Description

DigitalOcean (DOCN) offers the opportunity to invest in a cloud computing company that is well positioned to address a large growth opportunity as small and medium-sized businesses (SMBs) increase their demand for cloud solutions and platform tools. The ongoing shift to cloud computing is occurring across all customer segments driven by lower cost, increased flexibility, and faster innovation compared to traditional on-premise computing. DOCN has built a comprehensive cloud platform that simplifies cloud computing, enabling developers, start-ups, and SMBs to build, deploy, and scale software applications. The company has a differentiated platform that appeals to this underserved segment of the market with a core focus on simplicity, affordability, community, open source, and customer support that separates it from the large hyperscale players (Amazon AWS, Microsoft Azure, Google Cloud). DOCN is positioned to benefit from several secular trends including the continuing adoption of cloud computing, proliferation of cloud-native start-ups and SMBs, the increasing importance of developers and growing use of a multi-cloud approach, all of which are driving the adoption of DOCN’s developer focused cloud platform.

I am positive on the long term growth outlook for cloud computing and DOCN’s value proposition in the cloud infrastructure market for developers and SMBs. In the most recent quarter, DOCN delivered 30%+ revenue growth and improving profitability, consistent with the company’s long term targets. However there were also signs of slowing growth given challenges in the business environment this year including macroeconomic headwinds and factors impacting customers in certain geographies (Ukraine, Russia) and verticals (cryptocurrency). In their 3Q earnings call commentary regarding the business environment, management noted that they aren’t ready to call a bottom in terms of lower growth. These headwinds will continue to weigh on results and could lead to growth in the near term below the company’s targets. DOCN is down -63% YTD, which reflects business headwinds impacting the software sector, and while some of the pressures on near-term growth are baked into the current price, further declines in valuation could provide an attractive entry point. 

Company Overview

DOCN is a leading cloud computing platform offering on-demand infrastructure and platform tools for developers, start-ups and SMBs. The company addresses the core cloud computing needs of this customer base with products and services that are more targeted to their needs as compared to hyperscale cloud offerings, which are more suited to large enterprise companies. Compared to the large well-known public cloud players, the DOCN platform differentiates on the principles of simplicity, transparent and predictable pricing, community, open source, and strong customer support. DOCN has designed its global cloud platform to ensure a simple, reliable and affordable cloud computing experience which entails maintaining a high-performance global infrastructure, offering a highly curated set of solutions and providing a superior customer experience. The combination of these three elements enables customers to focus their time and attention on building and running their applications or businesses rather than managing the underlying infrastructure. The pricing model is consumption-based and renewable monthly. The company provides detailed monthly invoices, irrespective of the customer’s size or number of products purchased, making it easy for customers to track usage on an ongoing basis and manage their spending.

DOCN has more than 620,000 customer accounts that use its cloud platform to build, deploy and scale software applications. Typical users include software engineers, researchers, data scientists, system administrators, students and hobbyists. Customers use DOCN’s platform across numerous industry verticals and for a wide range of use cases, such as web and mobile applications, website hosting, e-commerce, media and gaming, personal web projects, and managed services. DOCN’s customers are spread across over 185 countries, and approximately two-thirds of revenue has historically come from customers located outside the United States. In 2021, 38% of revenue was generated from North America, 30% from Europe, 22% from Asia and 10% from the rest of the world.

DOCN provides a variety of cloud products and services that are specifically designed to address the needs of individual developers, start-ups and SMBs.

Compute Offerings. Provides customers with flexible server configurations sized for any application, and predictable pricing that is the same across regions and usage volumes. Current compute offerings include:

- Droplets (Virtual Machines): Accounting for a significant majority of DOCN’s revenue, Droplets are Linux-based virtual machines with dedicated compute, memory and storage. Developers can spin up the virtual machine of their choice in under a minute. DOCN offers basic Droplets and Dedicated Droplets, such as general purpose, CPU-optimized, memory-optimized or storage-optimized configurations, which provide flexibility to build and scale applications. Droplets help provide developers with full control over their infrastructure.

- Managed Kubernetes and Container Registry: Kubernetes is an open-source system for managing containerized applications in a clustered environment. DOCN’s Managed Kubernetes service provides scalability and portability for cloud-native applications. Through this service, the company manages the Kubernetes master and the underlying containerized infrastructure. DOCN also offers Managed Container Registry, which lets customers easily store and manage private container images for rapid deployment to DOCN’s Managed Kubernetes service.

- App Platform: PaaS offering that allows customers to build, deploy and scale applications quickly using a simple, fully-managed solution. DOCN handles the infrastructure, application runtimes and dependencies so that developers can push code to production in just a few clicks, enabling faster time to market.

- Functions (Serverless): Serverless computing has become a popular trend in cloud application development because it allows for freedom from server management and the ability to pay only for what you use. Functions allows customers to run blocks of code on-demand for Serverless computing. The aim is to simplify the cloud programming experience and help developers develop code, test, and deploy without the need to manage the underlying infrastructure or worry about server requirements.

Storage Offerings. DOCN’s storage solutions allow customers to store and quickly access any amount of data reliably in the cloud. DOCN offers several kinds of storage offerings depending on the customer’s needs, including Spaces (Object Storage), Volumes (Block Storage), and Backups.

Networking Offerings. DOCN provides a suite of networking capabilities to secure and control the traffic to customers’ applications. Data transfer costs can quickly become a major expense for the developer of any reasonably complex cloud application. DOCN provides a generous amount of bandwidth with each successive Droplet purchase. This bandwidth is pooled for the customer’s account and shared by all applications or resources running in their account, which serves as a key differentiator in the marketplace. Key networking products include Cloud Firewalls, Managed Load Balancers, and Virtual Private Cloud (VPC).

Managed Databases. A fully-managed database that provides customers with the application performance they need without the operational demands that come with building and running a database server. DOCN currently offers managed offerings for relational databases (SQL) such as PostgreSQL & MySQL, as well as in-memory key-value data structure stores such as Redis. In addition, the company offers DigitalOcean Managed MongoDB, a fully-managed database as a service offering in partnership with MongoDB.

Cloudways. After completing the acquisition in September, DOCN is now offering Cloudways as its Managed Cloud Hosting solution. Cloudways allows customers to quickly build a new website while outsourcing stack optimization, uptime performance and security, including bot and DDoS protection. Cloudways customers are still able to choose the cloud provider of their choice by selecting among DigitalOcean, AWS, Google Cloud, Vultr and Linode.

Large, Growing Public Cloud Market Opportunity

DOCN competes in the Infrastructure-as-a-Service (IaaS) and Platform-as-a-Service (PaaS) markets which represent two of the largest and fastest-growing markets across the entire economy. According to IDC, the combined market for IaaS and PaaS reached $159B in 2021 and grew 37% yy. The combined IaaS and PaaS market is expected to grow to $531B in 2026, representing a 27% CAGR. DOCN caters to the SMB segment of the market and according to IDC, the worldwide IaaS and PaaS market for individuals and companies with less than 500 employees is estimated to be $72B in 2022 and expected to grow to $145B in 2025, also representing a 27% CAGR. The IaaS market, which is comprised of compute and storage, is estimated to be $47B or 65% of the total opportunity in 2022, while PaaS, which includes database management systems, application platforms and other platform services is estimated to be $25B or 35% of the opportunity. DOCN’s FY24 target of $1B in revenue implies a 30%+ CAGR and still represents less than 1% penetration of the total market opportunity.


Source: DigitalOcean

The key drivers of growth for these markets comes from increasing cloud adoption as well as the growing number of SMBs and developers worldwide. There are more than 32M SMBs in the United States alone, according to the World Bank, and more than 100M SMBs globally. Although the failure rate is high, the number of SMBs is growing with ~14 million net new SMBs created globally each year. IDC estimates that the number of developers will increase at an 11% CAGR in the coming years and DOCN should benefit from continued momentum in infrastructure software tools targeted at developers. Companies like Datadog and Atlassian have succeeded in building momentum with developers by offering powerful and easy-to-use tools. When companies look to upgrade their technology stack, they are increasingly turning to their developers for input. Developers recommending solutions contributes to a flywheel effect and viral growth for developer focused companies and DOCN should benefit from the robust developer community interacting with the platform on a consistent basis.

Efficient Customer Acquisition Model Complemented By Investment in Direct Sales

DOCN has a highly efficient self-service digital customer acquisition model that enables customers to quickly get started on the platform without the need for assistance. This model focuses on a low-friction onboarding motion that combines low and transparent pricing, content and tutorials to help developers get started, and an easy sign-up process that simplifies enrollment and allows customers to create their first Droplet in a matter of minutes.

DOCN’s large and active developer community is another significant differentiator for the company’s go-to-market strategy. This community serves as a major resource for customers and prospects to learn how to most effectively use DOCN’s solutions. DOCN has been committed to providing free resources for the developer community and offers more than 7,000 technical tutorials as well as tens of thousands of community generated Q&As on their website which attracts more than 10 million visitors per month and forms the top of the sales funnel. DOCN also holds tech talks, events like hackathons for developers and has a partnership with GitHub Education program where students can get credits to use DOCN products. These resources help drive lead generation, conversion, retention and expansion with prospects and customers as DOCN leverages its robust developer community to continue spinning the flywheel.

Today, 90% of DOCN’s revenue comes through the self-service funnel and DOCN’s primarily inbound, self-service go-to-market model has generated high returns on marketing spend. Over the past three years, Sales & Marketing as a % of revenue has averaged just 11% and was flat at 10% in FY21 even as ARR growth accelerated by 1200bps.

Historically, DOCN has not relied on an outbound sales force to drive customer growth. However, management sees an opportunity in the market for direct selling into SMBs and is in the process of scaling an outbound sales team that will complement the self-service model. Given this, S&M spending is expected to grow faster than revenue which will weigh on returns on marketing spend in the near term. But as new sales reps ramp, the company will benefit from another source of top line growth which should drive further adoption among SMBs.

Expanding Product Offering Drives Additional Cross-Sell Opportunities

At DOCN, roughly 81% of customers spend less than $50 per month on the platform (referred to as Learners) and generate 14% of total revenue while 19% of customers spend more than $50 per month (referred to as Builders and Scalers) and generate 86% of total revenue. The large pool of Learners provides a strong base for growth as DOCN helps them graduate into Builders and Scalers. It’s notable that 94% of customers spending more than $500 per month (Scalers) started small from the self-service channel and grew over time. The cohort of customers spending more than $50 per month has been growing more than 3x faster than total customers which points to DOCN’s success in helping customers expand their businesses with the DOCN platform and increase their spending over time. This is also reflected in DOCN's average revenue per customer (ARPU) which has steadily grown from $40.16 in 2019 to $59.96 in 2021 at a 20%+ CAGR and reached $79.22 in 3Q22. ARPU growth is indicative of DOCN’s ability to land with emerging businesses and expand with them over time as their consumption increases. In addition, DOCN is accelerating that expansion as customers leverage the breadth of DOCN’s product offering and buy additional services.

DOCN's origins were predominantly in IaaS, and Droplets currently represent the majority of revenue. But in recent years, the cadence of new product introductions has improved and the company has launched key PaaS offerings like Managed Databases, Managed Kubernetes, and the App Platform. These newer offerings are proving to be popular with customers and are experiencing rapid growth with Managed Databases growing 95% yy, Managed Kubernetes growing 47% yy and App Platform seeing its user base grow 120% yy. This has led to increasing PaaS contribution and PaaS has grown from 0% of revenue 3 years ago to 18% in 2Q22. Given the elevated growth of these products, PaaS should continue to outgrow IaaS and increase its contribution to total revenue. DOCN’s CEO expects PaaS contribution mix to reach 30% to 40% over time which is consistent with the relative mix of PaaS and IaaS within the total public cloud market opportunity.

With the ongoing expansion of DOCN’s product offering, the company should now be able to retain many customers who would have otherwise graduated from the platform. This provides multiple benefits such as improving customer churn and also driving up Net Dollar Retention (NDR) due to increased cross-sell activity. The company has also improved its customer success and support team that is focused particularly on assessing and addressing the early signs of churn and mitigating them through intervention. The goal is to provide more dedicated support in the early months of the customer journey in an effort to help them get up and running successfully, reducing the likelihood of churn. Customers that make it through the first 5 months on DOCN’s platform have historically churned at a ~3% rate, well below the company average, illustrating the importance of DOCN’s focus on support and nurturing customer success.

Valuation

DOCN is a strong player in the cloud computing industry that operates an attractive business model and addresses a large market opportunity. Cloud computing should benefit from strong secular tailwinds in the coming years and DOCN offers exposure to these favorable secular trends within the underserved market for developers and SMBs. Combined with the demonstrated ability to grow as their customers scale and increase multi-product adoption via cross-selling, DOCN represents a high-quality long term growth company with the potential to become the dominant SMB cloud provider.

DOCN has issued FY24 financial targets of 30%+ revenue growth, $1B in revenue, Non-GAAP operating margin of 25% and FCF margin of 20%. In the most recent quarter, DOCN delivered results consistent with these multi-year targets: another quarter of above 30% revenue growth and guidance for FY22 revenue growth above 30%, Non-GAAP operating margin of 17% and FCF margin of 10-11%. These results demonstrate solid execution given challenges in the business environment this year including macroeconomic headwinds and factors impacting certain customers such as the war in Ukraine and disruptions in the cryptocurrency market. DOCN was early in seeing the impact of these headwinds during 1H22 given its consumption-based model but noted that the impact continued in the third quarter. Although headline growth could still meet expectations due to the benefit of recent M&A and price increases which are not expected to be recurring, business headwinds will continue to weigh on results in the near term and DOCN has shown signs of slowing organic growth excluding non-recurring items. Management has also said they aren’t ready to call a bottom in terms of lower growth and will remain cautious in setting forward expectations. This could possibly point to a more back end loaded FY23 outlook with growth below the company’s targets in the near term and a ramp expected towards the end of the year.

DOCN trades at 4.7x EV/2023 Revenue, towards the lower end of the stock’s historical range and cheaper than peers in the analytics and infrastructure software. Relative to growth expectations, DOCN trades at 0.16x EV/Revenue/Growth which is 45% below peers and among the lowest in the software space. The valuation discount likely reflects several factors including DOCN’s slowing organic growth, lower gross margins and higher capex. Although DOCN operates a more capital intensive infrastructure business, management has made significant improvements in capital efficiency and resource utilization which has increased gross margin +1000bps over the last two years while decreasing capex as a percent of revenue by -1100bps. Through these initiatives, together with a greater focus on opex controls, management is on track to increase Non-GAAP operating margin by +550bps in FY22 to 17% and FCF margin by 480bps to 10.5% while continuing to drive 30%+ top line growth. DOCN’s ability to drive operating leverage compares favorably with other high growth software peers and supports the argument for a smaller valuation discount. DOCN trades at 27.8x EV/2023 FCF and 25.2x 2023 P/E which is well below high growth peers, many of whom have yet to deliver positive earnings or meaningful FCF. A modest contraction in the valuation discount and expansion in multiple over time would represent compelling long term upside for DOCN shares. For those who view the tech sector to have further general downside, DOCN is a potential long leg in tech pair trades. Going into earnings over the next few quarters, consideration should be given to the potential for a subdued near term growth outlook which could serve as a possible overhang for the stock and provide a more opportunistic entry point to invest.

Risks

- Competition from well-capitalized, large-scale public cloud service providers with greater financial resources including Amazon, Microsoft and Google, and from smaller, niche cloud providers including OVH, Linode and Vultr
- Consumption-based model is subject to more rapid changes in business behavior and budget considerations and introduces more variability compared to a subscription model
- Pressure from macroeconomic headwinds could prompt buyers to more carefully scrutinize their purchases or delay purchasing altogether and SMB customers may be more sensitive to a downturn in the economy
- Ability to sustain high revenue growth which will require successfully executing on several initiatives including scaling the direct sales force, introducing new products to meet evolving technology needs, upselling existing customers, improving customer retention and effectively managing capital efficiency
- Reliance on third-party data center providers to ensure the functionality of its platform and products via leased space in data centers where the company does not maintain operational control and may be subject to service disruption, security breach or failure to provide adequate support
- The business of public cloud companies involves the storage and transmission of customers’ proprietary information and a security breach could harm the company’s reputation and negatively impact the business

Catalyst

- An improvement in sentiment in the software space
- Cuts in estimates and earnings reports whereby the upcoming potential near-term earnings misses are put behind the company
- Another tech bubble. Cathy Woods take-private. Puru tweets. MrZacKMorris wins case against the SEC and re-starts discord channel