DigitalOcean Holdings, Inc.

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 4/5

DigitalOcean Holdings, Inc. provides a cloud computing platform primarily aimed at developers, startups, and small-to-medium-sized businesses (SMBs), offering infrastructure-as-a-service (IaaS), platform-as-a-service (PaaS), and managed services.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview and Revenue Distribution: DigitalOcean provides cloud computing services to businesses of varying sizes and industries, focusing on offering developer-friendly infrastructure, ease of use and affordability. Its revenue streams are derived primarily from selling cloud services, which include:

  • Infrastructure-as-a-Service (IaaS): This involves providing virtual servers (droplets), block storage, load balancers, virtual networking, and other foundational infrastructure components. IaaS is the most important segment and forms the bulk of the revenue.
    • This includes its core droplet offering (virtual servers), block storage, load balancers, managed Kubernetes and its managed database services.
  • Platform-as-a-Service (PaaS): This includes managed databases, application deployment platforms, and serverless computing options. PaaS facilitates easier application development.
    • This segment includes its app platform and managed database offerings.
      • Managed Services: These are value-added services offered on top of the underlying IaaS and PaaS platforms.
    • This segment includes its managed service capabilities, such as server monitoring and backups, security, and other managed services.

The company’s revenue is derived primarily from the subscription fees it charges for the use of its infrastructure and services. As of September 2023, the company had more than 150,000 customers across 180+ countries.

Revenue is primarily recognized based on customer utilization. As for the geographical distribution, a majority of the revenue is driven by customers in the United States, followed by Europe and APAC.

Industry Trends and Competitive Landscape: The cloud computing market is intensely competitive and characterized by several trends:

  • Rapid growth: Cloud adoption continues to grow significantly, driven by the need for scalable and flexible infrastructure by businesses of all sizes.
  • Intense Competition: DigitalOcean competes with major players like AWS, Microsoft Azure, Google Cloud, and others. These major players have significantly greater resources and more developed enterprise sales teams. It also competes with a variety of other cloud and hosting providers who have particular market focuses.
  • Specialization: Cloud providers are focusing on more specialized services to suit varying customer needs, and industry consolidation is also increasing.
  • Edge computing: The need to process data closer to the user is driving the increase in edge computing
  • The increasing importance of AI and machine learning also requires a move toward high-performance computing, which could be a boon or headwind for smaller cloud providers like DigitalOcean.
  • The rising cost of energy (both electricity and natural gas) is putting a strain on energy intensive businesses, including cloud providers.

DigitalOcean has carved a niche by focusing specifically on developers, startups, and SMBs, offering simpler, more user-friendly, and affordable services. Their focus is on making cloud services accessible and appealing to the developers and start-up community that don’t want to use services designed for larger enterprise customers.

What Makes DigitalOcean Different?

  • Ease of Use: DigitalOcean aims to be highly accessible and easy-to-use for developers and smaller businesses by having a simple platform that developers quickly get up to speed on. This is the most important differentiator of the company.
  • Community focus: They have built a strong community among developers through providing support, tutorials, and resources.
  • Simplicity and transparency: DigitalOcean is widely lauded for its simplicity (no sales rep, flat pricing, transparency) and consistent pricing model, which tends to be easier than the pricing of other companies.
  • Transparent Pricing: They are highly transparent about what their clients will pay, without the need to negotiate contracts.
  • Developer-Centric: They are specifically designed for developers, who are the ones that tend to pick the platform in their organizations.
  • SMB Focus: Most cloud providers are focused primarily on the enterprise, with SMBs falling behind in the priority list, while DigitalOcean has an explicit focus on SMBs and startups.

Financial Analysis: Let us focus on more recent numbers, as it is key to understand how the company is doing right now. Based on the 10-Q filed on 11/08/23:

  • Revenue: For the three months ended September 30, 2023, DigitalOcean reported revenue of $177.3 million, a 20.9% increase compared to $146.7 million in the same period of 2022. For the nine months ended September 30, 2023, they reported revenue of $510.8M, a 21.2% increase compared to $421.6 million for the nine months ended September 30, 2022.
  • Gross Profit: GAAP gross profit was $117.1 million, or 66% of revenue for the three months ended September 30, 2023; whereas it was $97.3M, or 66.3% of revenue, for the same period in 2022. For the nine months ended September 30, 2023, they posted a GAAP gross profit of $338.3 million, or 66.2% of the revenue, compared to $281.8 million or 66.8% of the revenue, for the same period in 2022.
  • Net Loss: For the three months ended September 30, 2023, net loss attributable to common stockholders was $20.8 million, compared to $32.7 million in the same period in 2022. For the nine months ended September 30, 2023, net loss attributable to common stockholders was $98.9 million, compared to $149.8 million for the same period in 2022.
  • Non-GAAP Diluted Net Income Per Share
  • For the three months ended September 30, 2023, the non-GAAP diluted net income was $0.40 per share and $17.4M, compared to $0.28 and $11.3 million for the same period of 2022.
  • For the nine months ended September 30, 2023, the non-GAAP diluted net income was $1.07 per share and $46.4M compared to $0.67 and $27.2M in the same period of 2022.

  • Cash and cash equivalents: $444.8M on September 30th, 2023 compared to $171.9M on December 31st, 2022. They gained this mostly due to a common stock offering in 2023.

    • Other Metrics: Customer churn is improving, net dollar retention remains stable at 110%, average revenue per paying customer is rising, and ARPU is also improving. They are expanding their cloud capacity and product features, expanding in India, and leveraging strategic partnerships, particularly for AI.

Comments: DigitalOcean saw YoY revenue growth improve from around 12% to 20%+, and has begun achieving positive net income in recent quarters. Their gross profit remains roughly stable. One potential concern is that their margins haven’t improved as fast as revenue. The company is starting to focus more on non-core offerings, which may dilute margins. Their focus on cost cutting and expense optimization should help maintain current operating margins. They see a path to consistent free cash flow, but it will depend on their margins holding up as they move to higher-growth offerings.

Recent Concerns and Controversies: In their latest earnings call and subsequent filings the company discusses the slowdown in the SMB/startup environment, macroeconomic uncertainty, and currency headwinds, which were partially offset by strong performance in areas such as international expansion, developer programs, and managed databases. There was mention of some weakness in SMB markets due to macroeconomic factors which slowed growth some. They have taken steps to optimize costs, cut down on excess marketing spending, and are looking to be more profitable. They have also announced their acquisition of Paperspace in a move to increase their AI capabilities, showing that the company recognizes the importance of new technology. This acquisition is in part designed to improve developer productivity and the company’s developer focus. They also highlighted continued efforts to build the right kind of infrastructure to improve operational efficiency and reduce costs going forward. Their main areas of focus for growth are: data analytics, AI and machine learning, and expanding to higher-growth segments.

Moat: DigitalOcean’s moat is weak (2/5), and comes primarily from their brand and community focus:

  • Brand Loyalty and Developer Focus: DigitalOcean has carved a niche for itself among developers with its developer-friendly focus and community. These strengths act as a soft competitive advantage and help with customer retention. The brand has a strong positive connotation with the target customers of the company.
  • Simplicity and ease of use: While competitors tend to have complex offerings, DigitalOcean has created a simpler, more easy-to-use offering. Their customers are loyal to them because of their simplicity and ease of use and are unlikely to switch because they dislike their options in large public cloud providers.
  • Pricing Power: Because of the above factors, particularly a focus on niche markets, their customers may be more price inelastic than companies using more commoditized offerings.

However, the economic moat is considered fragile because:

  • Replicable Products: Although DigitalOcean offers simple products, these can be easily replicated (and they have been) by competitors, which will make it hard for them to keep margins up long term and limit their pricing power.
  • Scale Weakness: The company is much smaller than its direct competitors, therefore, they have less resources for marketing and scaling, potentially giving them a cost disadvantage. They also have more difficulty in reaching larger and more stable enterprise customers than some larger public cloud companies.
  • High Competition: As mentioned above, the cloud market is incredibly competitive, with AWS, Azure, and Google Cloud already having a significant amount of users. New entrants and niche players also continue to compete.

Legitimate Risks that Could Harm the Moat and Business Resilience:

  • Intensified Competition: The biggest threat to DigitalOcean’s moat is from the large players that have more resources and the fact that its products can be relatively easily replicated.
  • Technology Changes: Given the speed of technology innovation in cloud computing, DigitalOcean needs to continuously develop its platform and offerings to maintain its value and relevance. They need to keep pace with all their competitors (or risk falling behind) in areas such as AI.
  • Macroeconomic Conditions: A slowdown in the economy could hurt DigitalOcean’s core customer base (SMBs and startups), resulting in reduced demand.
  • Pricing Pressure: If the competition engages in more significant price cuts, it may harm DigitalOcean’s profitability.
  • Increased Customer Concentration: If they become overly reliant on a small number of customers, their financials could suffer if those customers churn, fail, or downsize. They need to continue to diversify their customer base.

  • Inability to Attract New Customers: If their products are not attractive enough, or their platform isn’t able to deliver more value to customers than competitors, they will struggle to attract new customers or keep existing ones.

    The company is well positioned to grow further by emphasizing its strengths and differentiating itself from larger competitors; however, the business faces a variety of risks that could erode its value in the long term.

Understandability: 2/5 DigitalOcean’s business model, while simple to grasp in the abstract, can become complicated when considering the intricacies of cloud computing infrastructure and the competitive landscape. The large amount of options that customers have in this industry, and its complexities, make the company’s performance harder to predict. It’s not complicated, but not trivial either.

Balance Sheet Health: 4/5 DigitalOcean’s balance sheet is quite healthy, due to its cash-rich position due to recent fundraising, and its conservative levels of debt:

  • Liquidity: The company has plenty of cash and cash equivalents to handle its operational needs and to survive any sort of downturn or market stress, and more if it plans to make more acquisitions.
  • Debt: They have a moderate amount of debt outstanding, which they claim to be actively paying off. With a low debt-to-equity ratio, it does not pose any major risk to the company’s financial health.
  • Working Capital: The company has a working capital that is adequate for its operations, given it’s mostly a recurring revenue model, so the need for a significant amount of inventory or other such assets is low.

The one major concern would be that their earnings are not growing fast enough and they are not yet profitable. They will need to maintain a high rate of revenue growth while also maintaining and increasing their margins in order to improve their balance sheet long-term.