To call Amazon an e-commerce giant would be an accurate description -- but an incomplete one. The company does far more than just sell stuff online. It also produces original video content, sells advertising, and provides shipping and logistics services, among other things. But its most important "other" business is undoubtedly its cloud-computing platform, Amazon Web Services (AWS).
Why is AWS so important to Amazon? You'll have to look beyond revenue. While AWS made $91 billion in sales last year, it was only 16% of the whole company's total. However, the nearly $25 billion it earned in operating income amounted to 67% of Amazon's entire amount. In short, AWS is crucial to Amazon because it supplies most of the company's profits.
AWS is a huge player in the cloud space and a great business in its own right. But one small rival is currently growing at a faster pace, and investors would do well to pay it some attention.
The smaller, faster-growing AWS rival
With only $693 million in trailing-12-month revenue, DigitalOcean (DOCN 3.30%) is less than 1% the size of AWS. But its small size doesn't mean it's a low-quality business. In fact, this company has many desirable traits.
For starters, DigitalOcean is growing fast. In 2023, its revenue rose by 20%, while AWS grew by 13%. Moreover, at the midpoint of management's guidance range, DigitalOcean expects 10% top-line growth in 2024.
It's growing right now by acquiring new customers. It ended 2023 with 644,000 customers, 5% more than it had a year prior. Granted, it did acquire a fair number of those new customers through acquisitions. And spending per customer has dropped recently, which is a little concerning. But DigitalOcean operates under a usage-based business model, and revenue for many usage-based enterprise software companies has dipped due to macroeconomic conditions. This isn't a problem unique to DigitalOcean.
It's encouraging to think of how easy it would be for DigitalOcean's customers to increase their spending from here. A whopping 75% of DigitalOcean's customers only spend $15 per month with it on average. Moreover, 56% of its recurring revenue comes from less than 3% of its customers. Just getting a small share of its customers to increase their spending could have an outsized impact on DigitalOcean's financial results.
The final thing worth noting is management's emphasis on free cash flow. In 2023, the company had an adjusted free cash flow margin of 22%, up from just 13% in 2022. It's rare for a company this small to focus on (and be successful at generating) positive free cash flow. But DigitalOcean appears to be doing so with ease.
DOCN Revenue (TTM) data by YCharts
Is DigitalOcean stock a buy?
I believe DigitalOcean is a good business, and one that has promise. But I don't necessarily believe it's a timely investing opportunity.
DigitalOcean has performed well, but it just replaced its CEO in February. New chief executive Paddy Srinivasan has experience building businesses and says he'll keep the company focused on free cash flow generation, among other things. But that transition at the top adds a layer of uncertainty.
Moreover, DigitalOcean's growth prospects for 2024 are muted. As already mentioned, it's only guiding for about 10% top-line growth. That's good, but hardly head-turning.
If the stock were cheap, then perhaps I could overlook the uncertainty about the company's leadership and its modest near-term growth forecast. But DigitalOcean isn't a compelling bargain, either. It trades at over 5 times its sales and over 30 times its free cash flow. Those valuations seem fair, given its growth rate -- but not cheap.
DOCN PS Ratio data by YCharts.
In conclusion, for those who already have DigitalOcean in their portfolios, I see good reason to hold the stock. But I'm not a buyer right now. This is a good business, and I'll be watching its growth rate for signs of improvement. I'll also be watching its key metrics to see how they hold up under Srinivasan's leadership. But I'll wait for the stock to land on a better valuation before buying it.
