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Youd think that DigitalOcean (DOCN) would be trading at nosebleed multiples considering its positioning in the cloud computing sector, but the recent volatility in the tech sector has sent the stock crashing 60% from all time highs. The company has seen accelerating revenue growth and has sustained solid positive adjusted EBITDA margins as well. After a recent convertible note offering, the company has around 30% of its market cap held in cash. I expect the company to sustain solid growth over the long term which coupled with high profit margins should help the stock earn a premium multiple and reward shareholders with strong returns.

DOCN came public at $47 per share in March of 2021. The stock briefly traded as high as $133 per share, before falling all the way back down to around $52 per share.

YCharts

The stock now trades barely above its IPO price, despite having grown considerably in the past year.

DOCN is a cloud computing company with 600K customers across 185 countries.

DigitalOcean 2021 Q3 Presentation

Just to make sure we are all on the same page, DOCNs primary competitors are the likes of Amazon Web Services (AMZN) and Microsoft Azure (MSFT). Cloud computing provides the backbone of the cloud. Before things were available on the cloud, you would have to download software and use products locally on your computer without the internet. The cloud makes it so you can use applications like Facebook (FB) without downloading any software. Amazon Web Services provides servers which allow FB to operate on the cloud. In some sense, the internet as we use it today is powered by cloud computing providers like DOCN.

Unlike Amazon Web Services or Microsoft Azure, DOCN is a smaller operator and specifically caters to smaller businesses. This makes sense, as it isnt easy to compete with mega-cap tech giants in the cloud computing space. DOCN offers lower prices and (in its own words) a simpler platform, making it easier and cheaper to get started.

DigitalOcean 2021 Q3 Presentation

This dynamic does make sense. Azure and AWS likely offer more capabilities and thus use that to justify higher prices. For smaller companies looking for a simpler solution, DOCN makes a lot of sense.

Even in this smaller market, DOCN sees its total addressable market growing rapidly to $116 billion by 2024.

DigitalOcean 2021 Q3 Presentation

Both MSFT and AMZN look investible today, but one is unable to invest directly in their cloud divisions. DOCN offers a way to invest in a quality pure-play cloud computing operator, something that may appeal to many tech investors.

DOCN has seen its revenue growth accelerate over the past few quarters. Revenue growth came in at 37% in the latest quarter.

DigitalOcean 2021 Q3 Presentation

DOCN has coupled the rapid growth with solid adjusted EBITDA margins of 30%.

DigitalOcean 2021 Q3 Presentation

Sure, it is not real profitability due to the heavy influence of equity-based compensation, but it does mean that DOCN is generating cash flow and thus not in risk of falling in financial distress.

It is worth noting that DOCN has seen improving net dollar retention rates as well.

DigitalOcean 2021 Q3 Presentation

DOCN has historically seen elevated churn rates, but it appears that it is improving its churn rates through improving its product offerings. I note that DOCN completed a $1.3 billion convertible note offering in November at a 0% interest rate and conversion price of $178.51 per share - talk about perfect timing. Including that offering, DOCN should have around $1.8 billion of cash on its balance sheet.

Consensus estimates call for DOCN to sustain 30% growth rates for many years.

Seeking Alpha

Like AWS, DOCN is highly profitable and it is reasonable to expect the company to generate solid profit margins over the long term. If we assume 30% long term net margins and a 1.5x price to earnings growth ratio (PEG ratio), then DOCN might find itself trading at 9x sales in 2030, representing a stock price of $336 per share. That represents 546% upside, or annualized returns of 23% over the next 9 years. For a company with ample net cash on its balance sheet and positive cash flow generation, that is a very attractive potential return profile. I note that I have not even factored in the cash making up over 30% of the market cap.

The key risk is definitely competition with mega-cap tech cloud computing giants. What if AWS and Azure try to reduce prices to take market share away from DOCN? It is unlikely that DOCN will be able to innovate fast enough to offer a competitive product if the prices are comparable.

Another risk is the companys customer concentration. Management noted the following on its conference call:

One of the key drivers of our faster revenue growth is that we are nurturing and attracting increasingly larger and more rapidly growing businesses to our platform, what we would consider the typical SMB. These larger customers represent roughly 15% of our total customer base, yet generate roughly 85% of our total revenue. They grow substantially faster than our reported top line growth with ARPU growth of over 50%. (2021 Q3 Transcript)

An optimistic take is that DOCN will benefit from very predictable growth as it will come from a handful of sources. A pessimistic (but more realistic) take is that DOCN may be subjected to revenue volatility if any of these larger customers decide to switch cloud providers. It isnt that easy to switch cloud providers, but it is not impossible.

I rate shares a buy on account of the long term secular growth drivers of cloud computing and the high profit margins. I expect shares to be volatile in the current environment, but wouldnt be surprised if multiple expansion occurs over time. In particular, I could see the stock trading up to around 22x sales on positive sentiment, as profitable tech stocks with solid secular growth stories have tended to maintain premium multiples relative to the tech sector.

Link:
DigitalOcean: Pure-Play Cloud Provider With 30% Cash, 30+% Growth, Positive Free Cash Flow - Seeking Alpha