Many years ago, businesses would collect customer and operational data and store it on physical servers located on-site. Today, they rent hardware capacity from enormous, centralized data centers instead for a fraction of the cost, which is a practice called cloud computing.
Data-center operators like Amazon Web Services, Microsoft Azure, and Alphabet's Google Cloud dominate the cloud industry. Their services have expanded way beyond simple data storage to include hundreds of different solutions designed to help businesses thrive in the digital age, and a growing number of them center around artificial intelligence (AI).
DigitalOcean (DOCN 0.68%) is another cloud computing company, except it focuses specifically on serving small and mid-sized businesses (SMBs). It's now expanding into AI to give its customers access to the technology at an affordable price. It could be an incredible growth opportunity, so here's why investors might be glad they bought DigitalOcean stock when they look back on this moment in five years.
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DigitalOcean is diving into AI
Amazon, Microsoft, and Alphabet are trillion-dollar companies, so their cloud divisions are incredibly well-resourced. However, it also means catering to small businesses won't really move the needle in terms of revenue, so they prefer to focus on larger enterprises that can afford to spend millions of dollars on cloud services. DigitalOcean, on the other hand, is valued at just $3.5 billion, so it derives plenty of value from start-ups and businesses with less than 500 employees.
DigitalOcean offers those customers personalized support, cheap and transparent pricing, and simple functionality because it knows most of them don't have in-house technical teams. It also offers a relatively narrow portfolio of services to suit its target market, which streamlines its cost structure and keeps prices affordable.
Last year, DigitalOcean bought Paperspace for $111 million, which is a start-up that manages data centers geared toward AI developers. It provides some of the industry's leading semiconductor hardware, including the H100 GPU designed by Nvidia, yet its pricing is as much as 70% cheaper than cloud giants like Microsoft Azure.
Like DigitalOcean, Paperspace has a lean cost structure because its product offering is extremely narrow, and those savings are passed on to the small-scale developers it serves. By combining the two companies, customers gain a holistic solution that covers all of their cloud and AI needs, which they probably couldn't afford if they used the leading cloud providers.
DigitalOcean Chief Executive Officer Paddy Srinivasan says demand for its AI GPU compute capacity will outstrip supply for the foreseeable future. In fact, while it's still early days, the company's annual recurring revenue for AI services soared at an annualized rate of 128% in the three months between December 2023 and March 2024.
DigitalOcean's revenue growth has slowed recently, but for a good reason
DigitalOcean generated $184.7 million in revenue during the first quarter of 2024. That was a record high, but it represented growth of just 12% compared to the year-ago period. During 2022, the company's revenue routinely grew more than 30%, but growth began to slow in 2023 as management pivoted its focus.
Like most tech companies, DigitalOcean used to operate with a growth-at-all-costs strategy, which meant investing heavily in sales, marketing, and research and development, even if it resulted in net losses. However, since interest rates began to soar in 2022, companies like DigitalOcean have shifted their focus to protecting capital, which means trimming costs to deliver profits instead.
During Q1, DigitalOcean slashed its operating expenses by 20% compared to the year-ago period, which led to net income of $14.1 million. That was a positive swing from the $16.3 million net loss it delivered in the same quarter of 2023.
Simply put, decelerating revenue growth certainly isn't a good thing in isolation. However, in an uncertain economic environment where debt is expensive and raising fresh equity capital can be challenging, a company's best bet is to protect its cash. Most analysts believe the U.S. Federal Reserve will begin cutting interest rates in 2024, which should boost economic activity. When favorable conditions eventually prevail, DigitalOcean can easily pivot its focus back to growth.
Why DigitalOcean stock is a buy now
DigitalOcean values the addressable market for SMB cloud services at $114 billion annually, a figure that could almost double to $213 billion by 2027. The company's projections suggest it will generate as much as $775 million in revenue this year, so it has barely scratched the surface of that opportunity.
But AI could drive the value of DigitalOcean's addressable market substantially higher. PwC estimates the technology will add $15.7 trillion to the global economy by 2030, and Cathie Wood's Ark Investment Management believes AI software companies could generate $14 trillion in revenue by then. There is no telling whether those forecasts will ring true over the long term, but applications like ChatGPT are already driving a productivity boom thanks to their ability to instantly generate text, images, videos, and computer code.
DigitalOcean (with help from Paperspace) is a picks-and-shovels play on that opportunity. Its data center infrastructure and cloud platform are the tools SMBs need to participate in the AI revolution, and as the company's CEO said, demand is already outstripping supply.
DigitalOcean stock is trading about 70% below its all-time high, which was set during the tech frenzy in 2021. Its valuation was a little unrealistic back then, but investors have also punished the company for its slowing revenue growth of late. However, that might present a golden buying opportunity for investors with an investment horizon of at least five years, because AI could grow to become a significant contributor to DigitalOcean's business by then.
