DigitalOcean: Underperforming In A Competitive Landscape
Summary
- The public cloud market has an incredible supply glut. DigitalOcean is lucky to have breached a $1 billion valuation but profitability going forward is highly questionable.
- IaaS companies have high switching costs versus other public cloud companies, but this does not imply that DigitalOcean has a moat. Only time can tell.
- The company is underperforming or merely good in key metrics, suggesting that, in the least, the company is not exceptional.
- It will be very hard for the company to maintain a high valuation.
DigitalOcean (NYSE:DOCN), the cloud infrastructure provider to developers, startups, and small-and-medium-sized businesses ("SMBs") filed its S-1 registration form to go public. The filing shows a $100 million placeholder number, which the company will update when it announces its IPO price range target.
The company earned $203.1 million in revenue in 2018, $254.8 million in 2019 and $318.4 million in 2020. By its own calculations, it finished 2020 with an annual run rate ("ARR") of $357 million. DigitalOcean grew its revenues by a compound annual growth rate ("CAGR") of 16.16% between 2018, when it earned over $203 million in revenue and 2020, when it earned more than $318 million in revenue. In that period, it steadily reduced its operating losses, from $27,29 million in 2018, to $29,9 million in 2019 and $15,79 million in 2020. Net losses, on the other hand, have modestly grown, driven by interest expenses and net other expenses: nearly $36 million in 2018, $40,39 million in 2019 and $43,568 million in 2020.
The New York-based cloud company, amidst layoffs in early-2020, was able to conclude a $100 million debt raise, which it followed up in May with $50 million in Series C funding at a $1.15 billion valuation that prior backers Access Industries and Andreessen Horowitz participated in. According to Crunchbase, the company, founded in 2011, has raised a total of $455.6 million throughout its funding rounds. The company envisages a market opportunity worth $116 billion by 2024.
DigitalOcean has a net dollar retention rate of 103%, up from 100% in 2019. The biggest risk that a cloud software company faces, especially during periods of economic difficulty, is downgrades and churn. The most important thing is the preservation of relationships and this is reflected in net dollar retention. The hurdle rate that separates the good from the rest of the pack, is 100% to 106%. The truly exceptional companies post net retention rates of 120% and above. DigitalOcean is merely good. This is the single most important metric in evaluating cloud companies, but it does tend to decay with time.
A Supply-Side Glut, But DigitalOcean Will Survive
Asset growth effects tell us that a rise in capital expenditure reduces expected returns. In other words, phenomena such as intense competition and the costs and expenses that arise as a result of that competition, have negative consequences for future returns. As you will see below, the public cloud market fits this description, with consequences for DigitalOcean’s ability to become profitable and defend that profitability.
The competitive landscape is vicious. Firstly, venture capitalists have pushed hard for exits in cloud companies, sensing perhaps that the unique conditions we are living in would provide them with historic opportunities to make outsized gains. Secondly, the transformation of the economic landscape over the last two decades has resulted in exponential growth in the public cloud industry. As it is much faster than it has ever been to set-up a cloud company, given the emergence of easily deployable infrastructure like Amazon Web Services ("AWS") (AMZN) and easy-to-use website builders, there is now a glut in supply. To this point, 2020 witnessed a record number of private cloud unicorns in 2020, as the chart below from Bessemer Venture Partners shows:
There are 140 public and private cloud companies with valuations of over $1 billion each, and over 57,000 companies in total in the public cloud space. Such is the intensity of competition that, there is only a 0.245% chance of making it to a $1 billion valuation. DigitalOcean has done well to get over that hurdle, but as the shift to cloud accelerates, there will be fewer new customers to convert. The supply of customers is limited and will grow in value as the shift to cloud accelerates, which will push up CAS.
Supply-side growth has resulted in a more expectant and demanding customer. Cloud companies are constantly pressed to improve their already historically superlative quality, and increase the number of available features, such as integrations. Many of these features were once enough to earn a company thousands of dollars in revenue, but are now merely bare minimum functionality. The benefits of supply-side growth to consumers are obvious, but these benefits come at the cost of the ability of cloud companies to defend their profitability in the long-term, or, in most instances, to even earn a profit. Switching costs have plummeted and average customer acquisition costs ("CAC") have risen. Not only does the typical cloud firm face a rising CAC, but customers are also increasingly dissatisfied with products. The average net promoter score ("NPS") has fallen by a third in the last five years. At 65, DigitalOcean’s NPS is very good, within a competitive industry where 55 to 60 is considered the threshold for excellence.
Because DigitalOcean is an IaaS company, its switching costs are high. Switching from an IaaS provider is a different kettle of fish to switching from a SaaS provider. An analogy is that you can have a hundred apps on your phone but it is very hard to have 100 phones. Yet, even as an IaaS provider, the only real way to know a company has a moat is with time. It may be hard to have 100 phones but that did not mean that BlackBerry would survive as a mobile phone provider. In an industry as young as this, it is very hard to know just how wide a moat is. With its ARR of $357 million, a good net dollar retention rate and an excellent-for-its-industry NPS, DigitalOcean does have the ingredients to survive in this fierce market. At $116 billion by 2024, the company is operating in a market whose suppliers are providing non-negotiable necessities and this is reflected in revenue growth throughout the pandemic.
Conclusion
A back-of-the-envelope estimate for what DigitalOcean is worth, would be 10 times the ARR of $357 million, or $3.57 billion, multiplied by the trailing twelve months growth rate (roughly 25%), which gives us just over $890 million. This is a very conservative measure that sidesteps the issue of profitability. Another way to address valuation would be to look at public markets. DigitalOcean has a gross margin of 56.2%, in an industry where the median gross margin is 74%. At 25%, its revenue growth rate is also below the median growth rate of 29.5%. By all key metrics, it is underperforming cloud companies valued at over $1 billion in the public markets. It will be interesting to see just how aggressively the company prices its IPO. Given the appetite for tech stocks, the company is likely to do well initially, but sustaining high valuations will be very difficult.
This article was written by
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Comments (4)
Not really. Cloud computing is filled with mega-class players.