Cloud provider DigitalOcean (NYSE:DOCN) is taking the plunge and competing with big cloud behemoths like Amazon's (NASDAQ:AMZN) AWS, Microsoft's (NASDAQ:MSFT) Azure, and Alphabet's (NASDAQ:GOOGL)(NASDAQ:GOOG) Google Cloud. DigitalOcean focuses on providing simplicity and transparency to small and medium-sized businesses, which the big providers have failed to do. By targeting this unique customer demographic, DigitalOcean has the opportunity to succeed and become the best niche cloud provider in this market.

A better option

Large cloud providers like Amazon and Microsoft get the biggest bang for their buck by providing sophisticated, pricey applications to large enterprises. But those applications are challenging to set up for customers with little or no cloud experience on these platforms. 

The cloud connected to many computers.

Image source: Getty Images.

Small and medium-sized businesses, or SMBs, typically need is just one or two straightforward applications, preferably ones that are easy to set up -- a trait that's hard to find on AWS. DigitalOcean offers these SMB customers a simple, cheap way to obtain basic cloud applications. 

The company focuses on a few critical services like managed databases, droplets, and app platform building, which is typically all that SMBs need. And unlike its larger, more opaque rivals, the company clearly lays out base prices for all its services on one easy-to-read page. 

DigitalOcean also has a community where developers can learn and chat with other customers, ask questions, and learn about everything related to the cloud, even if they're not already customers. DigitalOcean offers free tutorials on how to code, manage databases, or just about anything an SMB might need to know to operate on the cloud. Most large enterprises already have expert developers within their companies -- experts SMBs might not be able to afford -- making this communal aspect yet another distinct advantage for DigitalOcean.

This community aspect drives strong word-of-mouth marketing. Developers already using DigitalOcean typically advocate for the site on these community boards, which helps the company cheaply acquire new customers. This is likely why DigitalOcean only spent 11% of revenue on sales and marketing in the trailing 12 months, or TTM. While Amazon and Microsoft's sales and marketing expenses have been lower as a percentage of revenue, these businesses already have a broad market share. DigitalOcean, however, is quickly gaining a lot of traction in the space while having to spend relatively little on sales and marketing expenses to grow its customer base.

Picking up steam

DigitalOcean has a larger market opportunity than most investors might think: The company currently estimates it at $44 billion, but expects that figure to increase to $116 billion by 2024. By that time, the company further expects another 14 million new SMBs each year to which it can sell. 

So far, DigitalOcean seems to be succeeding. Revenue growth has been accelerating -- from 24% growth in the third quarter of 2020 to 35% growth in the most recent quarter -- reaching $366 million in revenue during the trailing 12 months. Net dollar retention -- how much more each year's group of customers spends the following year -- has also been ramping up, hitting 113% last quarter, compared to 102% one year ago. 

Annual recurring revenue growth has also accelerated. The company has grown its ARR by 25% or more in each of the past four quarters, with the second quarter growing 36% year over year to $426 million.

Digital Ocean's bringing in more customers, and getting each one to spend more on average. ARPU grew 25% to $58 in the most recent quarter, and customers surpassed 600,000. Its customer count has been growing consistently in the mid-single-digits from one quarter to the next. 

This growth in every aspect of its business could push DigitalOcean into profitability. During the last six months, it had just $5.5 million in net losses, compared to $197.5 million in revenue. 

The risks of upsetting whales

The major risk for DigitalOcean is the chance that Amazon, Google, or Microsoft could shift a focus toward SMB customers. These cloud providers have billions in capital that could be funneled toward this, which could potentially wipe DigitalOcean out. The only way that DigitalOcean could survive this is if it establishes strong relationships with its customers. It is showing success on this front with its high retention numbers and an NPS score of 64 out of 100. DigitalOcean and its customers prizes the company's simplicity -- but to grow, it'll need to expand its offerings, and thus risk eroding its own competitive advantages. That paradox basically puts a hard cap on its potential growth. 

DigitalOcean is operating in a market that has been largely neglected by the large whales of the industry. It is providing a communal, friendly space for SMBs, resulting in strong growth. Looking forward, investors should watch ARPU, retention, and customer growth for this business. These metrics will give a good idea as to how well the business is building lasting relationships with its customers. If it can do this effectively, it could potentially stave off competition, which would lead to long-run success and growth. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.