Description

EXECUTIVE SUMMARY: DigitalOcean (DOCN) is a Cloud Service Provider (“CSP”) with a focus on SMBs and developers. Despite sporting a “rule of >40%” profile (including a ~20% FY23E LFCF margin), DOCN has traded off with high-growth, low profitability SaaS companies over the last two years (DOCN down 15% vs. IGV down ~5%). Fundamental upside to FY23E consensus coupled with the market’s underestimation of DOCN’s LT market opportunity and competitive differentiation creates an opportunity for a base case >2-1 FY25E risk-reward[1] and a >4-1 upside risk-reward even when modeling a ~$25 p.s. downside, which is highly unlikely due to strategic value as well as a clear path to a >3x MOIC LBO at its current valuation[2]. An undemanding base case which assumes 1) below end-market topline growth, 2) deteriorating net retention and S&M efficiency, and 3) ~3x of xEBITDA multiple deterioration from current generates a ~2x MOIC by FY25E.

DOCN LONG THESIS SUMMARY

1. Even factoring in near/medium-term headwinds, industry research sources project CSP TAM to grow at a 25-30% CAGR through 2026
2. DOCN has carved out an attractive and underserved niche in SMB cloud by creating a focused offering at a superior price
3. >105% net retention and efficient sales organization (>3x LTV/CAC) supports a ~20% topline CAGR and operating leverage
4. Despite relatively higher capital intensity vs. SaaS peers, DOCN has been FCF positive since IPO; management is guiding to a >20% FCF margin for FY23E
5.  “Cloud” bearishness has left this dominant niche vender growing >20% w/ >35% EBITDA margin trading at a ~4% FY23E LFCF yield (<20x FY23E EBITDA)
6. Unlike most high-growth cloud/SW peers, DOCN has reduced sharecount since its IPO; YTD the company has repurchased >5% of FY22A FDSO and is targeting annual buybacks of ~125% of FCF for FY24 and thereafter
7. With current TEV of ~$5bn, the buy vs. build math for strategics appears compelling; CEO and CFO have collectively led three exits in recent years (two to strategics, one to PE)
8. PE sponsor could achieve a ~3x MOIC LBO at current valuation underwriting 10% discount to consensus revenue and margin

COMPANY OVERVIEW

Introduction: DOCN provides Infrastructure and Platform as a Service (“IaaS” and “PaaS”, respectively) to its customers, primarily businesses with <500 FTEs and independent developers. Founded as a virtual machine vendor in 2012, DOCN went public in March of 2021. Today DOCN provides >650k customers globally with a variety of I/PaaS products across 15 datacenter regions.

DOCN Revenue Model / Products

• Revenue Segments: 100% monthly recurring cloud software and services. DOCN segments this by customer spend:
  • Customers spending >$50 per month, “Builders/Scalers”: 85% of FY22A revenue, ~35% FY19-FY22A revenue CAGR
  • Customers spending <$50 per month, “Learners/Testers”: 15% of FY22A revenue, ~15% FY19-FY22A revenue CAGR
• Products and Services[3]
  • IaaS/PaaS: Virtual Machines, Managed Databases, Container Platform, App Platform, Private Cloud, Storage
  • Managed cloud services (<10% of PF FY22 revs, ~50% YoY growth): Added via Cloudways acquisition. Allows customers to outsource management of applications and services in addition to IaaS and PaaS needs.
• Key Performance Indicators: DOCN’s straightforward operating model is primarily driven by a handful of metrics
  • Net retention (107% Q1 ‘23): Despite high $ churn (est. 20-25%), DOCN has generated >100% net $ retention since IPO
  • Sales efficiency (85% FY22A)[4]: Efficient marketing/inside-sales focused org focused on SW development communities
  • GAAP R&D + G&A % of revenues (~55% in FY22A): Mgmt has struggled to find operating leverage in these areas since IPO but announced a $60mm cost savings plan (~10% of FY22A revenues) to achieve help EBITDA margin targets
  • GAAP GM ex-D&A[5] (79% FY22A): DOCN has been able to achieve scale with its colocation partners and in other cloud costs areas
  • Capital intensity (128% FY22A)[6]: DOCN has steadily increased revenue and profit $s generated on hardware capex and capitalized software $s
• DOCN Differentiation: Wins due to a combination of affordability, ease of purchasing/onboarding, and support quality
  • Price: Cheaper vs. peer offerings; equally important is pricing transparency (e.g., real-time consumption updates)
  • Focused offering: Product set meets all the needs of an SMB user without the complexity of hyperscaler platforms
  • Support: All customers receive support as part of their subscription; hyperscalers have service fees / minimum spend requirements to receive comparable support

Market and competition: Competes in the global CSP (i.e., IaaS + PaaS) market, with availability across the world. Gartner sizes this TAM at $234bn in 2022 and projects a 25% CAGR through FY25 ($116bn/29% CAGR, $118bn/22% CAGR for IaaS/PaaS, respectively). DOCN’s serviceable addressable market (i.e., SMB CSP) is a subset of this market which IDC sizes at $98bn in 2023 and projects a ~26% CAGR through 2026.

• “Hyperscaler” CSPs: Segments of diversified tech firms; scale/complexity encourages focus on large enterprises
  • Competitors (% mkt share): AWS (35%), Microsoft Azure (19%), GCP (9%), Alibaba (5%), Oracle (1%)
• SMB-focused competition / smaller CSP vendors: Mix of dedicated smaller CSPs and cloud efforts by CDNs
  • Competitors (% mkt share): DigitalOcean (0.3%), Linode/Akamai (0.1%), OVH (0.2%), Vultr (0.1%)

WHY DOES THIS OPPORTUNITY EXIST?

• Misconceptions about competitive dynamics: Many view DOCN as competing w/ hyperscale CSPs, when these have limited capabilities/interest in SMB due to the larger enterprise TAM; some efforts by hyperscalers (e.g., AWS Lightsail) have failed to gain traction
• Consensus views on slowing cloud growth / SMB macro headwinds: While both factors are addressed in the base and downside cases, many datapoints (e.g., new business formation) point to continued SMB strength. Further, a great deal of the street’s angst about 2023 vs. 2022 cloud growth is driven by the fact that most CSPs operate on annual contracts and there is an expectation that budgets will shrink YoY. DOCN operates on monthly contracts, suggesting that the impact of lower cloud spending may be 1) more smooth compared with larger peers and 2) already in DOCN’s LTM numbers
• Capital intensity: Despite the extraordinary capital investments by CSPs, these are largely hidden within the balance sheets of diversified companies, leading many investors to value them on xEBITDA or even xRevenue; DOCN’s capital investments are obvious, leading some investors to comp DOCN to lower-quality businesses (e.g. Datacenter operators, RXT, etc.)
• Financial noise: A change in management’s GM reporting and guidance methodology causes a cursory review of financials in Bloomberg, CIQ, etc. to make GM headwinds look drastically worse than reality: GAAP and Cash GMs should remain roughly flat in the low-60%s and mid-70%s, respectively (the difference driven by considerable D&A). Also, some bears point to Cloudways as the main driver of >20% growth shown in consensus #s – an adjustment based on the acquisition announcement shows that apples-to-apples organic growth should be in the high-teens, at least.

WHERE I COULD BE WRONG / BEAR CASE

1. Guide/cons. and my base case call for significant efficiencies in opex lines whereas historical margin expansion has been driven by GM expansion – despite almost doubling revenue since its IPO, DOCN has shown limited OPEX leverage
2. The cloud market could decelerate more suddenly than Gartner/others project (i.e. 26% three year projected CAGR vs. 34% 3 year historical CAGR)
3. Hyperscalers could chose to focus more on the SMB market (and choose to build the business vs. buying DOCN)
4. The “graduation problem” (i.e., customers “outgrowing” DOCN’s solutions and increasing churn) worsen
5. Sales efficiency has deteriorated since the IPO – albeit to still above-average levels – this trend could continue or worsen
6. Downside protection from LBO math could be impaired by Tech/SW PE’s general aversion to capital-intensive businesses

CATALYSTS: Upcoming catalyst in Q2 earnings (typically early August), other potential catalysts include:

• Updated cloud forecast releases from Gartner, IDC, sellside research etc.
• CSP peers’ (especially MSFT, AMZN, ORCL, GOOG) results; these provide helpful leading financial and sentiment indicators, as peers typically report before DOCN
• Continued re-emergence of SW LBO market (e.g. Duck Creek, Coupa, User Testing, ForgeRock, and Avalara announcements)
• Speculation about Hyperscaler’s focus on SMB markets for M&A (bullish) or increased internal focus (bearish)

RISK/REWARD

APPENDICES TABLE OF CONTENTS

1. FY2023 Guidance Summary
2. Illustrative LBO Math and Sensitivities
3. IaaS / PaaS Overview and DOCN Product Summary
4. Competition Overview
5. Detailed Customer and Revenue Overview
6. Management and Board
7. Top Holders
8. Third Party Market Survey Results Excerpts
9. DOCN Quarterly SMB Review and Survey Results Excerpts

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APPENDIX A: FY23 GUIDE (FROM Q1 EARNINGS PRESENTATION)

APPENDIX B: ILLUSTRATIVE LBO MATH AND SENSITIVITY

APPENDIX C: IAAS / PAAS OVERVIEW AND DOCN PRODUCT SUMMARY[7]

APPENDIX D: COMPETITION[8]

APPENDIX E: DETAILED CUSTOMER AND REVENUE OVERVIEW

APPENDIX F: MANAGEMENT AND BOARD

APPENDIX G: TOP HOLDERS

APPENDIX G: THIRD-PARTY BUYER SURVEY RESULTS[9]

APPENDIX H: DOCN QUARTERLY SMB REVIEW AND SURVEY RESULTS AND OTHER EXCERPTS[10]

Catalyst

CATALYSTS: Upcoming catalyst in Q2 earnings (typically early August), other potential catalysts include:

• Updated cloud forecast releases from Gartner, IDC, sellside research etc.
• CSP peers’ (especially MSFT, AMZN, ORCL, GOOG) results; these provide helpful leading financial and sentiment indicators, as peers typically report before DOCN
• Continued re-emergence of SW LBO market (e.g. Duck Creek, Coupa, User Testing, ForgeRock, and Avalara announcements)
• Speculation about Hyperscaler’s focus on SMB markets for M&A (bullish) or increased internal focus (bearish)