DigitalOcean (DOCN 0.68%) is not like the large cloud infrastructure providers that dominate the market. While Amazon Web Services (AWS), Microsoft Azure, and Alphabet's Google Cloud cater to enterprise customers with complex requirements and vast budgets, the average DigitalOcean customer spends less than $100 per month.
This focus on individual developers and small businesses yields opportunities and risks. The market for infrastructure-as-a-service and platform-as-a-service among individuals and companies with fewer than 500 employees is currently worth $114 billion, and IDC expects it to nearly double to $213 billion by 2027. While the big cloud providers play in this market, the simplicity of DigitalOcean's platform is appealing to those without vast IT budgets.
The downside to DigitalOcean's focus on smaller customers is a lack of stickiness. When a large enterprise goes all-in on AWS, that's the ball game. That enterprise is unlikely to seriously consider switching providers because the disruption and cost involved with untangling itself from AWS would be too high. For a small business using DigitalOcean, moving some virtual servers and small databases would be doable.
A growth story with caveats
DigitalOcean's growth has slowed down recently. Revenue increased by 12% year over year in the first quarter of this year, much lower than the 20% boost the company mustered in 2023 and the 34% growth it managed in 2022.
Part of the problem is churn and a lack of expansion from existing customers. DigitalOcean's net dollar retention rate -- which measures how annual recurring revenue has changed by taking into account expansions, contractions, and lost customers -- dipped below 100% in the third quarter of 2023 and has stayed there ever since. NDR was 97% in Q1 of 2024, compared to 117% in the first quarter of 2022.
DigitalOcean is still winning new customers, so revenue continues to march higher. The number of clients spending at least $50 per month rose by 8% year over year in the first quarter to 157,500. This customer group accounts for 87% of DigitalOcean's monthly revenue. Acquisitions, including managed hosting provider Cloudways and AI platform Paperspace, have helped push up average customer spending.
A careful expansion of its platform is also helping the cause. DigitalOcean has been launching new high-value services, including managed Kafka, while aiming to maintain the simplicity for which it's known. The company's platform will never be as expansive as AWS, but there's still room to add additional services.
The state of the economy is playing a role in DigitalOcean's slowdown as companies look for ways to reduce costs. The good news is that this is likely a temporary situation. As this pressure on spending eases, and as DigitalOcean's investments in AI infrastructure start to pay off, revenue growth should reaccelerate.
Reasonably priced
Despite the slowdown and increased investments in AI, DigitalOcean continues to churn out prolific quantities of cash. The company converted 22% of revenue into free cash flow in 2023, and it expects a free cash flow margin of around 20% this year. The dip is due to the company's ramped-up investments in its AI business.
Based on the company's guidance, free cash flow should total about $154 million this year. WIth a market capitalization of $3.3 billion, the price-to-free-cash-flow ratio works out to roughly 21. That valuation looks reasonable given DigitalOcean's total addressable market and the likelihood that revenue growth accelerates in the years ahead.
DigitalOcean's results are sensitive to economic conditions, but the company fills an important niche in the cloud computing market. With a $200-billion-plus market opportunity ahead of it, the stock looks like a solid buy for long-term investors.
