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

Hi. Good afternoon, everyone. Welcome to the second day of the Barclays TMT Conference. My name is Vinod. And this afternoon, we're delighted to have Yancey Spruill, CEO of DigitalOcean with us. Yancey, thanks for joining. We really appreciate it.

Hi, Vinod. Thanks for having us. Appreciate it and looking forward to this conversation.

Great. So maybe let's just start on a high level. You have your recent IPO. So for investors who aren't too familiar with your story yet, can you just talk a little bit more about what you do? And are your core products similar to EC2 and S3 from Amazon?

Yes. So we are a public cloud infrastructure. That's the colloquial name that folks like us go by. We provide basic compute network and storage. We call our compute -- unit of compute a Droplet, which is -- that roughly is 90% of our revenue along the Infrastructure as a Service, and we have various configurations, call it good, better, best in compute network and storage that comprise 90% of our revenue. We also have, as of 2 years ago and growing, a set of platform and Software-as-a-Service tools like managed Kubernetes, managed databases, serverless marketplace that are roughly 10% of our revenue today. And those enable some -- our 600,000 customers that we have in 185 countries, 70% of whom are outside the United States. We help those customers who start as developers, testing ideas, launching -- thinking about launching a business, ultimately launching a business. And we have this suite of products that are perfectly -- are purposely tailored towards the SMB and developer ecosystem, which is about a $50 billion market for cloud spend today. There's 30 million software developers in the world, going to 50 million software developers by the end of this decade, and there's 100 million small, medium-sized businesses around the world. And those are growing by about 14 million net new businesses a year. So we have a purpose-built business focused on that end of the market, and we differentiate through a simple, easy, intuitive service. And the time we've already been on this call, we could be up and running coding on our platform. Our community investment, which attracts 5 million visitors to our website a month because of our documents and tutorials that are a part of that. Support for all customers regardless of price point and our commitment to open source, in other words, removing barriers to innovation for developers for those ideas to get on the Internet. And that combination of differentiators allows us to get a price premium to smaller competitors. And we're priced at a 50-ish percent discount to the hyperscalers. And so that's our business, roughly $450 million at the end of last quarter, ARR run rate growing upper 30s, and the EBITDA margins in the low 30s. And importantly, we do all that, and we're free cash flow positive today.

That's all impressive. And the SMB market has always been a pretty tough nut to crack. It seems like you guys have really done a good job with that. I want to dig into a little bit of what you just talked about. From a competitive perspective, can you talk about some of those factors and how they hope you compete with, let's say, Amazon Lightsail? And do the same factors also help you compete with smaller vendors in the market? Or are there maybe a slightly different set of factors that help differentiate you from them?

Yes. Actually, the focus on simplicity and community, our support model and our commitment to open source actually enable us -- they're highly differentiated and collective against Linode, Vultr, OVHcloud, who compete on the lower end. We get a price premium to them. And we've gotten the price premium to them for many, many years because of those differentiators. And at the same time, yes, Amazon Lightsail, they did launch a slim-down set of infrastructure service capabilities. We think the Lightsail is probably suggesting they were targeting the rapid growth that we were seeing in the developer ecosystem 4, 5, 6 years ago. They launched that in 2016. DigitalOcean was just crossing $100 million in revenue when Lightsail was launched. And the conventional wisdom is, okay, AWS is in your space, lights out, you're done, you're going to 0. We're nearly 5x bigger than when Lightsail was launched. So I think it speaks to the power of our differentiators, the enduring nature of them, and also the fact this is a massive market. And so I think that there's room for -- it's not a winner-take-all market, and I think that's why we've seen sort of the traction we've seen.

That's great. And I wanted to talk about -- a little bit more about kind of the customer journey, your base. Your small customers, they spend maybe $10, $12 a month, really small, about Netflix subscription basically. And your larger customers, however, could spend quite a bit more. Can you kind of take me through that journey from a customer just onboarding, a developer onboarding to becoming a true small business with 10 to 25, 50 people? And then also what products they would consume as they kind of go in that journey?

Yes. I think it's the beauty of our business. It's -- we create this ecosystem where entrepreneurs, developers can come at a low-friction, low-cost environment and test ideas, learn, grow. We have so many customers who come to DigitalOcean reading our tutorials, learning how to code, and [ Gower ], python or whatever it is. And they test, and they're episodic, and they come in at $10, $15 a month, and they may stay there forever. A subset of them, over time, gets some traction and idea, and they launch a business, and it scales really rapidly. And we have this ecosystem that allows us to incubate those customers while they're testing, learning. We do events to help them think about being an entrepreneur, all the rest of it. And then we also have the capabilities, highly performing capabilities that allow them to scale a business. And as we've been adding managed databases, our Kubernetes, and as they add employees and customers, you can envision somebody going from 1 customer to 10 customers to 100 customers. You can't keep tracking your customers on the whiteboard or Excel spreadsheet as you get to 100-plus customers. You need a database tool. And so we now have that. And one of the things you're seeing with us accelerate ARPU and revenue growth expansion is because we have -- they add -- they go from 2 developer teams to 2 teams of engineers deploying code. You need deployment tools like a Kubernetes app platform. And you see the adoption as they go from the early, early stage of just testing to launching the business and getting traction. And we have an ecosystem that's very focused on curating them. But what's important, you mentioned -- the SMB has been a tough nut to crack. And the reason is -- the good news about SMB is they actually spend a lot of money, but it's in aggregate. The bad news, individually, they spend very little money, and they're everywhere. And so you have to have a very efficient way of attracting them or attaching to them. You can't go high-dollar-sales people flying around the world to go get $10 a month customers, even $700 a month customers a year, which is our average across the 600,000. And so the self-serve go-to-market motion, the importance of community where we get 5 million visitors to the website to come read our tutorials, to come read our documentation, our Q&As and learn more about how to do X, Y, Z in open source, in cloud is critical and vital because it leads to tens of thousands of new paying customers a month. And so that's how we make the tech stack work and the product set work, but then we have on the front end an efficient way, a low-cost way. So the unit economics from an LTV to CAC perspectives. And that's how we're able to do all this and only spend 10% of revenue on sales and marketing.

Got it, got it. That makes -- that's great. And I want to kind of dig in a little bit into some of your larger customers. I think before, you've talked about 15% of your customer base contributes about 85% of revenue. And within these larger customers, are there different subsets of these large customers, your top 25, maybe the tier after that, the tier after that? I want to get a better sense in terms of, where are they in their customer journey. Is there a particular customer subset that's consuming most of your PaaS services? Just if you could provide more color on that, that would be helpful.

Yes. I mean, it's -- all of our tails are long tails, so that 85% of the 500,000 that generate about 15% of revenue, the good news is they're growing year-over-year. They have positive net dollar retention that has significantly improved. So that's a good base. And then as they graduate on our platform to $100 a month, $500 a month, $1,000 a month, $3,000, $4,000 a month. $4,000 is about the average of the 90,000 customers who comprise 85% of our revenue. Safe to say the $10 a month customers, they sign up day 1, where 100% of their cloud spend is on infrastructure as a Droplet. And as they launch into adding new customers and thinking about how to deploy their code more efficiently, they add a Kubernetes, they add a database. And so you look at customers that are in the thousands of dollars a month. From $10 to $1,000, a lot of that growth is just their organic growth of going from 0 to $500,000 of their revenue. And as they get to $500,000, $1 million of revenue, they start to look at adding more employees, they add more customers, they need more tools to help them with productivity, like database management, like Kubernetes with core deployment like App Platform, like our marketplace that they get security tools, website building tools, et cetera. So as they get into the $1 million-plus, you start to see them adopting more tools and also adopting more Droplet velocity because they need more density, if you will, or more capacity on their Droplet. They need load balancers because they're working on customers around the world, so they need Droplets in different locations. And so they need to manage those loads across different data centers. They need more storage, and we have block and object storage. And so you see as customers grow, they buy more. And that's why those customers expand and have net dollar retention materially higher than the average. That's why their ARPU grows at such rapid rates because they're consuming. They have core organic growth, so they consume more infrastructure because their customers are adding their customers. And then we are able to give them more things to buy like a database, managed database, a Mongo, a Postgres, et cetera, a Kubernetes. And that's how we're growing more rapidly with those customers, who, by the way, are growing dramatically faster than 37%. Their net dollar retention is higher. We're graduating more customers into that 85% driving our revenue than the 7% total customer base. And so we've done a good job with this ecosystem of starting them at $10 a month, $15 a month and nurturing them, incubating them and then unleashing -- having an environment that allows them to unleash that idea into an SMB. And that customer journey is vital, and we need both sides of the barbell. We need those 500,000 customers to be testing and growing, and we need to add to that because that nets down to the 90,000 who are growing really dramatically and driving 85% of our growth. And that ecosystem is core to our business model. Simplicity, community customer support and open source are vital to both.

So just kind of bridging from that, as you add more and more services, more products, as some of your larger customers grow big, you say they will consume more of that. But at some point, is it possible that some of these customers are like, "Hey, we need even more," and they try to go up for multi-cloud? Or is that something that happens? What's the churn dynamic like there?

Yes. So absolutely, as you see customers get traction into the what I would -- this is anecdotal, but let's say, $1 million-plus of their own revenue, they start to think about multi-cloud because they need multiple tools. And for example, we have a lot of customers who've been here many, many years before we had any PaaS offerings who were scaling nicely with the infrastructure, but we didn't have a Mongo. We didn't have serverless. We didn't have Kubernetes. So they went to another cloud provider. So multi-cloud is absolutely integral to the customer journey. And what we see is customers who do go multi-cloud -- we still capture a majority of their spend. They don't churn -- customers on DigitalOcean for a year or more, they don't churn, de minimis churn. But they do go multi-cloud. And part of our PaaS in our innovation strategy is to add relevant tools while maintaining simplicity that are relevant for these early stage and ramping SMBs. But also we don't want complexity. And so if it means adding 900 products to add to each corner case of our customers, we'd opt not to do that. We'd rather have them go multi-cloud for businesses that are sort of highly overlapping with our core customers. But we'll add innovation like Mongo, like serverless, where we know there's a high degree of ask from our customers. And that's how we're going to focus. And I think that speaks to our effectiveness of that, and that's how we've gone from 0% to 10% of our rapidly growing business have done from these PaaS applications because we are focusing on relevant innovation as opposed to just overwhelming customers with a lot of products. And if they want to go multi-cloud, that's part of simplicity. That's part of reducing flexibility. Our customers really value simplicity more than the individual products. It's the experience that allows them to test, learn, grow and launch. That's an experience and that's as valuable. And that's why we get a price premium to these lower-cost providers. And that's why customers come to us every month from Amazon, Azure or GCP because it's the experience that's purpose-built for them. That's about unleashing them and removing obstacles and friction and complexity. And we do it at a much significantly cheaper price than the hyperscalers. And that's part of the special sauce of our company. And it's not about overwhelming with product. It's about simplicity of the experience and relevant new innovation that's relevant for these early-stage businesses.

So it's really you staying core to your values. And also, that's, at the same time, opening up an opportunity in that as you add some of these new products, your customers can get them over time. And I would say that looks like retention on that aspect could benefit from that. That's got up into the mid-1-teens now, I think, from slightly over 100% when -- through the IPO. And that's not too long ago. That's pretty impressive the move that you've made there. Can you talk about where that can go now going forward?

Yes. So I'm incredibly proud of our team for getting churn from the high-teens to low double digits. For our type of customer base, that's not insignificant achievement, and we feel pretty good about where we are. I'm sure we'll improve that modestly over time, not to the extent we've done over the last 2 years. And that now, churn is no longer a headwind to the business, it's a tailwind because we're keeping more of those customers and incubating more of those customers, which is the keys to the kingdom for us in terms of growth strategy. So that's exciting. And at the same time, we're driving expansion by turning our customer service and support model into more proactive. We're using data science, et cetera. And we've driven expansion from high-teens to high-20s, and we're not done there. We're really focusing our effort on going deeper into the cohort, trying to find those $10, $15 customers earlier in their journey and look at signals to try to get them accelerating on the platform. And so we think we can do better than the 116% we reported last quarter over time, and we're investing to do so. And similarly, we're trying to focus on relevant innovation to keep ARPU at these levels. And if we can keep ARPU at these levels, upper 20s year-over-year growth, and do a little bit better than 116%, although 116% is not too shabby for an SMB-focused company. And I think we're going to endure pretty high growth rates. Well, 37% takes us to $1 billion-plus in 2024, which was our target when we came here 2 years ago. And we're well ahead of pace to do that. And by the way, that's a $2 billion revenue business in 2026.

You're saying you can maintain that 30%, 35% growth rate through 2026?

We are very focused on managing our business for durable growth. And as we said on the last earnings call, we were comfortable with at least 31% next year, and we're comfortable that we're on track for $1 billion by 2024.

Got it. And you mentioned some product innovation, adding Mongo. You acquired Nimbella for serverless. And you've also hired a new Head of Product, I think Gabe Monroy. Can you talk about some of the products, features customers have been asking you about the most?

Yes. So obviously, Mongo and serverless have been some of the top requested products here. And so the voice of the customer and listening to our customer, we get a lot of signals. It's -- all of our customers are digital. We see what they're doing over a long period of time, and so we're getting smarter about leveraging data science and pattern matching and feeding that into the customer prioritization -- the product prioritization algorithm. And obviously, now as we're adding customer success, engaging more proactively with customers, we're adding outbound selling. We're getting a lot of signals that we used to as the voice of the customer to input to the product prioritization scheme. What you'll see from our customers is they want our infrastructure, they want more optionality on compute network and storage options. As we have a growing and scaling customer base, they want more volumetrics, more tools, et cetera. So we've been adding -- we have launched a premium Droplet earlier this year. We launched premium storage options. We launched more flexible options around networking and load balancing, and we've seen a lot of adoption there. So we'll continue to invest in the core functionality around Infrastructure as a Service. And at the same time, we'll add new Platform-as-a-Service capabilities, service being a -- serverless being a net new platform. We're looking at others. We're going to add more to our data -- our marketplace, which we've seen a lot of traction with customers coming to DigitalOcean because of the flexibility options we have in the marketplace. So we're going to add more over time while focusing and preserving simplicity as a foundational aspect of the product experience. And we're going to listen to our customers in terms of how to prioritize and scheme or sequence those new capabilities.

Okay. And can you talk about -- you mentioned some premium compute and storage offerings, can you talk about the uplift that you would get from a pricing standpoint?

Yes. So as a great example, we have a $5 Droplet as our entry virtual compute option. And customers who are ramping or have a certain use case, they need a little bit more reliability, a little more feature functionality, but they're not yet at the volumetric where it makes sense to go to the next highest Droplet or a $10 Droplet. And so we launched a $6 premium Droplet. They could pick their Intel or AMD chip. So 20% uplift, we saw a pretty significant adoption this year. In a world where people think, "Oh, this stuff is a commodity server with virtual compute," people opted for a 20% uplift versus a 100% uplift because they weren't ready for it. And they're happier. And so we see a lot. We've done that with load balancers and some networking tools. We've seen that with storage-optimized options. And so what's clear is as our customers grow and scale on the platform, there's a differentiation that happens in how they ramp. And we're getting a lot of insight into that. That's led to some of those innovations, and there's more, we think, that we can do there. And it also speaks to an opportunity around packaging. We've historically been all a la carte, pick your Droplet, pick your location, pick your Kubernetes, pick your Postgres, whatever it is. And as we learn more about customers and the use case, using data science, et cetera, I think -- and we haven't really explored this yet, but I think as we get out in the next year or 2, the notion of packaging as a lever, as a value multiplier for our customers and for our investors is something that will be on the table.

No. That's intriguing. And kind of staying on the topic of go-to-market a little bit, you don't spend that much compared to a lot of other SaaS companies. I think only 10% of S&M. Can you talk about how maybe the buckets are divided between the self-serve motion, your growing direct channel, and how you kind of see this evolving over time?

Yes. So the majority of our sales and marketing is marketing spend, is in community and the self-serve motions, paid demand gen, branding, et cetera. We have now been standing up the sales capability. As we add EBITDA and free cash flow leverage over the next few years and recently, it's not coming from there. So we've been at 10%. I think we'll at least be at 10%. We'd love to spend more than 10% on sales and marketing because that's a signal that we're going to be growing faster than where we are today. And so we're looking to add an outbound selling capability. We have the executive leaders starting this quarter to drive that. We're adding a partner channel capability, both in terms of team. We put investing in process and executive leaders. We're very excited about the opportunity. Some of our largest customers are managed service providers and digital agencies who are outsourced -- managing outsourced cloud spend and managing the website for companies. And so they're a great channel partner opportunity for us. So we're investing in those areas. I can't see sales and marketing going or any leverage coming from that. And hopefully, it's higher than 10% over the next year or 2. And we'd love to spend more because that means we're going to be growing faster than 37%, and we're actively pushing our teams to look for opportunities to grow faster.

Got it. And this labor market is pretty tight in terms of bringing on more people from sales. Can you just talk about how long maybe it will take you to kind of hire, kind of grow that outbound selling motion? Is this something that will take a year or is this like a multiyear type of endeavor?

It's definitely harder to hire. One thing that helps us, we're fully remote, and we're leaning into remote. And we also look to -- like we're not going to go hire a Cisco 5 million quota-carrying salesperson to come here and sell $10 a month, $1,000 a month customers, right? So we're looking at people who understand SMB, understand cloud. And for them, we're kind of a premium opportunity. So we're really attractive. We've been adding to the team during the course of this year. We've added some leaders who have been running here to come work here. So we're excited. And -- but it's a multiyear journey of sales as opposed to self-serve, is only 3% of revenue today from 0 just a couple of years ago, and pretty confident we're going to have that be several multiples of 3% of revenue as we get into the -- as we hit our first $1 billion, for example, by 2024, and we're investing to make that happen.

Got it. And I just want to talk a little bit more now kind of on the margin side. You guys are, I think, free cash flow positive, margin positive as well. Is this -- do you think you could lean in a little bit more in terms of -- into some of your investments on the S&M, R&D side? Do you want -- are you really investing enough is, I guess, what I'm trying to get at? And where do you plan on taking more of a balanced approach?

Yes. Well, first of all, philosophically, we believe you can walk and chew gum at the same time, meaning we can accelerate growth and accelerate margins and free cash flow. And the common denominator in that is we prioritize. And so -- but we -- our bias is to grow faster. And having said that, we could print materially higher EBITDA and free cash flow margins this year if we wanted, if it was about that. But we're reinvesting in areas where we're seeing opportunity grow faster. And we're reinvesting in areas to make the platform more efficient from an infrastructure so that we can sustain when we get to 20% free cash flow margin in a few years. We want to sustain that. We don't want to be episodic. We want to sustain high EBITDA margin, and we want to sustain high growth. And so we're investing this year and not pegging the needle on margins now. So we are doing what you suggest. But we just believe that it's not everything, it's above the line. We have a line, we draw it, and we're pretty strict in criteria around that. We're happy to spend more, but it better be above the line. And if it's not, go back and work out the business analytics so that it gets above the line. And we want to grow faster. We know that you create a lot more value growing at 43% versus 37% by sacrificing 300 basis points of EBITDA margin. That's going to create a lot more long-term value for our investors. So we're heavily incented as management both philosophically and economically to do that, and that's what we're doing.

Got it. And then I think for my last question, since we're almost out of time here, I just want to circle back to customer growth expansion. And you had mentioned, I think, 70% of revenue was global, outside the U.S. Are you talking -- are you taking more different strategies in different countries? And can you also just touch on data sovereignty and how the platform is put to that?

Yes. So we have data centers in the EU. We have them in the U.K. We have them in Asia. We're looking to -- obviously, in the U.S., Canada. We're looking to expand that into certain regions where we're not today, in Asia Pacific as well as South America, Africa. So we will look to globalize. We obviously comply with GDPR and the U.S. laws around this. It's an open question where it's going. Obviously, we don't want the walls going up in the Internet from governments, so we're monitoring very closely how that works. We have a system that works today, and we'll look to evolve if the world evolves. And we're also doing some experimentation. We announced recently that we launched Google Pay for our customers to give more flexibility from just the credit card options that we've had historically. That's a regional play. Not everyone in the world uses credit cards. Most of them, where they don't, they're using Google Pay. So we're seeing that's a way to be responsive to the opportunities regionally. We're experimenting with language, local language options as part of our upbound selling. We're doing a lot of data analysis on some experimentation. So we'll see how it plays, whether we need multiple websites, different languages, documentation, tutorials, and how to evolve that to respect the global nature of our customer base. So more to come on that, but we're looking into that, work very formally with experimentation today. Google Pay is an example of how we're trying to be responsive. And we're monitoring rules around privacy and all the rest of it and see how that implies, and we stand ready to invest. It's a big opportunity. We don't see any of those things sacrificing the opportunity. It may lead to a different investment margin profile. We'll see how that plays out, but it's a big opportunity. We think that we're on the cusp of a multibillion-dollar revenue opportunity over the next few years, one in which we can do that with free cash flow today and ramping from here, and we're just getting started.

That all sounds great. Well, yes, I think we're out of time now. But Yancey, thanks so much for joining us today. Really appreciate you joining, and we'll see you next time.

Yes, Vinod. Thanks. I enjoyed the conversation. Thanks for having us at the conference. We've had a great day, and appreciate you thinking of us for this opportunity. So have a good rest of the conference and good rest of the day. Thank you.

Thanks. You too.