DigitalOcean Holdings, Inc. (DOCN) Earnings Call Transcript & Summary

That's some testament that you hardly lose any customers as long as you've been -- like a year. I mean you rarely, rarely hear that. Congratulations. I guess on that point, if I get large enough, I mean, how does your pricing for compute and storage compare to the big 2 guys out there?

Well, we tend to be 20 -- depending upon the use case, what you're using, but anywhere as little as 20% cheaper to 60% cheaper than the hyperscalers. And people come to us all the time. We talked about it in the -- we used our case study in the earnings call in Q1 to talk about somebody who had moved -- migrated from one of the hyperscalers in Q1, and they're still ramping with us, and they're saving 60%. But they're also having comparable performance in terms of the use case for them and the volumetrics, they are -- they were roughly a $10 million, $15 million revenue business growing rapidly. We don't have all the capabilities of the hyperscalers, and we never will. We don't aspire to because our customers don't need it. They need a more simplified use case for infrastructure. So yes, they need infrastructure, but it's a totally different use case. And we'll see people come from the larger players because they realize they don't need all that breadth and depth of capability. They need the basics. They need simple, easy intuitive. They need help with documentation and support, and they certainly need to spend a lot less money. So -- and I mean we're committed to keeping that differentiation to serve those customers and growing customers organically on our platform.

And yes, I think with AWS, when I was following them about 5, 6 years ago, when they started adding more value-added services like you guys have now, the AI, database, Kubernetes, I know you have a few other products, that really seemed to help their margins out quite a bit. And I think it also helped them on the pricing side for their basic compute and storage products in a lot of ways. And I think it's -- 20%, 25% of the revenues now are, call them, value-added services for a lack of a better word. I think you guys are around 10%, wanting to head to 20%. But can you talk a little bit about how it's changing the business model and maybe adding to profitability or maybe pricing power for your core businesses or even adoption of your core business?

Yes. Well, they're certainly synergistic. It's not either adopt IaaS or PaaS like a lot of folks tend to think about it. They're very synergistic. And I'll explain that. But principally, what they're doing is they're really helping to support acceleration of ARPU. We would have ARPU growth that would be interesting if we just had an Infrastructure as a Service. But what would happen is when people needed a database, they have to go somewhere else. And every business needs a database at some level of scale. So by us adding a database, we've added a foundational capability. Us adding a Kubernetes and an App Platform, we've added foundational capabilities that as companies scale, it's not 2 people are on a beer keg and a computer writing code, but it's 2 teams of 10 developers. You need tools, software tools, productivity tools that enable you to go fast in software deployment. That's what Kubernetes and App Platform do. So by us adding that, we still have that natural tailwind of our SMB customer, but we get them more to buy with us. So that's a tailwind to really driving ARPU growth. And by the way, as customers are successful in executing their business, they consume more compute, network and storage because they have more customers. They have more applications, et cetera. So it pulled IaaS. So I think you're -- what you said about some of the other folks, the larger folks, that's why we say 80-20. It's not like -- some people ask us, well, why doesn't PaaS just go to the moon and IaaS become smaller? Because the Infrastructure as a Service is core and foundational to what our customers need. The software and services they buy around that are driving their productivity, but it's still about the infrastructure. And so we think 80-20 is a reasonable place to land when we get to our first $1 billion in a few years of revenue. And maybe it changed a little bit around the margin, but the key for people to remember is that as businesses grow, and yes, they'll grow with PaaS, and it is a little bit less capital-intensive revenue, if you will. So it does help margins in most cases. But it's still -- the pull-through on infrastructure is pretty significant as well. So it helps to pull that along.

Well -- and I've always been struck at how -- I mean AWS was reducing EC2 prices or compute prices for like 25% a year the first 7 years, and they haven't really reduced them in the last 5. And I think a lot of it is because of bundling in these new services. But it also kind of help them go from 30% EBITDA margin to 50% EBITDA margins, I think. I think it was a key element. And obviously, scale was very important also. But do you see this as a bit of an inflection point for your free cash flow margins going up, adding these value-added services and driving that to 20%?

Well, I think we came across an inflection over the last quarter or so on free cash flow for sure. And it's important we -- when I say we, Bill and I, our team, our Board, we talk about growth and free cash flow. So we're a Rule of 40, Rule of 50. We strive to drive a business at Rule of 50, enduring business that's high growth and high free cash flow. And we're very focused on it. I do think that one of the things we see is as customers grow and they buy a managed service, then the -- it's so sticky, right? You're embedded in the workflow of the customer. And so as we can add some more targeted managed services, it's just going to allow us to accelerate ARPU and sustain that high level of growth and absolutely sustain and then continue to -- well, accelerate in the near term and then sustain what the point of arrival is, a pretty attractive business growing where we are, plus -- hopefully 20% plus free cash flow in the next several years. So we think that we have that opportunity. It's a massive market. we're very differentiated. And I think investors -- our team is now seeing and believing that -- certainly, our team is now believing that we could do this, that we can grow above the market. We don't -- we're not reselling hardware, right? We're not selling a commodity. When we came here 2 years ago, there was a perception that, yes, it sells commodity. We need PaaS to grow out of the commodity. It's not a commodity. We have a differentiated capability. We get a premium to lower-priced competitors who do try to say we're just -- we're doing all the data center stuff for you. We'll pay -- you pay us for that. You don't get -- the whole service support, the whole managed service model to support your workflow is not how they're pricing it. We think that's not the right way to do it. It's a big market. So they could build nice businesses. But we feel like to get the true multibillion-dollar potential, we got to be embedded in the workflow and serve our customers with this value-added capability, the managed services, the value-added services that you point out that complements the infrastructure and make infrastructure better, too. We're investing in infrastructure. It's not all about PaaS. We just launched our Premium Droplet in Q1, its first price increase in the history of the company on compute. And we offer a $6 Droplet now with a premium, higher processing, higher availability, other aspects chip. And it's a great -- it's become almost -- it's approaching a mid-single-digit product in less than 2 quarters, not cannibalizing the $5 Droplet because there are customers who are early in their journey. They don't have a lot of customers yet on their platforms. They're -- they're building their business at DO. And $5 Droplet, they could use a little bit more horsepower, but they don't need a $10 Droplet. And so we've threaded the needle. And so I think there's a lot of opportunities, I think, critical example of learning our customer, learning about their use case and using innovation to better tailor our offerings to help support their growth. And those are the things that are driving ARPU. They're driving NDR and driving us now into the mid, upper 30s on growth rate.

And I know this is always a balancing act, keeping things simple and easy to use, but customers -- certain subsegment demand a lot of services. But I guess in particular, what do you guys do about security and networking? Do you help customers bundle in? Do you partner with anybody else?

So when we look at sort of what are we really selling ultimately, whether it's 2 people or -- with just an idea or it's 2 people building a business, we're selling trust. They can come here. This is a place that they can test, learn, grow. And although they -- most people really don't care about security as they get customers on their platform, they care about reputation, et cetera. So security, we have a meaningful investment in security, dozens of people who focus on process, technology tools, standardization protocols around how we develop code, deploy code, process around onboarding. A key aspect of the onboarding workflow is filters for security. We kick thousands of people off the platform weekly -- or excuse me, each month, who are spammers or phishers or otherwise up to bad things. We have -- we work with best practice sort of roundtables, if you will, including people in the hyperscaler world. We're peers with them in what we see in the Internet and helping each other to keep the Internet as good as possible. Obviously, it's a never-ending whack-a-mole type of thing, but we are heavily invested in it. We'll continue to invest in that capability. It's part of our orientation. And it's -- the way we like to say it is we keep the cloud secure for everybody else. And we're very transparent with our customers about what we do there. And frankly, it's a differentiator. Some of our smaller competitors don't invest at that level, and they have issues on their platforms that we don't have. And we see growth because of that investment in security. I'm pretty passionate about it, just for my background. But it's really important to us, and it's a meaningful investment, and we'll continue to do that. That's not an area we need leverage. We invest at the growth rate to make sure that we're trying -- you can't stay ahead of it, right? It's just the world is scary, but we invest heavily to do our best to keep the cloud secure for our customers who are doing good things on the Internet, on digital.

And I guess for example, would you have your own DDoS product? Or do you partner with other people? And I know there's like 20 -- well, there's like probably 100 different security products. But do you have many partners or you've developed a lot of this in-house and run it in-house?

Yes. It's one of those things, right? You start out with security because you have to. And I think as we've matured and evolved as a company, we're now starting to think about, well, this is valuable to customers. I've had many conversations with the customers who have been here for 6, 7 years. And they're still paying whatever they pay for a Droplet and like that Droplet has more [ 9s ] than when you bought it, and it has security. You don't even see that. And so how do we productize that is something that we're definitely talking about. We certainly are in some conversations with potential partners, and we're excited hopefully to add some security feature functionality into the platform. I do think it's an opportunity because obviously, in the last 6 months, the heat map is getting hotter. And so everybody is very aware of this. And so I think it's an opportunity for us to help evolve our brand, again, to create even more of that differentiation about what we do is help you succeed. And a key aspect of that is to create a secure cloud for you to succeed in and create some knowledge and awareness. And then I think there is productization opportunities around security and our core functionality that we'll look to launch over time.

And how about things like -- I know -- how about things like VPN or even collaboration or communications products? You're getting to a huge customer base. I mean are there ways to kind of jointly market to them with experts in these fields, not to overcomplicate things?

Yes. I think the answer is right now, we don't know. I think near in, we're focused on adding some services that drive productivity around customer targeting, et cetera, for our customers, things around serverless, which is an aspect of simplicity. I mean historically, you write code. You think about all the aspects of deploying code. And I think back to what I was an engineer, how complex all that was, and it's just getting simpler. And now people, even if they are developers starting a business, they're also the CMO and the Chief People Officer. They don't want to think about all this complexity. So can we make it easier for them to configure their apps, configure and deploy code and we worry about the infrastructure [ in the background, more application ]. Those are areas that we think create more simplicity, more productivity, remove more barriers for customers. So I think in the near term, coupled with security, as we just talked about, I think those are some of the areas that are priorities. Over time, do we add more complete cloud, if you will, to what you said or -- we'll see. We certainly got it back to the mid-30s. We're hoping to do more through what we're doing now in some near-term product road map. And we'll see what sustains that or allows us to continue to accelerate it and is that an area we want to go down. We'll just have to see how that plays out over time.

So great job on the growth. It looks like you can grow here in the comfortably well above 30%, and congratulations. And Bill, it seems like the easiest place to pull the free cash flow operating leverage is on CapEx right now. And I know you've talked about getting down below 20%. Can you talk about how long that's going to take and what the main levers are to pull to drive that CapEx down?

Sure. We are targeting sub-20%, and we see that over the next 2 to 3 years. And our ability to achieve that is basically driven by 2 things: one, very much a very -- a traditional procurement lens. Previously, we were buying -- before we got here, we were buying servers on an as-needed basis. And as a result, we were paying a lot of retail. We took more of a view looking at over the next 6 to 8 quarters. And with that kind of volume in mind, we began discussing with the suppliers, not only the box folks but also the component manufacturers, as a way to drive down the cost. And we've already achieved a meaningful reduction in our average cost of server. And we're continuing to work with those suppliers to drive it further. And we do see more room there again, again, not only just in terms of the overall box but what goes on inside, particularly related to the chips. As Yancey mentioned, we've just done a premium chip offer working directly with AMD and Intel. So we see further opportunities to drive those costs down, and we'll keep working on that. But the other part of it, Tim, is more around the capacity utilization. Historically, the company sold capacity and didn't go in and look at actually how the capacity was utilized. And what we've been identifying is ways that we can effectively pack these more server -- pack these servers better than we have historically. Now some of that is, I would say, pretty straightforward. We weren't utilizing or we had too much lag time before we were filling up servers. But now we're looking at ways that we can pack them differently depending upon use cases and whether we have an opportunity since we do operate globally to look at times where the platform is not being utilized to maximum level and might be able to offer opportunities to customers to get different pricing in order to run a different time frame. So we think we have a lot of room to continue to grow here. And it's important to remember that we see very rapid growth. We are making sure we are investing ahead of that growth, so we don't get caught out by the shortages that are basically impacting us. We've been working through that over the past 4 quarters. We know that will continue. We've been very agile in terms of moving around orders to ensure we can get the supply we need. But we feel pretty comfortable as we look out 6, 8 quarters that we can get to that sub-20% level. And that is, to me, the biggest thing that strikes me in speaking to investors. Initially, everybody focused on CapEx, CapEx. And now we're getting across that we're free cash flow generators today and increasingly going forward. So while we do invest a lot in hardware, we're going to be a 10% free cash flow generator next year. We're a free cash flow generator today, and we will continue to be so going forward.

I learned a lot today, and I didn't think about you guys deploying your serverless product, which is brilliant. And it sounds like you're going to enter the spot market for processing, which is also brilliant because I'm sure a lot of these developers would love to have low-cost processing power and maybe it's not time-sensitive. So 2 really, really cool products. But I guess, Bill, I know we're almost out of time. Can you give us a sense of what your asset utilization was of your services and where -- if you have like spot market out there that you're selling capacity at different times of the day to increase that utilization, what it can kind of go to?

We're not doing that yet, Tim. Really, we're at the beginning of this journey in terms of understanding our customers. One of the things I say is that before it was like field of dreams, build it and they will come. We didn't really learn who they were that were coming. Now we're learning so much more. And we're also diving into how the utilization, how the platform runs. We brought on Chris Higgins, formerly of Oracle and AWS, who's really helping us get there. So we are focused on the number. We do see upside relative to it. We haven't spoken to it. And spot, I think, will be further down the road for us, but we think that is a real opportunity.

Well, I'm sure that you have dozens of other opportunities we really haven't touched on because they're out there, right? And the customers want it. But you guys are experts at making it simple and delivering it really, really well. Well, congratulations and great job. I know the stock has been performing also a lot better here recently, and you guys had a phenomenal quarter that we didn't get into too much, but -- and it sounds like the momentum is still building. But I really appreciate the time, everybody. And have a great rest of the day, not that there's much left in it, but thanks so much for attending. Thanks, Yancey. Thanks, Bill.

Thank you, Tim.

Thanks for having us at the conference.

Thank you.

Absolutely.