Hi everyone
First time posting here after a couple months learning and observing your methodology and absolutely fascinated by the “crowdsourcing thinking” approach - thanks everyone for sharing with beginners like myself!
I was planning to make my maiden appearance with a refreshed discussion of DOCN (Digital Ocean) given it has recently posted a meaningful acceleration and is nearing the “Saul threshold”, however in the last 24h there has been a meaningful corporate development around their capital structure so I will do that in my next post and sharing this instead
Onto the news: DigitalOcean Announces Pricing of Upsized $1.3 Billion Convertible Senior Notes Offering (https://investors.digitalocean.com/news/news-details/2021/Di…)
Highlights:
- Priced convertible notes with $1.3bn principal amount with a 0% interest rate, with a facility for the lenders to lend a further $200m within 13 days
- The notes are senior unsecured obligation bearing no interest
- The notes will be convertible from July 1st, 2026 at a conversion rate of 5.6016 shares of common stock per $1,000 of principal amount, representing a conversion price of 178.51$ per share, representing a premium of 50% over yesterday’s closing price of 119.01$
- DOCN will be able to redeem the notes earlier than maturity ONLY AFTER December 2nd 2024 ONLY IF the last reported sale price exceeds 130% OF THE CONVERSION PRICE for a specified period of time
- Net proceeds for DOCN will be $1.27bn (or $1.46bn with the extra allocation within 13 days)
- DOCN expects to use $350m to repurchase stock CONCURRENTLY to the offering of the notes
- This should leave it around ~$1bn of cash on its balance sheet to fund capex, organic expansion and M&A+, which is on top of the existing $0.6bn it had as of September 30th
Besides relaying the news, I thought it would be interesting to get intelligent thoughts on the implications of this announcement on the health of the UNLERYING BUSINESS, as I know the focus of this board is not on speculating tomorrow’s share price movements but the long term prospects of the businesses we own
I hope we can get a discussion going that is AGNOSTIC of DOCN’s core business, of which I appreciate not everyone will be familiar with, as the question I am asking myself is the following:
“If I know nothing about the business (this could be a biotech developing cures with molecules I have never heard of as far as I am concerned), what is an announcement like the above telling me about the confidence in the prospects of the business of a) management’s and b) institutional debt investors who purchased the notes?”
I will volunteer some of my thoughts below but curios to hear people’s angles on this:
- At adjusted EBITDA of $36.4m in 21Q3, annualised run rate EBITDA sits at $145m; prior to this issuance the business had no debt, so this implies a ~8.5x leverage or, on an LTM EBITDA basis, 10.3x. The latest QoQ EBITDA uplift was 16%, so assuming that stays constant in the NTM it would imply NTM Adj EBITDA of ~211m and leverage of 6x. Definitely not trivial leverage ratios although of course IF growth remains at levels currently seen, or even better accelerates, we should be seeing a pretty fast deleveraging, which bodes well for the underlying business
- The debt investors are collecting 0% interest rate and their claim is unsecured, so clearly they will be making their return stems from three scenarios:
- EITHER they expect to be paid back at par IF the share price does not appreciate past the conversion price, but that seems a very dumb bet at a time in which inflation is on the cusp of triggering rates increases AND you could take shelter in much safer government bonds, so I will assume this scenario is unlikely
- OR, they expect to become owners in the business IF, at maturity in 2026, DOCN is unable to put up the £1.3/1.5bn in cash to buy them out AND the share price has not appreciated past the conversion price making it desirable for the investors to tender their debt for the underlying stock
- OR, and to me this is the only reasonable option, they expect to convert their debt at a 50% premium to yesterday’s price, at a time in which the share price will be MEANINGFULLY higher, and thus they will profit from the spread, almost like having bought a LEAP call option dated 2026 with a strike price of 178$. Clearly this is a bullish signal in the health of the underlying business in my view. An interesting question then is what share price do these investors expect to see in 2026 that would tell us on quite HOW BULLISH they really are, and to attempt an answer there I’ll come to my third and final observation
- The early redemption facility allowing DOCN to buy back its debt before maturity in December 2024 is conditional upon the share price “exceeding 130% of the conversion price for a specified period of time”. To make things easier consider just the previous close on December 1st, although it’s probably more likely the average volume weighted price of the last 60 days or something. 130% of the conversion price of 178.51$ would imply an early conversion price of 410.6$, which is 3.5x higher than yesterday’s closing price and sets a lower bound for the return these investors are expecting to make. We could get in the weeds of what we would have to believe about the growth rates of the business to justify such a share price, but I will wait for my larger DOCN discussion post to do so. For now I will just observe that again this a massive sign of confidence in the ability of the business to get there, as these lender have handed to management TODAY $1.3bn in exchange for a minimum return of 50% over the next 5 years (simplifying), but realistically expect to make something closer to 3.5x their money: management agreed to this early repayment clause, which means they expect it to be in the interest of shareholders to repurchase said debt in 2024 at this conversion price instead of waiting until 2026 for even further dilution, so unless I am missing something from the picture I would interepret this as akin to the CEO saying "by December 2024 I expect it to be advantageous to pay 410$ a share to buy back this debt instead of waiting until 2026 and then have to issue stock for 178$ each when the share price will be MUCH higher and thus dilute more than I would in December 2024.
- One last consideration, courtesy of an interesting August report from Citron that I found to be great reading (https://citronresearch.com/wp-content/uploads/2021/08/Digita…, page 10 of 14), is to look at the MIP, management incentive plan, to understand what performance management believes realistic to get a shot for them at a massive upside. Based on 5 tranches for a total of 3m shares, the highest band matures when the average share price over the last 90 days reaches 280.5$ (earlier tranches mature at 93.5$ [already secured], 140$, 187$ and 233.5$) and subsequently mature over a 7-year period from the date of grant which was July 27, 2021. The CEO is no newbie to SaaS having previously been COO/CFO at Sendgrid before it was acquired by Twilio, so he must be pretty confident in his ability to execute on this plan and secure his $85m incentive plan
These are, however, just my personal speculations, so I am curios what other members of the board think or what their reaction might be. I suppose we do not see everyday high growth SaaS companies issuing convertible debt, so it will hopefully make for a learning opportunity, certainly for me
YComp,
Long DOCN ~18%