Can this Pure-Play Cloud Provider 10X in 10 Years?

Unicorn Portfolio Update 3: #6 of 20 stocks added

Company Overview

DigitalOcean is a cloud computing platform provider that prioritises the developer's needs. With its mission-critical infrastructure and fully managed offerings, DigitalOcean enables small and medium-sized businesses or even individuals and startups to rapidly build, deploy and scale on the cloud. Their mission statement sums it up nicely:

Our mission is to simplify cloud computing so developers and businesses can spend more time creating software that changes the world. 

DigitalOcean offers a suite of products to help their customers reach this goal.   

Why we love this company? 

Conviction (8/10)  X  Upside Potential (8/10)   

DigitalOcean is a disruptor in the cloud infrastructure domain but it is going up against the big dogs. So how does this company compete against the likes of AWS, Azure and Google Cloud? Well, firstly they differentiate themselves by focusing on small and medium-sized businesses (SMBs). The ease of setting up a cloud server on DigitalOcean is perfect for smaller businesses who might not have the cloud expertise necessary for enterprise cloud platforms and that is what DigitalOcean is all about Simplicity -- Affordability -- Reliability. The Total Addressable Market (TAM) for this niche is much larger than what you might think and it is growing quickly. The predicted Compound Annual Growth Rate (CAGR) for public cloud services in companies with less than 500 employees is 27% for the next 3 years. That must surely be some of the best growth rates we have seen for any industry. If DigitalOcean is able to only capture a small percentage of this market share the stock should deliver very good results. 

We dove into reviews from the developer community and it is clear that their support is truly exceptional. DigitalOcean also provides unmatched performance at their price level. In fact, they pride themselves on offering only high-performance servers. All disk drives are SSDs, network speed is 1Gbps, and droplet (DigitalOcean's name for their servers) startup time is just 55 seconds. This compares favourably to the startup time of 1 to 3 mins from most large scale cloud providers.  Independent performance tests place DigitalOcean nodes at or near the top of performance tests, far above Amazon machines. An image of the performance vs price is attached.  DigitalOcean is gaining preference as a preferred non-hyperscale public cloud service provider by developers. The platform has evolved beyond core compute/storage Infrastructure as a Service (IaaS) and transformed into a Platform as a Service (PaaS) where customers have access to an on-demand, cloud-hosted platform for developing, running, maintaining and managing their applications. 

Moat (5/10)

This is our least favourite part of this company. It does not have a very wide or deep moat. 

We can see switching cost as its biggest moat but as small businesses grow they might still decide to switch to one of the larger cloud providers. Although DigitalOcean is not a household brand name we do give them some points for their community moat. They grew the users of their free content community from 5 million to 9 million in one year, which is very impressive.   

Management (7/10)

Unfortunately, the original founders are no longer involved. The new CEO, Yancey Spruill was only appointed in 2019, but he receives tremendous appraisal on Glassdoor. Prior to DigitalOcean, Spruill was the COO and CFO of SendGrid where his guidance proved fundamental for taking the company from IPO in 2017 to selling it to Twillio in early 2019. Gabe Monroy the current CPO was vice president of the Azure Developer Experience group in Microsofts Developer Division. It seems like there is more than sufficient talent in top management but we have to deduct points for not being a founder-led company. 

Financials (7/10)

The company released its 2022 Q1 financial earnings on 4 May 2022 and some of the highlights from their presentation are attached as images. 

• The company is growing nicely at roughly 30% and is already Free Cash Flow positive. 
• The Net Income Margin is still negative and the Gross Margin sits at a mediocre 60%. We do expect both of these margins to improve drastically in the next three years. 
• The Balance Sheet is positive with $1.7B in cash and debt of $1.4B. 
   

Risks (5/10)

• Competition. Competition. Competition
• This is a David versus Goliaths story.
• The war in Ukraine is also having an impact on their financials but we do believe this is now mostly priced in.

Conclusion

Compared to Palantir (read our first article) analysing this company was not nearly as complex and it should not be. DigitalOcean might not be the most exciting stock but they keep going about their business and continue to deliver quarter after quarter. 

Why are we adding it to our Unicorn Portfolio? Even though it scored a 68 on our Unicorn Scorecard, not quite as high as we would like to see, DigitalOcean represents an asymmetrical risk/reward opportunity at its current valuation for the next three years or more. It has fallen 18% today (at the time of writing) after its earnings release yesterday. The earnings were a bit mixed but there were plenty of positives. 

Does DigitalOcean have 10-bagger potential? Maybe, but it wont be an overnight sensation and will take years or maybe a decade or two - provided that they can continue to fend off the competition. We will continue monitoring this landscape but we do believe there is plenty of room for players other than the Big 3.   

Portfolio Updates Summary

• Buy $250 DOCN at $35.12

Disclosure

This is not financial advice and only the opinions of the author. The $10K is not real money and only a demonstration of a typical portfolio.