EQUITY RESEARCH May 2021 7 Monthly Highlights FEATURED ARTICLES: DigitalOcean, Inc. 2 Sixth Street Specialty Lending 4 Coverage Universe (as of 4/30/21) 6 Outperform Rated Stocks 20-21 Perform Rated Stocks 22 Not Rated Stocks 23 Initiation of Coverage 24 Rating Changes 24 For analyst certification and important disclosures, see the Disclosure Appendix. Monthly Highlights Oppenheimer & Co Inc. 85 Broad Street, New York, NY 10004 Tel: 800-221-5588 Fax: 212-667-8229 Monthly Highlights May 3, 2021 CLOUD AND COMMUNICATIONS Stock Rating: DigitalOcean, Inc. Outperform 12-18 mo. Price Target $55.00 Pure-Play Public Cloud Platform for SMBs/Developers, DOCN-NASDAQ (4/30/21) $43.57 Initiated Outperform, $55 PT 11% 3-5 Yr. EPS Gr. Rate NA SUMMARY 52-week Range $45.49-$36.65 DigitalOcean is a very successful niche cloud provider, focused on ease of use for Shares Outstanding 127.0M developers and small businesses that need low-cost and easy-to-use cloud computing. The Float 40.0M Avg. Daily Trading Vol. NA cloud gives SMBs/developers flexibility to run applications and store data in a highly secure Market Capitalization $4,588.1M environment that can be accessed from anywhere. Every industry has scale providers and Dividend/Yield NA/NM niche ones. In cloud, AWS and MSFT are the scale providers with DigitalOcean and Fiscal Year Ends Dec Rackspace the niche providers. We believe that DOCN can grow revenues at 30%-plus per Book Value NM year for the next five years. It is turning FCF positive, and these margins should expand by 2021E ROE NA 100-200 basis points per year. On 4/14/21, we initiated coverage with an Outperform rating LT Debt $242.2M and $55 price target. Preferred $173.0M Common Equity $(72)M KEY POINTS Convertible Available Yes Roadmap for Cloud Growth: The cloud is a once-in-a-century, general purpose Note: Trading range since 3/23/21 IPO technology. It is a $100B market, growing 30% per year, but is only 20% penetrated Rev. today. Cloud is set to drive major global productivity improvements. Much of these ($/mil) Q1 Q2 Q3 Q4 FY Mult improvements will come from capturing data through 5G/IOT, storing it on blockchain, 20 20A 72.8 76.9 81.2 87.5 318.4 NM and then using AI to automate. 2021E 92.4 98.4 103.9 112.9 407.7 NM 2022E -- -- -- -- 530.0 NM DOCN Is Serving High-growth SMB and International. We estimate that SMB is ~20% of the cloud market. Europe makes up 30% of DOCN's revenues, and total international revenues are ~70%. We estimate that international markets are two years behind the US in terms of cloud adoption, and as a result will grow faster—positive for DOCN. SMB Public Cloud Segment Underserved by Hyperscalers: Fortunately for DOCN, AWS and Azure are complex platforms to manage, and both companies are focused on moving upmarket to large enterprise with more services. SMBs do not have resources to manage all the certifications, complex integrations, and billing from AWS or other large cloud providers. Many small businesses simply need an interactive website and self-service model. Creating Unique Cloud Developer Platform: The other niche that DOCN pursues is the small developer. Its platform is easy to use and affordable. DOCN has fostered a community of users that share tools, documentation, and support to create innovative Timothy Horan, CFA Matt Wilson, CFA applications. We are in the early stages of this platform development, but it will benefit 212-667-8137 212-667-6360 SMBs also. [email protected] [email protected] Platforms can develop network effects that can be highly valuable, improving quality Noah Herman and attracting even more participants. We have identified a number of platform 212-667-7119 companies (developer focused) that DOCN can attempt to emulate. These companies [email protected] generally trade in the 20x-plus revenues range. With DOCN at ~10x revenue and growing at 30% per year, we think it is relatively inexpensive and well-positioned. Stock Price Performance DOCN is a pure-play cloud infrastructure provider focused on the SMB market. It also provides developers cloud services to deploy and scale applications. DOCN's global infrastructure is housed in 14 colocation datacenters w orldw ide in eight geographic areas and w ith customers in 185 countries. 2 Monthly Highlights Price Target Calculation Our $55 price target is based on 12.5x our FY2022 revenue estimate of $530M. Cloud and SaaS peers currently trade at 14x 2022 revenue estimates. Our $55 price target is also supported by our DCF, which assumes a 7.0% WACC and 5% long-term growth rate. In year 2027, we estimate 33% Y/Y revenue growth in 2027E and 40% adjusted EBITDA margins, with a terminal value of $9.5B. Key Risks Key risks to our PT are macro slowdown, which could increase SMB churn; increased price competition from new entrants or hyperscale cloud providers ; failure to accelerate revenue growth to 30%-plus; and selling pressures from lockup expiration (post IPO). (For more detail, please see our report “Pure-Play Public Cloud Platform for SMBs/ Developers, Initiate Outperform, $55 PT,” published on 4/14/21) Stock prices of other companies mentioned in this report (as of 4/30/2021): Amazon (AMZN-NASDAQ, $3,467.42, Outperform) Microsoft (MSFT-NASDAQ, $252.18, Outperform) 3 Monthly Highlights May 3, 2021 FINANCIAL INSTITUTIONS/BUSINESS DEVELOPMENT COMPANIES Stock Rating: Sixth Street Specialty Lending Outperform 12-18 mo. Price Target $23.00 Initiated Coverage with Outperform and PT of $23 TSLX-NYSE (4/30/21) $22.28 SUMMARY 11% 3-5 Yr. EPS Gr. Rate 9% Sixth Street is an externally managed BDC that focuses on providing flexible, fully 52-week Range $22.34-$13.05 committed financing solutions to middle-market companies. We are forecasting earnings Shares Outstanding 71,736.0M per share of $1.97 and $2.01 for 2021 and 2022, respectively, which equate to an ROE of Float 68,920.0M 11.5% and 12.3%. We project that Sixth Street can earn a 12% ROE, and given an Avg. Daily Trading Vol. 488,132 estimated cost of equity capital of 8.5%, we calculate a fair value of $23.00/share or 1.45x Market Capitalization $1,603.5M book value. On 4/15/21, given the stock is trading around $22, we initiated coverage with an Dividend/Yield $1.64/7.36% Outperform rating and PT of $23. Fiscal Year Ends Dec Book Value $15.86 KEY POINTS 2021E ROE 12% LT Debt $1,199.0M Preferred NA To maintain its ROE of 12%, TSLX will need to increase leverage to 1-to-1 by growing Common Equity $1,161M the portfolio by $120M. If the economy is strong and loan yields are pressured, Sixth Convertible Available Yes Street could increase leverage even higher if it finds attractive investment opportunities. TSLX has plenty of liquidity. Management estimates it has $1.3B of liquidity with $91M EPS of unfunded commitments and $143M of convertible notes due in 2022. Diluted Q1 Q2 Q3 Q4 FY Mult 2020A (0.80) 1.43 1.21 0.79 2.64 8.4x Conservative leverage. Debt to equity is currently at 0.96 to 1 at year-end, in line with 2021E 0.49 0.49 0.50 0.50 1.97 11.3x TSLX’s target range of 0.9 to 1.25. We have estimated net portfolio growth of $100M in 2022E 0.50 0.50 0.51 0.51 2.01 11.1x 2021 and $20M in 2022 for total growth of $120M. We estimate debt to equity at NII 12/31/22 of 1.0 to 1. TSLX is investment grade by four rating agencies. Diluted Q1 Q2 Q3 Q4 FY Mult 2020A 0.51 0.59 0.61 0.48 2.19 10.2x Differential advantage. TSLX has generated a NII margin of 10.2% since IPO in 2014, 2021E 0.49 0.49 0.50 0.51 1.97 11.3x well above the industry average of 7.4% over the same time frame. From 2014 to 2022E 0.50 0.50 0.51 0.51 2.01 11.1x 2020, the industry NII margin declined 185 bps, likely from competitive pressures. We Historical financials are earnings per share, which includes believe TSLX's strategy of providing customized solutions directly to borrowers has unrealized appreciation and depreciation. Forward estimates are net investment income, which excludes allowed the company to maintain its margin. portfolio marks. Good diversifier. Sixth Street tends to outperform in volatile dislocated markets as it generates high fee income. Most BDCs underperform in these environments, which makes TSLX a good addition to a BDC portfolio. As part of a portfolio, TSLX could lower a portfolio's overall risk. In 2020, during COVID-19, TSLX had its highest EPS of $2.64 for an ROE of over 16%. Mitchel Penn, CFA 212-667-7136 [email protected] Stock Price Performance Sixth Street is an externally managed BDC that focuses on providing flexible, fully-committed financing solutions to middle market companies. The typical borrow er has an enterprise value of $50M to $1B, EBITDA of $10M to $250M, and a loan amount of $15M to $350M. The portfolio is currently comprised of 95.6% first liens. 4 Monthly Highlights Price Target Calculation Our $23 price target is based upon TSLX earning a 12% return on equity with a n 8.5% cost of equity capital. Key Risks Competition—As competition for loans increases, loan yields decline, which would likely pressure a BDC’s return on equity.