Digital Ocean: A Cloud Player To Accumulate When No One Is Looking (NYSE: DOCN)

A very much analog ocean

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The Do-Over

Let’s start with chart analysis, because in Digital Ocean’s (NYSE: DOCN) case, the pattern is very simple to interpret. This is known amongst high-end technical analysts as the do-over, as in, if you missed it first time –you get a do-over.

DOCN Chart

DOCN Chart (TradingView)

Digital Ocean you can use it as a place to put your cat videos if you want, but for the most part its appeal is to technical users as a host for applications being developed or those which have been developed but In other words, if Amazon AWS (AMZN) is a mainframe, then Digital Ocean is an AS / 400.

There are a lot of tier-2 cloud players in this world and most of them are “ho-hum-why-bother.” What helps DOCN out is its financial fundamentals. Let’s take a look. Here are the last two years.

DOCN Financials

DOCN Financials (Company SEC filings, Cestrian Analysis)

The data is a little patchy in 2020 on account of this being a new IPO. But we have enough data to make out some clear trends.

Revenue growth is solid, neither stellar nor dull, but solid –that’s 36%-plus on a trailing twelve month basis and growth has been consistent for the last four quarters.

Gross margins are quite good for a hosting business (which has a lot of pay-aways to make) and they’re rising quickly as the company grows –that’s a good sign for the strength of the business model. 62% on a TTM basis and trending up.

EBITDA very good at 31% on a TTM basis, which is all very interesting, but in reality in a capex-intensive business like this one, you should ignore EBITDA because it’s not a real thing. It’s an accounting thing, but not a real thing.

Cash flow is a real thing, and at DOCN it’s remarkably good. Not in absolute numbers ($ 27m of unlevered pretax cash flow in the last year –barely enough to fill up your F-350 by the time this article is published), not in margins (6% TTM UFCF margins in and of itself is … meh) but in the following ways –they may look boring to civilians but to rabbit hole dwelling folk like ourselves, well, this is what exciting looks like in a young business:

  • Capex as a percent of revenues is coming down nicely, from 33% for the year to 31 Mar 2021 down to 24% for the year to 31 Mar 2022. What does that mean? It means the company is scaling its revenue faster than its capital base, which means its return on capital is increasing, which means that all things being equal this should be a going-up stock over time.
  • Change in working capital is modest –in the year to 31 Mar 2022 the company leaked only 2% of revenue into the hopper called “working capital” which is a hopper used to contain and disguise all manner of nasties in poorly-managed companies. What This tells you is that this management team is focused on getting paid by their customers at more or less the same rate that they pay their suppliers. And from such a small company that’s great to see –there’re plenty others with way more scale that are way worse at this –Cloudflare (NET) is the main offender that springs to mind. Again this bodes well for the future as the company scales.

The balance sheet is hardly Fort Knox but it isn’t Mt Gox either. $ 91m of net cash but more importantly $ 1.5bn of gross cash and marketable securities. Should keep the wolf from the door for awhile.

Fundamental valuation isn’t too challenging after the last few months’ tech wreck, at least on an EV / revenue basis. Probably best not to think about the cashflow multiples for a while!

DOCN Valuation

DOCN Valuation (Company SEC filings, Cestrian Analysis, YCharts.com)

And then there’s that chart.

If you missed DOCN on the way up? Here’s your do-over. Young stocks like this can be volatile and there’s no tradable pattern in our view, but as a long-term buy and hold, with a plan to just enjoy the benefits that that’s a stock we would be happy to accumulate in this period of weakness, and that’s in fact what we’re doing in staff personal accounts.

We rate the stock, accordingly, at “Accumulate,” ie, buy up in stages on red days, and once you get to your target allocation, sit back and let the immutable Laws of Fundamentals do their thing. We think this can be a winning strategy here.

Cestrian Capital Research, Inc –20 May 2022.

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