2023-03-22 12:24:57 ET
Summary
- The DigitalOcean Holdings, Inc. bull case is focused on both its attractive growth rates and alluring free cash flow potential.
- While the bear case brings into question its usage-based revenue stream.
- Presently, I don't find DigitalOcean Holdings such a compelling investment.
Investment Thesis
DigitalOcean Holdings, Inc. ( DOCN ) is a cloud platform offering on-demand computing for startups and SMBs.
The business has solid growth rates and compelling free cash flows. Indeed, what else could investors want than a rapidly growing, cheaply valued, cloud computing business, with strong secular tailwinds?
Beyond the headlines, there are aspects to its business model that I struggle to be compelled by. What's more, I find its capital allocation strategy subpar.
On balance, I don't find myself bullish on this stock.
Revenue Growth Rates Remain Attractive
Contrary to many cloud businesses that are seeing their revenue growth rates substantially decelerate in early 2023, DOCN continues to guide toward attractive growth rates.
Although to be frank, there are probably around 300 basis points of its guidance coming from its recent acquisition of Cloudways that took place towards the end of Q3 2022. In fact, recall that Cloudways contributed towards 300 basis points of revenue growth in Q4 2022.
But now, consider this.
A Bearish Concern
Allow me to pose you a question.
- Would you be willing to pay per usage? For example, say your mobile phone charged you per WhatsApp message you sent.
How willing would you be to send WhatsApp messages even if the cost was $0.00001? You'd still probably think twice before you send that message. So I don't believe the fact that most of DOCN's SMBs customers spend less than $50 per month matters that much. It's the consistent charges for usage that matter.
Furthermore, let's say you have a competing phone contract that charges you a high fixed sum per month, but then you don't have to think about your usage, would you consider this, on demand usage contract? I believe that you would. Why?
Because nobody likes to be left with an unexpectedly large bill for using a product you need.
How does this relate to DOCN? DOCN's business model is a usage-based business model. That means the more use the customer has on the platform, the more they'll be charged. That means that the customer is desensitized from fully embracing the platform.
Now consider Amazon.com, Inc.'s ( AMZN ) Amazon Web Services. AWS is also predominantly a usage-based revenue stream too. But a part of AWS has fixed-based prices for fixed quantities. This offers customers the choice to get on longer-term contracts, with the weighted average remaining life of AWS long-term contracts being 3.7 years .
This certainty of the length of the contract allows customers to better budget and control their expenses. And for Amazon, it allows them the ability to lower their contract prices , thereby allowing AWS to continue to gain market share.
Incidentally, it's ironic that at a time when AWS is lowering its prices, DOCN is raising its prices.
As you undoubtedly know, the best businesses in the world are often those that do whatever they can to deliver maximum value to their customer . You can think of Amazon's retail business or AWS, Costco ( COST ), or Netflix ( NFLX ). These are companies that think of the customer's experience in the first instance. And not about price gouging their customers.
In the performance chart below, I've highlighted some usage-based computing companies. See if you can discern a pattern.
DigitalOcean could probably still thrive with this business model, but I believe that usage base models work better in a strong macro environment. When financial conditions tighten and customers are more price sensitive, I believe that sets up DOCN for lackluster performance.
The Bull Case Discussed
Undoubtedly, the bull case is built on the fact that DigitalOcean Holdings, Inc. is priced around 19x forward free cash flows. For this multiple, I've disregarded many of the one-off restructuring charges that are expected to take place in H1 2023.
Now, what matters most is not how much free cash flow a business makes, but oftentimes a company's capital allocation decisions.
Case in point, in 2022 DOCN spent $600 million to buy back shares in the company at an average price of $44. Today's share price is approximately 20% lower at $35. So, who benefitted from this capital repurchase program? I'll tell you, the investors that were looking to exit the company.
What's more, DigitalOcean Holdings, Inc. exited 2021 with 107 million shares outstanding. And the guidance for 2023 implies that DOCN will exit 2023 with approximately 117 million shares outstanding, a 9% increase in the total number of shares outstanding over a 2-year period. That is despite spending $600 million on buying back shares.
The Bottom Line
I'm not openly bearish on DigitalOcean Holdings, Inc. But I'm not bullish either. Indeed, I'm happy to readjust my views in the next several months if I find that DOCN integration of Cloudways leads to higher sustainable free cash flows.
For further details see:
DigitalOcean Holdings: Bull And Bear Case