Cloud infrastructure has been a major trend in the past years. Everything is moving into the cloud; company software, company storage, cybersecurity and even my personal pictures from the vacation last year. Many well-known names are often mentioned when cloud infrastructure is the topic, with Amazon Web Services (AWS), Google Cloud and Microsoft Azure among those that have built up large scale cloud infrastructure. These cloud providers naturally tend to focus on the larger companies and their services are not necessarily priced for single developers, one-person enterprises, entrepreneurs and other small businesses. Can you make a business out of servicing those individuals and businesses that are not in focus for the larger cloud providers; well we are about to find out...
The Idea, Product and Potential
Digital Ocean is providing IaaS (Infrastructure as a Service), PaaS (Platform as a Service) and SaaS (Software as a Service) internationally. Currently the IaaS side of the business is around 90% of the company's revenue, but CEO Yancey Spruill believes that they will be moving into a more 80/20 split between IaaS and the PaaS/SaaS side. Even though the IaaS space is crowded with huge tech giants, Digital Ocean have been successful in creating a very nice niche for serving the developers, entrepreneurs and small businesses. Today 500k+ of Digital Ocean's 600k+ customers are spending less than 50 USD a month with Digital Ocean, exemplifying the "small" in small businesses.
Digital Ocean was founded by Ben and Moisey Uretsky in 2011 as a cloud platform focused on
simplicity, flexibility and open-source, enabling developers to build great software. The mission of the company is to: "Simplify cloud computing so developers and businesses can spend more time creating software that changes the world". The platform has been serving Digital Ocean very well since, and in 2019, to prepare for their IPO (24. March 2021) and the next phase of growth, they handed over the lead of the company to Yancey Spruill, who they hired from SendGrid when SendGrid got acquired by Twilio. Ben and Moisey Uretsky stayed on the Board for a few years, but seems to have handed over their seats to new board members during 2021. Generally I am a little disappointed that the two founders are no longer engaged in the company at all, even having resigned from the Board in 2021, at the same time the financial performance of the company has improved since Yancey Spruill was hired as CEO in 2019, so only time will tell whether this was right for Digital Ocean or not.
Since 2019 Digital Ocean, under the helm of Yancey Spruill, have been focused on bringing more PaaS and SaaS solutions on top of the IaaS platform. This transformation is intended to keep customers on the platform longer, while also spending more on the platform. Bear in mind that working with smaller businesses and entrepreneurs, the churn of customers leaving the platform will eventually be higher, than when working with bigger customers. Digital Ocean have been quite successful in the transformation so far, with accelerating revenue growth over the last many quarters, significantly increasing net dollar retention rates and year over year increase in ARPU (annual revenue per user).
One recent example of bringing more optionality to their offering is the introduction of "Mongo for Businesses", where customers now have the plug-in option for using MongoDB database in connection with their Digital Ocean platform. Another new introduction which still has to see the light of day is "Serverless for Businesses", a functionality from newly acquired Nimbella, where the task of managing server locations can be handled by Digital Ocean, leaving the developer or business with more time to focus on their business. In relation to acquisition strategy CEO Yancey Spruill mentions that they deploy a conservative strategy with specific targeted innovation acquisitions. As the Digital Ocean platform is intended to be nimble, simple and less costly, they do not introduce every good product in the market, only the ones with high demand from their customers.
Looking at the market opportunity it is obviously huge. Currently Digital Ocean sees their TAM as all individuals and companies with less than 500 employees. Moving from a TAM of 72b USD in 2022 to 145b USD in 2025, according to IDC, is a CAGR of 27% and is obviously a huge tailwind for Digital Ocean.
The strategy to capture the big market is also changing a bit. Generally the company has displayed a great network effect, acquiring new customers with only a historical marketing spend of around 10% of revenue, which is significantly below many of those software companies we follow in the technology space today, especially in periods where companies are trying to increase market share. But sales and marketing spend have picked up a few percentage points, to 15% in the last reported quarterly earnings, and in an interview between Yancey Spruill and Motley Fool Founder and CEO Tom Gardner, Yancey Spruill also clarified that increased sales and marketing spend was a part of strategy. Obviously I expect some operational leverage to offset that impact in future years, also leveraging on their great network effect. The last NPS (Net Promoter Score) is can find is from 2021 and is 65, which I consider a very strong score.
The moat of the company seems to be coming from two major factors, firstly pricing, Digital Ocean clearly appears cheaper than many of their bigger competitors, furthermore they use consumption-based pricing versus the more recently popular subscription-based model. Secondly they seem to have a huge community around developers, and developers are very important in any company's digital transformation. This clearly shows in their obvious network effect.
Financials
The balance sheet of Digital Ocean remains solid. Long did they operate without debt, but in Q4 2021 they executed a private offering of approximately 1.5b USD convertible senior notes at zero-rate. The proceeds are intended to be used for two primary causes, firstly Digital Ocean bought back some shares, which I believe were the shares of the founders. The founders had at IPO approximately 13% ownership in the company, while the recent proxy statement (DEF 14A) did not list neither Ben nor Moisey Uretsky, secondly the proceeds are to be intended for strategic acquisitions. Currently they have 1.55b USD in cash and marketable securities while debt currently ranges to 1.46b USD, so still negative net debt of -90m USD.
My "Company Reports" file below, which I use for quarterly follow up on some of my investments, shows most of the important financial figures and will be commented below.
Generally revenue has been growing steadily over the last many periods, the growth has even accelerated over the last years (29% in Q1 2021 to now 36% in Q2 2022). What I particularly like about the revenue is the international distribution as depicted in the below picture from the last quarterly release. 38% in North America, 29% in Europe, 23% in Asia and 10% in RoW really shows a nice geographical spread. Annual Recurring Revenue (ARR) currently stands at more than 500m USD and is rising.
Beyond revenue I also see the Gross Margin increasing from 58% a year ago to 63% today. Overall 63% is not world class for PaaS or SaaS companies, but for IaaS companies that need to invest in significant CAPEX to continue to serve the growing number of customers, I believe it is decent, and the trend is very intriguing. To underline the positive outlook of this business the ARPU, moving from 53,7 USD to 68,9 USD yoy, and especially the Retention Rate, moving from 107% to 117% yoy, are increasing significantly; for me these are the most important signals that this company is heading in the right direction. Furthermore the company started reporting a new Key Performance Measure called "Customers Spending More than $50 per Month Percentage of Total Company Revenue ", and the KPI have been growing yoy with more than 80% indicating that the cohort is growing faster than the overall inflow of customers. Customers (623k in latest quarter) in general have been growing with a 6-7% clip yoy in the last periods.
On the operational profit, as mentioned earlier, I am positively surprised by the low sales and marketing expense, showcasing network effect. Meanwhile I see an increased rate of general and administrative expense that concerns me in relation to their future operational leverage. I am not surprised by the elevated G&A, as Digital Ocean are working with much smaller customers, but the trend is concerning.
Digital Ocean is still not net-profitable, at least on a GAAP basis. On a non-GAAP basis, deducting the stock based compensation expenses, they are on the other hand profitable. The Stock Based Compensation is currently 26m USD trending around 20% of revenue. I am not concerned with that level at the current point in time, especially after change in management. I am as well quite okay with the company using Stock Based Compensation to get the right talent in this crowded space, where the need of talent can make or break a company.
On the cash flow side the company is running with positive Free Cash Flow (FCF) which is very soothing to me, when you recognize the need for continuous CAPEX investments.
Management and Culture
There is clearly a transition happening in Digital Ocean after the change of management. For now this transition looks very positive if you look at Glassdoor. Very impressive numbers. I expect Yancey Spruill to continue to build his team and harvest on the great progression of the company.
The rest of the management and the board of directors looks experienced and with a certain knowledge within the industry. Nothing sticks out to me.
On the ownership side Yancey Spruill has quickly gained a 2,2% ownership stake in the company. This is of course not best in class when you compare with companies that are still founder-led, but at least he now has a significant amount invested in the company. In total all executive officers and directors holds a 4.1% insider stake of the company.
Stock
After IPO'ing back in March 2021 the stock have had a rollercoaster ride hitting an all-time-high around 129, and with the bear market coming back to current levels around 50, which is almost the same as IPO level.
In relation to valuation the stock trades at the date of writing this around a Price-to-Sales of 10, which is expensive, but if they can continue to grow at a 30%+ clip, I find this level very promising. Looking 10 years ahead with a revenue CAGR of 30%, an EBITDA margin of 20% coming from continued operational leverage, which I do not find excessive, combined with a Price-to-EBITDA ratio of 15 at that time, the company would be a 17.7b USD market cap, giving a CAGR of 13% on your investment. Very theoretical exercise, and it will for sure never pan out exactly like this, but I believe there are many indicators that this company could even surprise positively compared to these numbers as well.
Risks
Fighting in a crowded Cloud Infrastructure space with some of the biggest companies on earth can be quite frightening. Clearly the biggest risk for the company at the moment is exactly that fact. But, I believe the competitors would eventually rather acquire Digital Ocean than fight for the smaller customers, which gives me some comfort in the future of the company.
Another risk I see is the departure of the two founders, first stepping down from executive positions in 2019 and later on to leave the board in 2021. Yancey Spruill is clearly an executive with the right profile, furthermore the performance of the company has improved quite significantly over the last years, but only time (and results) will give us an indication if this was the right time for a complete change of leadership. Right now I am happy with what I see.
MoGeBat Score: 73
Concluding on the research made, Digital Ocean looks very interesting to me. The Cloud Infrastructure space is one a the fastest growing industries globally, and I believe it will continue like that for decades. The financials of the company got me very excited, especially the trends of accelerating revenue growth, increased gross margins, increased ARPU, significantly improved Revenue Retention Rate combined with a strong balance sheet, shows that the company has found a very good market niche. I will of course be watching the financials closely to see whether they can sustain their positive trends.
After the latest sell-off from the bear market this company is very fairly priced and I will definitely add this to the "Hotlist" shortlist, and might even be buying a small starter position in this company on Monday
I generally consider a MoGeBat Score of above 75 is highly investable, 65-74 investable, 55-64 only investable in very special circumstances (investing with the heart instead of the brain).
As usual comments are more than welcome... Furthermore you can subscribe to my Stock Research page to get notified when new research papers are available.
Disclosure: Morten Gerdes Bach might own shares of the companies mentioned. The information expressed herein are opinions and not financial advice.
Remember: If you want to do your own due diligence you can download the "MoGeBat Score" and "Company Results" files in the download section of my homepage.
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