Cloud provider DigitalOcean (DOCN -1.33%) is taking the plunge and competing with big cloud behemoths like Amazon’s (AMZN -1.44%) AWS, Microsoft's (MSFT -1.32%) Azure, and Alphabet's (GOOGL -0.98%) (GOOG -1.14%) Google Cloud. It is a cloud provider focusing on providing simplicity and transparency to small and medium-sized businesses, which the big providers have failed to do. By targeting this unique customer demographic, DigitalOcean has the opportunity to succeed and become the best niche cloud provider in this market.
A better option
For large cloud providers like Amazon and Microsoft, the biggest bang for their buck is by providing sophisticated and pricey applications to large enterprises. While that would be beneficial for that type of customer, those applications are challenging to set up for a consumer with little or no cloud experience on that platform.
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For these small and medium-sized businesses, or SMBs, all they typically need is one or two basic applications. They also need applications that are easy to set up, which is hard to find on AWS. DigitalOcean focuses on these SMB customers and offers them a simple and cheap way to obtain the basic cloud applications they are looking for.
The company focuses on a few critical services like managed databases, droplets, and app platform building, which is typically all that SMBs need. SMBs need one more thing: Price transparency. DigitalOcean fills that need as well by clearly laying out base prices for all its services on one easy-to-read page.
DigitalOcean also has a community where developers can learn and chat with other customers, ask questions, and learn about everything related to the cloud. DigitalOcean offers free tutorials on how to code, manage databases, or just about anything an SMB might need to know to operate on the cloud. Most of the large enterprises have expert developers within their companies, so this communal aspect is something that AWS or Azure don’t have on their platforms. SMBs, however, might not have the capital to hire these experts.
This community aspect results in strong word-of-mouth marketing. Developers using DigitalOcean are typically advocates of the site on these community boards, which helps the company cheaply acquire new customers. This is likely why DigitalOcean only spent 22% of revenue on sales and marketing in the trailing twelve months, or TTM.
Picking up steam
DigitalOcean has a larger market opportunity than most investors might think. Its current market opportunity is $44 billion, but this is expected to increase to $116 billion by 2024. The company also expects that there will be 14 million new SMBs each year that it can sell to.
So far, DigitalOcean seems to be succeeding. Revenue growth has been accelerating -- from 24% growth in the third quarter of 2020 to 35% growth in the most recent quarter -- reaching $366 million in revenue during the TTM. Net dollar retention has also been ramping up, hitting 113% last quarter, compared to 102% one year ago.
Both average revenue per customer, or ARPU, and customers have been increasing heftily as well. ARPU grew 25% to $58 in the most recent quarter, and customers surpassed 600,000. Its customer count has been growing consistently quarter over quarter, growing mid-single digits sequentially.
Annual recurring revenue growth has also accelerated. The company has grown its ARR over 25% in each of the past four quarters, with the second quarter growing 36% year over year to $426 million. This ARR growth could push DigitalOcean into profitability. During the last six months, it had just $5 million in net losses, compared to $197 million in revenue.
The risks of upsetting whales
The major risk for DigitalOcean is the chance that Amazon, Google, or Microsoft could shift a focus toward SMB customers. These cloud providers have billions in capital that could be funneled towards this, which could potentially wipe DigitalOcean out. The only way that DigitalOcean could survive this is if it establishes strong relationships with its customers. It is showing success on this front with its high retention numbers and an NPS score of 64 out of 100.
DigitalOcean praises its simplicity, yet a growth strategy for the company is expanding its offerings. If the company does this, it mitigates its own competitive advantages, so its product growth is basically capped, which could hurt the business.
DigitalOcean is operating in a market that has been largely neglected by the large whales of the industry. It is providing a communal, friendly space for SMBs, and this is resulting in strong growth. Looking forward, investors should watch ARPU, retention, and customer growth for this business. These metrics will give a good idea as to how well the business is building lasting relationships with its customers. If it can do this effectively, it could potentially stave off competition, which would lead to long-run success and growth for the business.
