AI And ML Acceleration Promise Bright Future Despite Analysts’ Mixed Forecasts

Key Takeaways

• DigitalOcean's emphasis on AI and machine learning, along with a new data center, signals strong future revenue growth and improved cost efficiency.
  
• Initiatives like recruiting key leaders and launching new products highlight the company's focus on innovation, customer expansion, and retention.
  
• Over-reliance on AI and ML for growth, alongside investments in new data centers and GPU access, could stress finances if market expectations aren't met.

Catalysts

Through its subsidiaries, operates a cloud computing platform in North America, Europe, Asia, and internationally.

• DigitalOcean's focus on AI and machine learning product acceleration, with a 200% year-over-year growth in ARR from these products, signals a strong growth catalyst expected to significantly impact future revenue.
  
• The opening of a state-of-the-art data center in Atlanta is aimed at supporting AI strategy and growth, indicating a future decrease in operating costs and an improvement in gross margin profiles over time.
  
• The recruitment of three critical executive leaders with strong backgrounds is set to enhance the company's product strategy, ecosystem growth, and direct and partner sales, potentially accelerating revenue growth and improving net dollar retention.
  
• The launch of new product features, including GPU droplets and Managed OpenSearch, demonstrates DigitalOcean's commitment to product innovation and velocity, likely to drive expansion within its customer base and positively impact future revenue and earnings.
  
• Strengthening customer success efforts and focusing on higher-value builders and scalers portray a strategic move towards improving net dollar retention rate, which can lead to increased ARPU and contribute positively to overall revenue growth.

Assumptions

• Analysts are assuming DigitalOcean Holdings's revenue will grow by 14.1% annually over the next 3 years.
• Analysts assume that profit margins will increase from 9.3% today to 12.3% in 3 years time.
• Analysts expect earnings to reach $134.4 million (and earnings per share of $1.19) by about September 2027, up from $68.4 million today. However, there is some disagreement amongst the analysts with the more bearish ones expecting earnings as low as $112.3 million.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 36.1x on those 2027 earnings, down from 49.0x today. This future PE is greater than the current PE for the US IT industry at 35.4x.
• Analysts expect the number of shares outstanding to grow by 3.62% per year for the next 3 years.
• To value all of this in today's dollars, we will use a discount rate of 8.11%, as per the Simply Wall St company report.

Risks

• The flat net dollar retention rate (NDR) of 97% indicates that expansion within the existing customer base is not growing, potentially hampering future revenue growth.
  
• Heavy reliance on AI and ML product growth, with over 200% year-over-year increase, suggests a significant bet on a singular growth avenue which could risk revenues if AI market adoption slows or changes unexpectedly.
  
• Opening a new data center to support AI strategy growth involves considerable upfront costs and long-term financial commitments, which could impact net margins if demand doesn't meet expectations.
  
• The strategic focus on fractional GPU access as a key differentiator in a highly competitive field with well-funded competitors might strain profit margins due to capex requirements and potential price wars.
  
• Despite efforts to improve, the challenge in increasing the pace of improvement in net dollar retention due to a challenging macro environment might limit the ability to boost revenues from existing customers.

Valuation

• The analysts have a consensus price target of $37.64 for DigitalOcean Holdings based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $47.0, and the most bearish reporting a price target of just $25.0.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be $1.1 billion, earnings will come to $134.4 million, and it would be trading on a PE ratio of 36.1x, assuming you use a discount rate of 8.1%.
• Given the current share price of $36.4, the analyst's price target of $37.64 is 3.3% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.