DigitalOcean Stock: Business Excellence And Commitment To Innovation (NYSE:DOCN)

Introduction

While IT giants dominate the cloud infrastructure industry, a rising star called DigitalOcean (NYSE:DOCN) has emerged in recent years, demonstrating a global presence in 190 countries and remarkable profitability despite its comparatively modest scale. The company doesn’t directly compete with tech giants as it focuses on small and medium businesses, yet this niche’s total addressable market (“TAM”) remains substantial. DOCN’s strategic differentiators align closely with the needs of its target audience, and the company’s robust revenue dynamics fairly mirror its strong market positioning. Of utmost significance is that this exceptional company is currently trading at a significant 45% discount, a valuation derived from the discounted cash flow analysis. Considering these favorable factors, DOCN merits a ‘Strong Buy’ rating.

Fundamental analysis

According to the company’s latest quarterly SEC filing, DigitalOcean is a leading cloud computing platform offering on-demand infrastructure and platform tools for startups and small and medium-sized businesses (“SMBs”). DigitalOcean offers cloud computing solutions, including virtual machines, storage, and networking, focusing on simplicity, community, and customer support. The company recognizes revenue based on the customer utilization of DOCN’s resources. The pricing is consumption-based and billed monthly in arrears.

The company’s customers are spread across 190 countries. For the three months ending September 30, 2023, 37% of DOCN’s revenue was generated from North America, 29% from Europe, 24% from Asia, and 10% from the rest of the world. This global distribution of customers and revenue diversification across multiple regions signifies a broad and resilient market presence, reducing the company’s dependence on any single geographic area and potentially lowering risks associated with regional economic fluctuations.

DigitalOcean identifies itself primarily as an Infrastructure-as-a-Service (“IaaS”) and Platform-as-a-Service (“PaaS”) company. These industries hold significant promise, as statista.com projects a robust CAGR of 16.5% for worldwide IaaS between 2024 and 2028. The same source expects PaaS to compound at 14.2% over the same period. The company’s assessment of the addressable market growth is even more optimistic, as shown below. It is crucial to underscore that DigitalOcean operates within the IaaS and PaaS markets, where well-established solutions from major players such as Google’s (GOOG) Cloud, Microsoft’s (MSFT) Azure, and Amazon’s (AMZN) AWS are also presented. However, it is also important to understand that DigitalOcean is more targeting SMBs, while larger players target enterprises. The company sets itself apart through its commitment to simplicity, live support, extensive community, and cost-effectiveness for users.

While benefiting from industry tailwinds is advantageous, the company’s ability to navigate this wave efficiently is crucial. Despite lacking an accounting background, I firmly believe that analyzing the financial performance dynamics provides valuable insights into a company’s efficiency. Hence, let’s examine the company’s historical performance in terms of revenue and operating profits. Usually, I prefer to look at trailing twelve months (“TTM”) to eliminate seasonality. While the revenue exhibits a robust upward trajectory, there appears to be a stagnation in operating profits. I don’t consider the plateauing operating profit to be a concern at this stage of the company’s life cycle, given that DOCN allocates a significant portion of its sales to research and development. For instance, DigitalOcean’s recent announcement to integrate Nvidia’s H100 GPUs into its Paperspace platform indicates a firm innovation commitment to creating customer value. This provides affordable access to cutting-edge technology for developing, deploying, and scaling AI models, showcasing DigitalOcean’s commitment to offering superior performance while keeping costs reasonable.

Let me also examine how key balance sheet metrics have moved in recent quarters. While the cash balance saw a reduction of more than half, it was primarily a result of robust share buybacks in 2023. Over the first nine months, DOCN repurchased shares totaling $485 million. Trading within a substantial $25 to $50 price range between January and September 2023 suggests that the current $35 per share is highly likely to be deemed attractive by the management, considering their aggressive buyback strategy during this period. The total debt level has been very stable, which is also a good sign for me.

DOCN appears to be on a positive trajectory, leveraging its youth to establish a strong presence in promising industries, showcasing improving financial performance and bolstering confidence in its robust financial position for long-term business sustainability. It is my opinion, and I would also like to support it with third-party opinions. Piper Sandler’s recent target price upgrade for DOCN, increasing it from $25 to $35, reflects a positive outlook on the company’s future prospects. Earlier, in November 2023, DOCN’s stock saw upgrades from two more reputable investment researchers: Oppenheimer and Goldman Sachs.

DigitalOcean’s announcement to integrate Nvidia’s H100 GPUs into its Paperspace platform is a positive move, especially for small businesses and startups. This provides affordable access to cutting-edge technology for developing, deploying, and scaling AI models, showcasing DigitalOcean’s commitment to offering superior performance while keeping costs reasonable.

Valuation analysis

DOCN debuted as a public stock in March 2021 with an IPO price of $47. I am adding this context because the current stock price is around 25% lower than the IPO price. At the same time, the significant 14.4% interest rate clearly indicates that a vast audience believes that DOCN should be traded even lower. The stock presently trades around the midpoint of its extensive 52-week range, ranging from $19 to $52.

I will employ the discounted cash flow (“DCF”) approach to determine a fair value estimate for the stock. Finbox recommends an 8.5% WACC for DOCN, which will be incorporated into my analysis. The constant growth rate for the terminal value (“TV”) calculation will be half of the WACC, i.e., 4.25%. I use the TTM free cash flow (“FCF”) margin of 18.75% for every year of my model’s horizon. Projected revenue growth for 2024-2027 stands at 15%, in line with the anticipated growth of the IaaS and PaaS industries during the same period. There are currently around 88 million DOCN shares outstanding.

My target price for DOCN is set at $50 per share, reflecting a robust 45% upside from the last closing price and highlighting substantial growth potential.

Mitigating factors

In my fundamental analysis, I emphasized that technological behemoths such as Amazon, Microsoft, and Google are currently prioritizing larger corporate clients; however, it is imperative to acknowledge the potential risk that they might venture into the SMB sector in the future, posing a challenge for DigitalOcean. Considering the incomparable financial resources of DOCN and these giants, it is evident that engaging in competition would present a formidable challenge for the company, potentially resulting in a loss of market share and detrimental consequences for its overall financial performance.

While offering infrastructure and platform services entails high customer switching costs, there is a flip side to the coin. Acting as the backbone for businesses places DigitalOcean in a position where any slight cybersecurity breaches or technical blackouts could severely compromise its business reputation, potentially resulting in legal actions if customers incur financial losses due to DigitalOcean’s technical shortcomings.

Conclusion

In essence, my optimism regarding DigitalOcean’s future stems from its robust customer base and global footprint, reflecting the widespread appeal of its IaaS and PaaS solutions. Positioned within rapidly growing sectors, the company’s efficient performance signals its ability to navigate and capitalize on this positive trajectory. With a target price significantly surpassing the current market share value, I firmly assign a “Strong Buy” rating for DOCN.