One way investors look for opportunities is to identify durable trends. In a world where more and more data is moving to the cloud, companies supporting cloud infrastructure seem positioned to take advantage of this secular tailwind.

Often, this means looking at the three largest leaders in this space: Amazon Web Services (AWS), Alphabet's Google Cloud, and Microsoft Azure. However, a lesser-known competitor to these titans has found a niche and built a strong business around serving that customer. With the stock down 65% this year, DigitalOcean (DOCN -0.90%) is worth a closer look before the end of 2022.

Winning in the SMB market

DigitalOcean provides cloud infrastructure for small and medium businesses (SMBs). Because it caters to this market, DigitalOcean has focused on things like simplicity, transparent pricing, and robust support. These areas of focus have proven to be particularly helpful to these smaller businesses that often have limited employees and resources.

According to DigitalOcean, the market for small and medium-sized businesses needing cloud infrastructure is expected to grow to $145 billion by 2025. By contrast, DigitalOcean's trailing-12-month revenue as of 2022's third quarter was $533 million. Investors should always take these kinds of total addressable market estimates with a grain of salt. That said, even if this estimated market size is wildly optimistic, the opportunity for DigitalOcean is still very large.

One risk investors should be aware of is that despite DigitalOcean's success in this space, there's a chance its larger competitors will decide to jump in as well. With the massive financial advantages of AWS, Google Cloud, and Microsoft Azure, any meaningful move into the SMB market by these three would threaten DigitalOcean's business.

DigitalOcean is delighting its customers

One area in which DigitalOcean could continue to succeed -- even in the face of stiff competition -- is its customers' happiness with the product. In Q3, the company had a net dollar retention rate (NDRR) of 118%, meaning customers are spending 18% more this year than they did last year. More impressive, this number was 116% in Q3 of 2021 and 104% in Q3 of 2020.

This retention number is also impressive because it includes churn, or businesses that have left. The increase in net dollar retention rate for Q3 was aided by the company halving its churn. Because of DigitalOcean's exposure to the SMB market, low churn is even more impressive because a smaller business is more likely to fail than a larger one. It's reasonable to assume a portion of the churn is due to some companies going out of business, not because customers were unhappy with the product.

That has translated to the growth of another important metric, average revenue per user (ARPU). DigitalOcean's ARPU has grown from $48.58 in Q3 2020 to $79.22 in the most recent quarter -- good for a 63% increase.

Strong results continue

In its short time as a publicly traded company, DigitalOcean has routinely put up strong results. The third quarter of 2022 was no exception. Here are some key performance indicators and their year-over-year (YOY) growth.

 

Q3 2021

Q3 2022

YOY

Revenue

$111 million

$152 million

37%

Gross margin

61%

64%

300 bps

Non-GAAP operating margin

15%

26%

1100 bps

Customers spending more than $50/month

94,600

142,100

50%

Data source: DigitalOcean. Chart by author. YOY = year over year. Bps = basis points. Non-GAAP = non-generally accepted accounting principles.

Investors should be particularly interested in the gross margin and non-generally accepted accounting principles (GAAP) operating margin results, as these are profitability metrics. DigitalOcean posted a net income of $10 million in Q3, but that was a first for the company. However, the positive trends in gross margin and operating margin indicate that sustained profitability could be on the horizon.

DigitalOcean has also been cash flow positive for most of its time on the public markets. In Q3, free cash flow was $22 million, up from $14 million in the year-ago quarter. That represented a free-cash-flow margin of 15%, up from 12% in Q3 of 2021.

Why is DigitalOcean a buy now?

When making investment decisions, it's important to consider future growth and present valuation. DigitalOcean's Q4 and full-year 2022 guidance suggest more of the same. At the midpoint of guidance, YOY revenue growth is expected to be 34% for both Q4 and FY 2022. At the same time, DigitalOcean currently trades near its all-time lows for its price-to-sales and price-to-free-cash-flow ratios.

DOCN PS Ratio Chart

DOCN PS Ratio data by YCharts.

DigitalOcean is not cheap. That said, it's putting up impressive results in a growing market, and the overall market sell-off has presented an opportunity to buy shares at a relatively less expensive valuation. Heading into the new year, DigitalOcean looks like a buy at this valuation.