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

Thank you for here -- for being here on day 3 of BofA's Global Tech Conference. I'm Wamsi Mohan, part of the tech team here at BofA. Delighted to welcome DigitalOcean to our conference. We have the CFO, Matt Steinfort. He's been the CFO since the beginning of the year. And so Matt, thank you so much for being here today. Since you recently joined DigitalOcean, can you maybe just give a quick introduction of your background and what brought you to DigitalOcean?

Sure, Wamsi. Thanks for having me. So I've been -- as Wamsi said, I've been the CFO at DigitalOcean for just 5 months now. I joined in January. Prior to that, I was the CFO at Zayo Group, which is a large -- at the time, private communications infrastructure company. We're about $2.5 billion in revenue. I was the CFO for 6 years, 3 of which were public, and then we took the company private in 2020 at -- before the pandemic hit. And at the time, it was the largest telecom tech, private, it was $14.5 billion, and I stayed the CFO for 3 years with that group before joining DigitalOcean. Prior to that, I was the CEO and founder of SaaS software company for 10 years. And prior to that, I was at a variety of corporate strategy and corporate development roles at Level 3 Communications, ICG Communications. I started my career at Bain & Company and Cambridge Technology Partners. And in terms of what attracted me to DigitalOcean was it's a phenomenal market opportunity. I mean the cloud infrastructure is kind of a core part of I think the Internet going forward will be relevant for decades to come. And -- so that was exciting. DigitalOcean has carved out a very interesting niche in that below the hyperscalers and above some of the lower -- kind of lower end cloud providers. So that was compelling to me. The economic model and the customer kind of acquisition model were very compelling to me. I mean the company, particularly coming out of telecom where we were trying to grow 3%, 4%, 5% and spending $1 billion a year in capital and burning cash every year, seeing a company that was able to grow in the 30s and now in the low 20s, but generate meaningful cash flow was very attractive to me. And then Yancey and I had actually met at Zayo. He was the Lead Director working on to go private. And so that's where I got exposure to Yancey. I have a tremendous amount of respect for him and for his team. So it was -- to me, a no-brainer. It's an exciting company and an exciting space, and I feel really good about our ability to make an impact and improve the operations.

Excellent. Yes. Well, so glad to have you over here in the seat. So what do you see as the TAM for DigitalOcean? And when you think about the growth of the company, so obviously, organic growth had been 30% to 40%. It's kind of decelerated some from there. How are you thinking about, a, the TAM; b, the growth as we think about the next few years?

Sure. So the TAM is very large. It's a very fragmented market. IDC suggests that the SMB portion of cloud infrastructure, which SMB is defined, I think, by them by customers under -- companies under 500 employees. It's like a $100 billion market, and it's projected to grow 26%. If you spend that in terms of the quantity, there's 100 million SMBs in the world today, and that's growing at about $14 million a year. So the market is enormous. But if you think about it, the challenge for a bigger company that's focused on enterprise trying to serve that space and why DigitalOcean is so well positioned is there's no one customer in that, that makes a difference, right? It's a law of large numbers. And so you have to have a very low cost of acquisition -- customer cost of acquisition, you have to provide the service in a much simpler way and -- so we think that the market is enormous. And again, if you take our -- the midpoint of our guide, we're less than 1% of that addressable market. So we think there's a tremendous amount to be able to grow and to capture share. And again, the market itself is projected to grow at around 25%, 26%. So we feel really good about that. I think our growth is a function of being able to take more of a wallet share of our customers as they grow and scale on our platform. And the bulk of our revenue and our growth comes from our larger customers. It comes from customers greater than $50 in spend. And so capturing more of their wallet and being able to -- as they go multi-cloud over time for diversity reasons and to be able to address more kind of deeper needs in specific technologies, we can pick some of that off, then we can definitely supercharge the growth from where it is today, which is clearly lower than it was along with the rest of the industry than it was last year.

So you guys are getting some pretty interesting disclosure around how you think about your 600,000 customers. And you segmented it across different spending markets. Can you talk to the audience about, a, like how does that pipeline change over time? How does that cohort, how have been the graduation rates of these cohorts and the spending trends? And what are you doing proactively to drive that increased spend or graduation rates? Or how much of that is organic versus how much of that is effort that you guys are putting behind it?

Yes. That's a great question because the -- when I first started, I had a number of sessions with Yancey talking about the business and talking about what the market is reacting to and what they're not reacting to. And one of the issues was people were expressing agitation around the customer count. Total customer count -- hey, your customer count is up by 1,000, down by 1,000, that seems concerning. And when we unpacked it, what we saw was -- and I think we knew this, but we weren't doing a good enough job of explaining it is the life cycle model at DigitalOcean is, people come to our platform to test an idea, to try an application, to try to build a business. Sometimes they only spend $15 a month when they start. Cloudways, which we recently acquired last year. It was our biggest customer, was doing $1 million a month when we acquired them. They started as a $12 customer. And so customers come on and they try and they experiment. And they stay for a really long time. The average age is 4 years for a learner, which is someone who spends less than $50. But every month, every quarter, every year, some portion of those get success in their own business. Their app takes off, the website gets successful, and they build a business. And they scale on our platform, and they become the builders and the learners. And the cutoffs are statistically important because we look at the data and the trends, but it's a little bit of a notional in that once you get to $50, you're running a business. You're not just like a hobbyist who's got a website and is paying like a Netflix kind of equivalent fee every month. You're a business. And once you hit that point, and we -- typically graduation rate from learner to builder has been around, call it, 2% to 3% -- sorry, 1% to 2% over the last 5 years. So -- but that's a -- when you're talking about a base of 460,000 of them, that's a decent amount that moved to make a real business. And then when you get to the 500 level, then that's when your product attach is really up, your churn goes way down. Those customers are incredibly sticky. They grow faster. That's where we get a tremendous amount of the value. So what we're doing to try to play into and accelerate that, we're doing things at multiple ends of the funnel. So if you think about -- we have 10 million customers or -- I'm sorry, prospects a month that hit our website. Tens of thousands of them actually try the application and play around. And then thousands kind of convert to the customers. So in that process, if we can better identify who is a candidate to be a builder or a scaler faster, and we can devote more resource to them early on to guide them. One part of the guide is just -- with the Cloudways acquisition, are you more likely to want to manage a solution or you're going to want to do it yourself? I mean we weren't asking questions before. Literally, we would -- customers would come in and sign up. And then we look backwards and try to figure out what they were doing and -- based on their usage. And now we're asking questions and trying to funnel them into the right channel so we can accelerate that. The other thing that we're doing is new motions for us from an outbound standpoint, using partners and direct sales to try to find builders and scalers that are already at that scale from what they're sitting on Amazon or Microsoft or one of the hyperscalers and see if we can attract their business. The third thing that we're doing is more of an inside sales motion, which is -- we know which of our customers, particularly the large ones are using other clouds. And so we can proactively reach out to them and say, what workloads did you move to them? Or are we not getting and therefore, what would we need to do in order to get that back or to have you move that workload to us. So that's informing our product development road map. So a very kind of holistic approach to kind of lean into that graduation life cycle and see what we can do to accelerate it.

From a trend perspective, how many of your scalers, so your highest-paying customers, outgrow the platform, so to speak?

Very few because the churn when you get -- our churn overall for the company, churn for us means if customer leaves this goes to zero. The churn has been relatively stable all of last year, and it was a little bit elevated end of last year. It's come down a little bit in the last couple of months. So that's a good positive sign. But the churn for the scalers, the largest customers is tight. It's -- if you think the overall business is in the 10-ish or 11-ish percent range, the churn for the scalers is in the low single digits. And that's a testament that customers grow on our platform and they don't leave. What we do see is they go multi-cloud. So we might lose a workload. Not -- it's not a workload we had, it's a workload they need that we don't get. So think of it as they've got a really complex storage requirement. Our storage doesn't scale enough for them. They go to Amazon S3. And that's what I was talking about before is if we can identify those friction points, what is it about our platform that we need to advance or repackage the pricing in a way that makes it economic to you so that we keep more of the -- we win more of those workloads. So very few customers graduate off of our platform to hyperscaler. But customers, certainly, they spread their workloads, and that's where we see a big opportunity.

And you also mentioned sort of looking at customers who are currently at hyperscalers and attracting them to DigitalOcean. What is the -- like how do you go about doing that? What is the value proposition that you are pitching to them that already have an existing sort of functional platform? So what is it that you are approaching them with, that's causing them to come because we've done survey work that actually has shown that customers are coming to DigitalOcean from hyperscalers. So what is it that you're doing to incite that?

Yes, it's - I'd say the general value proposition between us and the hyperscalers, regardless of whether they start on one side or the other. We're a lot simpler to use, right? So there's a complexity issue that they don't typically have. We're very simple to understand. The pricing model is very transparent. We have a higher level of direct support. So if you're a small customer on an Amazon that might be a big customer for us who probably don't even get to talk to anyone directly from them, and they're not giving you a lot of support. We provide support to all of our customers. But when you say, okay, that's maybe what wins you a customer who's starting from 0, what wins you a customer that's already there? It's economics in a lot of case. We're typically -- what we found is when customers migrate from a hyperscaler to us, they typically save 50% on their bills. And we've seen that in the other direction with Cloudways when -- before we had acquired them, they were contemplating moving a workload from us to Amazon and they did. And Aaqib who is now our Chief Revenue Officer, was talking to Yancey. He's like, "Oh, I did that. And then I got my first bill. It was way bigger than I thought it was." It was a mess, so they ended it. And so economics is a big factor. And that's where, again, we think that the niche we have below the enterprise level is a very compelling value proposition for us, very differentiated.

And they've seen actually at hyperscalers like Amazon and Lightsail before and other products that have been out in the market. Your growth rate was kind of unchanged through all that. So there is something more about the value proposition than just giving a lower price point, to your point?

Yes, absolutely. I mean think about the customer acquisition model we discussed. We take customers like $10 to $15 a month and take 18 to 24 months to grow to $50 or above or -- I mean, you have to be really patient for that. You got to provide a lot of service. It's got to be super easy. And you think of the market motions and mechanics, the cost structure of those bigger companies, they've got a bigger addressable market. I get it. They've got bigger potential with some of the enterprise customers. That's a different motion. It's unusual to find companies who can do both, be like I'm going to be a hardcore enterprise oriented. It's all about customization and complexity and getting embedded or I'm going to be one that's like deals with 10 million visitors a month and trying to convert thousands and hope that you just put them in your pool of learners and then that learner pool will grow over time. That's a very different motion, very different economics.

So it's not intuitive to a lot of people who think about hyperscalers who kind of have this notion of unlimited CapEx in some ways, right? And this is a capital-intensive business in some ways, can you talk about the returns on the business because I think that when you look at your business model through a lens of returns, it's actually very attractive?

Yes. No, that was the other thing that I talked about was one of the big draws for me in coming to the company. I mean a company growing in the 20% plus or minus range that's generating 30% free cash flows, which we said we'll approach that by the end of this year. That's a huge growth in free cash flow, right? That's a free cash flow CAGR over a couple of years of like 40%, 50%. And you combine that with the share repurchases we're doing to bring down the denominator. And it's a very compelling free cash flow per share story. And if you think of the margin kind of stack, gross margins, we have a lot of ability to drive improvement there as we grow into some of the recent investments we've made in the Sydney data center, some additional kind of networking capacity. On the EBITDA front, we've got the ability to drive pretty good margins there. We did a cost reduction initiative earlier this year where we announced about $60 million of run rate kind of expense coming out, $25 million was headcount, $35 million was non-headcount. And that's going to drive EBITDA margins close to 40% by the end of this year, and we'll take that 16% reported free cash flow margin in the first quarter to close to 30% by the end of the year. So it's very, very compelling from that standpoint. In CapEx, we think we can keep around 15% of revenue, which is where it was in the first quarter. We think that's a sustainable level and still enable us to invest in maintenance, to invest in the growth capital to match the scaling of our business and also invest in new kind of capabilities and new footprint.

How do you go about going from 16% free cash flow margins to over 30% exiting the year?

Yes. That's the -- take the EBITDA from -- it was 34%, I think, in the first quarter to close to 40%. That's primarily on the back of 2 things. One, the gross margin will increase from the 56% to 60% as we grow into those investments we made. But then the cost reduction initiatives that I just talked about that we did that mid-February, and some of it was immediate, like about half of the headcount reduction we did right away. The other half is a move and a migration of resources and roles from the U.S. to lower cost global capability centers. So we had about 120 roles that we shifted from the U.S. to Pakistan, India and Mexico, and that's a long-term structural change. So that's -- when we add developer resources, we're looking at where do we add them, U.S.? Do we add them in some of these other locations where we're getting really strong talent, very good productivity and a fraction of the cost. So you take all of those together, you keep CapEx at kind of around 15%, and you get to that 30% exit kind of run rate on that free cash flow margin.

And what about on the gross margin side, you mentioned, obviously, that you opened the Sydney data center, you can sort of scale into that, leverage that. What are other -- some of the other factors that get you there? And is there room to improve from procurement and what are some of the initiatives there that you're doing?

Yes. And if you go back to when Yancey joined the company, the company was spending 44% of revenue on CapEx, and they reduced it in the 20s really quickly. And how they do that? Well, they didn't have -- the company was founded by developers. It was really successful. They're growing like crazy, didn't have a lot of gray hair. Financial discipline, like, hey, you might want to get contracts with some of your larger vendors? You might want to do basic procurement? So they were able to just through some basic kind of disciplined functions. We're able to get that down. We're still doing that though. I mean, we just started signing up longer-term contracts with the co-lo providers last year. So that's kind of a new thing. We have opportunities -- tremendous opportunities on the bandwidth side. That's something, again, near and dear to my heart from my background. And then just kind of in an environment where you know that you're not -- the market is not growing as fast as it was and where you have a commitment to a free cash flow margin target, which we accelerated our long-term target to this year, you have to make, I'd say, more disciplined and you have a higher bar on investment. So you say, okay, well, we're not going to spend as much capital on this if it's not going to earn the return we want or search engine paid marketing, paid third-party placement. We weren't getting a great return on that. So we dialed the spend back. So it's -- I think there's a tremendous amount of opportunity. And I think you're seeing this perversely. It's part of the reason there's a slowdown in the overall market and a lot of companies are doing this, like, oh, if we're not growing as fast, we got to get the free cash flow faster. How do we do that? We look at all our spends, and we see -- man, we're spending -- we have 10 different HR applications and we have 12 different marketing automation things. And these were great ideas. And when everything was growing super fast, it was okay. But now in a different environment, everybody has got to be kind of, I think, more prudent in dialing in their spend, which is causing near-term headwinds, but we'll eventually run its course, and we'll be back to growth in that area.

Yes. Well, that's helpful. So Matt, your aggregate growth rates have slowed down despite the Cloudways deal. So do you think revenue growth in the next few years will be more driven by ARPU versus increased customer growth? Or how do you think about the balance between those?

Yes. I think both will certainly contribute. I do think ARPU growth is a bigger lever for us to pull because the self-serve funnel, the engine of the company, it's super predictable, it's reliable, and it's been relatively steady. So you're always adding customers into the beginning of the funnel that there are learners and then again, that pool, it can fluctuate as long as it's big enough, to generate enough kind of output. You'll see growth through the customers. We'll also add customers through those direct motions, trying to bring in customers later in their life cycle. That will all, I think, be very positive. But that's all we did. I think we're a high single digits kind of grower. But where you get the lift and you get into the more attractive growth rates as you figure out how to increase the ARPU. And not just the ARPU because people are kind of scaling their own business, but figuring out how do you get more share of their wallet as they become a bigger businesses. So enhancing our storage capabilities to be more fulsome, adding some basic capabilities that like role-based access control and other things that are necessary as you get to become more than a 5-person team that's using our platform and you need a bit more [ likability ] in that. So those are the kind of things that we're looking at. And we're looking at other applications, the AI and other applications that customers might be demanding. We certainly have a long kind of thoughtful product road map about how to integrate some of those capabilities. But I think growth will come from both, but I think ARPU is probably the bigger driver in the near term.

And when you think about that ARPU and I know that you've changed -- there's different ways to think about what you're offering, but you have premium droplets, for instance, products that can help you move up, you have richer CPU, GPU configurations, memory configurations. How do you look at your customer base and say which are the workloads and where is the probability of actually looking at the data, looking at the usage and saying, how do we recommend these to them? And how long has that process been underway? And how much more room is there to go on that?

I'd say there's a tremendous amount of room to grow there. And I'll give you an example. The premium dedicated droplet that we launched in the first quarter was a bandwidth optimized droplet. So it was -- just think if somebody uses their application, their gamer, they're a streamer, they need more bandwidth. And previously, they had to do 2 things. One, they had to buy a bunch of droplets to get the bandwidth they wanted. They didn't need more compute. They didn't need more storage. But because of the way we package the product, they had to kind of scale those things linearly, okay? The second thing was they weren't optimized together so that -- because they had to write software on top of our application to use these little building blocks instead of having something that was more easily consumable by them. So we got enough feedback from customers that there was a big demand there that we said, hey, we'll do this. And what we were able to do is we were able to launch a service or a SKU that we're able to charge them 2 to 3x what we would have charged them before. And they were happy because it reduced enough of the costs that they were having to do on their side that it offset it. And so when I see things like that, that's a tremendous opportunity because there's so many different verticals. There are so many different use cases on our platform. You could think of a lot of different optimized SKUs or even just unbundle your components a bit so people can configure them more easily themselves. That should drive a tremendous amount of growth potential. And I think we're actually -- even though the company has been around for what, 10-plus years, we're relatively early in that because the company was founded and a lot of the original developers and a lot of the original team, the persona they were solving for was the developer. Like don't do anything to mess up the developer experience, make it super simple, 1 product, 1 SKU, 1 price, and that's what that kind of development engine was geared around and we're in the middle of a transformation. We're saying, look, that's not where the value is. That's interesting. We got 470,000 of them. We need to make it an attractive place for them to come and -- come into the business and take care of them so they can grow. But all the growth is going to come from the bigger guys who have a different need set that's slightly more nuanced than the developer. And so I think we're very early in that game.

Can you talk a little bit last year in the middle of the year, you did a price increase. As you think about your guide for this year, is there contemplated in there another price increase or not?

There was a small price increase that we did with Cloudways. So we increased Cloudways' pricing by about 10% starting in April. That's the only like list price kind of price increase in there. The rest is more monetization like we're talking about, rebundling, repackaging the product.

So within your guide, we are not anticipating any other price increases. So that would be incremental if they were...

Yes. [indiscernible] able to offset risk score, it would -- but it's not -- the only price increase that was complicated was -- contemplated was Cloudways' price increasing.

And can you talk a little bit about the churn after the price increase, I mean, our survey work showed that there was very minimal churn, but curious to get like what data you guys have seen around churn metrics after the price increase?

Yes. Churn increased a little bit in kind of late fourth quarter. I don't believe it was attributed to the price increase. It was, I think, more attributed to weakness in the overall market. And we've seen that come back down. So -- and we didn't see a meaningful increase in churn at all with Cloudways so -- when we did that price increase. So it's -- churn has been -- if you -- in terms of green shoots, the churn performance has been pretty good. Most of our pressure is on customers themselves are just not growing as fast, and so they're not growing as fast on our platform. So that's slower expansion. And then we are still seeing optimizations on our platform by bigger customers. So the contraction is still a headwind.

You briefly mentioned AI in your comments earlier. I'm curious which customer cohort or like within your builders, scalers, learners, where do you see that the most or where do you see the most opportunity?

Yes. It's interesting because the needs of -- for AI of smaller businesses is certainly different than some of the large kind of headline names you'll read about in the press and folks are probably talking to conferences like this. Our customers don't go to these kind of conferences, you would never probably know of them. But we have gaming customers today that are using AI on our platform, 250,000 kind of ARR customers that are using our existing capabilities. They're not using or even asking us for GPUs. They can do it with the high kind of performance compute we have. So we're seeing the application and interest. We're not seeing a lot of people asking us for GPUs specifically within our customer base. But we have GPUs in our network. We're testing it. We're trying to figure out what the value prop is and what the -- how do we productize that for a smaller kind of -- set of customers. And that's something that's on our road map. And we're not having to say right now, but hopefully, we'll be able to say something soon about what our plans are there.

Okay. That's great. I also want to talk to you about capital return. You guys have announced a fairly large capital. I mean, a buyback plan, and you've been executing against that. What are your thoughts around sort of how aggressive you want to be? How do you think about being programmatic versus opportunistic in terms of buybacks?

Yes. So we got an authorization for $500 million of buybacks this year. We broke that into 2 different tranches. We had a $270 million what I would consider opportunistic program was still executed through a 10B, but we're depending on where the price set, we would be aggressive or more or less aggressive. And then we have another component, which is the $230 million, which is -- we're going to be in the market every day. and we're going to buy some stock. And we might buy a little bit more, a little bit less, but we're going to be in the market every day. And so we've been executing on both of those. We're probably about $350 million in, and we have got $150 million left for the balance of the year. And we think it's an important part of the overall capital return profile. Next year, we've said we'll do up to 125% of free cash flow. The intent is whether it's 100% or it's 125%, we intend, as part of our formula, to drive operating leverage to improve the free cash flow margins, and we intend to reduce the share count. And when you do that together, we think the outcome from the free cash flow per share perspective is pretty positive.

How do you think about the liquidity of the stock in light of that?

From a float standpoint?

Yes.

Yes. We're not concerned about the float at this point, although there's a short interest that might be concerned about the float particularly. But the -- we feel that we are well positioned given the flexibility we have, with the cash flow generation we have to manage to a reasonable leverage level and to be able to invest in M&A, to be able to invest in organic growth and still return a fair amount back to our shareholders.

Yes. Since we're almost out of time, Matt, I just would like to give you the opportunity to talk to the investor base and talk about why DigitalOcean is a compelling investment?

Yes. I think it comes back to the 2 things. The free cash flow profile, I think, is unique in the space. If you talk about Rule of 40 or Rule of 50, and you're talking about a lot of companies that are saying, "Hey, I'm going to cut costs now to try to accelerate free cash flow generation by a year or 2," and we're already there. So we're already generating very, very compelling returns. The other thing that I think that people have underappreciated is the durability of both the SMB market as a whole, which is 40% to 50% of GDP, depending on kind of where you're looking. In some countries, it's even higher. It's very, very durable, right? That's a market that's been around and will continue to be around and will continue to drive a lot of growth. And if you look at the resilience of our customer acquisition, we have a -- we can acquire customers at, I would say, effectively 0, but 10% of revenue on sales and marketing is incredibly low, it's incredibly efficient. And once we get them, again, we keep them for a very long time and they grow. And so it's like a free option where customers are paying you to be prospects and then some of them kick off and generate meaningful, attractive long-term customer value. And that I don't know that is fully appreciated by the market at this point.

Yes, absolutely. No, very compelling story with solid free cash flow profile, and you guys seem to be doing a phenomenal job. So thank you so much for being here, Matt.

Thanks, Wamsi.

Thank you.