect DigitalOcean's returns to one-for-one mirror those of Twilio and Shopify. Here is what is similar:

 

evangelistic culture

rapid TAM expansion and low market penetration

developer/customer centric vision

These are three factors that Twilio and Shopify had going for themselves that DigitalOcean also seems to have in its early days as a public company.

 

An evangelistic culture is another way of saying customers are obsessed with the product. Jeff Lawson, CEO of Twilio is considered a literal software evangelist while Tobi Lutke at Shopify is too. Customers adore the products that these two businesses build. The same can be said for DigitalOcean. They have the highest NPS out of any public cloud provider and continue to see accelerating NDRR reflecting the willingness of customers to come back. Building a cultural flywheel where the customers love the product and continue to use and recommend it is amazing.

 

The second thing that all three businesses have in common is a massive TAM. When Shopify and Twilio first hit the markets, I distinctly recall myself being deeply suspect of the valuations. EV/S ratios were through the roof and while the growth was good, it just seemed too frothy. Well, taking a step back, I now understand why investors were okay with such high multiples. Both Shopify and Twilio operated in markets that were already massive and growing quickly. When you operate in a massive, underpenetrated market that's growing fast, the high growth we see from Twilio and Shopify can be sustained for a lot longer than anyone might anticipate. Why? Because they have a double whammy of a fast-growing market, with fast-growing market share, supercharging revenue growth. DigitalOcean's TAM is already massive at $44 billion, but it's growing at a 27% CAGR until 2024 and will likely continue to grow after that. Low penetration in a fast-growing market is super important to sustaining high multiples.

 

And finally, the last comparison between the three is management's vision. Where do these three great CEOs focus their attention and resources? Enabling a world-class customer experience. In most cases, giving developers and businesses the simplified tools to get the job done and worry about building great products. Building embedded and programmatic communications with Twilio took a developer-centric approach. The same can be said about Shopify. Without getting too abstract, focusing on customer simplicity and really loving the product is super important, and it seems DigitalOcean follows Twilio and Shopify in leading in this regard.

 

2Q Report Breakdown

Now, let's break down DigitalOcean's most recent quarterly report: its 2Q earnings report. Starting with headline numbers.

 

(source: DigitalOcean IR)

Mid 30s revenue and ARR growth, an accelerant on a sequential and y/y basis. Customer spend upgrades up 1,100 basis points y/y as customers upgrade spend and churn reduces. Customer growth is strong in spite of light marketing. Monthly ARPU continues to grow quickly as businesses scale and scale platform spend.

 

(source: DigitalOcean IR)

Next, DigitalOcean gives us a look at their full year guide for both revenue and adjusted EBITDA. They're guiding to 2021 EBITDA of ~$1/share off revenues +~32% y/y. These results are impressive, especially when you consider the early innings nature of the business and the market they operate in.

 

(source: DigitalOcean IR)

 

Tied together with accelerating revenue growth, ARPU growth, ARR growth, and NDRR, and we can see that DigitalOcean's business is firing on all cylinders. With this level of execution, it's hard to make a case against the business, and the bear case feels like a series of uninformed qualms. With all this being said, let's jump into my valuation of the business.

 

Valuation

Valuation is tricky to pinpoint specifically with DigitalOcean for a few reasons:

 

hard to predict actionable TAM.

hard to model accurate LT market share.

long-term customer TAM.

little experience as a public co.

Let's talk about these points one by one. First of all, I'm not a developer. I'm going to be honest in that I do not have anywhere close to the amount of knowledge that actual devs have on the product. That muddles transparency for me into valuation, and hurts my ability to predict an accurate actionable TAM. How much of that $116B TAM mentioned earlier is actually going to move to public cloud? How much of it will be on-premise solutions long-term, and how much will be third-party vendors?

 

And within that, how much market share can DigitalOcean capture? In 2020, they were ~1% TAM capture and their $1 billion 2024 revenue target seems to imply market share doesn't move that much. Do competitors like Vultr and Linode really corner them? Do hyperscalers move down market and keep market share gains limited? It's hard to say. I'm no dev, but devs I've talked to really like the simplicity and transparency, not necessarily the feature set. I can't imagine them getting into a massive market share (15-20%) without rapidly expanding their tools for devs. That said, a large-scale TAM with a low market share provides an actionable runway outside of mere organic market growth driving revenues.

 

Additionally, what is the TAM in terms of customer growth? How many customers are reasonably addressable? How many SMBs will have digital presences and how many of those companies will be public cloud? That's all up in the air. We do know that DigitalOcean estimates that by 2030, total global developers will total 45 million. Can we think of that as a number of addressable paying customers? Hard to say.

 

And finally, this company's days as a publicly traded institution are few and the market has very little to judge the long-term stability of the business and its guidance on. As a result, we don't have enough data to make long-term predictions about the future of the business. As a result, I'm electing to take a different approach. According to Jamin Ball, the average mid-tier growth SaaS company trades at ~15x EV/NTMS.

 

DigitalOcean, even with a 30% revenue growth CAGR for the next few years and top of class EBITDA margins, isn't a top-tier SaaS company in terms of raw revenue growth. I'm electing to use a 2022 exit P/S of 15x to reflect a strong growth profile, large TAM, and high EBITDA margin structure. That said, growth isn't strong enough to justify a top of range multiple. As of right now, my internal valuation model is modeling 2022 revenues of ~$581.78M, versus consensus expectations for ~$547M. On 15x my revenue estimate, DigitalOcean's market cap comes out to $8.205B. On a current share count of 106.77M, that implies a share price of $76.85, thus my $77 price target.

 

Conclusion

In conclusion, DigitalOcean is a buy in my book. It is a unique pure play on SMBs transitioning away from privately hosted cloud solutions and towards the public cloud in general. They have an offering that simplifies cloud computing for small developers and keeps pricing transparent. While there is risk to investing in DigitalOcean, the long-term upside of the fundamentals seems bright. High EBITDA margins, a massive TAM, and continue acceleration across numerous KPIs should be drivers for upward mobility in price action. Initiating at Buy, PT set at $77.

 

(source: DigitalOcean logo)

Disclosure: I/we have a beneficial long position in the shares of DOCN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

 

Additional disclosure: I am not a financial advisor. This is not financial advice. Please do your own due diligence before initiating a position in any of the aforementioned securities

 

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