DigitalOcean: I Expect Growth To Accelerate In The Foreseeable Future

seekingalpha11-19

I give a buy rating for DigitalOcean due to anticipated growth acceleration driven by its AI strategy, larger customer base, and improving net dollar retention rate.DOCN's AI strategy positions it to ...

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J Studios Investment overview I give a buy rating for DigitalOcean (NYSE:DOCN) as I expect growth to accelerate in the coming years, supported by the success of its AI strategy, growing mix of large customers, and an improving net dollar retention rate. Once growth accelerates, valuation multiples should trade up accordingly. Business description   DOCNDOCN is a public cloud provider that specifically targets SMBs, early-stage start-ups, and individual developers. DOCN differs from large incumbents by offering a much simpler product with lower pricing, broad community adoption, and strong customer support. As of 3Q24, the business has over 600k customers across ~190 countries and has grown revenue at a rapid rate of >25% CAGR since FY18 to FY23. 3Q24 earnings (announced on 4th November 2024) DOCN reported 3Q24 revenue of $198.5 million, a 12% y/y growth, which enabled it to beat consensus estimates of $196.7 million (11% y/y growth). The main driver to revenue growth was average revenue per unit [ARPU], which increased to $103 in 3Q24, implying 11% y/y growth, and this marked the 3rd consecutive quarter of ARPU y/y growth acceleration. The beat vs. consensus at the adj EBITDA level was even greater, as DOCN reported adj EBITDA of $86.7 million (43.7% margin), beating consensus estimates of $74 million and 37.5% margins. Accordingly, management was confident to slightly raise FY24 guidance. The new guidance increased the midpoint of the prior revenue guide by $3.5 million, which is noteworthy as this $3.5 million is more than the $2 million beat that 3Q24 delivered vs. 3Q24 guidance, indicating an upgrade to 4Q24 revenue expectations. Management also raised the adj EBITDA margin guidance by 250 bps to 40-41%. Revenue growth should accelerate in the next few years I believe there are several reasons to believe that DOCN will see growth acceleration in the next few years. The main reason, I think, is DOCN AI strategy in innovating platform and application layers to enable easy use of GenAI at scale for customers without deep AI/ML expertise. Recall that DOCN acquired Paperspace (Jul’23), and the team has been focused on expanding its AI platform ever since. Currently, DOCN has three key AI products: GPU Droplet; Infrastructure-as-a-Service for AI [IaaS]; and Platform-as-a-Service for AI [PaaS]. In essence, these products allow DOCN SMB customers to better tap on to GPU/computing resources without committing for the full capacity, as the requirement is much lower but is also able to meet peak demand requirements (i.e., use more computing resources when needed).  GPU droplet, which allows for cheaper and more accessible fractional access to a single GPU inside a virtual machine rather than committing to a full GPU. IaaS is mainly designed for businesses that require access to raw computing power for model customization. Here, Paperspace GPU IaaS is essentially a server-side bare-metal GPU offering, meaning the whole server is devoted to just one user or app. As for PaaS, DOCN leverages Paperspace to offer comprehensive support (templates, coding collaboration, etc) to software developers working on AI-enabled applications throughout their entire lifecycle.  Given the strong demand for AI, I believe DOCN will win demand from the “AI Extenders” and “AI Consumers.\" These customer groups are a sweet spot for DOCN to target because they need additional AI and GPU computing resources but do not have enough demand requirements (or financial capacity) to justify spending hundreds of millions in CAPEX and time to build up their own AI and GPU capacity. For AI Extenders, they are not necessarily creating their own models; rather, they take advantage of open-source models, tweak them with their own data, and then put them to use. As a result, this task requires less GPU access than building the foundational model. For AI consumers, they create apps that use AI and make use of compute resources to improve and expand upon preexisting AI models. Take an AI-native supply chain app as an example: it uses a foundational model, but its main selling point is the algorithm it provides for supply chain forecasting. The app makes use of AI, but it doesn't necessitate the same amount of computational power as improving or constructing foundational models. Apart from this AI strategy, there are moving parts within the business that point to growth acceleration ahead. For instance, AI/ML annual recurring revenue [ARR] grew close to 200% y/y in 3Q24, driving contribution from AI/ML to track above the original 300bps contribution to growth in FY24. Furthermore, while net dollar retention [NDR] was stable at 97%, on a like-for-like basis, core DOCN business NDR has actually improved because 3Q24 faced a tough comp from previous year price increases. Lastly, larger customers are growing faster and make up a majority of revenue, as Scalers, representing 58% of total revenue, grew 19% y/y and Builders & Scalers, representing 88% of revenue, grew 15% y/y. Valuation   May Investing IdeasI see a very attractive upside to DOCN stock over the next few years if growth accelerates as I expect. In my model above, I assumed DOCN to see growth accelerate from low teens in FY24 (per guidance) to mid-20% in FY27, supported by the success of its AI strategy (driven by growing AI demand), a growing mix of large customers, and an improving NDR. I referenced my growth outlook by anchoring expectations against DOCN growth rate in 1H23 (revenue growth was >25%), which, I think, is entirely possible for DOCN to reach that level of growth as it now has the AI strategy that wasn’t present previously. Also, the macro situation in the US has gotten much better, with both rates and inflation coming down. Assuming growth accelerates back to 25%, DOCN should trade at a similar multiple to 2Q23: ~6.5x forward revenue. Attaching a 6.5x forward revenue multiple to my FY27 revenue equates to a share price target of $83. This may seem high vs. the current share price, but DOCN traded at this level in FY22. Risk FCF margin may stay depressed in the near term, as management comments for 15-17% FCF margins to continue into FY25 suggest CAPEX will sustain at a high level. In addition, management 4Q24 guidance implies net new ARR y/y growth to see further deceleration. This makes the near-term outlook rather uncertain, and until there is more visibility to growth acceleration, the share price may stay rangebound. Conclusion  I give a buy rating for DOCN as I am positive about its AI strategy. As the demand for AI-powered solutions continues to surge, DOCN should be well-positioned to deliver on its AI initiatives and capitalize on the growing market opportunity. Notably, as DOCN shows signs of growth acceleration, I expect the market to react very positively, driving valuation multiples upwards.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.2","shortVersion":"4.29.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2484681929"}