Good Morning!

After a few months off, I could not be more pumped to be back writing to the 5,000+ Crossover subscribers.

I am also excited to share that I have accepted a full-time position with Volition Capital as a Content Associate. I am grateful to Volition for this opprotunity, and I cannot wait to continue working with the team.

With my job at Volition being my #1 priority, The Crossover will likely look a little different moving forward. I am currently aiming to publish every other week and will be sure to keep you all updated as I figure things out.

Also, during this time away, I decided to add a new section — The Sports Section! Let me know what you think.

Three quick housekeeping announcements/reminders before we get started:

1. All opinions in The Crossover are 100% my own.

2. No Artificial Intelligence/ChatGPT is used in writing The Crossover. (Who needs AI when you have AL!)

3. The Crossover is not investment advice and is for education and entertainment purposes solely.

Showtime!

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DEEP DIVE

Digital Ocean: A Fundamental First Investment

Introduction

“Losing feels worse than winning feels good.”

-Vin Scully

As we all know, the past 2-3 years in the markets have been insane. First, we were making more money than we could imagine with companies trading at 10,000x sales. Then, Mr. Powell got to work and the realities of a closer to normal interest rate environment started to settle in.

As many things started to break, it became clear that the companies you owned and at what valuations really started to matter. If you found yourself in stocks that did not have the fundamentals to back up the valuation, you likely felt some pretty serious pain.

What became clear to me throughout this process was that losing hurts more in the market than winning feels good. Like a lot worse.

After living through this firsthand and investing money I worked hard for, the Klarman principles of “not thinking about how much you can make, but rather, how much you can’t lose,” started making a whole lot more sense.

Therefore, over the past few months, I have been asking myself some tough questions about my investment philosophies in the public markets. Specifically asking, “How can you set yourself up for serious alpha potential while also protecting your downside risk?”

Here are some of the key principles I have settled in on when evaluating companies during my due diligence process:

1. Generating & growing Free Cash Flow

2. Trading at a fair valuation

3. Emphasis on returning capital to shareholders

4. Operating in a rapidly growing sector

5. Experienced, trustworthy management

6. Generating & growing Free Cash Flow ( 😉 )

These concepts and principles are not rocket science. If anything, just the opposite.

However, the older I get and the more mature my investing style becomes, the simple brilliance of a Buffett-esque approach becomes more obvious.

Most of the principles from above do not need an explanation, but I wanted to touch on the one I mentioned twice: Generating Free Cash Flow.

There is real power in being FCF generating including:

• Allowing companies to be active in M&A through growing cash balance (and without dilution)

• In earlier stage companies, likely implies a strong profitability profile of the business and/or level of management competency and discipline.

• Enables companies to return capital to shareholders/ cancel out stock-based-compensation dilution

Additionally, building off of the last point, returning capital to shareholders can serve as a catalyst/floor to the stock price as well.

Simply put — Free Cash Flow is very very good and the name of the game.

The first two companies I have put this criteria to work with were Digital Ocean and Splunk.

On December 16, 2022, I wrote about Splunk, highlighting the growing FCF, strong management, and a possible private equity take out opportunity. In the more than six months since, the stock is up ~30%.

Since we have already taken a look at Splunk, I wanted to introduce Digital Ocean and look how I put this criteria to work.

Final note before we go swimming in the Digital Ocean:

I am not married to these principles. Sometimes, burning cash to invest and attack the opportunity in front of you is not only warranted, but preferred (within reason of course). A great example of this is $TOST, a company I have been a big believer in for a while now that is up ~60% since we wrote about it in July ‘22. I am also a sucker for a good value stock/special situation like Paramount which is most definitely not FCF positive. Paramount has not worked out so far, but I continue to be a big believer in the underlying value of the assets and that it will eventually be realized.

Digital Ocean

Digital Ocean describes themselves as “a leading cloud computing platform offering on-demand infrastructure and platform tools for developers, start-ups and small and medium-sized businesses (SMBs).”

While enterprises were flocking to AWS, Microsoft Azure, and Google Cloud, there was an opportunity to serve SMBs with simple cloud services, and $DOCN filled this opportunity with authority.

At the time of their S1, the company had:

• 580K customers in 185 countries

• ARR of $357M

• 30% adj. EBITDA margin

• 65% International Revenue

• ARPU of $47.78

Digital Ocean IPOd in March 2021 at $47 a share and $5B market cap. Due to the massive TAM, strong margins, global appeal, and the great work of Ophir Gottlieb of CMLviz, this company has been on my radar since day one.

With many of my stocks, I also love when there is a component to the business that can easily be overlooked or misunderstood — think PlutoTV with $PARA or Toptracer technology with $MODG.

Digital Ocean definitely checks this box with their “broad-based community ecosystem.” $DOCN has over 5 million unique monthly visitors to their websites accessing their 6,000+ library of technical tutorials and 28,000 community generated questions and answers.

This area of the business has continued to demonstrate significant growth and is considered a destination for developers industry wide.

To learn more about $DOCN’s market opportunity and technology, make sure to check out pages 1-7 of their S1 here.

Our Journey

The Crossover Portfolio added two positions of $DOCN at $26.75 & $27.81 on November 23rd and 25th respectively, around 2 weeks after their Q3 ‘22 earnings date.

What were their Q3 earnings, and what was I looking at when I made these moves?

• Revenue was $152.1M, representing 33% growth excluding an acquisition (more on this later)

• ARR of $640.6M representing 41% YoY growth

• FCF of $22.4M compared to $13.5M in Q3 ‘21

• ARPU of $79.22, 28% YoY growth

The company also shared their guidance for FY ‘22 which called for ~$575M in revenue and ~10% FCF of revenue.

Therefore, the company was trading at less than 4x ARR, ~4x revenue, and FCF multiple of ~60x.

Less than 4x ARR and ~4x revenue, I thought, was a slam dunk for a company growing at the speed that they were in such a massive, rapidly growing TAM.

A 60x FCF multiple did not scare me away at all. Why? Because even if they were FCF negative, the ARR multiple would be reasonable.

There were also two other points to me that really stood out to me:

1. Cloudways Acquisition

In August ‘22, Digital Ocean acquired Cloudways, a leading cloud hosting SaaS provider for SMBs. While Digital Ocean provides self-managed cloud services, Cloudways allows SMBs to outsource these processes. Simply put, Digital Ocean + Cloudways creates the destination for SMBs regardless if they want self-managed or outsourced management.

Cloudways, in its own right, was a great company doing $52M in revenue at a 50% 3 year CAGR. Digital Ocean shared that at the time of acquisition, Cloudways would be revenue growth rate accretive and cash flow margin neutral. Specifically, the profitability component really mattered to me and was a good sign.

At an acquisition price of $350M in cash, Digital Ocean was able to do the acquisition through existing cash balances and future cash flows (they have 30 months to pay them the amount). In other words, without diluting shareholders.

An acquisition like this felt like a 1+1 = 3 and gave the company true SMB cloud platform potential.

2. Emphasis on Profitability

On the Q3 earnings call, Digital Ocean CEO Yancey Spruill shared some commentary that was music to my ears. Here is what he had to say:

“Our second goal is to dramatically improve the profitability cash flow profile of the business. Those that know me well can confirm that free cash flow has always been an obsession for me, not a revelation made in 2022 when the world started seeing signs of economic turmoil. We saw an opportunity here as capital intensity was too high, operating costs were too disconnected from revenue and the resulting operating and free cash flow margins were significantly negative, which simply was not acceptable.”

I have become pretty FCF obsessed. Hearing a CEO share that “Those that know me well can confirm that free cash flow has always been an obsession for me” is exactly what I want to hear from a company I am invested in.

I might make a T-shirt with this quote on it. I will keep you updated.

Current Thoughts

As of June 9, Digital Ocean is trading at $43.85, or a market cap of $3.89B.

This represents a 60%+ premium to the Crossover Portfolio entry point.

Last month, the company delivered their Q1 Earnings and there was a lot to break down:

• Revenue was $165.1 million, an increase of 30% year-over-year.

• Annual Recurring Revenue (ARR) ended the quarter at $669.1 million, representing 28% year-over-year growth.

• Average Revenue Per Customer (ARPU) was $88.35, an increase of 16% over the first quarter 2022.

• Repurchased 7,759,973 shares for $266 million under the share repurchase program.

I absolutely love the strong revenue growth and ARPU growth, even in a tough macro environment.

Most interestingly, the company did a serious share buyback of over $266M at an average price of $34.27 per share. The company also shared that they had $175M remaining on their buyback program and expect to complete it in 2023.

Management signaled that they continue to expect to buy back stock aggressively, looking to decrease share count by 15-20% even after taking into account SBC dilution (which some of the buybacks cancel out) and the conversion of some of their outstanding convertible debt.

This is a serious return of capital to shareholders, and it is great. At the same time, it is interesting that this is their course of action at this size/early stage of a company. Is there a chance that the buyback program is too aggressive? Should they be more focused on investing in the platform?

Additionally, the company shared that they are projecting $710-$720M in revenue for this year and a 20-21% FCF margin. This would mean at a market cap of $3.9B, the company is trading at 5.5x sales and a forward FCF multiple of 28x.

At a quick glance, what is not to like?

What is cause for concern is that management has signaled that there are headwinds hitting the business.

“These headwinds have resulted in modest net expansion from our customer cohorts as their businesses have seen their own growth deceleration. And they have continued to focus on managing their spend in the midst of the ongoing economic uncertainty. While it is unclear how long these macroeconomic headwinds will persist, we remain committed to achieving our financial targets this year. Matt will provide more detail on our Q1 results and Q2 and full year outlook later on the call.”

So, when the next paycheck hits, will I be picking up more Digital Ocean?

I don’t know.

I need to see where the company is sitting and what the other relative opportunities are in the market. I also don’t love picking up stocks that have just gone on a big run.

Additionally, I want to spend more time looking into how SMBs are holding up and the impact that this will have on cloud spend.

What do I know for sure? I am not selling what I do own.

Digital Ocean is a winner, and you need to let your winners ride — especially at this valuation.

I think one lesson that the $DOCN story to date has shown me is that whether it is share buybacks or strategic acquisitions, investing in an FCF generating entity at a fair valuation is a recipe for success.

At the same time, the quality of an investment is not decided in 3-6 months, but rather 3-6 years, so, I am excited to see how the thesis continues to unfold.

I look forward to keeping you updated on my thoughts on $DOCN, as time goes on. Is this another company benefiting from a tech bounce back in 1H ‘23 or have our criteria helped us find a true, differentiated winner that will help us achieve meaningful alpha?

We shall see.

-Alan

Media Minute

The Inevitable Return of the Bundle

There is no way around the fact that the transition to streaming has cost legacy media companies tens of billions of dollars. The strategies they implemented and the way they attacked the opportunity will make great Harvard Business Review case studies and be analyzed for many years to come.

Right now, streaming is a significantly worse business than the cable business model which some call “the greatest business model of all-time.” However, I think it is unwise to think that legacy media companies will not find a way to replicate these profits down the road and create strong business models.

Whether it is through yearly subscriptions, ad-supported tiers, raising prices, rightsizing content spend, benefits of consolidation/scale, or distribution partnerships, there are many levers to pull.

In the words of my roommate, “there are a lot of smart people at these companies, and I am sure they will figure it out.” Netflix’s execution this past year of ad-supported tier and password sharing crackdown is a great example of the smart people figuring it out.

One of my favorite follows on Twitter shared an idea of how to stop the churn and return the industry to profits by re-creating the bundle:

Brilliant, logical, and an approach that I would think consumers would appreciate too.

A $39.99 bundle would be right around the cost of the current AVOD subscriptions and with this bundle, the media companies can easily raise prices by a few bucks a year.

Fast forward to 2035, and we are paying $125 a month again for our TV! What was old is new!

Also, I would leave premium/ad-free tiers out of this bundle as it would enable the companies to be more conservative/aggressive as they wish.

Interestingly, someone much smarter than that guy on Twitter from above previously shared a similar sentiment. That man was $WBD CEO David Zaslav.

Here is what he had to say:

“There should be a consolidation, but it is more likely to happen in the repackaging and marketing of products together…. “If we don’t do it to ourselves, I think it will be done to us. It will be Amazon who does it, or Apple who does it, or Roku who does it. They’ve already started. ”

Zaslav owns some of the greatest, most valuable assets in this space. His words matter and he has the ability to easily create a bundle with one of the other serious players in Hollywood. I would not be surprised if we see bundles sooner rather than later, with $WBD leading the way.

What I do know for sure? Watching everything play out in the Streaming Wars is far more entertaining to me than anything that Hollywood could produce!

CHARTS OF THE WEEK

1. US Factory Construction Skyrockets

2. “No One Knows Anything”

3. Streaming Share Time Update

Sports Section

The Power of Continuity

While watching the NBA Finals a couple weeks back, something jumped out at me (outside of the fact that I play like a very very very poor man’s Jokic).

What stood out to me? Continuity.

Denver Nuggets Head Coach Mike Malone has been the Head Coach (HC) of the Nuggets since 2015. Miami Heat Head Coach Erik Spoelstra has been HC since 2008.

While Malone and the Nuggets have been strong performers in the regular season, they consistently fell short of expectations before this year. Specifically, last year, they lost in the first round of the playoffs.

Similarly, in Miami, after the Big 3 era slowly collapsed, the Heat found themselves as a .500 ball club for years (outside of a Finals appearance in “The Bubble.”)

Interestingly, both organizations have stood by their head coaches through the ups and downs, and it is noteworthy that these were the last two teams standing.

The approach that the Heat and Nuggets have taken of sticking with their coaches, is a stark contrast to the NBA at large.

Whether it is the Sixers moving on from Doc Rivers, Raptors moving on from Nick Nurse, Suns moving on from Monty Williams, or Bucks moving on from Budenholzer, NBA teams are parting ways from phenomenal coaches. Each coach I named above either is an NBA Champion or Coach of the Year or both.

Also, it is not like there are a bunch of elite coaches sitting around to replace the accomplished bunch mentioned above. Oftentimes, either a young unproven NBA assistant will get a chance or a game of musical chairs breaks out where a recently fired HC becomes a HC for another team (Nick Nurse replacing Doc Rivers with Philly).

The greatest historical franchises have continuity. It is that simple. Whether it was Popovich and their Big 3 or Belichick and Brady, almost always, the key core was intact for a long period of time.

At one point or another, every great franchise has seen difficult times and disappointments. However, they stick with each other when there is disappointment.

Experiencing the highs and lows with a group of players and fellow assistants can help build trust and connection in an organization. Creating an environment where coaches and players are able to be themselves, take chances, and not walk on eggshells is how greatness can be attained.

I also always think about how making a deep run in the playoffs and then losing can be considered a disappointment. The old championship or bust mentality.

If a ball bounced just a little differently (think Kawhi vs. Sixers in 2019) or a key player didn't get hurt (Tatum Game 7?), maybe just maybe, it would have been your year.

How much of what makes sports so special, the rare, unpredictable events can coaches control? Basically zero.

Unless a coach has totally lost a locker room, I think sticking with them is the right move almost every time. When people ask me if Cavs GM Koby Altman should bring back J.B Bickerstaff, I answer 100% yes. It is clear J.B is a good coach and the locker room responds to him. Just because you fall short with an incredibly young, inexperienced team, does not mean that you are not the guy.

One final idea — the Cleveland Browns have had 12 HCs since 1999. 12. The Steelers have had 3 coaches since 1969. What a contrast.

When you look at the list of Browns HCs since 1999, I think it is clear that several of them could have been successful if given patience and time (or a quarterback!). For my Cleveland readers, Rob Chudzinski and Mike Pettine come to mind. However, we kept on blowing it up every couple of years and starting over from scratch.

Continuity allows for lessons to be learned, habits to be implemented, cultures to be established, and institutional history to be created. With so much turnover, this magic cannot exist.

And without that magic, all you are stuck with is a lot of dysfunction and more generic press conferences than you CAN count – which I could do in my sleep that this point.

-Alan

MEME OF THE DAY

GOLDEN NUGGETS

1. The energy after this Will Benson HR is everything

2. I absolutely cannot wait for Season 2 of Full Swing

3. For the amount of coverage Succession gets, not that many people (relatively) watch it!

Thanks for the read! Let me know what you thought by replying back to this email.

— Alan

Disclaimer: The Crossover is not a professional financial service. All materials released from The Crossover are for educational and entertainment purposes. The Crossover is not a replacement for a professional's opinion. Contributors to the Crossover might have positions in the equities in the The Crossover Portfolio or mentioned in the newsletter.