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

Hey. It's great to have you here. Good to see you in person again.

Let's try to get the macro questions out first because there are a lot of other stuff to discuss actually. But, like, on the macro side, like the -- if you think the big hyperscalers talk about, like, lower cloud migration in terms of new workloads coming over. They talked about, like, what people have overbought. And now we have, like, a bit of a consolidation period. For you, that should be slightly different? Or what do you see in terms of their…

We absolutely never have customers say they overbought. That's part of our value of simplicity. People pay for what they get. Our slimmed down product set is relevant features and functionality, so we don't see people overpaying. We have a very cost-conscious customer. Most of our customers are bootstrapped businesses. They're not institutionally financed companies, several million dollars in revenue, if you will. So they're small companies. So they're very focused on and conscious about cash and spending their money efficiently. So we're -- that's not a new conversation for us. It's interesting with the pricing changes we made, most of them got it. They've absorbed it. Certainly, our $50-and-up customers have absorbed it, better than the expectations we had going into this year. Smaller customers are probably a little bit more sensitive. But we're -- I think in times like this, this creates lots of opportunity to talk to customers about how they're using cloud, where they're going, how to best use our cloud. But I don't think we're in a situation where the CIO of our customers, which they almost -- none of them have CIOs. There's none of those dynamics that you're seeing in a large enterprise.

Yes, yes, yes. So it's like that 5-year IT budget that kind of -- yes.

No.

And like I don't know if you kind of follow a little bit the -- like, last week, we had, like, the big off-cyclical report and they talked about, like, October kind of being maybe slightly different. I have my suspicious feeling because it's kind of the last month of the quarter where kind of those big enterprise guys always have a problem. So in June, with ServiceNow and July with Salesforce, now it's, like, someone else. Like, anything that you can report back from what you're seeing out there?

Yes. So we had a really strong Q1 sort of in line with our expectations, the planning. It's almost like on April 1, the dimmer switch started to turn down the lights. We saw almost -- in the weakness this year or the sort of slower growth this year, I would put in 3 buckets. One, Russia, right? So Russia, we entered Q2, is about 2.5% of our revenue. We ended Q3, it was about 1% of revenue. So we saw a step down in customers from Russia principally people who couldn't comply with sanctions. We've talked a lot about keeping the Internet open, which we committed to do, but we saw that as a step down. Blockchain was 5% of revenue in Q2. We exited Q3, it was 2%. So those were 2 really jarring step-down functions that were headwinds in the growth. The third bucket, I would say, is sort of our ad tech customers, our e-commerce customers, our media streaming customers, everybody was growing slower. And the consumption-based model that we have, I think, is a strength of our business, but we saw it early. We saw it in April. We weren't insulated by 1-year contracts that are now renewing for a lot of these customers or companies that are probably at this conference. We saw it immediately. And frankly, we surveyed our customers in Q3 to understand their slower growth. What was this a signal of, and very consistently said it wasn't your price changes. It was that our business is slower, and thank you very much for having a consumption-based model, where we could adjust our demand side immediately. And so I know as an investor, that's sort of nerve racking. But the reality is it builds a really strong connection with customers. The fact that we're one vendor out of the many that they don't have to recut a deal or beg and plead, claw and scratch to try to recut and get -- better align their cash payments to what their demand side is. We were able to do that immediately. And what I would say is, so all 3 of those buckets have played into why growth is slower than we thought a year ago. The first 2 were really shocks to the system. They were step functions, really large. The other -- those sort of abated by the end of Q3. So there, we stabilized. Even now, I know there's been some questions about FTX or this blockchain. We're not seeing it. It's very stable. Russia has been very stable. People either found a bank that complied with sanctions or they didn't and they're gone. So we're -- those are no longer in the noise and creating a lot of mayhem. We're just growing slow. That third bucket is -- so we're growing slower. But I would say -- and I think we were very careful in the earnings call, and I'd be careful now. We're not calling a bottom, but it's much more stable. And that doesn't mean there can't be another leg down. We're not seeing that. It's -- we have our arms around the demand side right now. and it's a slower growing environment than it was a year ago that we wanted. But it's one that we are seeing month to month to month. It's now much more stable than it was in the middle of the summer, for example.

On that note, and it's, like, for both of you now, like what's the -- I mean, in theory, you have, like, a broad customer base. You have a relatively low ARPU per customer that should give you -- like, does it give you more visibility? Or less? Like, in theory, you'd be taking more, because you have lots of small things coming in. And then, like, what are the stuff that you're looking at for kind of demand signals there?

I sure -- I would answer this different than Bill. I mean there's a law of large numbers. And one of the things -- I used to be in a company that had large enterprise, big long-term contracts, not as many customers, but you could see all the revenue. And my last company and this one, you've got to get comfortable with hundreds of thousands of customers, and they behave, like, contract basis, et cetera. It's been a little distorted this year. But I do think there's a lot of visibility in that. So our cohort, which is over 80% of the revenue, that's what feeds into them. That's all retention. It's grown slower. Churn has been flat. One of the big green shoots, if you could call it that this year, is that churn has stayed at roughly 10%. That wasn't the thesis for a lot of folks around SMB. Okay, it's a recession. They're all going to 0. Well, I think if you look at our relative growth rate today, relative to a year ago and look at AWS or Azure and their reported numbers, their relative growth has been impacted. And I think that the myth of enterprise is going to be more insulated. In a downturn, I don't think that's true at all. I think our customers have been very resilient. It's half of GDP, small, medium-sized businesses. They're not going anywhere. And I think we've seen that, notwithstanding it's a slower growth environment than we want or certainly that we planned for going into the year.

Yes. Bill, anything for you to add? Like, what are you looking for? Like...

I think Yancey summarized it best. I think the one piece of visibility we look for and we're talking more about is that we're looking at the $50 and above, and those are the folks, the month-to-month that are making us feel better, because again, to Yancey's point, we're not seeing churn there. They've accepted the price increase. Clearly, what we're doing is essential to their business. We're attracting more of them. They're coming in and they're growing faster. So I think that's encouraging and speaks to the longer-term trend that we take a lot of confidence and that this market is growing 27%, and I think will continue for the foreseeable future.

Yes, yes, yes. Okay. Perfect. I think we kind of captured the macro thing now, hopefully. If there's any more questions, you can kind of ask them in the end. Like, more -- let's more think about, like, the evolution of DigitalOcean. Like, Cloudways was, like, a really interesting deal from my perspective, like -- and I don't want to kind of put words into your mouth, so I'd just kind of ask open questions. Like, what was the motivation for you? Like, what did you see there?

Yes. A year ago, when we started to sort of carve out, we built out our strategy M&A team. We've just done a big convert, reloaded the balance sheet, just gotten to free cash flow positive, which obviously we leveraged this year. What are we going to do for M&A? And the managed services, managed hosting was a clear area of priority for us. A, we were doing it as a channel or a window into a segment of the market that we weren't addressing, which is people who don't want to do it themselves. And Cloudways rose to the top of the list in terms of size and scale and reach and kind of a cultural alignment. They were a partner, a customer of ours. And the thesis is absolutely sort of bigger than what we thought. I think the addressable market, the TAM expansion that we got from this deal is at least as big as what our prior stand-alone DO was. It turns out there are hundreds of thousands of managed hosters and digital agencies who manage the cloud spend for small businesses. And there are a lot of people who are in the cloud who, in that size, they just outsource it. They don't want to -- they want to run their business. They want all their capital, their resources focused on that. That's what Cloudways represents. It's early. It's 90 days since we closed. We have -- already inflecting the growth rate, I think, of Cloudways our combined growth rate from revenue synergies because of the complementary aspect. A lot of people would come to DigitalOcean, read it. 10-plus million come to our website a month to read tutorials, learn how to do things in cloud, thousands, tens of thousands put a credit card down to become paying customers. Some of them leave in the first 90 days. With SMB, there's always volatility in that first 90 days to a year. But one of the reasons was people expect -- they like DO. It's simple, but they wanted a more managed experience. Well, we're now presenting them with the option to -- you could do it yourself or you could go with the Cloudways. And we're -- the early signs, again, it's early, are very, very, very promising. So -- and I think it speaks to that expansion of the addressable market that we now have. And it's both ways, we're seeing more retention in customer acquisition and the same with Cloudways. So that's the rationale. It expanded our offering. If you think everybody starting a business, they want, that it's going to be digital, then you have to decide you want to manage that digital infrastructure yourself? Or do you want to have someone do it for you. We now have a more complete offering, and that creates a larger addressable market for us.

Is there -- I mean like, as you know, I've been covering software for a while, and SMB, the key message in SMB was always they need -- they want handholding because they don't have a big IT department. They're not as sophisticated, et cetera. So in theory, for me, this looks like a perfect fit because like, yes, you can go to you and hosting, but actually, if someone handholds, it's even better.

Yes. I think this is the über-extension of handholding, which is you do it. And by the way, they pay 2x on a Cloudways if they pay a similar sized footprint on DigitalOcean where you do it yourself, you can figure the servers, scale them up or down. You pay 2x to have somebody do it for you at Cloudways at a higher-touch, higher-service environment. So it speaks to the value of where -- small businesses, they're not going to have a DevOps or they're not going to have a CIO. The product experience has to stand on its own. And for those who really want all their resources devoted to the customer, building the customer relationship, the managed experience is the right way to go. So it's very complementary. And in fact, if you look at one of the principal things that we've done in the first 3.5 years of being here, that kind of flipped the model. We've always offered support. That's always been a core foundational differentiator for whether you're a $5 a month customer or a $1 million customer. But we did differentiate it. It was just bundled with the service. About 6 months ago, we launched a paid support where we tiered it. You can keep support embedded in the product. Get to the back of the line. We will respond to you. You will get a personalized experience or you can pay and get to the front of the line and have guaranteed embedded, real-time access to the team, and we're seeing uplift in that. We also have been doing much more proactive support, which has been a big driver of ARPU growth as we've been going to 1,000 customers and really personalizing the relationship. We're now going to 10,000 and tens of thousands deep, and we started to act on that in Q4, and we've always seen an ability to upsell, drive ARPU by helping customers think about the next year or 2, which you're a small business, you're doubling or tripling, you're not optimizing, right? You're just trying to hang on for dear life. We've had a lot of success. But what does that really mean? We've created a higher touch business. It's just embedded with DO. It's a great success. And this is just a natural extension of that, of Cloudways.

And how do -- I mean, in theory, this could change the shape of DigitalOcean, like, over the long run? Because, like, and the other question is, remember, we almost have, like, an argument between the 2 of us, like -- I was like, look, you want more product. And you were like, no, I want to keep it simple. I do want more products, but I want to keep it simple. Cloudways is much, much broader in terms of the product they are offering. Like, so how can you think about that dynamic for the future?

It's interesting. Aaqib, who's our new CRO, who's the founder of Cloudways, CEO Cloudways, he would tell you, "Yes, we kind of have a pretty good product set now. We need to focus much more on tailoring that product set to the outcomes that customers need." So more monetization, I think, will be a key theme. And that comes from having that higher touch, higher support model. You're more engaged, you're more intimate with the customer than the do-it-yourself. And I think that is going to be the path. So will it reshape? I don't want to say that. We're a publicly traded company, so we want to make sure we set the right expectations. All I would say is we feel incredibly good about the money we spend, your money that we spent for this acquisition. We think it's going to help us on our path to $1 billion and beyond. And we think we have a more complete set of capabilities to offer customers. And there'll be some more product for sure. But I think it's much more about how do we help drive the outcomes of these early-stage businesses to reach their potential and a higher touch model is certainly a key aspect of that.

And then the other thing is like if you look at Cloudways' pricing, as you said, like, it's a lot of the time, it's going to blot more in you. Then you were doing, like, is there any lesson we should learn in terms of price elasticity? Because you're delivering, like, really good value, almost underpricing it. I don't want to go that far. Maybe you don't want to go there…

Yes. Well, I would say it. Yes, we -- part of my thesis taking this job almost 4 years ago was I think there's a lever here on price. We're underpriced in the market. 2 or 3 weeks into this job in September of 2019, I told the exec team we're underpriced. We started acting on pricing last year with the performance droplet. We are not -- we took action, a bigger action this year. I know lots of people, a big debate with all of our investors around the modeling of that. We're not done on price. We have not fixed the pricing gap, the value proposition that we offer to customers is not fixed. We took a good step this year. We told -- said on the last earnings call, we'll -- we're looking at some packaging and pricing around security features. We have a premium droplet coming out here. It's in beta, targeting bandwidth-intensive use cases. So we've tailored a droplet that we can upsell versus selling them a $6 or $7 to $10 droplet and have them tailor it. We took a lot of feedback from bandwidth-intensive use cases, and we'll offer that. That's part of pricing or packaging. I think there's a lot of opportunity. We -- and I think the upper level, when people are upper limit of this, when people migrate from a hyperscaler to us, they generally cut their bill by 50%. The fully managed experience with Cloudways says that people will pay a lot more depending upon how you present and what problems you're solving. So we have a lot of opportunity on pricing. And if you integrate the supply/demand curve, we are not pegging the needle on value maximization as it relates to price. Now how do we solve for that? I think a lot of it'll be packaging, bundling, as we've talked about. It'll be managed service, product mix and customer mix. right? When we took -- joined here, we were, I don't know, 70%, 75% of our revenue was $50 and up. Now it's approaching 90%. We got customer mix in our -- as a tailwind. We got product mix, and now we have, as a part of product mix, managed services, which is $1 there. It's 2x what we get in our core business.

Yes. And then the last question on that topic. If you think about that integration, you said, like, it's still very, very early days. Like, in -- I do cover Intuit it as well, who are kind of trying to do, like, something along those lines. But to upsell, cross-sell, it takes a lot of, like, trial error, like, try to see how they're going. Where are we on that journey?

Yes. One thing that I think we're looking at a much deeper integration. Obviously, we've made their CEO our head of CRO. Cross-sell is a danger for me, right? We don't want side shows that we have to create different incentives to salespeople. And also the value proposition is upfront. What are your goals of the platform? We want it to be integral, even if you decide to do it yourself. It may be that at certain breakpoints in your growth curve, you may say, "No, now is the time that we'll outsource it." So we want that value proposition to be upfront, and we present that. And so that's, I think, where we're going here.

Okay. So that takes you. Okay. Perfect. Just switching gears in the last few minutes, like you're one of the few companies in software that has a focus on growth and margins.

Boring, I know.

Like, what's wrong with you? Yes. Can you talk a little bit about, like now that the time's changed a little bit, I mean you always had that approach. But, like, are there changes coming now or even more? Like, how do you think about that?

As we said last week, we were free cash flow before free cash flow was cool. It's a country song. If nothing changes in the sense that we set a -- when we joined a $1 billion revenue target and a free cash flow margin target of 20%. We still are pushing that way. What you seen this year is in a lower growth environment. We've accelerated free cash flow margin. I think until the clouds part and until we have an all-clear sign, which, by the way, may never come around this economic environment. Our bias will be to target, slim our priorities on the highest impacting growth. We're still investing in growth like an acquisition, like pricing, like some of the new features, capabilities we're launching. So we're very focused on making the platform better to monetize growth. At the same time, we've accelerated free cash flow this year. We were generating more free cash flow this year than we expected going into this year. We cut back investment. We're probably going to end the year with 12%, 13% ex the acquisition headcount because we said in Q2, as the cloud started to come over us and be dark, that we're going to focus on storage and sales. That'll be our bias for net new hiring and net new funding of incremental initiatives. We pulled back on a lot of other things. And so we could get out ahead of that and build some momentum next year, and we raised the bar. So a year ago, I think more things were investable than we're saying now. And we are pivoting towards making sure that in the absence of clarity around the outlook, we are going to give ourselves and investors more clarity about the acceleration of free cash flow. And then that will absolutely be a theme next year.

And then the -- if you think about that decision about, like, the investing versus margin? Like, what's the criteria that you're using there? Like, how do you think about that? And I mean the difference is like long term, there's mid, and the short term. Those are guys in the middle.

Yes. I mean, we want new growth initiatives to contribute several hundred basis points of revenue 2, 3 years out. And I think in this environment, instead of trying to do 4 or 5 of those things, we might do 1 or 2 of those things. And that's just the way it is. And because we want to make sure that there is a balance and that, that balance a year ago, 2 years ago might have been more on revenue. And I think it's more in line today to free cash flow. It's just how we manage. It's just philosophically. I mean, this is a philosophy. And I think it's a good philosophy. And so that way, we weren't upside down. If you're burning 30% and counting on a 50% growth rate and then 2022 hits you, then you saw, like, what is free cash flow? Everyone is watching YouTube videos on what the hell is free cash flow. We manage the business that way. We told our company 3 years ago, we are pivoting to grow free cash flow. And by the way, we were growing in the low 20s then. And free cash flow is negative 25%. Everybody said, Yancey, you're giving up on growth. I was like, why can't you do both? We're growing 30-plus % now and free cash flows double digits heading higher. I think there's this thesis, and I hope it changes with interest rates being normal, whatever, that it's -- you can do both. Like, you don't go to business school to just grow, right? You learn business people have a relationship between the growth rate and free cash flow. Because ultimately, they're trying to deliver a compelling return on capital. Right? So that's what we do. And so this year hasn't been that different because we all looked at each other in May, April, May and say, hey, this is different. All right. Well, we got to get better in calibration because the growth isn't where we thought it was going to be which is just natural for us.

Yes, yes. It's funny, like, you do -- you sound like my professor I had in my finance school.

I have gray hair in the back of my…

On that note, like, do you remember when could you quarters ago like or initially when you became a public company, it was kind of an easy conversation in terms of like, oh, I can improve efficiencies here and here and here. Where are you on that journey now in terms of, like, what, in terms of the internal, things you can still change.

I still -- I don't want to put an inning on it, but we are still, I would say, discovering more ways that we can operate the business with less cost. We're finding opportunities to drive incremental revenue, and we're finding ways to do it in a much more cost-effective way. Cloudways is going to help us with this. We've already been looking at offshoring portions over the workforce as we grow. They've got 300 people working out of Pakistan with a very, very high talent bar. We're using them to help supplement us in our go-to-market. So we think there's more opportunities there. And the work that we've been doing, particularly with the data center providers and with the hardware suppliers is more on a partnership basis. This isn't a "you win, I lose," kind of…

Yes, yes, yes.

Because we're sitting with them and saying, have you heard Yancey say, 100 times, we're going to be $2 billion in 2026. That's where we're going. So it's providing real opportunities. So I still think we have that opportunity, and I know we have it on the cash flow side. That has -- I remember giving a room full of 500 people, DO folks, a lecture on what the rule of 40 was and now they understand it. So we clearly have more room to go on that.

Yes, yes, yes.

I mean, this is a great time in business. I know it's scary because top line's uncertain. But this is -- I'm an old man. I started my career in manufacturing as an engineer. And this is where you're fixing stuff, right? Don't come out of it -- what we told everybody is we want to come out of this period stronger, better, more efficient with more market share, growing faster than our competition. And you do that by you want to build more data centers, okay, self-fund them. How do I do that? Go get more efficiency, take costs out of the system. Everybody becomes better in this environment. I think we all get lazy when you think there is no alternative than to grow fast. And now you got to be balanced. And I think it's going to be a healthier company, and I'm grateful that we kind of got on that journey early because it's not like we're talking gibberish to people right now in 2022. They've been hearing this for years.

And last question for the last minute, like, talk a little bit about M&A. Like, asset prices are coming down. The recession's here. They were saying, like, you're not quite to the level where I wanted on the private side. You can still have that dream of, like, going crazy. Like, how do you think about that? And what are you seeing out there?

It's a lever. We always look at what is our product roadmap, our go-to-market, where are we going to invest to be where we want in a few years. You can't invest -- we shouldn't invest and we can't invest just mathematically everything on our own organically. And so M&A is a way to accelerate. Cloudways is a perfect example. Our serverless was another example. Some of our content that drives website visits. So it's a part of the tool kit for sure. There is a portion of our long-term growth rate that's going to be driven by inorganic. And to your point, we probably didn't do as much as we thought we could do, because when we all corrected last November and through this year as publicly traded companies, the private folks are just now, I think, seeing a different reality on what they're worth. So I don't know that we'll be doing as big as Cloudways, but there are product areas, like, AI, storage we talked about on the infrastructure side that'll be priorities, maybe more channel. But M&A will be part of the story for sure.

Good. Okay. Perfect. That's kind of slightly over running. It's a good closing statement. Hey, good to see you again.

Yes. Thanks for having us. Sorry about the World Cup.