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3 Risks to Keep in Mind Before Buying DigitalOcean

DigitalOcean (NYSE: DOCN) has seen a fast run-up recently, taking the spotlight as a challenger to cloud behemoths like Amazon Web Services, Microsoft's Azure, and Alphabet's Google Cloud. While the cloud infrastructure provider is seeing strong adoption and growth in its business, investors should carefully think about the risks associated with the company before investing.

1. Fierce competition

DigitalOcean faces competition from numerous cloud providers, both small and large. AWS, for example, has an offering specifically for small and medium-sized businesses. While it may not offer the price transparency or simplicity of DigitalOcean's platform, underestimating Amazon could be a detrimental mistake. Other cloud behemoths like Microsoft's Azure have similar offerings.

Image source: Getty Images.

DigitalOcean also faces competition from start-ups focusing on the small to medium-sized business (SMB) space, including Vultr, which has offerings similar to DigitalOcean's Droplets. Like Droplets, Vultr's products have been made simple and its pricing is transparent.

While Vultr is a private company and revenue is not known, some estimates put its annual revenue between $5 million and $7 million, which is much lower than DigitalOcean's 2020 annual revenue of $318 million. There are other private competitors like Linode, with annual revenue near $100 million, but many of the smaller competitors in the SMB space are nowhere near the size of DigitalOcean.

This gives DigitalOcean a scale advantage right now, but investors should be aware that this might not always be the case. Additionally, bigger competitors like AWS have a greater scale advantage.

2. Low insider ownership

Any investors who pay attention to insider ownership (how much stock executives and directors own of the business) might want to look away right now. After DigitalOcean's IPO, its CEO Yancey Spruill owns just 1.4% of shares outstanding, and two Venture Capital companies, Access Industries and Andreessen Horowitz, own 37% of shares outstanding.

With this level of ownership, Yancey has very little skin in the game -- or incentive to see the stock price go up -- while venture capitalists have a large amount of voting power. Insider ownership aligns management's success with shareholders' success, which is why it can be important to investors.

With most VCs having a shorter-term mindset, they could be looking for a quick buyout, which could end long-term investors' journey with DigitalOcean earlier than expected. VCs are also less likely to let managers take big, boom-or-bust bets, so they could be less likely to vote in favor of innovation because of the risk it may carry.

3. SMB customers are slow to buy in

Compared to enterprises, SMBs are slower to adopt and buy more products because of their lower budgets and higher price sensitivity, so DigitalOcean's customer retention is lower than that of other cloud companies, potentially resulting in slower growth. In the second quarter of 2021, DigitalOcean's net revenue retention rate -- which is the average revenue per user factoring in customer churn -- was 113%. This means that customers from this year spent 13% more than they did in the second quarter last year. Compared to other cloud companies, like Snowflake -- a cloud-based data storage company that mainly serves enterprises -- that retention rate is quite low. Snowflake has a net revenue retention rate for the second quarter of 169%

Net revenue retention does not determine the success or failure of a business, but if customers are rapidly adopting multiple products and spending more with a company, it can be easier for it to grow. In DigitalOcean's case, its target customer base is very price sensitive and slow to spend more with the company, so growth could potentially be slightly lower than if DigitalOcean were to serve larger customers.

None of these risks mean that DigitalOcean will fail, but they should be considered when looking at the company as a potential investment. With DigitalOcean increasing almost 100% since its IPO, investors can feel like they are missing out and end up following the crowd without fully considering the risks. There is tremendous potential for the business to grow, but understanding its risks is equally important to knowing why it stands out.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Jamie Louko owns shares of Amazon and Snowflake Inc. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Digitalocean Holdings, Inc., Microsoft, and Snowflake Inc. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool has a disclosure policy.


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