DigitalOcean May Be a 'Rule of 50' Company Says Analyst

Technology

Published: April 19, 2021 11:00 am

When a startup competes with some of the biggest companies on the planet, that startup had better have an offer that customers cannot refuse. Late last month, DigitalOcean Holdings Inc. (NYSE: DOCN) came public and traded down by about 6% at the end of its first week of trading. As of last Friday, the company’s stock traded almost 6% higher than it did at the end of that first week.

On Monday, nine brokerages initiated coverage on DigitalOcean, and seven rated the stock the equivalent of Buy, while two have it as a Hold. The median 12-month price target is $79.50, and the average is $58.55. The low target is $50 and the high is $101. The stock opened at $45.50 Monday morning. The stock’s IPO price was $47.00.

Canaccord Genuity analyst David Hynes Jr. is bullish on the stock, giving it a Buy rating and a price target of $55. Yet, it is over the longer term that Hynes is optimistic:

We think there’s a path for DigitalOcean to drive mid-20% growth today towards 30%+ over the next few years. When you combine that with a 5-year plan that could see [free cash flow] FCF margins approach 20%, it’s possible to think that this could be a “Rule of 50” business over time.

A Rule of 50 company is one that posts annual revenue growth plus EBITDA equal to or greater than 50% of total revenue. Such companies are few and far between and are almost always fast-growing, newly public firms that have good technology and a “price-disruptive model.”

DigitalOcean meets those requirements, says Hynes. Add to that a solid management team and a total available market in 2020 of $44 billion, rising to $116 billion by 2024, and the pieces are in place for long-term success.

In the near term, the cloud-based computing platform’s current ratio of enterprise value to revenue of about 10 times for 2022 “should be sustainable” and “we roll it forward to out year estimates over the next year or so, there’s every reason to think that DOCN should advance more or less on pace with growth, which will make this a rewarding investment.” Hynes believes that justifies the rating and $55 12-month price target.

Now, about that competition. The leading cloud-based platform providers are Amazon Web Services, Microsoft’s Azure and Google’s Google Cloud Platform. Although Digital Ocean is priced 20% to 35% lower than these giants, by itself that’s no guarantee of success. As Canaccord Genuity points out, there’s nothing to stop Amazon from kicking out an AWS Lite that would appeal to the small and medium-size businesses targeted by Digital Ocean.

In the same vein, DigitalOcean’s customers could, at some point, outgrow the company’s services and move up to one of the bigger cloud platforms. Hynes admits that this is a risk, but that multi-sourced cloud environments are becoming the norm and that means “there’s less risk of high-end customers completely attriting off of DigitalOcean, but more likely it’s possible that, at a certain scale, incremental workloads will be pushed to larger providers.”

Other Digital Ocean advantages are low costs that also deliver “a super-set of functionality and/or service” that’s easy to use and come with responsive support services.

BofA Securities also initiated coverage of DigitalOcean Monday morning, setting a price target of $50 along with a Buy rating. Analyst Wamsi Mohan cited a 2020 total available market of $47 billion (slightly more than Canaccord Genuity’s); a “predictable and consistent” annual return of around 25%; a competitive product with a proven ability to boost per-user revenue over time; internal growth initiatives; expected profitability in 2021; a diversified customer base; and potential for capital spending efficiencies.

Other firms initiating coverage Monday were as follows: