Microsoft's (MSFT 1.82%) stock rallied nearly 1,000% over the past 10 years and minted a lot of millionaires. That history rally was driven by the aggressive expansion of its Azure cloud infrastructure platform, the transformation of its desktop software into cloud-based services and mobile apps, and a rapid rollout of new AI services.
Microsoft could still have plenty of room to run, but it's already the world's most valuable company and probably won't soar another 1,000% over the next decade. Therefore, investors looking for bigger gains should check out smaller tech stocks with more upside potential like DigitalOcean (DOCN 3.30%), a provider of cloud infrastructure services for smaller companies.
Image source: Getty Images.
What does DigitalOcean do?
Microsoft's Azure, Amazon Web Services (AWS), and Alphabet's Google Cloud Platform (GCP) are the three largest cloud infrastructure platforms in the world, but these platforms mainly serve large enterprise customers instead of smaller businesses and start-ups.
DigitalOcean addresses that gap by carving out smaller and cheaper "droplets" of individual servers for smaller companies. It also acquired the cloud start-up Paperspace last year to add GPU-powered AI processing services to its servers.
When DigitalOcean went public in 2021, the bears claimed it would struggle to stay relevant as Microsoft, Amazon, and Google rolled out more cloud infrastructure services for smaller customers. The bulls claimed it could carve out a niche with a cheaper and more flexible solution that wasn't tethered to a stickier cloud ecosystem.
DigitalOcean is defying the bears with its steady growth
DigitalOcean steadily expanded its customer base and grew its average revenue per users (ARPU) over the past three years, even as the macro headwinds reduced its net dollar retention rate and throttled its revenue growth in 2023.
|
Metric |
2020 |
2021 |
2022 |
2023 |
|---|---|---|---|---|
|
Total Customer Growth |
6% |
6% |
11% |
5% |
|
ARPU Growth |
19% |
25% |
25% |
10% |
|
Net Dollar Retention Rate |
103% |
113% |
112% |
96% |
|
Revenue Growth |
25% |
35% |
34% |
20% |
Data source: DigitalOcean.
DigitalOcean operates 16 data centers across nine regions and serves customers in 190 countries. Most of its recent customer growth has been driven by its "Builders" and "Scalers", who spend more than $50 and $500 per month, respectively, on its platform. That cohort accounted for 86% of its revenue in 2023. That growth in higher-value customers, along with its improving scale and tighter cost-cutting measures, consistently boosted its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) and adjusted free cash flow (FCF) margins over the past three years.
|
Metric |
2020 |
2021 |
2022 |
2023 |
|---|---|---|---|---|
|
Adjusted EBITDA Margin |
30% |
32% |
34% |
40% |
|
Adjusted FCF Margin |
(18%) |
6% |
13% |
23% |
Data source: DigitalOcean.
As a result, DigitalOcean turned profitable for the first time on a generally accepted accounting principles (GAAP) basis in 2023. Those rising profits suggest it still has plenty of pricing power in its growing niche of the cloud market.
DigitalOcean looks cheaper than Microsoft
For 2024, DigitalOcean expects its revenue to rise 9% to 12%, its adjusted EBITDA margin to decline to a range of 36% to 38%, and its adjusted FCF margin to dip to a range between 19% and 21%. It attributed that slowdown to the persistent macro challenges, which are driving many companies to rein in their spending on cloud-based services. But as its revenue growth slows down this year, it plans to boost its ARPU and stabilize its net dollar retention rates by expanding its portfolio of machine learning and AI services.
From 2023 to 2026, analysts expect DigitalOcean revenue to grow at a compound annual growth rate (CAGR) of 13%, its adjusted EBITDA margin to expand to 40%, and for its GAAP net income to rise at a CAGR of 67%. Those estimates imply its business will stabilize as the macro environment warms up. Based on those expectations, its stock looks reasonably valued at 6 times this year's sales and 16 times its adjusted EBITDA. It also still trades about 20% below its IPO price.
Microsoft, which is expected to grow its revenue at a CAGR of 15% and its adjusted EBITDA at a CAGR of 18% from fiscal 2023 to fiscal 2026 (which ends in June 2026), trades at 12 times this year's sales and 24 times its adjusted EBITDA.
Why DigitalOcean could outperform Microsoft this year
DigitalOcean only has a market cap of $3.4 billion, while Microsoft is worth $3.05 trillion. However, I believe DigitalOcean's smaller size, stable growth, and lower valuations could help it outperform Microsoft's stock this year.
The market doesn't have high expectations for DigitalOcean, but it's set a pretty high bar for Microsoft, which has become one of the market's hottest AI stocks through its investments in OpenAI. If DigitalOcean maintains steady growth rates while Microsoft falls short of Wall Street's rising estimates, it could generate much higher near-term returns.
