Cloud computing is taking over the world. Seen as a way for companies to both free up time and save money, the speed with which cloud-migration has become the norm for most businesses has been astonishing. The idea that firm’s should run their own legacy hardware systems is rapidly becoming obsolete, and the growth of the cloud industry the last decade has been enormous, despite the fact it’s just begun to get going.
A diverse set of companies is leading the way in this revolution, and one promising name at the forefront of change is DigitalOcean.
DigitalOcean specializes in providing cloud computing services for small and medium-sized businesses (SMBs), whose limited operational know-how and financial resources mean they stand to gain massively from the features that it brings.
DigitalOcean’s Market Share and Opportunity
The competitive advantages that businesses now enjoy from cloud adoption is so critical to their future success that it’s no longer a matter of if they eventually migrate to the cloud, but when.
Benefits include greater flexibility and scalability, as well as the potential to leverage inbuilt cloud capabilities that would have been near-impossible for SMBs to run on-premise previously, due to the high-cost and technical expertise required.
As such, the two principal sectors that DOCN operates in – i.e. the Platform-as-a-Service (PaaS) market, and the Infrastructure-as-a-Service (IaaS) market – have witnessed strong growth lately.
According to research undertaken by the International Data Corporation, the Worldwide Public Cloud IaaS and PaaS markets are predicted to generate revenues of $400 billion by 2025, representing a compound annual growth rate (CAGR) of 28.8% for the period between 2021 and 2025.
Spending on public cloud infrastructure is growing faster than that in the traditional IT market, and that appears not to be showing any sign of letting up.
Indeed, DigitalOcean is perfectly placed to ride these tailwinds, as the company already has a global footprint with customers and data centers present in roughly 185 countries.
The company only makes 38% of its sales from the North America market, suggesting that further expansion is ripe in this most critical of geographical locations.
DOCN’s Platform and Product Portfolio
DigitalOcean’s great benefit is that it brings the power of decentralized cloud computing – once reserved only for larger enterprises – to an audience of individual developers and SMBs.
DOCN’s global cloud platform is designed to deliver a reliable and cost-effective solution that frees up businesses to focus on building excellent applications, rather than being bogged-down managing peripheral infrastructure concerns.
The company has created a set of expertly curated computing, storage, database and networking solutions that perfectly address the needs of its customer base. A selection of these include:
- Droplets: Droplets are scalable virtual machines that can act as stand-alone or integrated servers. They come in basic and special-purpose varieties, and can be memory-, storage-, or CPU-optimzied.
- Spaces: Spaces functions as an object storage service in which you can serve and store your files. Spaces also improves performance, minimizes load times, and utilizes CORS rules manager and SSL to beef up security.
- Virtual Private Cloud (VPC): DOCN’s VPC can mimic the kind of security reminiscent of on-premise systems, and is highly customizable to meet your precise needs. VPC’s can be created easily through DigitalOcean’s dashboard, API or CPI, and are set as default when customers don’t wish to customize their network settings.
DigitalOcean Financials
DigitalOcean had a good third quarter for the fiscal year 2021. Its revenue of $111.4 million increased 37% year-over-year, and its GAAP Gross Profit jumped 61% at $67.9 million.
The company’s loss from operations also improved, showing an operating margin loss of just 1%, compared to a loss of 8% for the same period a year ago.
Adjusted EBITDA grew from $26.4 million in 2020, to $36.4 million in 2021, and its cash flow from operations was also up 36% at $40.2 million.
Many of the DOCN’s key performance indicators also showed excellent growth this year too. For example, the business’ 598,000 customers signaled an increase of 7% year-on-year, with its top 25 clients accounting for only around 10% of its total sales.
One of the most important metrics for a company like DOCN is the Average Revenue Per User (APRU), a figure that shows a firm’s ability to land new high-spending customers, as well as its success in getting existing clients to use its services more. On this point, DigitalOcean did brilliantly, managing to up its APRU from $48.6 in the third quarter 2020, to $62 for the same period in 2021.
Another critical measurement for Infrastructure/Platform-as-a-Service businesses is the Net Dollar Retention Rate (NDR), a number that shows how much more a customer spends from one reporting period to another. Again, DigitalOcean did excellently here too, increasing its NDR by 1200bps from 104% to 116%.
Source: Unsplash
Revenue Model
The cloud computing industry has been refining its pricing model the last few years, with a move away from the forward paying subscription structure of older software licensing systems, to one where payment is now aligned with a consumption-based approach.
DigitalOcean employs this usage-based model, in which customers are billed solely for the computing, networking and storage services they actually access. For the customer, this essentially means that DOCN operates a kind of self-service model where its highly-simplified user interface allows workers to quickly start using its platform tools with little technical expertise or customization.
At the moment, DigitalOcean generates the majority of its revenues from the sale of its Droplets product, which are sold and delivered on a monthly subscription basis. The Basic Droplet product is charged at $5 per month, with the Storage-Optimized Droplets potentially rising to $2,480 per month depending on use.
Additionally, the firm uses a freemium model for its PaaS offering, with its upgraded Basic and Professional packages charging $5 and $10 per month respectively.
Competition
As it stands, there’s a certain asymmetry in the Platform-as-a-Service market right now. At the upper-end, companies providing solutions for larger enterprises – such as Amazon AWS and Google Cloud Platform – already have their respective target audiences captured. These would be bigger businesses with complex workloads, often needing to migrate their legacy infrastructures to the cloud from various on-site premises.
Conversely, at the lower-end, where DOCN mainly aims its sights, the SMB and early-stage start-up crowd is much less mature. Here, the products and services ordinarily offered by the likes of Amazon and Microsoft Azure are not such a good fit, since the needs of these smaller developers require much tighter tailoring.
For instance, the global enterprises that traditional cloud vendors cater to don’t demand a well-curated suite of offerings. Instead, they can pick-and-choose from a broad range of services which are more-or-less just “off the shelf” kind of products.
On the other hand, SMBs, normally with smaller IT departments, need greater levels of customer support and more intuitive and conveniently packaged applications.
This principle also applies to pricing policy too: the big-name cloud providers usually have intricate billing set-ups that lend themselves to opaque and unpredictable pricing practices. A knock-on effect of this is that smaller firms are unable to adequately manage their subscription budget over the long-term.
Will Microsoft and Amazon Eat DOCN’s Lunch?
DigitalOcean is seeking to carve out a foothold in a cloud computing market that is both highly competitive and increasingly unpredictable. With large, well-funded players such as Microsoft and AWS eyeing the lucrative SMB space, it isn’t unthinkable that these megaliths will someday develop product offerings of their own to capitalize on the nascent opportunity before them.
Additionally, smaller start-ups with the ability to attract customers on a more competitive price point could further erode DOCN’s position in the market.
What’s more, DigitalOcean’s client base is composed mainly of SMBs, which are notoriously more likely to suffer adverse effects from economic volatility than larger enterprises.
The consequences of this, such as lower spending on IT budgets and general financial uncertainty, could lead DigitalOcean’s own customers to reduce or delay their product subscriptions – or trim down the size and overall value of any new contracts – which would, ultimately, increase churn and have a negative impact on DOCN’s revenue figures and operating performance.
Is DOCN Attractively Priced?
DigitalOcean is a company still in the growth-stage of its life-cycle, and most investors shouldn’t be too worried about paying a premium for the business at this point. However, the firm has witnessed over 50% of its value wiped-out since last November, and it should have improved its valuation metrics quite considerably.
The company’s all-time share price high of $133.40 was reached on November 19, 2021, but, like many other growth stocks lately, it’s been hard hit from the recent pull-back. It now commands a forward price-to-sales multiple of 16x, which is certainly better than its peak ratio of a little above 30x.
However, DigitalOcean’s EBITDA margin is expected to rise to 33.5% by 2023 – which outstrips its rivals in the sector by quite some way.
Worryingly, DOCN has a steep forward price-to-operating cash flow of 89x, which, at its current stock price, doesn’t bode well.
But, with its performance metrics as detailed earlier looking so good, there’s nothing to imply that the business isn’t in great shape. That said, on a GAAP basis, the company still isn’t profitable, having made a loss-per-share in the third quarter of $0.02.
DigitalOcean Stock Forecast: Conclusion
As it is, DigitalOcean is a great company with a massive global reach. Its client base is enormous, and its revenues, unlike so many other subscription-based IaaS/PaaS businesses, doesn’t suffer from customer concentration.
Sales and margin growth are pretty much best-in-class for the industry, and, the operation doesn’t face any serious competitive threat at the present time.
For investors who want exposure to the cloud computing revolution, but already hold Amazon (AMZN) or other FAANG stock in their portfolio, DOCN makes for some great diversification. And, at current prices, it isn’t likely to be this cheap for quite some time.
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