2023-05-27 00:58:49 ET
Summary
- DigitalOcean is a prominent public cloud provider targeting SMBs, startups, and individual developers.
- The company differentiates itself from larger competitors with its focus on simplicity, predictable pricing, strong community, and customer support.
- Considering the overall pressures faced by the cloud industry and the risk to the company's revenue outlook for 2023, I assign a hold rating to DigitalOcean shares.
Investment Thesis
DigitalOcean Holdings, Inc. (DOCN) is a leading public cloud provider that specializes in catering to SMBs, early-stage startups, and individual developers. It differentiates itself from larger competitors through its emphasis on simplicity, predictable pricing, strong community, and customer support. DigitalOcean has gained recognition in the market and has invested significantly in its security measures, positioning itself ahead of smaller competitors. However, considering the overall pressures faced by the cloud industry and the risk to the company's revenue outlook for 2023, I assign a hold rating for now to DigitalOcean shares. This rating reflects my caution and uncertainty regarding the company's ability to achieve its revenue goals, which rely on generating a significant increase in new annual recurring revenue throughout the year.
Q1 2023: Maintaining Full Year Guide
In the first quarter, DigitalOcean reported revenue slightly surpassing the upper end of its guidance range and EBITDA performing well above expectations. Net dollar retention was at 107%, a 5-point decrease compared to the previous quarter, but with signs of improvement in March and April. The revenue guidance for the second quarter aligns with the Street's estimate, and the company maintained its full-year revenue guidance for 2023. However, I believe there is limited potential for DigitalOcean to exceed consensus revenue expectations for 2023 due to two factors: firstly, the company missed the Street's estimate for first-quarter ARR, and secondly, the guidance assumes stronger growth in net new ARR for the latter part of the year. The product initiatives driving this anticipated improvement in net new ARR are still in their early stages, including the recent launch of CPU-Optimized Droplet and upcoming releases of Security, Storage, and Database offerings later in the year.
DigitalOcean achieved a net addition of $10.3 million in new annual recurring revenue during Q1 2023. While there were positive indications of improved net dollar retention in March and April, the company's revenue guidance for 2023 remains unchanged and expects a ramp-up in generating new ARR throughout the year. The anticipated growth is based on management's confidence in new product initiatives and monetization efforts. However, the extent of ARR generation resulting from these initiatives remains uncertain as customers are still optimizing their environments, leading to higher contraction rates.
Addressing a Large Underserved Market
DigitalOcean aims to tap into a lucrative market opportunity estimated at $72 billion, which is projected to grow at a compound annual growth rate of 27% to reach $145 billion by 2025. The growth in this market is driven by individuals and small to medium-sized businesses who prefer to leverage third-party Infrastructure and Platform-as-a-Service solutions.
The founders of DigitalOcean established the company with the goal of providing a specialized cloud platform tailored to the needs of developers, startups, and SMBs. They recognized the immense potential in this market, considering there are approximately 332.99 million SMBs worldwide. However, these smaller players had historically been underserved by the major public cloud providers.
By offering a purpose-built, consumption-based platform, DigitalOcean has successfully lowered the barriers for developers, startups, and SMBs to adopt new cloud technologies, reducing upfront costs in the process. This offering allows customers to simplify and streamline their infrastructure and platform requirements, enabling them to focus more effectively on their core competencies.
Product Led GTM Strategy
I consider DigitalOcean's go-to-market strategy to be a crucial element in its success. While the product offering itself is essential and forms the foundation of DigitalOcean's value proposition, the company has strategically designed a product-led growth strategy to specifically target and attract developers, startups, and SMBs as long-term customers. This emphasis on go-to-market strategy is reinforced by the fact that developers typically prefer to avoid direct interactions with sales representatives. In an interview, Chief Marketing Officer Carly Brantz highlighted the significance of nurturing relationships with developers, as they tend to have a natural resistance to engaging with sales professionals. This initial barrier to engagement with developers may be higher, but once overcome, it can create a sustainable competitive advantage. DigitalOcean's achievement of critical mass with over 600,000 customers indicates that the company has successfully garnered mindshare and traction within the developer and startup community.
Valuation
DigitalOcean's shares trade at a 5.8x EV/Sales multiple on the CY23 revenue estimates. The multiple places DigitalOcean at a slight discount to the EV/Sales multiple of ~7x for software companies growing low-teens and double-digit FCF margin, as DOCN's implied organic revenue growth for 2023 is slightly below the FTM growth rate for the group. Additionally, DOCN's GMs lag the group's, and it's difficult for us to see much upside to the multiple from here unless organic growth improves to 20%+ over the coming years, which I will continue to monitor. Hence, I assign a hold rating to the stock at current levels.
Conclusion
DigitalOcean is well-positioned to capitalize on the ongoing trends of cloud migration and digital transformation in the long run. DigitalOcean's continuous product rollouts aimed at expanding its Infrastructure as a Service and Platform as a Service offerings will contribute to the expansion and diversification of its product portfolio. However, considering the challenges and uncertainties faced by the cloud industry and the potential impact on DigitalOcean's revenue outlook for 2023, I am currently recommending a hold rating for DigitalOcean shares.
For further details see:
DigitalOcean: Leading The Way In Cloud Services For The Developer Community