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

Well, I think the growth in our builders and scalers is going to be a good long-term measure in the sales efforts, the partner efforts are about bringing in larger customers. So ARPU growth and then customer growth within the builders and scalers, those customers anywhere from $50 all up to $250 or higher. And those are people -- $50 is a breakthrough moment where below that, you're not sure as a customer just you're testing, doesn't have any aspirations to run a business, build a business. Today, anyway, a lot of those customers over time graduate into building and running a business on the platform. So that's why we use the builder breakpoint. So I think ARPU growth and customer growth with -- and our ability to accelerate that customer growth across builders and scalers will be a key thing to look for around the success proof points of us building out direct sales partner channel capability.

Got it. And how critical is the partner channel for DigitalOcean at this point? How are you sort of thinking about the channel?

I think it's pretty significant. I mean we're dealing in a market. It's a $100 billion market with 100 million small, medium-sized businesses. So it's very fragmented. And I think we have -- the self-serve is an incredibly efficient. We get 10 million or so visitors a month through our website, reading our content. That allows us to sign up tens of thousands of new customers. So it's very efficient but it's still not the world in terms of who we serve. So we think the partner channel is just going to be a network effect that's going to allow us to extend and get more leverage in terms of customer acquisition, but do it efficiently in terms of the average customer coming in is not spending that much. So it's not going to be efficient to be able put in a high-price field sales force like a lot of enterprise businesses do. So we think the channel is critical to us attracting more customers, driving growth and doing so in an efficient way that doesn't disrupt. We're roughly 10% of revenue in sales and marketing as a percentage of revenue. So it's very efficient. And that's enabling a lot of the profitability and free cash flow. So we want to preserve that while still growing the business.

And you mentioned that this is about a $100 billion market opportunity. You are exposed to more of the SMB side of things. How do you sort of think about -- or I guess, how do you sort of segment the market within that $100 billion? What is sort of the low-hanging fruit opportunity within that market that you can sort of penetrate?

Well, I think our self-serve does a good job of capturing low-hanging fruit, high-intent users who come in and start low when people come in through self-serve, I mentioned tens of thousands. They typically might spend $20 a month. And then they may stay in that phase for 2, 3, 4 years, and then they move quickly up and grow quickly and large over time. So that's very efficient. We have that dialed in. There's more we can do. And we're certainly working to continue to optimize that and grow that. But I think the -- bringing in new channels and routes to market, given the fragmented nature of the market is really the path to sustaining a rapid growth rate over time.

So last quarter, you launched a premium dedicated Droplet, which is meant to target bandwidth intensive applications like video streaming and ad tech. What has been the customer feedback so far? And what does this really mean for that customer ARPU growth that you mentioned?

The feedback has been great. I mean, the adoption is really strong. So we're really excited about it. The feedback is good. I mean, we created that SKU. And again, essentially, we repackaged existing tools to give a more customized product unit. And we did that in response to our customer feedback because customers, you meet with a gaming company. And what we'd hear is we love DigitalOcean. We were ramping and scaling. It's great. But they had to inject some workflow on top of our standard product to get it to work exactly like they needed it to, given the way our Droplets are configured, it's sort of a very vanilla use case. And so we took that feedback and customized the Droplet that had more bandwidth per unit of compute, which is more -- and then we layered in some other software. And so why our customers like it, it allows them to almost dive right into using the product versus having to customize it. So it's taken friction out of the system for them, and it's -- and it allows them to scale more efficiently because now it's a much more purpose-built unit for them. And it's at a much higher price point than they were paying us. And so they're happy to pay us more because it simplifies their workflow so they can focus their team on more customer-centric activities and not managing the infrastructure on DigitalOcean. So as I said earlier, I think this is a real opportunity for us is not just explicit new products, but taking existing tools and tailoring them more to whether it's a VPN use case or an e-commerce use case or in this bandwidth-intensive use case, where it's the same set of tools with a little bit more software on top of it. But because it more directly applies to the use case for our customers and they don't have to inject their team, their own software development, their own maintenance. We can charge a pretty meaningful premium, 2x, 3x what we were getting for a standard Droplet, and they're happy to pay that because it takes cost out of the system for them and makes it more scalable over time.

So I mean it's almost been a year since the Cloudways acquisition back in September of last year. Can you just give us some context on the driving forces behind the acquisition? And how has Cloudways performed relative to your expectations?

Yes. So I think in your earlier question about other channels, Cloudways is a product extension. So for DigitalOcean, if you come to DigitalOcean, you're going to have to set up your own compute. I mean you have it, we have the documentation. It's simple, easy, but you -- it's more of what I call do-it-yourself. And as you grow over time, you're going to have to make decisions. We can help you with support and documentation, but you're essentially driving the infrastructure. With Cloudways, it's a managed hosting service, which it's much lighter touch. And so much more configuration, much higher service model, which is very complementary to our platform. What we've seen historically is customers would come to DigitalOcean, read some tutorials, look around on the website, sign up for an account, and we'd see some of them churn after 60, 90 days. And one of the reasons they give us is I was looking for a more managed experience. I thought this was a Wix. I thought this was a Cloudways. And so by having that product extension, we're now more full service. So when you think about the $100 million size of SMB users or small businesses, which is the market, we probably can address a much higher percentage of them now by having the full suite of capabilities. And you're seeing that. In the last earnings call, we said we new customer growth that Cloudways is 46% year-over-year for net new customers. And a lot of those are what we've done in the first 4, 5 months post transaction. We're taking customers that come to DigitalOcean. We're engaging with them. Why are you here? What are you expecting? What are you looking for? And where appropriate, we're directing them over to Cloudways as opposed to a year ago, they would have had to just onboard on DigilOcean, and we have to hope that it worked out. Now we're upfront, better managing the experience, which is going to lead to higher retention, higher growth, et cetera. And so really excited about where we are with Cloudways. It's -- M&A is always -- you have a thesis upfront, and we've been able to get some pretty instant gratification in terms of synergies on the revenue side.

So maybe just following up a little bit on just M&A, but what is your capital allocation priorities at this point?

Well, our priorities are to invest in the business, organic growth. As we look out over several years, M&A is a key tool for us. We spent over, I think, approaching $400 million or so in M&A since -- over the last several years. So that's a big area for us to be able to accelerate growth, get into new product areas, do things faster, leverage the balance sheet to go faster, add talent to the ecosystem for DigitalOcean. So that's a critical priority for us, but we also balance that with share repurchases. And so we look at long term, given the free cash flow generation, given some leverage targets that we've set, given our preference for investing internally and managing the risk of maintaining a certain level of cash that we'll have excess cash over time. And our decision is to return a portion of that to investors, which we've been doing. We're currently operating under a $500 million authorization from the Board that we announced in Q1.

Right. I think we'll just take a quick pause here just to see if anyone has any questions. You can just raise your hand and someone with a microphone will come and assist you.

I had a question regarding the size of customers and maybe the maximum size? Like is there a point where they outgrow what you can offer them? And could you be thinking in the future of targeting larger customers?

So we see customers grow very large on our platform. In fact, Cloudways was a customer. Their first invoice in 2014 was $10 and their last invoice last August was $1 million. And so we have lots of customers that grow fairly large over time, and we rarely see them leave because the performance of our compute especially relative to the price point and the fact that we offer this support. And I know it sounds like marketing terms, but if you're a 1- or 2-person or a 5-person team, you just can't rely on a DevOps or in an IT department. So our value proposition is very compelling, especially when you consider the price point relative to a larger player. What we do see is customers go multi-cloud. And a lot of reasons they'll do that is, one, it's just prudent risk management. But -- and we also offer what I would say is a very -- its simplicity is core to our value proposition, is also our product solution. So when you look at what early-stage businesses need, they don't need a very dense, broad set of products. They need a simple and easy, intuitive solutions. And so because of that, we aren't going to be everything to everybody like you see in more of the enterprise mode. So it makes sense for them to go for certain applications, multi-cloud. And so we do see that. And in fact, we see that as part of our value proposition around simplicity that we don't put up these obstacles to customers. The traditional model and enterprise tech is try to lock your customer up in any way you can whether it's the technology and how easy or difficult it is to work with other tools, the contract, et cetera. That's not our model. We're trying to make it easy for our customers to build applications to realize their aspirations. And so that is a differentiation for us. And I think because we don't put up that friction, people do grow with us over time to be very large. And we don't see them. We see them graduate on our platform. We don't really see them graduate from our platform.

I just wanted to ask about capital allocation because what you guys have found a pretty unique with kind of committing to have a lot of debt, buying back a lot of stock instead. And I'm just curious what your thought process on that is and what your -- I guess, how you think about what level of debt you're comfortable with, especially if you have to refi the converts.

So the question is what level of leverage we're comfortable with?

Yes. And just kind of your -- could you talk about your -- how you think about capital allocation?

Well, again, I think we -- when we look at sort of the buyback framework, we look at a multiyear projection and free cash flow projection, assuming a range of growth rates. And we look at our priority for executing on a product road map, an infrastructure road map over time. And so we're focused on delivering that organically. So we're investing in the business organically. And then we have a portion allocated for M&A, nameless M&A, just a capital allocation that we are going to leverage M&A as part of our core strategy to sustain long-term growth. And then we look at what's left. How much cash is left. And then everybody has got to make a decision, what do you do with the cash, the excess cash, if you will. And our approach is to take a portion of that excess cash within the constraints that we're going to manage the 2.5x to 3x net debt to EBITDA. And we're going to take some of that excess cash and buy back stock. And I think we went public, we've reduced the share count pretty meaningfully over the last couple of years in -- and we've done $400 million of M&A. And we've invested to drive new products like the premium Droplet, the security product, add new data centers at a host of capability. So we're trying to do it all in a balanced way. And I think that will be the formula for us over time.

Just an extension on the first question about the customer size. When the customer is growing into a fairly larger size by usage of your product offerings and given that there is a multi-cloud environment. Now do you see those customers moving or migrating to the larger hyperscalers of the world?

We do in some instances. We also see fairly regular people migrating some or all of their workloads from some of the larger players to us. So I think one of the paradigm shifts that cloud -- and this is one of the really powerful things about cloud infrastructure relative to the old sort of historical enterprise is this notion that you're going to have -- you're going to dominate a customer because they got to be on your platform. You make it so difficult for them to go is really it was a barrier, I think, to customer growth and happiness. One of the things last year as the economy started to slow and our customers' growth rate started to slow, they immediately -- their bills immediately corrected. And as opposed to if you have one of these 1 or 2, 3-year contracts with somebody else, that's a fixed price, the minute your demand goes below what you expected, you have an upside down contract. We would have customers thanking us for the fact that they immediately can adjust with the consumption-based model. So we don't see people leaving 100%. We definitely see them adding new workloads to a different cloud provider. And I think that us not making that difficult and just focusing on the core differentiators that we have that we believe are powerful and valuable for our customers, and that has worked. And that's why I think you've seen over the last year or so, we've kept churn stable in a challenging environment because people aren't leaving, even though they may spread their workloads out for various reasons.

Another question on Cloudways. It seems that you are -- Cloudways works with DigitalOcean, but it also works with Google and AWS. So can you tell talk a little bit more about this multi-cloud strategy and what it brings to use it long term?

Yes. So Cloudways offers AWS and Google Cloud. It gives customers an option based upon what product mix they're going to want to use for the managed hosting solution because it's managed, it's a much easier dynamic. And so we haven't really put a pin on this yet in terms of how we can productize that. But the relationship with Google and AWS is very good. And so I think longer term, there's a real opportunity since we've always encouraged as a part of simplicity multi-cloud to potentially productize that. I haven't worked on that as part of the synergies. First part of the synergies was getting our customers better optimized across the product set, whether you want to do it yourself or manage, that's working very well. I think a longer-term opportunity is how can we productize the multi-cloud so that customers can do it all on our platform. It's pretty exciting. And the conversation with AWS and GCP, they're intrigued by it as well.

I think we have time for maybe just 1 more question. But in your discussions with investors, what do you think is really the underappreciated story with DigitalOcean?

Well, we've said since we gone public that this will be a free cash flow machine, and it was on the come then and now it's here. And I think the power of the economics of our model are not fully understood. I think that will be clearer this quarter as the margins will have a 2 handle, and we'll be expanding from here. I think that will open people's eyes to it's here. It's not on the come. And I think the other piece is, that the SMB economy is not well understood by institutional investors, the business press. We spend a lot of time trying to educate. That's why we do our surveys, et cetera. But most of these customers don't go public. They don't raise institutional capital. They're not press worthy, I guess. And so there's just not -- there's this perception that it's very frail. And if you were to look at the decline in our growth rates over the last 6 quarters, 4 quarters relative to everyone else, we're in the soup, right? It's not -- and if you'd have told people a year ago, "Okay, the world is going to slow." Everyone said, "Well, you're going to slow faster." And that's not really the case. We're slowing like everyone else. And in the U.S., the President, a couple of weeks ago cited new business formation is as strong as it's ever been in the U.S. SMBs 40% of the U.S. economy and some economies at 60%. It's about 50% globally. That's a huge chunk of the global economy, and I think that it's not well understood, but it's very durable and resilient. And I think we're seeing that in our business. Our customers are optimistic. They're still growing. They're still investing. They're still being innovative, and we're helping them to do that. And so I would think the power of our model and just who we serve is we'll keep working on educating folks about what we do. But it's an exciting part of the economy.

Yes. I think that's a great way to sort of end our discussion, and thanks so much for taking the time with us today. Would appreciate it. Thank you. Thanks.