A very analog ocean

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Do it again

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

DOCN Chart

DOCN Chart (TradingView)

digital ocean is a low-cost cloud hosting provider. You can use it as a place to put your chat videos if you want, but for the most part its appeal is for technical users as a host for apps that are in development or ones that have been developed but can only be deployed at the departmental level. 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 are its financial fundamentals. We’ll take a look. Here are the last two years.

DOCN Financials

DOCN Financials (Company SEC Filings, Cestrian Analysis)

The data is a bit patchy in 2020 as it is a new IPO. But we have enough data to see clear trends.

Revenue growth is solid, neither stellar nor lackluster, but solid – it’s over 36% on a year-over-year basis and growth has been consistent over the past four quarters.

Gross margins are pretty good for a hosting business (which has a lot of earning to do) and they increase rapidly as the business grows – a good sign for the strength of the business model. 62% on a TTM basis and trending up.

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

Cash flow is a reality, and at DOCN it’s remarkably good. Not in absolute numbers ($27 million in unleveraged pretax cash flow over the past year – barely enough to fill your F-350 as of this writing), not in margins (6 % UFCF TTM markups by itself are … meh) but in the following way – they might sound boring for civilians but for rabbit hole people like us, well, here’s what the excitement looks like in a young company:

  • Capital expenditures as a percentage of revenue are falling nicely from 33% for the year to March 31, 2021 to 24% for the year to March 31, 2022. What does this mean? This means that the company is increasing its revenue faster than its capital base, which means that its return on capital is increasing, which means that all things being equal, it should increase over time.
  • The evolution of working capital is modest – in the year to March 31, 2022, the company has paid only 2% of its income into the hopper called “working capital”, which is a hopper used to contain and disguise all manner of villains in mismanaged businesses. What this tells you is that this management team is focused on getting paid by their customers at more or less the same rate they pay their suppliers. And from such a small company that’s great to see – there are many others with much more scale that are much worse at this – Cloudflare (NET) is the main offender that comes to mind . Again, this bodes well for the future as the business evolves.

The record is barely Fort Knox but it’s not Mt Gox either. $91 million in net cash, but mostly $1.5 billion in gross cash and marketable securities. Should keep the wolf away from the door for a while.

Fundamental valuation isn’t too difficult after the tech sinking of the last few months, at least on an EV/income basis. It’s probably best not to think about cash multiples for a while!

DOCN valuation

DOCN valuation (Company SEC Filings, Cestrian Analysis, YCharts.com)

And then there’s this painting.

If you missed DOCN on the way up? Here is your redo. Young stocks like this can be volatile and there is no tradable model in our view, but as a long-term buy and hold, with a plan to simply take advantage of the benefits the fundamentals should give the share price ? This is a stock that we would be happy to accumulate in this period of weakness, and this is what we are doing in the personal accounts of the staff.

We price the stock, accordingly, to “Accumulate”, i.e., buy in stages on red days, and once you reach your target allocation, sit back and let the immutable laws of fundamentals take their course. work. We think this can be a winning strategy here.

Cestrian Capital Research, Inc – May 20, 2022.

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