Digital Ocean: AWS for SMEs

As my first stock analysis on SubStack I choose Digital Ocean. I came across Digital Ocean while reading the Battery OpenCloud Report 2022 and was intrigued by the underlying growth and the strong margin profile of Digital Ocean.

Overview:

It’s best to use Digital Ocean’s own description of what it does and why their customers chose them.

DigitalOcean simplifies cloud computing so developers and businesses can spend more time building software that changes the world. With its mission-critical infrastructure and fully managed offerings, DigitalOcean helps developers, startups and small and medium-sized businesses (SMBs) rapidly build, deploy and scale applications to accelerate innovation and increase productivity and agility.

The two main products are IaaS (Infrastructure as a Service) which includes compute, storage and networking products and PaaS (Platform as a Service) which provides a development and deployment environment.

While we all have heard of by now of Azure, AWS and Google Cloud, these solutions are more tailored towards enterprises or larger companies. Digital Ocean fill the gap for SMEs who are looking into leveraging the possibilities of the cloud without having to run their own large server deployments. Digital Ocean offers these customers an easy way to scale and use their cloud offering.

These are the main pain points DOCN solves for their customers:

·         Easy setup of infrastructure and platform technology

·         Predictable pricing (unlike AWS)

·         Live, personal support

Fundamentals:

DOCN now has 144k customers who spend more than 50$ a month. The revenue split across geographies is nicely diversified with North America contributing 38%, Europe 30% and Asia 22%.

Digital Ocean expects its TAM to grow with a CAGR of 26% for the next years and therefore double its market opportunity by 2026.

Digital Ocean’s Revenue grew from $318m in 2020 to $576m in 2022. The growth has been 30% on average. While revenue is nice, we as fundamental investors are mostly interesting in cashflow or to be more precise in Free Cash Flow (FCF). Digital Ocean managed to go from -57m to +78m FCF in the last 3 years.

A company which focuses so much on Free Cash Flow is a great sign. That means they understand what is really important in business. The CFO stated in the Q4 call: “As Yancey mentioned, free cash flow and free cash flow per share are our North Star metrics.”

A Net Dollar retention rate has been above 100% and rose to 115% in 2022. And the ARR has been rising constantly over the last quarters and is now at 659m as of Q4/22. In cloud business models, the ARR is the better metric compared to the revenue and you can see that with DOCN as well. The ARR of 659m is 14% higher than the reported revenue for 2022.

Yancey L. Spruill, the CEO of Digital Ocean said the following in the earnings call for Q4/22.

“Since our 2021 IPO, we shared targets of delivering $1 billion in revenue and 20% plus free cash flow margins in 2024. While growth was 30% or better, we were comfortable ramping to a 20% or better free cash flow margin target over a number of years. Given the lower growth environment, we are accelerating free cash flow margins to our longer-term target range this year and at the same time we are pushing out the $1 billion revenue target by one year to 2025.”

Balance Sheet:

Digital Ocean has long term debt of 1.47bn deducting 141k cash and 723k marketable securities. Most of these marketable securities are in US treasuries and commercial papers. Therefore, the net debt of Digital Ocean is $606m.

Outlook and Valuation:

In 2022 DOCN repurchased $600m worth of shares at an average price of 44$. A new $500m share repurchase program was announced from 2023 onwards. At a current market cap of $3.2bn, a $500m share repurchase program would be enough for 16% of all outstanding shares.

With an outlook of 700-720m in revenue for 2023, and 21-22% FCF as of revenue we are looking at a FCF of 152m at the midpoint.

With a market cap of $3.2bn and a net debt of $606m we arrive at an EV of $3.8bn. Assuming the forecast for 2023 is correct, we have an expected EV/FCF of 25 for a company which is operating with a score of 50 for the Rule 40.

For those who don’t know the Rule of 40 yet: The Rule of 40 is a principle that states a SaaS company’s combined revenue growth rate and profit margin should equal or exceed 40%. Digital Ocean has roughly 30% revenue growth and a FCF margin of 20%.

At these prices and the underlying growth, Digital Ocean is valued very attractively.

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Invest at your own risk, this is not financial advice!