The massive and still-expanding cloud computing industry is dominated by the "big three" -- Amazon's (AMZN -1.44%) AWS, Microsoft's (MSFT 0.13%) Azure, and Alphabet's (GOOGL -0.55%) (GOOG -0.44%) Google Cloud. For most large organizations the world over, when it comes to migrating operations to the cloud, it's likely one of these companies will at least play a role.
But DigitalOcean (DOCN 1.78%), which recently made its initial public offering, is making waves by working with a different segment of the economy: small- and mid-sized businesses (SMBs), start-ups, and individual developers. There's lots of white space available in this realm, and DigitalOcean is making fast progress.
Here are three reasons this tech platform could become a top name in the cloud industry in a decade's time.
1. DigitalOcean serves the forgotten and under-served
A lot of today's high-end tech was built with large organizations in mind. There's a reason for that. As DigitalOcean CEO Yancey Spruill pointed out to me in a recent chat, it's because most global IT spending comes from large enterprises. The nascent cloud industry is no different. To get the most bang for their buck, tech firms have mostly built products and go-to-market strategies catering to the largest organizations. Though the cloud is efficient, simplifies operations, and theoretically makes participating in the digital economy easier than ever, SMBs remain an under-served segment of the economy.
It's not like SMBs are a "niche" market. On the contrary, they make up roughly half of GDP. The problem, according to Spruill, is that they are widely distributed all over the place with some 100 million SMBs worldwide, and typically spend a small amount on tech on an individual basis. If any single group was going to benefit from the advent of the cloud, it would be small businesses and aspiring entrepreneurs. But a better platform addressing their unique demands (primarily affordability and ease-of-use) is needed to support them.
That's where DigitalOcean comes in. DigitalOcean cites a study from researcher IDC that shows SMBs (those with less than 500 employees) spent $44 billion on cloud infrastructure and platform services in 2020. But that figure is expected to swell to $116 billion per year by 2024, representing average annual growth of 27% per year. With annualized revenue totaling just $426 million in Q2 2021, there's a huge opportunity here for DigitalOcean to grow along with SMBs and other aspiring digital entrepreneurs in the years ahead.
2. DigitalOcean has fast-and-steady revenue growth
DigitalOcean's platform, which aims to obliterate the barriers preventing SMBs and entrepreneurs from participating in the digital economy, has picked up lots of fans. As of Q2 2021, it had a massive user base of over 600,000 customers spanning 185 countries. And since DigitalOcean is designed to be affordable (as little as $5 a month for a pre-formatted app hosted by DigitalOcean) and designed to scale if a developer's idea takes off, this is a story of increasing usage from existing customers as much as it is one of new customer acquisition.
The result is a business that is steadily growing at a fast pace. In Q2, revenue was up 35% from the year prior to $104 million, compared to a mid-20% growth rate in 2020. Part of that acceleration in the top line is no doubt the result of an easy lap of last year's results during the start of the pandemic. However, Spruill said on the last earnings call that a steady increase in new customer acquisitions (targeted at a minimum of 10% growth) and average revenue per user (expected growth in the mid-teens percentage rate) make DigitalOcean confident it can sustain a 30% or more sales pace for the rest of 2021 and into 2022.
Shares trade for just over 13 times trailing 12-month revenue. If DigitalOcean continues to deliver on its growth trajectory, that looks like a great long-term value -- not to mention it would put this cloud platform on course to reach $1 billion in annualized sales within a few years' time.
3. DigitalOcean has an exceptional business model and solid balance sheet to match it
By virtue of how it's structured, DigitalOcean has a fantastically efficient business model. According to Spruill, its cloud platform uses open source software, and the company has compiled lots of tutorials on its website geared toward helping developers of all kinds -- even those not utilizing DigitalOcean. The company receives some 5.5 million site visits a month and thousands of developers that arrive via a tutorial end up converting into customers every month. And given developers and SMBs tend to have tight-knit circles of compadres they share ideas with, this generates great word-of-mouth marketing.
As a result, DigitalOcean spent just 11% of total revenue on sales and marketing in Q2 (or 9.5% when excluding non-cash employee stock-based compensation), a figure that often swells to a 20% to 30% range for similar high-growth cloud firms. This is an efficient business, and though it's still very small, it's already profitable. Adjusted EBITDA profit margin was 30% in Q2, and free cash flow generated through the first half of 2021 totaled $13 million.
Factoring in a balance sheet that features $577 million in cash and equivalents and zero debt as of the end of June, DigitalOcean is in exceptionally good shape to continue growing along with its SMB and aspiring entrepreneur users.
DigitalOcean has all the right stuff I look for in promising up-and-coming tech firms. I plan on buying a starter position (usually less than 1% of my portfolio value) soon. If this small cloud infrastructure and platform service isn't on your radar yet, add it to your list of companies to do some digging on.