Thanks everyone for joining us today. Welcome to JP Morgan's 51st TMC conference here. My name is Noah Herman. I'm an Analyst on the Software Equity Research team here at JP Morgan. With me today we have DigitalOcean and their CEO, Yancey Spruill. Thank you so much for coming here today.
Its great to be here.
Appreciate it. Maybe you can, you know, briefly just introduce yourself. Give just a brief introduction of DigitalOcean and the value proposition that the company provides the customers.
We're a cloud computing provider, global scale, global capabilities. The business was founded with the purpose of creating a simple, easy, intuitive set of cloud tools that allow anyone from a software developer through small and medium-sized businesses to simply, easily, rapidly deploy digital applications. We have over 600,000 customers in 185 countries, about $670 million ARR at the end of last quarter, and we generate a lot of free cash flow.
Great. No, that's a great overview. Maybe, you know, I think, you know, when investors hear public cloud, you know, they think about AWS, Azure, GCP. Can you sort of explain, you know, what, you know, the value proposition that DigitalOcean provides that maybe these public cloud vendors can't?
Yeah. We really focus on, you know, four key attributes of differentiation. One is simplicity, ease of use. The second is our open platform, the support that we offer customers. The third is support. Our documentation, our community investment. Our customers come to us, they don't have large IT departments. They don't have a DevOps team. The product experience really has to stand on its own. That value proposition of simplicity is really powerful for them. And the fact that when they need help, that we offer support. All of our customers get support. An example of simplicity is just in the time this call started, you could be up and running coding on our platform.
It's really easy, for people to get up and running and scale their applications as their businesses grow.
Maybe we can touch a little bit on the, just the current demand environment. You know, I think you have close to, at this point, 700,000 customers. You, you probably have a really good read on global SMB usage and consumption trends. You know, just that customer cohort's business confidence. You know, how do you sort of see them behaving, and what does that really look like, you know, as we sort of enter June? Are they really bracing for, you know, a recession, or is it all kind of, you know, systems go at this point?
You know, we just published our current survey of our customers where we periodically survey our customers, and, you know, they tend to be positive. You know, I would say that's reflected in the conversations we have with them directly, but cautious. You know, the demand environment has definitely slowed. Our customers are smaller. They tend to be higher growth than GDP, for example. But that growth rate is not as high, and we've seen that play out in our slower growth today versus, for example, a year ago, where our customer churn has held pretty constant. Our customers are staying, they're just growing slower. Their net expansion, which is a big fueler, a big fuel for our growth rate historically, has just come down.
Right. You know, maybe just to double-click on that with the net expansion, you know, obviously, customers continue to optimize their cloud usage, which sort of drove, you know, NNR to moderate a little bit further last quarter. You know, that said, how along or do you think customers are along this optimization journey at this point? You know, how much really further can customers optimize their cloud usage?
We have a consumption-based model. Customers spend what they use in the month. Optimization happens immediately. If their demand goes down, their growth slows, they consume less compute or storage or other applications, they pay less. That's a feature of our platform. They're not in an upside-down contract. The notion of optimization for us is a real opportunity where we go in and talk with our customers about what the way forward for them is over the next year or two in terms of growth, and how can they have a better configuration in terms of the application, the product mix, that gives a more efficient growth path. You know, we did see pickup in customers asking about, "How could I do this better?
How could I do this differently?" I don't know that we're seeing that as much today as we were, you know, say, a quarter ago, but it's really a great opportunity. It's part of our value proposition, frankly, where a lot of these customers you can imagine spending $10,000, $50,000 a month, they're not relevant at our competitors, and they can't talk to anybody,
Mm-hmm
let alone have a more personalized experience that helps them think about their, and manage their infrastructure as they scale. Optimization really has been a good opportunity for us to engage with customers.
Got it. Maybe we can, you know, talk a little bit about just AI.
Mm-hmm
I t's pretty much coming up in every conversation here at the conference. You know, DigitalOcean is in the infrastructure layer, which is expected to really be a net beneficiary of the generative AI trend. You recently indicated that you might be introducing GPU-based Droplets as well. I mean, do you see AI as a potential tailwind for the business medium term?
A few points. First, there are AI power focused businesses that run on our platform today using our standard high-performance computing tools. Second, I think however this plays out, you know, AI is an application that needs to run on compute, needs storage, and needs bandwidth to get the applications out to customers. Those are all tailwinds for us. The third is we have been spending a lot of time, and we've said this since we were public, that we thought, one of the areas that we will wanna invest that's net new capabilities on our platform is to have a, some sort of an AI capability. Helps our customers with sales and marketing, operational optimizations. We still believe that, are focused on that at the right time.
Also GPU is a unit of compute, and so, you know, we want that as part of our portfolio. We're looking at it actively now. Nothing to talk about specifically in terms of an offering, but we are. This is gonna be something that's part of our future in terms of, I think, an explicit product offering, but I also do believe this will be a tailwind for our business just because of the role we play in the ecosystem.
Maybe just touching on some of the new initiatives that, you know, you talked about last quarter. You know, maybe you can talk about some of the new initiatives that are contributing to sort of hit the upper end of the revenue guidance range. You've launched the Premium Droplet. You raised prices for Cloudways. What else is really coming down the pipeline over the next year?
Yeah. We had launched a new data center that's ramping nicely in Asia Pacific. We had a number of go-to-market motions. We launched our Partner Pod program late Q4. There's a number of things on the go-to-market side and the product side in Q1. We'll have a security offering coming out here at the end of this quarter. We're gonna ramp up some Object Storage capacity in other regions, and we'll have some other storage coming in the back half of the H2 of this year. There are a number of things, and the way we laid out the guidance is, if none of those hit, which they're hitting, was the bottom end of our range, and then at the top end if they all hit.
We're managing that portfolio of activity today. You know, are excited about getting new things in customers' hands. The Premium Droplet's a great example. It was designed for. We talk about it as a new product, but really it's a new SKU off of existing. We took standard capability and tailored it for bandwidth-intensive use cases, like streaming media, ad tech, where people need a lot of bandwidth, need some storage, and need a lot of compute. The way our standard products are configured, they move in equal proportions. We tailored something that's more bandwidth intensive at a much higher price point than a typical gaming company who runs on our platform, and we're seeing a lot of migration and adoption because, you know, we've packaged and bundled.
I think that's a big opportunity for us, is not the explicit price increase like we did last year or with Cloudways earlier this quarter, or explicit product, but it's more granular product SKUs that enable different use cases on the platform. We're not a one-shop-fits-all sort of approach, and we see a lot of opportunity. We've had some success with sort of more tailored droplets over the last couple years, and I think you'll see more of that packaging as we go forward.
You mentioned that, you know, next quarter, I think, that you'll be launching a security product.
Yeah.
Could you maybe just elaborate on why it makes sense to kind of go into that market and, you know, just any other details around that?
As our customers go from having one customer to thousands of customers, you know, at the smaller end, they don't care so much about security, 'cause if they go down, they have an issue. As they grow, they care a lot about security.
Mm-hmm.
What we're going to do is offer people a choice, where they are on the needs for security and more security. I think you'll see that as another theme of, again, introducing new SKUs, new capabilities, that give our customers more options for where they are in the life cycle of their business.
Oh, that's interesting. You know, maybe we could talk a little bit about just the organic revenue growth of the business. Obviously investors are a little concerned that organic growth is taking a step, you know, down currently given the macro. You know, that is definitely broad-based across all of software.
Thank you for saying that.
You know, I mean, do you consider it possible for organic growth to really return to that 25%-30% threshold at some point?
Well, obviously we're in a lot of uncertainty, you know, let's just talk about our guidance. Our guidance is low to mid-20s for the year. We're comfortable with that. There's another aspect. If you look at the exit trajectory implied in our guidance is low to mid-10s, and I think that is a good foundation, you know, as we go into next year. There's a number of things coming this year that'll layer on top of that. There's more things that we have on the table. That's all we're gonna say about growth. I think if anybody's at this conference or any other conference talking about 2025, 2026 vision, I need to be listening to what they're saying. We're not in that position today.
We know about this year. We're comfortable where we are this year, and we're working hard to continue to get that higher growth rate, but we're dealing with the current realities as best we can.
Right. Maybe on the profitability side of the equation, you know, I think we, you know, we continue to be really impressed by the company's strong commitment to free cash flow generation. You said that you aspire to be at a 30% free cash flow margin.
Yeah.
on a sustainable basis. You expect to be there for Q4.
Mm-hmm.
You know, what are some of the levers that you can pull to sort of get there and achieve that on a sustainable basis?
Yeah. It's really important. We decided to accelerate to our longer term free cash flow targets this year because of the uncertainty on top line. you know, we can control expense, we can control capital a lot better than we can control demand. That's why we moved to accelerate margins. we're pretty comfortable that we can sustain where we exit this year just from managing, you know, operating leverage, prioritizing new growth initiatives, being very efficient and diligent on the capital side. there are a number of levers that we're gonna pull, but we're ramping very nicely on free cash flow.
I think, you know, the numbers that people see this quarter, will reframe the entire conversation around where we are, on free cash flow margin relative to this growth rate. I just think, you know, our team, when we looked at it last fall, given how challenging it is to think about growth and the certainty of that versus a year or two or three ago, the right thing to do is to control the things you can control, and we're doing a good job, of managing expense growth, still investing in the business.
Mm-hmm.
Both on the product side, on the go-to-market, on the infrastructure side. We're adding new things, but we're just doing it in a much more disciplined, much more targeted fashion that's allowing us to have, you know, pretty significant operating leverage as we move through the year.
I think, you know, one of your key initiatives for 2023 is the go-to-market. What are some of the steps you're taking and, you know, what are some of the key metrics that investors should really focus on to kind of measure maybe the productivity from the new go-to-market initiatives?
Well, I think the growth in our Builders and Scalers is gonna be a good long-term measure. You know, the sales efforts, the partner efforts are about bringing in larger customers. ARPU growth and then customer growth within the Builders and Scalers, those customers anywhere from $50 all up to $250 or higher. 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. That's why we use the builder breakpoint.
I think ARPU Growth and Customer Growth with o ur 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 a direct sales partner channel capability.
Got it. How, 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 s mall and medium-sized businesses, so it's very fragmented. You know, I think. The self-serve is an incredibly efficient. We get 10 million or so visitors a month to our website reading our content, that allows us to sign up tens of thousands of new customers. It's been a very efficient. It's still not the world in terms of who we serve. We think the partner channel is just gonna be a network effect that's gonna allow us to extend and get more leverage, in terms of customer acquisition, but do it efficiently in terms of, you know, the average customer coming in is not spending that much.
It's not gonna be efficient to be able to put in a high price field sales force like a lot of enterprise businesses do. We think the channel's critical to us attracting more customers, driving growth, and doing so in an efficient way that doesn't disrupt. You know, we're roughly 10% of revenue and sales and marketing as a percentage of revenue, so it's very efficient. You know, that's enabling a lot of the profitability and free cash flow. We wanna preserve that while still growing the business.
You mentioned that this is about a $100 billion market opportunity. You know, you are exposed to more of the SMB side of things.
Yeah.
How do you sort of segment the market, within that $100 billion? You know, what is sort of the low-hanging fruit opportunity within that market that you can sort of penetrate?
Well, you know, I think our self-serve does a good job of capturing low-hanging fruit. You know, high intent users who come in and start low. You know, when people come in through the self-serve, you know, I mentioned tens of thousands, they typically might spend $20 a month. Then, you know, they may stay in that phase for two to two, three, four years, and then they move quickly up and grow quickly and large over time. That's very efficient. You know, we have that dialed in. There's more we can do, and we're certainly working to continue to optimize that and grow that.
I think the, you know, the bringing in new channels and routes to market, given the fragmented nature of the market is really the path of sustaining a rapid growth rate, over time.
So last quarter, you launched a premium dedicated droplet w hich is meant to target bandwidth-intensive applications like video streaming and ad tech.
Mm-hmm.
What has been the customer feedback so far, and what does this really mean for that customer ARPU growth that you mentioned?
The feedback's been great. I mean, the adoption is, you know, 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. We did that in response to our customer feedback because customers, you know, you'd meet with a gaming company, and what we'd hear is, "We love DigitalOcean. We're ramping and scaling. It's great." 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.
We took that feedback and customized a Droplet that had more bandwidth per unit of compute, which is more, and then we layered in some other software. Why our customers like it allows them to almost dive right into using the product versus having to customize it. It's taken friction out of the system for them, and it allows them to scale more efficiently because now it's a much more purpose-built unit for them. You know, it's at a much higher price point than they were paying us. They're happy to pay us more because it simplifies their workflow so they can focus their team on more, you know, customer-centric activities and not managing the infrastructure on DigitalOcean.
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, you know, a bandwidth intensive use case, where it's, you know, the same set of tools with a little bit more software on top of it. 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, you know, 2x- 3x what we were getting for a standard droplet. They're happy to pay that 'cause it takes cost out of the system for them and makes it more scalable over time.
Mm-hmm. I mean, it's almost been a year since the Cloudways acquisition back in September of last year.
Mm.
Can you just give us some context on the driving forces behind the acquisition and, you know, how has Cloudways performed relative to your expectations?
Yeah. I think in your earlier question about, you know, other channels, you know, Cloudways is a product extension. For DigitalOcean, if you come to DigitalOcean, you're gonna have to set up your own compute. I mean, you have it. We have it. We have the documentation. It's simple, easy. You. It's more of a, what I call, do it yourself. As you grow over time, you're gonna 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. We'd see some of them churn after 60, 90 days. One of the reasons they'd give us is, "Well, I was looking for a more managed experience. I thought this was a Wix. I thought this was a Cloudways." By having that product extension, we're now more full service. When you think about the $100 million size of, you know, SMB users or small businesses, which is the market, you know, we probably can address a much higher percentage of them now by having the full suite of capabilities. You're seeing that.
In the last earnings call, we said we customer growth at Cloudways is 46% year-over-year for net new customers. A lot of those are what we've done in the four or five months post transaction, we're taking customers that come to DigitalOcean, we're engaging with them. You know, "Why are you here? What are you expecting? What are you looking for?" Where appropriate, we're directing them over to Cloudways as opposed to, you know, a year ago, they would've had to just onboard on DigitalOcean and, you know, we'd have to hope that it worked out. Now we're upfront better managing the experience, which is gonna lead to higher retention, higher growth, et cetera. Really excited about where we are with Cloudways.
It's, you know, M&A is always, you have a thesis up front. We've been able to get some pretty instant gratification in terms of synergies on the revenue side.
Maybe just following up a little bit on just M&A, but, you know, what is your capital allocation priorities at this point?
Well, our priorities are to invest in the business, you know, organic growth. You know, as we look out over several years, M&A is a key tool for us. We've spent over, I think approaching $400 million or so in M&A since over the last several years. 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. But we also balance that with, you know, share repurchases.
You know, we look at long term, you know, 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, you know, 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. Okay.
Hi.
Hi.
Thank you for this exchange. 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? Could you be thinking in the future of targeting larger customers?
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. 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 one or two person or five person team, you just can't rely on a DevOps or an IT department. 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.
A lot of reasons they'll do that is, one, it's just prudent risk management. We also offer what I would say is a very, you know, simplicity is core to our value proposition. It's also our product solution. 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. Because of that, we aren't gonna be everything to everybody, like you see in more of the enterprise mode. The, it makes sense for them to go for certain applications multi-cloud. We do see that. In fact, we see that as part of our value proposition around simplicity, that we don't put up these obstacles to customers.
This, you know, the traditional model in 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. That is a differentiation for us. I think because we don't put up that friction, people do grow with us over time to be very large. We don't see them. We see them graduate on our platform. We don't really see them graduate from our platform.
Hey, I just wanted to ask about capital allocation, 'cause what you guys have done is pretty unique with kind of, you know, committing to have a lot of debt, buying back a lot of stock instead. I'm just curious what your thought process behind that is and what your, I guess, you know, how you think about what level of debt you're comfortable with, especially as you have to refi the converts.
The question is what level of leverage we're comfortable with?
Yeah. 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 a free cash flow projection assuming a range of growth rates. We look at our priority to, for, you know, executing on a product roadmap, an infrastructure roadmap over time. We're focused on delivering that organically. We're investing in the business organically. We have a portion allocated for M&A, a nameless M&A, just a capital allocation that we are gonna leverage M&A as part of our core strategy to sustain long-term growth. We look at what's left, how much cash is left. Everybody's gotta make a decision. What do you do with the cash, the excess cash, if you will?
Our approach is to take a portion of that excess cash within the constraints that we're gonna manage to 2.5x-3x N et- debt to EBITDA, and we're gonna take some of that excess cash and buy back stock. You know, I think we went public. We've reduced the share count pretty meaningfully over the last couple years in. 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, add a host of capabilities. We're trying to do it all in a balanced way. I think that'll be the formula for us over time.
Just a 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, 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, you know, fairly regular people migrating, you know, some or all of their workloads from some of the larger players to us. 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 gonna dominate a customer because they gotta be on your platform. You make it so difficult for them to go, is really was a barrier, I think, to customer growth and happiness. You know, one of the things last year as the economy started to slow and, our customers' growth rate started to slow, you know, they immediately their bills immediately corrected.
As opposed to if you have one or two to three 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. We don't see people leaving 100%. We definitely see them adding new workloads to a different cloud provider, and I think that, you know, us not making that difficult and just focusing on the course differentiators that we have that we believe are powerful and valuable for our customers, and that has worked.
That's why I think you've seen over the last year or so, you know, 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 Cloudways works with DigitalOcean, but it also works with Google and AWS. Can you talk a little bit more about this multi-cloud strategy and what it brings to you long term? Thank you.
Yeah. Cloudways offers AWS and Google Cloud. It gives customers an option based upon what product mix they're gonna want to use for the managed hosting solution. Because it's managed, it's a much easier dynamic. We haven't really put a pin on this yet in terms of how we can productize that, but it... You know, the relationship with Google and, and AWS is very good. 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. 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 wanna do it yourself or managed. 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. In the conversations with AWS and GCP, they're intrigued by it as well.
I think we have time for maybe just one more question. In your discussions with investors, what do you think, you know, is really the underappreciated story with DigitalOcean?
Well, we've said since we gone public that this will be a free cash flow machine. It was on the come then, and now it's here. 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 two handle and will be expanding from here. I think that will open people's eyes to it's here, it's not on the come. 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. You know, most of these customers don't go public. They don't raise institutional capital.
They're not press worthy, I guess. There's just not. There's this perception that it's very frail. If you were to look at the decline in our growth rates over the last six quarters, four quarters, relative to everyone else, we're in the soup, right? If you would've told people a year ago, "Okay, the world's gonna slow," everyone said, "Well, you know, you're gonna slow faster." That's not really the case. We're slowing like everyone else. In the US, the president, a couple weeks ago, you know, cited the new business formation's as strong as it's ever been in the US. SMB is 40% of the US economy. In some economies, it's 60%. It's about 50% globally.
That's a huge chunk of the global economy, and I think that it's just not well understood, but it's very durable and resilient, and I think we're seeing that in our business. You know, our customers are optimistic. They're still growing. They're still investing. They're still being innovative. We're helping them to do that. You know, 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. It's an exciting part of the economy.
Well, yeah, I think that's a great way to sort of end our discussion, and thanks so much for taking the time with us today.
Good to be with you.
Appreciate it.
Thank you.
Thanks, Yancey.