DigitalOcean Holdings, Inc. (NYSE:DOCN) Q3 2023 Earnings Call Transcript

DigitalOcean Holdings, Inc. (NYSE:DOCN) Q3 2023 Earnings Call Transcript November 2, 2023

DigitalOcean Holdings, Inc. beats earnings expectations. Reported EPS is $0.44, expectations were $0.36.

Operator: Hello and good afternoon. My name is Jeremy and I’ll be your conference operator today. At this time, I would like to welcome everyone to the DigitalOcean Q3 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. [Operator Instructions] I would now like to turn the call over to Rob Bradley, Vice President of Investor Relations.

Rob Bradley: Thank you, Jeremy and welcome, everyone, to DigitalOcean’s third quarter 2023 earnings call. Joining me today is Yancey Spruill, our Chief Executive Officer; and Matt Steinfort, our Chief Financial Officer. Before we get started, I would want to cover our Safe Harbor statement. During this conference call, we will be making forward-looking statements, including our financial outlook for the fourth quarter and full year as well as statements about goals and business outlook, industry trends, market opportunities and expectations for future financial performance and similar items. All of these statements are subject to risks, uncertainties and assumptions. You can review more information about these in the Risk Factors section of our filings with the SEC.

We remind everyone that our actual results may differ and we undertake no obligation to revise or update any forward-looking statements. Finally, we will be discussing non-GAAP financial measures on our call and reconciliations between our GAAP and non-GAAP financial results can be found in our earnings press release which was issued earlier this afternoon and in the investor presentation which can be found on our Investor website. With that, let me turn the call over to our CEO, Yancey Spruill. Yancey?

Yancey Spruill: Thanks, Rob. Good afternoon and thank you all for joining us today. I’m pleased to share our solid Q3 results, representing another quarter with an attractive balance of growth and profitability. This afternoon, I’ll share an update on the search for our next CEO, some broader macro observations that have been informed by customer and partner interactions and briefly recap some of the exciting product announcements that we’ve made recently. I will also highlight a recent customer win that gives us enthusiasm for our product trajectory before turning the call over to Matt to go over the financial results and updated financial outlook. On the CEO transition front, the search process is well under way and the Board is making good progress in our recruitment of a new CEO.

There has been very strong interest from numerous leading technology executives and we are confident that we will hire an outstanding executive with extensive cloud infrastructure expertise. The Board of Directors is deeply engaged with several candidates and we will continue to move these candidates through the interview process as the search progresses. It is still too early to communicate a specific timeline for the hiring of a new CEO, but the Board is working with focus and deliberate speed to fill this critical role. Third quarter results were encouraging as the business delivered solid performance from both the top and bottom line perspective. Revenue grew 16% year-over-year to $177 million and our first quarter having lapped the Q3 2022 pricing actions.

And as we indicated, we had started to see at the tail end of Q2 we continue to see positive signs through Q3 and in early Q4 that there are abating trends from the growth headwinds from our cohort that we have seen over the past 12 to 18 months. Our margin profile for the core DigitalOcean business was very strong for the quarter and enabled us to absorb the incremental costs from our Paperspace acquisition, while remaining within our targeted range of adjusted EBITDA and free cash flow margins. The combination of a stabilizing revenue growth rate and the efficiency we have created in our core business is allowing us to deliver robust free cash flow margins. As we look to accelerate our top line growth rate, we continue to build distinct revenue growth drivers through product and infrastructure investments.

A big portion of our focus over the past several months has been on our ongoing efforts to deliver on our product road map and continue to add critical capabilities that enable our customers to build and scale their own businesses. Through numerous interactions with customers, prospects and partners, we continue to fine tune and evolve how we can best serve customers as they navigate the complexities of the cloud markets. The consistent sentiment from our customers is that simplicity is foundational to our value proposition and relying on DigitalOcean to remove the complexities of the cloud is a productivity multiplier for them. We are focused on enhancing our platform’s performance, reliability, security and scalability, which enables us to retain and grow the spend of our customers and positions us to win new customers.

Over the past several months, we have delivered an increase in velocity of product releases and announcements as we focus on meeting our customers evolving needs. In September we launched Managed Kafka, a new fully managed database service. Managed Kafka is a critical tool for businesses whose model involves significant data streaming. However, for small and medium business customers, it often comes with increased complexity. With our new fully Managed Kafka as a service offering, companies can focus on their development environment and not be slowed down by complex processes. Customers have provided strong positive feedback about Managed Kafka, citing that it is allowing them to focus their time and resources on their customer facing activities, referring to their increased productivity as a game changer.

In September, we also introduced premium to general purpose droplets, extending the premium features of enhanced CPU, memory and storage to offer improved performance to a broader way of cloud native applications. Our first generation premium dedicated droplets saw broad adoption and drove strong ARPU growth when launched in the beginning of 2021, as customers expanded their computing capabilities and migrated certain workloads to this premium compute offering. Now we’ve taken it one step further and expanded the opportunity for more customers to use these enhanced features with this new premium general purpose offering.

PostgreSQL: On the Paperspace front, we continue to be very excited by the addition of their AI/ML capabilities and the expanded market opportunity that this business creates for DigitalOcean. While we are still only a few months into the integration process, the demand for Paperspace’s services has been very strong and we continue to learn more about the market and how customers are leveraging our capabilities to develop and grow their businesses. To give you a sense for one such use case, I’ll provide an overview of one of the exciting customers we recently added to the Paperspace platform. The company is Nomic, which was founded in 2022 to improve the explainability and accessibility of artificial intelligence. To date, Nomic has released two products, an open source AI model GPT for all, which is which is the third fastest growing repository in GitHub history, and Atlas, a tool that allows users to visualize unstructured data sets used to build large language models.

Nomic selected DigitalOcean to access High Performance Compute along with their along with our intuitive software, customer support and reliability. Their Co-Founder was quoted as saying. Our team loves Paperspace. It’s far more intuitive than other compute providers. It allows us to spend less time managing infrastructure and more time building great products for our customers. Their testimony to DigitalOcean’s combination of simplicity, reliability and support along with the current demand environment that we see excite us for the opportunity ahead. The RFPs that we are seeing span across multiple verticals for multiple applications and demonstrate the opportunity for new customers to join our platform to not only build their AI applications, but also to scale their products while utilizing the breadth of our IaaS and Paas capabilities.

In summary, we’re making good progress with our efforts to bring on a new CEO and during this transition, our business is seeing stabilizing revenue trends while continued to deliver significant free cash flow. We are seeing very encouraging signals that our top line growth rate is stabilizing relative to the last six quarters of deceleration. We continue to work to reaccelerate our growth rate through targeted product and go to market initiatives. The improved operating leverage we have created in the business over the past year is enabling us to make strategic investments while still delivering compelling free cash flow margins. We remain excited about our near and long term potential in the large standing $100 billion addressable market for SMB cloud infrastructure in which we compete.

As we approach the end of the year, I’d like to thank each and every member of the DigitalOcean team for their commitment to our customers and for delivering these solid results. With that, I’d like to turn it over to Matt to provide details on our financial results and our outlook for the balance of the year.

Matt Steinfort: Thanks Yancey, and welcome to all of you who are joining us on today’s earnings call as we review our solid Q3 results. In Q3, we continued to execute our strategy of accelerating the achievement of our long-term margin targets in the core DigitalOcean business while positioning the company for accelerated future growth through both organic and inorganic investment in our platform despite the ongoing macro headwinds. We have driven these margin improvements by achieving the savings that we had identified at the beginning of this year, which included improvements in our gross margin as we grew into capacity investments made in 2022 and the achievement of identified savings in both headcount and non-headcount related expenses.

As we have continued to execute on these savings, we have increased our overall profitability and free cash flow margin significantly allowing us the flexibility to make targeted investments in growth. During the first three quarters, we have continued to invest in organic growth by our product roadmap as Yancey described and in July, we invested inorganically in the acquisition of Paperspace, which meaningfully increases our total addressable market. With our strong balance sheet, our continued focus on improving operating leverage and our commitment to share repurchases, we have made material progress driving earnings per share increasing 22% year-over-year. As we approach 2024, our strategy remains the same. We will continue to drive operating leverage while balancing investment across organic and inorganic growth opportunities and share repurchases.

With that context in mind, I will review the highlights in the third quarter. Revenue in the third quarter was $177.1 million, which was an increase of 16% year-over-year and 4% quarter-over-quarter and our first full quarter that lapsed the pricing increase we implemented in early Q3 2022. Contributing to this growth was Cloudways, which grew 11% quarter-over-quarter and the addition of Paperspace, the AI platform we acquired in early July, which contributed $3 million to our results for Q3 and which surpassed the $1 million in monthly revenue mark in September. Profitability was very strong as we delivered $75.8 million of adjusted EBITDA, a 43% margin for the second consecutive quarter. Adjusted EBITDA margin improvements are the result of improving gross margins as we grew into the incremental data center and bandwidth capacity investments that we had made in late 2022 and the ongoing benefit of the efficiency improvements that we had identified in Q1 of this year and have been realizing throughout the year.

Free cash flow was also a highlight in the quarter as we generated $56 million which was 32% of revenue. This 500 basis point improvement from Q2 was a result of both lower capital expense and working capital timing. Given the working capital timing dynamic coupled with our anticipated near-term Paperspace investments, we expect free cash flow margin in Q4 to be lower than Q3 levels. While free cash flow margins can be lumpy quarter to quarter, we continue to be confident in our full year free cash flow margin expectations. Finally, non-GAAP earnings per share was $0.44, which is a 22% year-over-year increase as we have increased our profit margins while having simultaneously reduced our shares outstanding through our systematic share buyback program.

As expected, net dollar retention declined in Q3 to the mid-90s coming in at 96% as we lapped the price increase that was implemented in July of 2022. Fortunately, despite the difficult year-over-year comp in Q3, we did continue to see evidence of the ongoing stabilization of market demand that had started to show signs of bottoming in Q2. As it has been for most of 2022, churn remained stable at historical levels around 11% to 12% for each of the months in Q3, which is consistent with historical churn levels in early 2022 prior to the market slowdown. Contraction which has historically been in the 12% range in early 2022 showed improvement as we progressed through the quarter ending at 15% after starting the quarter at over 16%. We also saw positive signs in expansion in Q3, which was the final metric we said we needed to see for stabilization as it had continued to decline in Q2, albeit at a decelerating rate in Q3, expansion stopped declining for the first time in over a year and was fairly consistent at 23%.

While we have not yet seen a meaningful improvement in NDR, we are encouraged by the relative stability of the key component metrics in Q3. We expect NDR to improve in Q4 and early 2024, driven in part by the continued strength of the Cloudways business and more favorable year-over-year comparisons. From a customer perspective, our durable customer acquisition and graduation model remained solid despite the challenging growth environment. We graduated 4000 builders and scalers on our platform in the quarter and we now have more than 154,000 on the DigitalOcean platform. These customers who spend more than $50.00 per month with DigitalOcean continue to represent 86% of our overall revenue and remain a key focus of our product, sales and customer success investments.

Average monthly revenue per customer or ARPU was $92.06 which was an increase of 6% year-over-year, which like NDR faced a difficult year-over-year comp as we lapped the price increase from last July. Before providing guidance for Q4 and for the full year 2023, it is important to understand where we are in the 2024 planning process. We are working diligently to finalize our plan and budget for 2024 with a focus on delivering double digit growth with healthy profit and free cash flow margins. Our strategy will remain the same in 2024. We will continue to drive operating leverage in the core DigitalOcean business while investing to take advantage of the compelling market opportunity we have with Paperspace. As we shared last quarter, despite the continued market pressures, we believe we have a solid foundation for double digit top line growth for 2024 with our steady self-serve funnel generating around 5% growth, Cloudways generating around 3% growth and Paperspace producing at least 3% growth.

Key to growing faster than this will be getting NDR above 100% at some point in 2024, which we are working aggressively to accomplish. We look forward to providing more specifics on our plan at our next earnings call in February when we report our Q4 and full year results. In terms of financial guidance for Q4 of 2023, we are targeting revenue to be $178 million. For the fourth quarter we expect adjusted EBITDA margins to be in the range of 36% to 37% and non-GAAP earnings per share to be $0.36 to $0.37 based on approximately 100 million to 101 million in weighted average fully diluted shares outstanding. For the full year, we are targeting revenue to be $690 million. Given the strong performance driving margin improvement in our core DigitalOcean business, we continue to project adjusted EBITDA margins to be in the range of 38% to 39% for the full year, despite our increased investment in our Paperspace AI/ML business.

We project non-GAAP earnings per share to be in the range of $1.52 to $1.54 with weighted average fully diluted shares outstanding for 2023 of $102 million to $103 million. And finally, given the strong progress we have made on improving margins in our core DigitalOcean business, for the full year 2023, free cash flow will be 21% to 22% of revenue, consistent with our initial February guide, despite the incremental investment we are making into our Paperspace business. That concludes our formal remarks and we’ll now open the call up to Q&A.

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Q&A Session

Operator: All right, perfect, thank you. [Operator Instructions] Our first question comes from the line of Raimo Lenschow from Barclays. Raimo, please go ahead.

Raimo Lenschow: Thank you and congrats on a great quarter and it’s nice to see the stabilization and improvement. My first question is on Paperspace. Can you kind of talk a little bit about what you’re seeing in the customer base in terms of how you see the adoption there? Because like at the moment for us AI, there’s a lot of like big companies and co-pilots and stuff like that. Can you talk a little bit about like practical use cases, how like SMBs or are using this and what are you seeing there in terms of excitement about that? And then I had one follow up on financials. Thank you.

Yancey Spruill: Well, the customer base, I think Nomic that we provide an example is a good example of — there are a diverse array of use cases, verticals. People targeting building large language models for specific use cases, creating tools that enable people to use AI productively. These are tech enabled businesses. I don’t know if we would call them SMBs, because I think they have aspirations to grow very rapidly supporting a broad set of use cases. But the good news is, the value proposition that we offer and the complimentary aspect of the Paperspace platform, which is built around simplicity is making it easy for people to come onto the platform. And I think that’s been a distinguishing characteristic for us over the life of DigitalOcean and exciting to see that value proposition be weighted heavily as we move into the AI opportunity.

Raimo Lenschow: Okay, perfect. And then a question, quick question on the free cash flow. So obviously very strong performance this quarter and you called out CapEx and working capital a little bit as factors here. But how do you think about that those two factors that you mentioned there in terms of like in theory some of that could be driven forward or was it just timing? Thank you.

Yancey Spruill: Thanks, Raimo. If we are still staying with our full year guide for this year of 21% to 22% and that’s what we will have some of the working capital catch up in the fourth quarter. It’s — looking at free cash flow margin on a quarterly basis is tough just because it’s a lot influenced by timing of payments. So that will normalize in the fourth quarter. And then in the fourth quarter also given some of the equipment purchases we made when we acquired Paperspace that are coming in, we expect that to hit partially in the fourth quarter as well. So again the full year guide of 21% to 22% is still the right way to be thinking about it and it’s great that we have the margins as high as we do this quarter which is evidence again of the core DO business.

As we said we were going to drive free cash flow margins into the high 20s and approach 30 by the end of the year and we’ve done that and we’re using that as a means of funding the growth opportunity that we have to drive more revenue in the Paperspace business and yet we’re still able to come in at 21% to 22% for the year. So excuse me and we’re really happy with the progress we made.

Raimo Lenschow: Yes, excellent. Yes, no, really good performance. Thank you. Thank you.

Operator: All right. Our next question comes from the line of Mike Cikos from Needham & Company. Mike, please go ahead.

Unidentified Analyst: Hey, guys. This is Matt [indiscernible] for Mike Cikos over at Needham. Thanks for taking our questions. I know you hit on this a little bit, but it’s kind of coming from a different angle, is there anything one time or anything I guess that sticks out as far as shifts and timing of expenses that you would call out in the reduction to the implied 4Q EBITDA guide?

Matt Steinfort: Timing of the expenses related to the EBITDA, the decline — oh, the sequential decline in EBITDA, no, it’s, I mean this is again it’s with Paperspace being on board that’s clearly causing some a couple of basis point impact on the margins. It’s just a different margin business given it’s not at scale. And then as we invest to grow the business into next year, both the core DigitalOcean business and the Paperspace business there’s nothing that’s kind of one time in nature. It’s — again the guide for EBITDA of what is 38 to 39 for the year is the right way to think about it. I don’t get caught up in the margin kind of the quarter-over-quarter margin fluctuations. You’ve got to think about it over a longer period.

Unidentified Analyst: Got you. That’s helpful. Thank you. And then in any way is the customer base showing any potential signs of greater caution given news on the broader macro or digital native pressures in the F&B space?

Yancey Spruill: I think what we said is we’re pleased with churn has been relatively stable now for several quarters as we move through the year. We saw improvement in contraction as we moved through Q3 and that continues at a better level than it was six months ago and we’re seeing stabilizing signs in expansion. And so I think those are the biggest tell-tale signs for us as it relates to what our customers and new customers and existing customers are seeing that things seem to be stabilized.

Unidentified Analyst: Great. Thanks so much for the color.

Operator: Our next question comes from the line of Josh Baer from Morgan Stanley. Josh, please go ahead.

Josh Baer: Great. Thank you. Congrats on a good quarter. Was hoping you could break out some of the metrics around Paperspace, the contribution to ARR and just how to think about the contribution to the different customer cohorts?

Yancey Spruill: So from an ARR standpoint, I think we said what it was $2.8 million in the quarter, it’s going to be just a little over $3 million. We’re going to end up around $6 million for the year. So from an ARR standpoint it’s going to be what, north of 12 because that’s where the quarter is ending. But from a customer account standpoint it added about I want to say 12,000 customers in total to the customer base and again the average revenue per customer there is a lot bigger. So it’s closer to average is 900-ish. So they tended to be added to the scalers segment and the builder segment.

Josh Baer: Great. Thank you and apologies if I missed this. Just looking at CapEx as a percent of revenue is pretty low. I understand that can be lumpy and it is a priority to invest in Paperspace. But how should we think about the trajectory of that CapEx spend and is it a good leading indicator sort of for your demand in top line growth? Thanks.

Yancey Spruill: No, I don’t think it’s a good leading indicator of the demand because it is lumpy. We were originally tracking to be about 15% for the year. What we said with Paperspaces will be closer to 17% and in CapEx as it percentage of revenue for the year. And some of that is just it’s lumpy. I mean we ordered gear right out of the gate when we bought Paperspace and we increased that amount because we’re seeing a lot of really good demand and just the supply chain around GPUs, it’s unpredictable. And so we didn’t get everything that we ordered in Q3, in Q3, and we’re going to get — start to get some of that in Q4 and then we’ll start to get some more of it in early next year. So it’s really is working capital and the timing of that CapEx purchase, but it’s not – that’s why we’re saying for the full year, we’re still sticking to the 21% to 22% free cash flow and still the target of around 17% CapEx as a percentage of revenue for the year.

Josh Baer: Got it. Thank you.

Operator: Our next question comes from the line of Patrick Walravens from JMP. Patrick, please go ahead.

Patrick Walravens: Great. Thank you very much. And it’s nice to see the business stabilizing. So my question is on with Paperspace, how are your GPU cloud data centers different than your traditional CPU cloud data centers that you had with DigitalOcean, and what’s that GPU cloud data center footprint look like today and where are you going to take it? Obviously, it’s been a big issue in the industry lately.

Yancey Spruill: Well, GPU servers have heat different heat consumption, much higher heat consumption. So the physical footprint is less dense than you might with standard compute. I think that’s one of the principal differences. We’re still evaluating, as Matt mentioned, in the 2024 planning process around what the level of investment pacing and that may include how to think about evolving the data center infrastructure for both companies for the combined company and incorporate the fact that it’s going to be a mix of GPU and standard compute CPU going forward. I don’t think any decisions have been made on that. We’ve been fortunate some of the Paperspace data center footprints are very close in proximity, including one particular case in the same building and we’ll see how we evolve that as the demand.