Since its IPO in early 2021, shares of DigitalOcean Holdings (DOCN -2.79%) are up an incredible 118% as of this writing. The third-quarter earnings update showcased the momentum this cloud computing firm is riding. Revenue growth accelerated to 37% year-over-year, keeping the company on track to reach its goal of $1 billion in annual sales by 2024.
One thing that separates DigitalOcean from other small, fast-growing tech firms is that it turns a profit. Thanks to its efficient operation, the company generates more than enough cash to invest in new research and development to improve its platform. As 2021 comes to a close, expect to see lots of new innovation at DigitalOcean to support its expansion in 2022.
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An incredibly lean operating model
DigitalOcean hauled in $111 million in revenue during the quarter, a tiny company among the public cloud-computing titans by every measure. Many small firms in this arena have to spend massive amounts of cash to promote growth -- not DigitalOcean. Even while expanding at a double-digit percentage rate, it generated a 33% adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) profit margin during the third quarter.
The company is frequently asked why it doesn't spend more to grow even faster, but the company is in fact already beginning to ramp up its spending. CEO Yancey Spruill said on the earnings call that margins would have been even higher if not for that fact. And for the fourth-quarter outlook (which calls for 35% revenue growth to at least $117 million), adjusted EBITDA margin is expected to dip to a range of 30% to 31%.
As Spruill and company often point out, this ability to invest in research and development and turn a healthy profit is thanks to the company's efficient business model. Its cloud platform is scalable as its customers grow (gross profit margin was 61% in the latest quarter versus 54% last year). And its focus on open source cloud software, complete with extensive online tutorials, blogs, and incredibly affordable services (more on that in a moment), bring in thousands of new individual and small business customers every month.
As a result, sales and marketing expenses were only 12% of revenue last quarter -- an incredibly low figure for a high-growth technologist like this.
An ideal partner for the modern digital-first small business
DigitalOcean has a lot of appeal among small businesses and those looking to experiment with software development -- myself included. Spruill said on the call that of the 598,000 customers the company has, 15% of them (roughly 90,000) account for some 85% of revenue (which pencils out to $387 million based on the annualized run rate of revenue in the third quarter). That works out to an average of about $4,300 a year per DigitalOcean customer in that top 15%. Obviously a larger organization with more extensive technology needs would be spending quite a bit more than that. Nevertheless, it illustrates how incredibly affordable this cloud infrastructure is for a company with anywhere from a few dozen to a couple hundred employees.
Nurturing the success of these small customers (as well as the hundreds of thousands using DigitalOcean for idea formation and experimentation) is critical to the company's continued growth. That's where the increased spending will come in. Today, just 10% of revenue comes from cloud platform products with the other 90% composed of infrastructure (basically, virtual hosting and management of applications and web services). In another two years, DigitalOcean expects products to be over one-quarter of a $1 billion-a-year revenue total.
That's why the company recently hired Gabe Monroy, formerly president of Microsoft's Azure Developer Experience, as chief product officer. Helping oversee a software overhaul from legacy to cloud, Monroy will no doubt bring a fresh perspective to DigitalOcean and grow the list of developer tools available on the platform.
That isn't to say DigitalOcean is forgetting about its infrastructure. Spending on property and equipment (collectively called capital expenditures, or capex) will be at least 25% of revenue this year. Though that rate is expected to fall in 2022 as DigitalOcean continues to grow, it still plans to expand its data centers and servers to support its many users. Currently, DigitalOcean's virtual servers utilize CPUs, so adding GPUs for accelerated computing (like what NVIDIA designs, the hardware used in AI and machine learning) would be a natural progression.
Whatever comes next, one thing is for sure: DigitalOcean offers investors an intriguing mix of high growth and profitability. Spruill thinks his company is still in the early days of development and wants to build "a truly iconic cloud infrastructure and software business." Given the current direction things are headed, I wouldn't bet against DigitalOcean's odds to pull it off.
