NBDS - DigitalOcean: The Cloud Provider Making A Splash

• DigitalOcean is a cloud provider that specializes in serving small and medium sized businesses.
• The company has carved out a niche in a market dominated by Amazon, Microsoft, and Google.
• Its shares have fallen an eye-watering 75% from their 52-week high.
• Combine the opportunity ahead with its current share price, and I think DigitalOcean could be an incredible long-term investment.

Investment Thesis

Cloud adoption is a secular trend that has really taken off in the past decade, yet smaller businesses are being left behind. Enter DigitalOcean Holdings, Inc. (DOCN), the company with a clear focus on this smaller market. It has differentiated itself from the larger cloud providers, and has a huge opportunity ahead.

But does this make DigitalOcean a good investment right now? I put it through my investing framework to find out.

Business Overview

DigitalOcean is a cloud computing platform specializing in infrastructure and platform tools for small and medium-sized businesses (aka SMBs), with a mission to ‘simplify cloud computing so that developers and businesses can spend more time building software that changes the world’.

The company serves the SMB market segment, which has often been overlooked by the cloud giants such as Amazon ( AMZN ), Microsoft ( MSFT ), and Google ([[GOOG]], GOOGL ). These enterprise-focused vendors have a complicated implementation process, opaque and unpredictable pricing models, and offer a limited amount of support for SMBs. In short, they are not targeting businesses with fewer than 500 employees – that isn’t where they make their money.

DigitalOcean has taken a different approach, by creating infrastructure and platform technologies that can be implemented quickly, intuitively, and independently. Its cloud platform is purpose built for developers and SMBs, as the company looks to help everyone succeed in a cloud-first environment.

The company offers a wide range of products, and these fall into four categories:

• Compute : enables developers to build and release applications faster in the cloud, with simplicity at its heart. Droplets (DigitalOcean’s first product) sit within this category, and each Droplet a customer creates is a new virtual server that can be used either on its own or as part of a larger, cloud-based infrastructure. These can then be used to run programs, store data, run SaaS applications and more.
• Storage : allows customers to store and assess data reliably in the cloud, with several different types of storage offered depending on a customers’ need.
• Networking : a suite of networking capabilities to secure and control the traffic to customers’ applications.
• Managed Databases : provides a fully managed database that gives customers the performance they need without the demands that come with building and running their own database server. DigitalOcean also partnered with MongoDB ( MDB ) to provide a fully managed database as a service offering.

DigitalOcean also has its own infrastructure and technology network, with 14 data centers across the globe. It’s worth highlighting that the company leases data center space from the leading providers, rather than owning its own data centers, to provide DigitalOcean with the flexibility to enter new markets quickly.

Economic Moats

With every business, I look to see if there are any durable competitive advantages (aka economic moats) that will help the company continue to thrive whilst protecting itself from competition.

The first economic moat that I can see for DigitalOcean relates to switching costs, and this is common amongst cloud providers. If I have my digital operations linked to a cloud provider, it would be onerous to switch without any good reason.

It’s worth noting that DigitalOcean serves SMBs primarily, which are at greater risk of going out of business – so, you might expect to see low retention metrics through no fault of DigitalOcean. With this caveat, the dollar-based net retention rate looks even more impressive.

As you can see, customer growth is somewhat lumpy, which isn’t a surprise with a business targeting SMBs. Yet the DBNRR has been consistently improving over time, as DigitalOcean continues to upsell the customers that it retains – plus, I’m happy to say that Q1’22 resulted in the highest number of customers so far. Even more promising is the fact that growth in customers paying more than $50 a month is even faster.

In short, the companies that are surviving and thriving will continue to spend more on DigitalOcean’s solutions, thereby embedding DigitalOcean further into their business & increasing switching costs.

I would also make the case that DigitalOcean benefits from a counter-positioning moat, which is defined as having a business model so different from your competitors that it would harm them if they adopted it. Clearly there is big competition from the cloud giants, and whilst DigitalOcean has differentiated itself through simplicity, there are a few additional offerings that make up this counter-positioning moat.

Firstly, we have the extremely affordable pricing set by DigitalOcean. They charge a lot less than the cloud giants, whilst also focusing on customers that will use substantially less. DigitalOcean is designed to thrive with this kind of business model, whereas its competitors are more focused on trying to scale up as much as possible – and squeeze as much money from enterprises as they can.

The other reason I give credit for counter-positioning is DigitalOcean’s focus on customer support. SMBs don’t have the kind of resources that large enterprises have to manage their cloud platform infrastructure, and as such they require more assistance. Unsurprisingly, large cloud providers will focus a lot more of their energy into helping out the enterprises that are paying them millions, leaving little room for assistance to SMBs. On the other hand, DigitalOcean aims to provide superior 24/7 customer support and will offer this to all customers, regardless of size. Furthermore, it has a bunch of simple self-help resources and an active developer community – all of which has led to a strong NPS score of 65, and has created a tremendously loyal customer base.

This leads to another weak moat, and that is the network effect. There is not an awful lot of detail offered up by DigitalOcean, but they do outline the following in their 2021 Annual Report :

Our customers become great advocates for DigitalOcean and are a common source of new customer referrals.

So, more customers lead to more referrals, which leads to more customers, which leads to more referrals. Again, this is a weak network effect, but it’s there.

You could certainly argue that DigitalOcean have an economic moat with their brand as well, given the apparent customer loyalty and high NPS score – I won’t give them credit for this yet, but it’s something that could develop over time.

Outlook

Cloud adoption is ramping up across the globe, but perhaps unsurprisingly it has been slower amongst SMBs who simply do not have the same level of resources. The good news? This means that the opportunity ahead of DigitalOcean is still substantial, with the IaaS (infrastructure-as-a-service) and PaaS (platform-as-a-service) markets for SMBs expected to grow at a 27% CAGR through to 2025, reaching a size of $145 billion.

To put that into perspective, DigitalOcean’s revenues for the past 12 months were $462m, or 0.1% of that 2025 market size.

I’ll also highlight that DigitalOcean has always been a developer-focused company, and this should also pay off down the line. As per DigitalOcean’s 2021 Annual Report:

As software and cloud-based technologies have become essential across industries and businesses of all sizes, the number of software developers and their strategic importance to organizations are both increasing significantly. According to IDC, the number of developers globally was 26.2 million in 2020 and is expected to grow to 43.2 million by 2025.

This is a company with multiple tailwinds helping it to grow, and if it can execute on its plans, then DigitalOcean should have a bright future ahead of it.

Management

When it comes to fast-paced, innovative companies, I always aim to find founder-led businesses where inside ownership is high. As much as DigitalOcean has impressed me thus far, unfortunately it fails to tick both of these boxes, as the co-founders no longer work in the day-to-day running of the business. Yancey Spruill, former CFO and COO of SendGrid took over as CEO in 2019, and as we will see shortly, he appears to be doing a great job.

I want to invest in companies where leadership has skin-in-the-game, and once again DigitalOcean does not tick this box for me – but, it’s also higher than I expected. CEO Yancey Spruill has a 2.3% shareholding in DigitalOcean, which is a lot lower than I usually like to see, but it’s actually not bad for a non-founder CEO.

I also like to take a quick look on Glassdoor to get an idea about the culture of a company, and DigitalOcean gets some of the best scores I’ve ever seen from the 220 reviews left by employees. Any score over 4.0 is impressive, and DigitalOcean smashes this across the board. There isn’t really any individual aspect to pick out; this looks like an all-around fantastic place to work. I must credit CEO Spruill on creating what appears to be an extremely strong culture, and given his own 96% CEO approval rating, I think employees are giving him credit as well.

Financials

To me, DigitalOcean’s financials paint a picture of a company that is improving, but still has a long way to go. This can be seen in a positive light, as it means the company’s success still lies very much ahead of it, and long-term investors can benefit from the ride upwards.

Revenues have grown at a 28% CAGR over the past few years, and showed signs of accelerating in 2021. Gross profit margins have also been improving over this period as economies of scale start to kick in. As with any cloud provider, margins are all about scale, so the bigger DigitalOcean gets, the more these margins will improve. As we can see from the 2021 Annual Report:

While we intend to spend a significant amount on capital expenditures on an absolute basis in the coming years, our capital expenditures as a percentage of revenue has declined significantly and will continue to decline.

But everything is trending in the right direction, this is undeniable. EBIT margins are getting closer to breakeven, the company has moved from a net debt position to a net cash position, and free cash flow was positive for the first time in 2021.

As mentioned, this is a company in the early stages of a big opportunity. The financials are heading in the right direction, and they are doing so quickly – I personally would expect this to continue as DigitalOcean scales up and captures more of the opportunity ahead.

Valuation

As with all high growth, disruptive companies, valuation is tough. I believe that my approach will give me an idea about whether DigitalOcean is insanely overvalued or undervalued, but valuation is the final thing I look at - the quality of the business itself is far more important in the long run.

I have assumed 2022 revenue growth at the midpoint of management’s guidance, and 30% annually thereafter. I would normally bring down revenue growth in future years, but DigitalOcean has been accelerating revenue growth and has a huge opportunity ahead. So in this instance, I think that stable revenue growth is actually conservative, as DigitalOcean is capable of achieving more in my view.

I’ve also assumed a gradual increase in FCF margins as DigitalOcean continues to benefit from scale, but I have not assumed any substantial margin expansions. I still expect its spending on data centers to continue, as this is a capital-intensive business, but economies of scale will continue to play out.

I believe the EV / FCF multiples used are reasonable for a company with the growth prospects of DigitalOcean, and I have included both a low and a high case scenario for these in case you feel I’m too optimistic or pessimistic. I have also included the impact of their share repurchase in 2022, and have not assumed any further repurchases or dilution (a company that is repurchasing its shares should not then have to go on and dilute shareholders in future).

Put all this together, and I can see DigitalOcean’s shares achieving a 27% CAGR through to 2026 in my mid-range scenario.

Risks

There are two main risks that I see with DigitalOcean right now, and the first is competition. I think it has done a great job as distinguishing itself from the big players, but that could also be because the likes of Amazon, Microsoft, and Google haven’t tried too hard to enter the SMB market. If they do, these companies have the scale and resources that could prove difficult for DigitalOcean to compete with – but, there is no evidence of this yet.

The second short-to-medium-term risk is that of a recession. SMBs are likely to be more affected in a recession, and as a result so will DigitalOcean compared to large cloud providers. Whilst I don’t think this impacts DigitalOcean’s long term story, it could hinder growth – yet this is a secular trend, and I think DigitalOcean will still continue to grow even in a recessionary environment.

Summary

I’m a big fan of the approach that DigitalOcean has taken, as it looks to dominate this small but substantial sector of the cloud market. Whilst they might not be founder led, I think that CEO Spruill is doing a fantastic job with this company, and it's continuing to succeed on all fronts. DigitalOcean is at the start of a decades-long transformation, and I for one will be joining the company on this journey.

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