The Tide Is Rising - Time to Grab Your Board

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In this edition, you’ll read an in-depth analysis of a great stock we’ve been watching: 👇

Stock Deep Dive: Digital Ocean (DOCN-US, $2.6B MCAP)

There has been one area of the market that investors have HATED.

Software.

Despite the recent (and ongoing) correction, AI names have still had a gangbuster 1yr period. But not all of the tech space has been the same.

Software has not meaningfully participated in this rally as multiples continue to compress.

We had a period where a lot of investors had left software for dead, thinking that AI was going to kill it.

However, when you start to look at some of the charts and think through just how AI will be distributed, software starts to make a heckuva lot more sense.

This week’s pick, we’re diving into a less sexy software business. One that is growing only moderately, but doing so at a highly profitable rate.

Let’s dig in!

• Why now?👉 Massive Multiple Compression

• Overview 👉 What Does Digital Ocean Do?

• How Do They Win? 👉 Value Proposition

• How Do They Make Money? 👉 Droplets, DBs, Marketplace

• By The Numbers 👉 Key Metrics

• Risks 👉 Potential Pitfalls

Why now?👉 Massive Multiple Compression Overdone

Over the course of the last couple of decades, software has been the primary driver of both productivity enhancement and digitalization, bringing the world online.

The business model is an attractive one - super high gross margin, recurring revenue, near-zero marginal cost for distributing one more subscription, and all with strong balance sheets.

Yes - there are heavy OPEX items like R&D and Sales (especially stock-based comp), but it stands to say that these are stellar business.

We went through this period over 2020 where software stocks were up and to the right. This was due to near-zero interest rates and a global pandemic that brought everything online overnight. Multiples went haywire:

With EV/NTM multiples in the 35x range, it wasn’t uncommon to hear, “well the growth rate is higher than the revenue multiple, so its OK to but.”

How times have changed…

now, we have the high growth cohort trading in the sub 10x range as growth has pulled back significantly and you can’t really discount these companies so far into the future anymore.

However, I think that you have to take a step back from the whole AI killing software scare. In reality, businesses move incredibly slow when adopting new killer technologies, and I think that people are maybe ignoring the possibility that software can be the distributing service for AI.

We’re seeing more and more software companies start to introduce AI SKUs and add to their product offering enhanced capabilities. I think it will take a couple more quarters, but its a largely attractive risk/reward exchange here that could pay off if you get ahead of it.

Digital Ocean is a great company to test the waters again.

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