There's no doubt cloud infrastructure is an area of the tech sector that has massive secular tailwinds behind it. By one estimate, the U.S. cloud computing market is projected to grow to $1.7 billion by 2029, a significant increase from $480 billion at the end of 2022. The easy answer for investors looking to capitalize on this opportunity is the "Big Three:" Amazon's AWS, Microsoft's Azure, and Alphabet's Google Cloud Platform.

However, there's a smaller company with a unique offering that is also worth considering. Digital Ocean (DOCN 1.26%) is posting impressive growth numbers and becoming a compelling alternative to the cloud giants, especially for small businesses. Here are three things about Digital Ocean that smart investors know.

1. Digital Ocean is growing with its customers

Digital Ocean's business strategy is to offer transparent and affordable pricing, robust customer support, and a community of developers for users to rely on. While a large enterprise with a substantial IT department may not need as much hand-holding from its cloud provider, these features are especially important for small businesses that may not have the expertise or the headcount necessary to navigate a more complicated cloud provider's product offerings. 

One potential risk for this business strategy is whether or not Digital Ocean can grow with its customers. Every large enterprise was once a small or medium-sized business, so if Digital Ocean wants to keep its customers over the long haul, it will need to continue to support them as they get larger.

Fortunately, there's some evidence this is happening. At the end of 2018, only 0.1% of customers moved from spending less than $50 per month (called Learners) to spending between $50 and $500 per month (Builders). However, by the end of 2022, that rate had increased to 2.4% Similarly, the percentage of Builders who transitioned to spending more than $500 per month (Scalers) grew from 1.7% in 2018 to 4.1% in 2022.

These metrics show that not only are customers spending more over time, but more are doing so now than in the past. If this trend continues, Digital Ocean should have no problem keeping its customers as they scale.

2. Profitability and free cash flow are improving

In 2022, Digital Ocean grew its revenue by 34% over 2021. However, revenue growth has always been strong for the company. What is important to keep an eye on is profitability and cash flow. Fortunately, there has been some progress with these metrics as well.

Digital Ocean has not yet reached consistent profitability according to generally accepted accounting principles (GAAP), but it has made progress on a non-GAAP basis. 

Metric

FY 2020

FY 2021

FY 2022

Adjusted EBITDA margin

30%

32%

34%

Non-GAAP operating margin

6%

12%

18%

Data source: Digital Ocean.

Non-GAAP metrics should always be taken with a grain of salt, but the majority of the adjustments from GAAP metrics are due to stock-based compensation. This shouldn't be ignored, but the adjusted numbers do show the improving operating efficiency of the business.

The progress made on free cash flow is even more impressive. In 2020, Digital Ocean posted a negative free cash flow of $57 million. Free cash flow turned positive in 2021 at $25 million, then it jumped significantly to $78 million in 2022. These metrics are a positive sign for investors and suggest that Digital Ocean should continue to generate more profits and cash as the business continues to scale.

3. The future looks bright

In addition to the large market opportunity, there are other reasons to be hopeful about Digital Ocean's future. Management's outlook for both Q1 and fiscal year 2023 suggests continued strong results. At the midpoint of guidance, Q1 revenue is expected to grow 29% and full-year revenue is expected to grow 23%.

Adjusted EBITDA margin is also expected to improve to 37.5% for the full year 2023, a nice improvement over the 34% result in 2022. Free cash flow, which represented 13% of revenue in 2022, is projected to be between 21% and 22% of revenue in 2023.

Digital Ocean currently trades for roughly 7 times sales and 53 times free cash flow. This may not seem cheap, but both metrics are below their historical average and not far from their all-time lows. There's a long runway for growth ahead of Digital Ocean, and its consistent growth and improving profitability and cash flow make it a compelling investment.