The market continues to be messy, but we’re going to take a partial swing at a profitable software company playing in a big, growth market – cloud services.
This company is like a smaller version of Amazon Web Services and Microsoft Azure. But without all the other parts of those much, much larger companies.
We may be a bit early. But we’ll manage that risk by taking a half position in a company that’s likely to grow above 30% for years and is very profitable.
Cabot Small-Cap Confidential Issue: June 2, 2022DOWNLOAD ISSUE PDF
The Big Idea
Recent earnings reports from Microsoft (MSFT), Amazon (AMZN) and Alphabet (GOOG) show Azure and other cloud services growing by 49%, Amazon Web Services growing by 37% and Google Cloud growing by 44%.
The combined annual revenue of these three businesses is well over $120 billion, larger than the GDP of many countries!
While there may be many questions about where the U.S. (and global) economy is going, one trend that’s not likely to be disrupted is the shift to the cloud. The bottom line is cloud computing offers lower upfront costs and better flexibility and scalability than on-premise solutions.
That’s why businesses continue to view software and cloud-based technologies as mission critical.
It is also why Microsoft, Amazon, Alphabet and others expect to increase investments this year to further build out data centers, servers and network infrastructure. And it’s why the number of software developers continues to climb year after year.
The thing is, while the mega-cap technology companies offer amazingly powerful platforms, they also carry prices to match. That often makes them out of reach for individual developers and many small and mid-sized businesses.
That has created a gap in the market for smaller cloud service providers. These players give smaller clients the ability to leverage the benefits of cloud infrastructure for prices they can actually afford.
In this niche market, customers are looking for high-performance cloud infrastructure that’s easy to use, offers a variety of off-the-shelf solutions, comes with top-notch customer service and plugs them into a community of engaged users to bounce ideas and questions off of.
The leader in this market is the company I’m adding to the portfolio today. It’s not the biggest in the cloud services market. But when it comes to serving the little guy – and there are a heck of a lot of little guys out there – it’s arguably the best.
Better still, it’s growing at about the same rate as the big boys and is very profitable.
DigitalOcean (DOCN) offers a cloud computing platform with on-demand infrastructure and platform tools for developers, start-ups and small-to-medium-sized businesses (SMBs). It has a market cap of $4.8 billion.
Infrastructure solutions span compute, storage and networking. And developers can extend the native capabilities of DigitalOcean’s cloud with fully managed application, container and database offerings.
Essentially, DigitalOcean offers a niche-focused version of the cloud services provided by the hyperscale cloud service providers, Microsoft (MSFT), Amazon (AMZN) and Alphabet (GOOG), at a price point that’s accessible to its target market.
One founding principal of the company is that the transformative benefits of the cloud should be easy to leverage, broadly accessible, reliable, and affordable. With that in mind DigitalOcean’s developer cloud was designed to be relatively simple to use.
In the span of minutes (not days) developers can set up thousands of virtual machines, secure projects, enable performance monitoring and scale up and down as needed.
By focusing on simplicity, community, open source and customer support, DigitalOcean has strived to differentiate itself from larger peers and attract a broad range of global customers who want to build applications on its platform.
The strategy is working. As of the end of March 2022, DigitalOcean had roughly 623,000 customers (+6.5% over a year ago). Larger customers are increasing their spend with the company at a faster rate than customer count growth. In Q1, 2022, 102,000 customers paid over $50 per month, up from 85,000 customers paying that rate a year ago (+20%).
Users include software engineers, researchers, data scientists, system administrators, students and hobbyists. These customers use DigitalOcean’s platform across many industries and for a wide range of use cases, including web and mobile applications, website hosting, e-commerce, media and gaming, personal web projects and managed services.
Customers are spread across 185 countries. Roughly 38% of revenue is generated from North America, 29% from Europe, 23% from Asia and 10% from the rest of the world.
DigitalOcean has designed its cloud platform to be simple, reliable and affordable. It is highly focused on performance, customer service and offering a curated set of solutions that helps clients spend more time building apps and collaborating to grow their businesses, and less time managing clunky infrastructure.
Here are a few notes on key solutions.
Compute Offerings: Compute offerings help developers build and release apps quickly in the cloud, at a reasonable price. There are four main compute offerings:
Droplet: The company’s first product, Droplet, was launched in 2012 and is a virtual machine that provides flexibility to build, test, secure and grow client applications from start-up phase to scale. In 2021 the company began offering Premium Droplets, which are still simple but offer enhanced speed and memory performance.
Managed Kubernetes and Container Registry: The Managed Kubernetes service was launched in 2018 to provide scalability and portability for cloud-native apps. For just $10 per month clients can get started and scale up as their needs evolve. Managed Container Registry lets customers store and manage private container images to deploy to the Managed Kubernetes service.
App Platform: Launched in October 2020, the App Platform is a Platform-as-a-Service (PaaS) solution allowing customers to build, deploy and scale apps quickly. It handles the infrastructure, app runtimes and dependencies so developers can get code to production quickly.
Serverless: Nimbella, a serverless platform provider, was acquired in September 2021. This type of solution gives freedom from server management and means customers only pay for what they use.
Storage Offerings: Storage solutions help customers reliably store whatever they need in the cloud. There are three main solutions: Spaces (object storage), Volumes (block storage) and Backups (disk images of Droplets).
Network Offerings: Network solutions secure and control traffic to client apps. Since data transfer costs can add up quickly, DigitalOcean pools bandwidth for a customer’s account so it covers all applications and/or resources they run. Networking solutions include Cloud Firewalls (free), Managed Load Balancers and Virtual Private Cloud (for enhanced security).
The Developer Experience: DigitalOcean is intently focused on creating a company that draws developers into a community of highly engaged users. To that end, the company offers a ton of resources to help users get started on the platform quickly and grow usage of services over time. These resources include a community education website, management and collaboration tools (free) and a DigitalOcean Marketplace (pre-configured apps).
Price Increases: In May, management announced the first price increase in years. It is aimed at “reframing” the value proposition for DigitalOcean versus the competition and is not in response to inflation and more because its technology is a critical layer of IT infrastructure. The price increase went into effect this week (June 1) and applies to Droplets, Snapshots, Load Balancers, Floating IPs, Custom Images and select Managed Database and Managed Kubernetes solutions.
$300 Million Share Buyback: On May 24 DigitalOcean announced its second $300 million share buyback program of 2022 (the first was announced in February). Purchases will be made on the open market. This should help offset stock awards to employees as well as fill in any open market demand gaps during bouts of market volatility.
Product Development: Key to any cloud software/platform growth story is the development and release of new products to meet evolving market needs. DigitalOcean has been doing this over the years (Managed Database in 2019, App Platform in 2020, Premium Droplets in 2021, Nimbella acquisition in 2021, etc.). I expect to see more of the same in the coming years.
The Business Model
DigitalOcean has a consumption-based pricing model where revenue is generated based on usage of its cloud computing platform for compute, storage, networking services, etc. Revenue is billed monthly in arrears, making it easy for customers to track usage on an ongoing basis. Pricing is extremely transparent and is available on DigitalOcean’s website.
The company has a self-service customer acquisition model supported by tons of content and how-to guides on its website. Customers tend to get up and running quickly without a lot of assistance. This self-service, low-friction model makes it easy for users to try, adopt and use DigialOcean’s products. A small portion of revenue comes from a targeted sales force that is focused on inside sales, outside sales and partnership opportunities.
The Bottom Line
DigitalOcean grew revenue by 25% in 2020 and by 31%, to $418.4 million, in 2021. Adjusted EPS in 2021 was $0.34 and cash flow per share was $1.16.
In Q1, 2022, reported on May 4, revenue rose 36% to $127.3 million (beating by $1.1 million) while adjusted EPS rose by $0.04 to reach $0.07 (missed by $0.05). Digging deeper into Q1 trends, annual run-rate revenue (ARR), calculated as the total revenue from a month multiplied by 12, was up 35% to $524 million as of March 31, 2022. Net dollar retention was 117%. Average revenue per customer (ARPU) jumped 28.3% to $68.90. Customer concentration is low as the top 25 customers make up approximately 11% of revenue.
At the end of March 2022, the company had $465 million in cash and equivalents and $1.1 billion in marketable securities. It also had a $250 million untapped credit facility.
Management indicated the Ukraine-Russia conflict has directly impacted roughly 3.5% of revenue. Guidance for Q2 included revenue of $133 - $135 million (consensus currently at $134.7 million) and adjusted EPS of $0.09 to $0.10 (consensus currently at $0.10). Full-year revenue guidance is $564 - $568 million, up 35.3% at the midpoint (consensus currently at $570 million, +36%) while adjusted EPS guidance is +94% to a range of $0.70 - $0.71 (consensus is at $0.66).
Stepping back, management sees DigitalOcean as being able to grow revenue above 30% for years while generating 20% free cash flow margins. The term “cash machine” has been uttered! Anticipated cash flow will be used to invest in the business, product development, M&A and (possibly) share buybacks (as we’ve seen lately).
Russia: DOCN doesn’t have employees or direct operations in Russia, Belarus or Ukraine but some customers do. Sanction measures, actions on SWIFT, have impacted roughly 3.5% of revenue.
Hyperscale Cloud Providers Move Down Market: So far MSFT, AMZN, GOOG, etc. haven’t devoted a ton of resources to the SMB market. If that changes DOCN could face stiffer competition.
Adoption of More Solutions: Key to a software/platform growth story is customers adopting more solutions. In DigitalOcean’s case this means customers continue to expand beyond Droplets.
Continued Success of Self-Service Model: This model has proven successful thus far as new customers are organically drawn to DigitalOcean’s website and the rich learning content they find there. It will need to continue.
DigitalOcean may bump up against hyperscale cloud service providers, including Amazon (AMZN), Microsoft (MSFT), Alphabet (GOOG), Oracle (ORCL) and IBM (IBM). But more commonly it goes up against niche cloud service providers that serve small and medium-sized businesses. These more direct competitors include OVH, VULTR, Heroku and Linode.
Trading Volume: DOCN trades an average of 2.37 million shares daily. We won’t move this stock.
Historical Price: DOCN came public at 47 on March 24, 2021. Shares were down 10% that day and traded in the 35-45 range for a few months before moving back above the IPO price. The stock took off in August and soared to an all-time high of 133.4 by November 19. The stock fell with the market and in February and March seemed to have found support near 43. By the end of March 2022, it was back near 60, but then DOCN fell another 50% or so to land at 30 on May 11. Over the last three weeks DOCN climbed steadily and regained the 43 level, even trading as high as 50 last Friday. It is off a few points this week.
Valuation: DOCN trades at an EV/Forward Revenue multiple near 9.0. That’s up from the low of 5.6 on May 11 and down from the high of over 15 from late 2021.
Buy Range: Expect to buy between 40 and 55 in the near term. BUY HALF.
The Next Event: Management hosts an investor day on June 9. Q2 earnings likely in early August.
Updates on Current Recommendations
|Stock Name||Date Bought||Price Bought||Price on 6/1/22||Profit||Rating|
|Avalara (AVLR)||2/1/19||40||83||108%||Hold Quarter|
|CS Disco (LAW)||9/2/21||57||22||-61%||Buy|
|Ingles Markets (IMKTA)||5/5/22||95||89||-7%||Buy Half|
|Inspire Medical (INSP)||10/4/19||59||174||198%||Hold|
|Procept BioRobotics (PRCT)||3/3/22||25||40||59%||Hold Half|
|Rani Therapeutics (RANI)||10/7/21||17||11||-34%||Buy Half|
|Repligen (RGEN)||11/2/18 and 12/31/18||59||167||182%||Hold|
|Revolve Group, Inc. (RVLV)||4/1/21||46||29||-37%||Hold|
|Sprout Social (SPT)||9/3/20||36||52||42%||Hold Half|
Glossary Please email me at email@example.com with any questions or comments about any of our stocks, or anything else on your mind.
Buy means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying t Buy means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying the stock no longer apply, and I recommend exiting the position.
Sell a Half means it’s time to take partial profits. Sell half (or whatever portion feels right to you) to lock in a gain, and hold on to the rest until another ratings change is issued.
Disclosure: Tyler Laundon owns shares in one or more of the stocks mentioned. He will only buy shares after he has shared his recommendation with Cabot Small-Cap Confidential members and will follow his rating guidelines.
The next Cabot Small-Cap Confidential issue is scheduled for July 7, 2022.
About the Analyst
Tyler Laundon is chief analyst of the limited-subscription advisory, Cabot Small-Cap Confidential and grand slam advisory Cabot Early Opportunities. He has spent his entire career managing, consulting and analyzing start-up and small-cap companies. His hands-on experience has taught Tyler that the development of a superior business model is the biggest factor in determining a company’s long-term success. Accordingly, his research focuses on assessing the viability of management’s growth strategies, trends in addressable markets and achievement of major developmental milestones.
Tyler’s small-cap portfolios favor a high allocation to stable, high growth companies, upon which he layers strategic purchases of higher risk, event-driven investments. He first began publishing his analysis of small-cap opportunities in 2009. Since 2012, he has led his subscribers into 10 doubles. Between 2012 and September, 2015 his small-cap recommendations generated cumulative returns of over 2,300%, including both winners and losers, and outperformed the Russell 2000 Index by an average of 28% per year.
Prior to joining Cabot, Tyler founded and operated a small business for 15 years. He then worked as a consultant for start-up technology companies, as well as Vermont’s largest health care institution. From 2009 to 2015, he was the chief analyst of growth stocks at Wyatt Investment Research, where his research spanned the full spectrum of the growth stock universe, from micro-cap start-ups to multi-national mega-caps.
Tyler holds a B.S. and MBA from The University of Vermont, where he graduated Valedictorian. He has been a long-time contributor to the Wall Street’s Best Investments, has been quoted by U.S. News & World Report, and has presented investing ideas and strategies for The Money Show and Bloomberg Markets LiveINSIGHTS.