The cloud has been growing in importance over the past few years, and the market for developing cloud-based applications is only expected to become more prevalent. Infrastructure as a service (IaaS) focuses on helping businesses develop and operate underlying network infrastructure. Its market for small and medium-sized businesses (SMBs) is expected to be worth $91 billion by 2025 -- representing growth of 94% from 2022.
However, many SMBs have had a difficult time increasing their cloud presence. Some of these SMBs have little cloud experience, and hiring expert developers is expensive. Instead, many try building a cloud presence independently, but operating alone on platforms like Amazon's (AMZN 0.75%) AWS or Microsoft's (MSFT -1.00%) Azure is daunting. Without cloud expertise and support on these platforms to help them, many SMBs find it difficult to build simple cloud-based applications.
DigitalOcean (DOCN 1.58%) saw these problems and created an SMB-focused cloud solution to enable cloud adoption for this customer base. So far, its services have been rapidly adopted by SMBs, and that continued in this quarter. Shares of DigitalOcean have been a rollercoaster ride. They have fallen 53% from their all-time high set in November 2021, yet as of this writing, they are still up 43% since the company's IPO in May 2021. After these strong earnings results, it might be wise to add some shares of this niche leader to your portfolio.
Image source: Getty Images.
A steady financial machine
DigitalOcean acts as a steady compounder, a rare sight among tech stocks. The company grew its fourth-quarter revenue 37% year over year to $120 million, and this growth rate has been consistent for the past three quarters, only wavering between 35% and 37%. This was driven by the company's larger customers, defined as those spending more than $50 per month. This cohort grew Q4 revenue 44% year over year, representing 83% of total revenue.
The company's total customer count reached 609,000 in Q4 2021 -- growing slightly year over year. Its overall net retention rate during the quarter was 116%, meaning that customers from Q4 2020 are now spending an average of 16% more on the platform.
With its impressive customer support, which includes a community of developers to answer questions and provide tutorials on developing basic applications, DigitalOcean is gaining market share and becoming the go-to platform for small businesses to create their cloud presence.
While its growth rates may not stand out compared to other tech stocks, its profitability and cash flows do. The company generated $30 million in free cash flow (FCF) in 2021, representing 7% a margin. On top of that, DigitalOcean's net loss is improving: Q4 net loss was $12 million, which decreased 13% year over year. The company also has over $1.7 billion in cash and cash equivalents, which can subsidize its losses while repurchasing up to $300 million in stock to offset dilution over the next few years.
Industry growth incoming
The SMB industry is large for DigitalOcean, and it looks like it may grow rapidly. There were 100 million SMBs globally in March 2021, which is expected to grow by 14 million annually until 2025. This means that DigitalOcean's customer pool is getting larger every year.
With the customer base expanding, CEO Yancey Spruill has an optimistic outlook on the long-term future. He noted that the company is shooting for 40% year-over-year revenue growth in the future and 20% FCF margins by 2024. Although there is still work to do to achieve this, the company's accelerating top-line expansion and improving cash flow are certainly moving the business in the right direction.
Why I like DigitalOcean for the next decade
The competitive advantages that DigitalOcean has over competitors like AWS could help push them toward these goals. AWS targets big-name customers like Netflix (NFLX -0.31%) -- customers that likely spend millions of dollars each year on AWS products -- so the SMB space is simply not worth their time.
Amazon would have to invest a significant amount in developing the same level of customer support that DigitalOcean has to effectively compete. Doing that might not even take market share from DigitalOcean. In its best-case scenario, AWS would attract customers spending just $50 per month -- mere specks of dust compared to its larger clients. This niche market is simply too small to appeal to AWS, leaving the opportunity wide open for DigitalOcean.
The company's competitive edge, strong financial position, and consistent growth could combine for incredible returns for investors over the long term. If DigitalOcean can gain market share in this space as it continues progressing toward its long-term goals, investors could be well compensated. Shares trade at 13 times sales, which is not a nosebleed valuation, so it might be wise to invest now. Your future self might thank you.
