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

Okay. Good afternoon, everyone. I am Mark Murphy, software analyst with JPMorgan. And it's a great pleasure to be here with Yancey Spruill, who is CEO of DigitalOcean. Yancey, first off, thank you for taking time out of your schedule to be here with us.

Thanks for having us.

Maybe you could, for the benefit of anyone in the audience who might not be familiar already, maybe you could spend just a couple of brief moments with an intro of DigitalOcean and yourself?

Thanks. We're a public cloud infrastructure company. We serve over 620,000 customers across 14 different data centers. We provide them basic compute network and storage as well as software and platform as a service applications, over $520 million of ARR, growing north of 30% and free cash flow positive.

So thank you for that. I think typically, Yancey, when we say public cloud, investors will think of, of course, they'll think of AWS, they'll think of Azure, they'll think of the Google Cloud platform. How would you explain to someone, what is the value proposition of going with DigitalOcean? In other words, what is it that you're giving the customer that the hyperscalers cannot provide, your differentiation? Like would you say it's product, would you say it's pricing, would you say it's community, would you say it's global coverage?

Yes, yes, yes. First off, I would say we are focused on developers, software developers, entrepreneurs, small, medium-sized businesses. We size that or IDC sizes that market segment about -- in the cloud at about $70 billion, growing about 27% a year. That's a very different segment than the enterprise market segment that the hyperscalers that you mentioned. So it's a different market. We are differentiated on 4 key things. First is simplicity and the time since we started this chat, you could be up and running coding on our platform. Very simple, easy to use, all the apps work well together. The second is community. We invest a lot, over 40,000 digital documents, tutorials, videos that we have online that help people. People come to millions, 9-plus million people come to our website a month to learn how to code, to learn how to do things in open source software, to learn how to do things in the cloud. And we make that available for free. It's a great acquisition. That's why we're so efficient in terms of go-to-market. But it also is how we build community and the virality of the entrepreneurial community around the world. Third is we provide support to all customers free of charge, whether you're a $2 customer or a $100,000 a month customer. That's very different. And then we're all open source. We're not requiring you to write proprietary software or customized software to link to our stack. We're all open source, we're easy to use. That's part of simplicity, lowering the barriers for people to get their ideas on the Internet and launch and start the scale of business. And then by price. In terms of, we're half the price of the hyperscalers on average. So we have all of those things that are very different experience for customers to build on DigitalOcean, and we're 50% of the price that they offer to their customers.

What are the most typical use cases that you find among your customers? I think we find that with investors, they get the notion at a high level, but they want to kind of click a level deeper. What are the nuts and bolts of what your customers are doing on the DigitalOcean platform? And if you could just touch on websites and apps, mobile apps, et cetera.

Yes. So we're a very higher performing, Stack Overflow put out a survey last year on ranking cloud from the market's perspective, and we were ranked fourth, behind the 3 hyperscalers in terms of capability. And I think it speaks to, we have really high-performing compute, storage, networking capabilities. We have a global infrastructure, low latency. And so because of the performance of the compute and the global nature of the infrastructure, people who have high computational intensity type use cases, like to do that on DigitalOcean. So things like media, streaming, education, entertainment, gaming, VPN, e-commerce runs on our platform. Ad serving, so small ad networks around the world that need a lot of computational and performance run on our platform. People launch SaaS applications that are developer tools, productivity tools right on our platform and blockchain, which is very computationally intensive, runs on our platform.

So -- and if by the way, if you were fourth, you must have been ahead of some platforms, perhaps Alibaba, Oracle, IBM, you must have been ahead of some pretty…

We didn't get a bronze medal, but we were happy with 4, given who was on the list.

Yes. No kidding. So Yancey, we always like to factor in what we're hearing directly from your own customers. And when we were doing the diligence, there were multiple of them who told us that they had moved some kind of a footprint off of AWS. They had moved it on to DigitalOcean, and they said, here's what happened. We're spending about half as much and the support times that we get go from, I think, some of them were saying it was 3 to 4 days to 30 seconds with DigitalOcean. I will tell that to investors. And commonly, they'll just say, well, how is that possible, right, given the scale of something like an Amazon?

Yes. I think that they -- we're geared from day one for developers and entrepreneurs and small businesses. So we built in support because that's integral to the experience. Our customers don't have DevOps. They don't have IT departments. They are small companies that are focused on trying to build applications to build their business. And so having support has always been integral. That is part of the product. I think when you look at -- we have customers coming all the time from some of the hyperscalers and their profile is typically they've got to 1 million, 2 million, 3 million of revenue, launching a second, third product. Their use case in the cloud is evolving, and they might be spending $100,000, $50,000 with the hyperscalers. They are irrelevant. They don't matter. They're too small. Those folks are geared towards large enterprises, 8-figure spenders in the cloud. Our customers just aren't that or they won't be that for a long time. And so they can't get support unless they're above a certain price point or have to pay for it. There's no documentation. The support and documentation are not marketing words, they're integral to the product experience and we've built that in and -- because that's our core customer. And so that's why we invest in that and it's a real differentiator for us.

So we are on this topic of the pricing, right, and the advantage for your customers. What's changing is we're moving into an inflationary environment. And we noticed that and that's actually -- it hasn't been that way since the 1980s, right? So you made some recent pricing changes. There's a $4 Droplet, which is a reduction of something like 20%. But I think presumably it's going to be an increase for some of your customers on the -- so like Droplets and Load Balancers and Kubernetes and that type of thing. Can you walk us through the changes? And I think what many of us are wondering about is, so for the typical customer, how is the bill going to change?

Well, about half of our customers will see roughly a $2 increase, a little over $2 or roughly half of our customers. Our smaller customers may see smaller than that, and our larger customers will see larger than that. This is the first time in 10 years that the company has taken a step back and thought about pricing despite the fact that over those 10 years, we've added many [ 9's ] to reliability. We've added security. We've added many features to Droplet. We've added storage, we've added Load Balancers. And this has been multiple years in thinking. When I took this job, one of my thesis was, over time there was a real opportunity to reframe the value proposition relative to Linode, Vultr in terms of our principal competitors as well as refactoring the relationship or the value proposition versus the hyperscalers. So I remember coming back from Tel Aviv after my first set of customer meetings 3 years ago, and I told the team, we are dramatically underpriced relative to the value our customers see in the platform relative to the investments we've made. And I think this is just a first step in sort of rebalancing that relationship. And we launched a $4 Droplet at lower performance because a lot of our customers come to DigitalOcean to test. They may not even aspire at least in the near-term on launching and running a business. And they had more memory and compute than they necessarily needed. And we had to allocate that capacity to them. At the same time, we have plenty of $5 Droplet customers who are using over 100% of their capacity and we allocate it in the same way. And so what this is going to allow us to do is better match the earlier-stage use case, which by the way, is going to be a significant capacity utilization improvement. So we're going to be able to be more efficient. I know capital intensity is less of an issue now than it was a year ago, but this allows us to be more capital efficient, more operating efficient and better match that use case. And at the same time, for those people who are really building and scaling a business, given all the capabilities, we think that this will better match and give them more -- better match the pricing to the value proposition we offer.

So now is the right time because you've been building in all of these layers of functionality for 10 years, right, without really changing pricing. And that had kind of gotten a little out of whack. And is it -- are you all -- is the inflationary environment also, I mean, is it those 2 things converging where you say it's the right time?

I wouldn't say so. I mean, we launched a premium Droplet a year ago that gave customers an option to select an Intel or an AMD chip. And it was basically sized similarly to the $5 Droplet, had a little bit more different performance characteristics. And we saw a pretty significant adoption of the $6 Droplet. And that had resulted from a lot of work we had started year -- just after I joined, we retained a firm, consulting firm who's really good in software pricing, cloud pricing. So we've done a ton of analytics and that launch sort of emanated from feedback we got from customers and the analysis that we had done. And the uptick was great. And so I think that signal, and this was in Q1 of last year, was a pretty powerful signal that there is an opportunity from a packaging pricing perspective. And we brought a new Chief Product Officer in the fall, had to get game up to speed. And so the timing is no better time than the present.

Do you have any thought on -- of course, as a financial analyst, would be trying to figure out how to map that through, right, into our financial forecast. I'm sure we'll learn more when you report Q2. But is there any high-level thought process since you had some consulting work done? You have a lot of data, how you think about how it might affect customer churn? Do you think, is it a safe bet, it will net out positively for revenue? Any other thoughts on the elasticity?

Yes. We get these fancy titles to do [ MPB ] positive decision. So suffice to say, we expect this to be accretive to our revenue pie, our growth rate. And -- but there's puts and takes, right? We have a lot of people who might go down from a $5 Droplet to a $4 Droplet. We have more than that, that are probably going to go to the $6. They may even go to the $10 Droplet because this -- the thing about pricing when you're an infrastructure provider is people then think about this is an opportunity to rethink how they're using it, where their business is going. We've learned a lot in the last 3 years engaging with customers based upon certain signals. And in those conversations, they realize they're underutilizing the platform. That's been a big driver of net dollar retention, driving down churn and driving up expansion. It's that conversation about where are they going and how can they better be optimized on the platform. And we think that that will happen here. But there's definitely puts and takes. I know if our investors saw our spreadsheet, they hyperventilate, goes, oh, there's yes, churn, we do expect some churn. The value net of the churn and some downgrades is going to be positive. And we have a lot of conviction on that. This is an essential service. Forrester published a report in Q1 saying that people that run their apps on DO have a 200% IRR. Maybe now they'll redo the price analysis as 196% IRR, right? And so there's a really compelling value proposition for what we enable. If you're a digital business, you're running in the cloud or on some computer. And so this is cost of sales. This isn't -- do I come to the JPMorgan conference in Boston or not, T&E, right? This is essential cost of sales. We tend to be 2%, 2.5% of our customers' revenue. So very small part, which ties into the IRR point that Forrester made. So really, really efficient way to get online and build a business in our cloud. And we've added a ton of value over time. And I think that we're well positioned now to clearly differentiate from a Linode, Vultr on the low end. We were priced essentially at parity, yet having massively more capability. And I think this reframes that conversation, and we're still 50% cheaper than the hyperscalers.

So getting online and getting in the cloud is a great vision. We -- part of the way AWS and Azure go about and Google, is they have -- they do offer proprietary services, right? So Amazon has Redshift, they have SageMaker, Microsoft has Active Directory and Synapse and SQL; Google has plenty of their own flavors. DigitalOcean has taken this different path, right, where you have -- you use a lot of open source essentially, but you haven't done anything that I would look at and say it's highly proprietary. And it's -- so your customers are avoiding lock in. Have you ever debated or considered launching anything proprietary or is it very -- is it important to you to keep that purity?

Yes. I think open source is one of the 4 differentiators. For us, serving SMB, early-stage businesses, is about removing barriers. Enterprise technologies historically for 60 years, been about introducing barriers, making it sticky, making it so difficult to try another platform, go multisource, et cetera. That's the opposite of what developers and early-stage entrepreneurs. They want simplicity. They want to be able to aggregate open-source software. What does that mean for them? It lowers the cost and increases the -- reduces the time to get their ideas on the Internet. So that's what our business, for who we enable, putting up barriers would be a problem. So we love Microsoft or Azure, AWS, GCP, they're great innovators. We're not really innovating in terms of novel technology. We're using some of their technologies like Kubernetes or serverless, and we're introducing it in a lighter fashion, that's what's more relevant features for the early-stage use case, but we want to keep it open-source. Simplicity is vital to the experience for customers. And that's really what we're enabling. We are a tech-enabled service that creates this unique experience that makes it so easy for somebody to get their idea onto the Internet and potentially launch that into a business. That's why the customers love DigitalOcean.

So I want to bridge from that and think back to your Q1 report on what's happening in the environment. You have guided to this impact from Russia and Ukraine of about $8 million to $10 million in revenue to the full year. But you also reiterated, right, the guidance for this fiscal year. And that was before a price increase that I think you're saying could knit out positively. What is it about this, the business demand, the environment that you're seeing that would allow you to kind of have confidence, right, in hitting that plan, while you are absorbing this hit from Russia Ukraine?

Well, I mean, reiterating our outlook that we set in February without information of the war and some of the other dynamics, we were hoping to being raised throughout the year. So I think that reflects some uncertainty, obviously, it reflects what's happening in, unfortunately in Ukraine. And Q2 came in a little bit below consensus to reflect, we couldn't pivot, if you will, Q2 started a month after we set our expectations. But at the same time, for the full year, what we said was our self-serve new customer acquisitions were above plan in Q1 into the month of May. And our sales efforts were above plan. We had serverless coming online, which we announced yesterday is available. And we had pricing initiatives that we also could look at. And so the combination of those were tools that we had and some reflected, some not like pricing wasn't it reflected in that number for the full year. But I think that's our job, right? We got to have multiple plays to run regardless of the environment and we're trying to run them.

So okay. So sticking with the environment, you have over 600,000 customers. You should have a pretty good lens into what's happening like the state of SMB globally. I would think, right, so their usage, their consumption trends -- and maybe you have sales reps out there from time to time just kind of taking a pulse of the business confidence. How do you see them behaving, right now? So we're about to enter June. Do you feel like these SMBs are collectively kind of bracing for a recession or feeling any kind of strain or do you think it's pretty normal out there?

I think people are plugging away. And we're comfortable with the outlook we set and we're serving our customers. And we have an Investor Day coming up and we were with some investors who participated in that. And these are passionate people chasing dreams. And I don't think dreams are going to get deferred in economic downturns. In fact so many small businesses become large businesses, emerge from the ashes of economic disruption. So none of our customers have chief economists that debate the merits of GDP and Fed funds and QE easing and all of the rest of it that this crowd is so actively involved in. I think they're just trying to get the next customer, which for them could be the first customer, it could be a 50% growth in their customer base. So these are early-stage businesses growing, and they're focused on that.

Okay. So SMBs are plugging away into an economic contraction. Is that the way to think about it?

We all are.

So now in amidst this, you announced the $300 million repurchase program. I'm wondering if you can update us on that. What is the signaling, what is the logic? Should we do something about how you want your capital structure to look at this juncture?

Well, I think this is going to be -- our aspiration is to grow sustainably at 30% or better, generate more than 20% free cash flow, certainly in a couple of years when we get to our first $1 billion and then grow beyond that. If we do that, this is going to be a cash machine. We set a free cash flow machine. And when we look out multiple years at what we want to do, our principal use of cash is to invest in the business, whether it's new data centers in Australia, M&A. The product that we launched yesterday was an acquisition we made Q3 of last year. So we want to invest in the business because we see a large growth opportunity. Having said that, when you generate a lot of free cash flow and you grow the rates we have and allocating for M&A, we're going to have flexibility to do that at an efficient capital structure as possible. And we look at the buyback, we started with $300 million earlier this year. We said that was tied to employee grant dilution. We're going to manage to offset that. When we look at it now, we think that we have the opportunity to slim the capital structure that's just going to drive returns for investors. So we think we have a compelling opportunity, 30% growth, 20% free cash flow. We're free cash flow positive today. By the way, we don't have to re-factor anything. That's just how we run the business. We're going to scale and double margins. Guidance for this year is 8% to 10%. We're very comfortable, we can get that to 20% plus over the next 2 plus years and sustain it. And we think that we can do that and invest in the business and have some excess and it's not our money, it's yours. And so we're going to focus not only on growth but also driving superior returns for you all, compelling returns.

It's been a stunning turnaround in all those metrics in the last 1.5 years, 2 years. How about -- I'm not sure if you -- did you tuck in a comment on the convert in there or is that anything you want to speak to?

Yes. There's a lot of questions on converts. We did $1.5 billion convert. We woke up on Monday morning with JPMorgan. Thank you, and we thought we would do a $900 million convert and pay 0.5% of interest. We ended the day with $1.5 billion to convert 0 interest for 5 years. And which is incredible. And thank you very much. And when we look at right, we're trading at a massive discount to our view of the DCF value of our strategy. Everybody is, right, but we are. And so what's the relative return of that versus getting an 8% return, buying converts back today. None of you are paying me or Bill or any of us, certainly, our Board is not paying us to invest in 8% returns. And we're going to do a lot better than 8% return on the stock. So that's why we decided to buy stock and not convert.

So you had touched on the server list and I want to come back to that in just a moment, Yancey, but the -- I think MongoDB got started a little sooner. And we have a feeling it might be kind of monetizing a little sooner because of that. So I think you launched it last summer, you have been -- your messaging has been that this could drive a material uplift to the growth rate, 3,000 customers, which sounds like a lot, but you run the math even that is less than 1% of your base so far. So it feels like there's runway. How are ubiquitous do you picture Mongo usage becoming? And why do you think that that is kind of taking off just quite so.

Well, our class of database, MySQL, Postgres, Redis, now Mongo, we're going to be adding other engines to that over the next year or so. When you look at a signal what happens when these customers when they break through 50 to 100, 200. One of the first things they buy is a database because they have to do more analytics targeting customers, build a relationship with customers. So database as a service is critical. It's our fastest growing. It's our largest pass application. And Mongo is part of a suite, depending upon the use case and the decision of the CTO, people choose MySQL that choose Redis or they choose Mongo and digital businesses. So we think it rounds out the suite. It helps us acquire new customers. It was one of the most asked for net new capabilities like Serverless was until we launched it. And we launched products that are going to add 300 basis points to mix at 3 years after within 3 years of launch. And so it's well on track. It's growing much faster than our company growth rate. And a year into these subscription products, they start to become material and start to have real impact on top line.

Okay. So coming back to serverless, you mentioned this once or twice. And I think that you said it became available yesterday.

Yes.

So great timing to talk about it. It came through an acquisition -- is it possible to explain for a nontechnical audience, serverless probably doesn't mean a lot, too, to some of the people out here. Is that something you can attempt?

Well, serverless is a marketing term because everything runs on a computer. So they do run on a computer but the background serverless, and it's part of this bigger theme that we all live in our lives, you have an app store now to configure software instead of writing software. And serverless is similar to that where people can configure how their applications will run on our platform through configuration versus when in the more conventional infrastructure, you actually have to write the code, you have to worry about when you need to -- where you need to scale servers up or down, how you provision them, et cetera. Serverless allows you to set some parameters around that, that are event-driven. And then we're managing the infrastructure in the background. So a term that's frequently used in the tech world is abstraction. It's taking customers farther away from worrying about infrastructure while not sacrificing performance and allows them to focus more on app building that touches their customers. So this is a great product for early-stage businesses who don't have armies of developers where they can free people up to focus on more value-added tasks. And again, it was one of the most requested when you look at our customers who go multi-cloud, one of the leaders in that they were running AWS land to functions still running our infrastructure on us. But this gives them more option. And people say, we want to run it all on your platform because it's simple, easy to use and it's cheap -- still cheap.

It could serverless trace out in ARC, it looks like Mongo or are these...

Yes, I think we have a lot of expectations for servers to be a big product category for us. Absolutely. I mean, that platform was sort of our first foray into serverless. We launched 2 years ago. That's growing geometrically and is contributing and now with -- it's enhanced by our functions capability. So we feel really good about that new product category.

Okay. Why don't we do a quick scan of the audience. If anyone has a question, just raise your hand, and we will get you a microphone from the back. So I think Yancey, one aspect of this that has really stood out to us with DigitalOcean is that you are outgrowing the industry, right? So we look at SMB developer cloud peers are growing in the teens. I don't know if it's mid-teens or high teens, but it's in the teens -- the industry is supposed to be growing mid-20s. DigitalOcean, and you're bigger than the peers, and you're growing north of 30%. So how do we map that out at what are the factors that are kind of creating this favorable growth spread that you've had?

I think one is we got laser focus over the past 3 years on our customer and the customer and doubling down on what we call the DigitalOcean experience, simplicity, our community. We've enhanced I think when we joined 3 years ago, we had 20,000 documents tutorials. We've doubled that. Our support model, we scaled that. It's hard to scale support. You got to be really thoughtful about how to do that. We doubled down on open source and community. So I think our differentiators we've just invested heavily in them. We've been very data-driven, very metrics-driven and then also then the product experience. We've added infrastructure, enhanced our infrastructure, added low balancer capability, more Droplets, et cetera. But we've added managed databases. We've added Kubernetes. We've added a marketplace. We've added serverless, and that's giving customers more runway to spend with us. So if you looked at us 3 to 5 years ago or some of the people you just mentioned, if you're just infrastructure, that's fine, but they're going to need other applications as their employee base grows, as their customers grow. And if you don't have an outlook, then they're going to go multi-cloud. So we're able to capture share of wallet. So if you look at ARPU growth, half of our ARPU growth is we serve in early-stage businesses that have strong organic growth. But the other half of ARPU growth expansion has come from that we get more share of wallet because there's more apps on the platform.

What would you say to someone whose view is, well, pandemic pull forward, right? And that's one of the biggest questions that's been going across all of software for months now, including at this conference because you would have had maybe a little extra spring in some companies step perhaps to digitize, put up a website, roll out a mobile app, do some kind of streaming within the SMB space. What's your view on that topic?

Churn was 20% going into the pandemic, right? Two years ago, when we talked to people, they said your churn is going to go higher. We cut it in half, right? ARPU growth was in the mid-teens. We've nearly doubled it. We've added more products. We're serving customers better. I don't subscribe to the pull forward. I think the entrepreneurial markets and the data is coming out now on this financial crisis, but the history is pretty consistent that in economic distress periods, entrepreneurship accelerates. And I think the cloud could be a double whammy on that. It's just so easy to start a business in the cloud. Why I met a customer last summer, who was an engineer for one of the big tech companies in Europe, and he started playing around on DigitalOcean at night and we just launched a SaaS application that does team support management. It doesn't sound sexy, probably never going to present at JPMorgan, not going to go public, but he quit his job and now he's got a job, doing his passion, helping team sports and probably makes more income. He is not making hundreds of millions of dollars, but he's making pretty good income. And the barriers to him doing that were 10 bucks a month starting out on DO, a bunch of free tutorials to learn how to do it, and he's doing it. And this is unleashing people all over the planet. And a lot of people are scratching their heads like, "Oh, it's this great resignation. People aren't coming back to work." They don't need to go back to work because they can make $0.5 million, $1 million from their couch at home and have a lot of flexibility and be their own boss. And the cloud is in mobile is enabling that, and we're part of that theme.

Yancey, I know firsthand about all the team sports apps for managing kids on the weekends. It's what the weekend life is all about.

Absolutely.

And I think it's a great note to end on. It's this idea that DigitalOcean is here enabling that kind of entrepreneurship. So we are right on time. And I just want to thank you for taking time out of your busy schedule to be here with us.

Thanks for having us. Good to be with you. Thank you.