DigitalOcean Q2 2023 Earnings Call Transcript

Quartr
Provided by Quartr
August 3, 2023

There are 10 speakers on the call.

Operator

And thank you for standing by. My name is Regina, and I will be your conference operator today. At this time, I would like to welcome everyone to the DigitalOcean Second Quarter 2020 3 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session.

Operator

Conference Call. I would now like to turn the conference over to Rob Bradley, Vice President of Investor Relations. Please go ahead.

Speaker 1

Thank you, Regina, and welcome, everyone, to DigitalOcean's Q2 2023 earnings call. Joining me today is Yancey Spruill, 2, our Chief Executive Officer and Matt Steinfort, our Chief Financial Officer. Before we begin, I would like to cover our Safe Harbor statement. During this conference call, we will be making forward looking statements, including our financial outlook for the Q3 and full year as well as statements about goals and business outlook, industry trends, market opportunities and expectations for future financial performance and similar items. All of these statements are subject to risks, uncertainties and assumptions.

Speaker 1

Reconciliations between our non GAAP and GAAP financial results can be found in our earnings press release, which was issued earlier this afternoon and the investor presentation on our IR website. With that, let me turn the call over to our CEO, Jansy Spruill. Jansy?

Speaker 2

Thanks, Rob. Good afternoon, and thank you for joining us today. I'm pleased to share the results of another strong quarter for DigitalOcean. As discussed throughout this year, we made it a priority to position the company in 2023 and machine learning application development. In Q2, we delivered a quarter with an attractive combination of growth and profitability.

Speaker 2

Revenue grew a solid 27% year over year. We delivered strong adjusted EBITDA margins of 43% and delivered healthy free cash flow margins of 27% on the strength of progress we are making in transforming our cost structure. From a top line growth perspective, we continue to see slower growth in the core DigitalOcean Cloud business. We saw growth moderate across our diversified customer base with all regions and most industry verticals seeing slower growth, 3rd piece of the cohort performance puzzle that must stabilize is expansion, which continued to moderate in Q2, Although at a decelerating pace. Until we see stability in all three metrics, we can only say that we are bottoming, But have not yet reached a bottom for growth deceleration.

Speaker 2

With respect to churn, It has been stable in the low double digits about where it was before the broader slowdown occurred, which is a positive indicator of the strength of our value proposition. Contraction also stabilized in the 2nd quarter, potentially indicating that optimizations are moving behind us. Although it remains several 100 basis points higher than when the slowdown began. This reflects a change in our customers' practices. They have been much more disciplined about managing their cloud usage, a trend that we expect maybe with us for a while.

Speaker 2

As for expansion, we have been pleased to see the sequential deceleration of the declines as we move through this year. In speaking with our customers, they remain optimistic. Even though they are growing more slowly than they were previously, which we announced in Q1. There are several components to this transformation including prudently managing our 3rd party spend, leveraging our strong procurement capabilities, operating our capital infrastructure more efficiently and shifting our talent mix to be more global. We made significant progress in the quarter driving towards our longer term target free cash flow margins.

Speaker 2

We have taken advantage of this flexibility by investing on both the organic and inorganic fronts. Internal investment is focused on Graduating from learners to builders to scalers. Previously launched product capabilities such as the premium optimized droplet, which are tailored to specific bandwidth intensive use cases, enabled us to increase our ARPU and share of volume. While the expansion of our footprint, such physical footprint such as the new Sydney data center enabled us to do more to more effectively serve the global market opportunity. Other investments such as evolving the customer onboarding process are enabling us to better identify A good example of this is identifying candidates for a managed hosting solution through Cloudways instead of them self serving directly onto the DigitalOcean platform with a mismatch of their need leading to underoptimization of their experience.

Speaker 2

The newer capabilities that we've introduced over the past 10 months are growing significantly faster than is our overall company. We expect these offerings and the other capabilities on our second half 2. Roadmap such as enhancements to our storage capabilities to be more material drivers of our future growth. We also continue to invest to build out direct sales and partner channels to augment our proven self serve go to market motion. Well, it is early innings in the establishment of these new channels and they are not yet material contributors to growth.

Speaker 2

We continue to see them as important important growth levers next year and beyond. On the inorganic investment front, we are very happy with results we are realizing from the strategic acquisitions that we have made today. We are incredibly excited about the acquisition we recently announced. The Cloudways managed hosting business continues to be a very strong addition to our platform with performance that exceeds our initial expectations. We've seen net new cloud waste customers grow rapidly since the time of acquisition, benefiting from both our cross selling activities 2 and the strength of our highly efficient self serve model.

Speaker 2

Cloudways revenue, which grew 45% year over year in Q2, Continues to be a strong contributor to overall growth company growth aided by our focus on top of funnel and customer acquisition enhancements And it's becoming a larger percentage of our revenue mix and therefore an increasingly more meaningful contributor to driving a higher overall company growth rate in 2024 and beyond, which brings me to the exciting announcement that we made about a month ago that we acquired Paperspace for $111,000,000 We couldn't be more excited about this highly strategic and synergistic acquisition In the dynamic and explosively growing AI ML market, whose impact and opportunities projected to transformative to how the technology sector is driving the global economy. We are very focused on building an AI platform that enables 2. Developers and SMBs to leverage the power of these technologies to build and run applications, while maintaining our differentiation of in how we deliver these capabilities. Paperspace has tremendous potential. We've been very familiar with the team, having tracked them carefully over the years as they have built their business.

Speaker 2

The addition of Paperspace to the DigitalOcean platform makes 2. Tremendous sense on 3 key dimensions. First, DigitalOcean and Paperspace are philosophically aligned both in the segment of the market that we target 2. Smaller companies from individual developers to startups to emerging growth SMB customers to leverage technology to grow their businesses. We both win customers in this segment of the market by providing simpler, more cost effective solutions that can be leveraged on a consumption basis without the constraints of long term contracts, with a higher level of support than these customers get from the larger providers.

Speaker 2

We expect AI will be a force multiplier for small and medium sized businesses. Just as the advent of cloud computing Eliminated many of the barriers to entry for developers and startups to create a digital business, allowing anyone in any geography to start a business. We believe that AIML will provide a similar accelerant to new SMB creation and their subsequent growth

Speaker 3

as it

Speaker 2

will enable them to scale more efficiently, This simplicity strategy fits very well with DigitalOcean's key differentiators. With Paperspace, we will be able to 2. We provide multiple products for AI and ML use cases, including compute storage and databases, allowing these customers to scale on DigitalOcean's integrated platform. The second dimension of importance is there are substantial synergies between DigitalOcean and Paperspace that will accelerate both of our growth rates. Paperspace serves the fast growing segment of the market that brings together the combination of AI platforms and accelerated compute, which allows customers to build and maintain AI applications while providing the computational capacity required to do this at scale.

Speaker 2

Together, IDC estimates that the compound growth of the SMB portion of this market will be 36% over the next 3 years. Today, Paper Space has established itself as a leading player serving this market with a proven differentiated GPU based AIML product that serves over 12,000 paying customers today. Despite having invested very little in marketing or go to market. We will accelerate Paperspace growth by leveraging DigitalOcean's 2. More scale marketing and global go to market motions to increase the top of the funnel and drive new customers for Paperspace's business.

Speaker 2

There is also a significant cross selling opportunity to sell Paperspace capabilities to DigitalOcean's 616,000 plus learners, builders and scalers, Many of whom are already evaluating how AIML can be leveraged to accelerate their businesses. In addition, AI use cases clearly drive increased compute requirements, but Paperspace had no capability to capture those additional production workloads requiring customers to leverage other cloud platforms. Combined platform of AIML software and high performance and GPU base compute will enable us to capture more Paperspaces current and future customers' broader infrastructure needs for database as a service, high throughput networking, spaces and Kubernetes, driving higher ARPU and creating more stickiness and loyalty on the DigitalOcean platform. The 3rd dimension that has us so excited is how cleanly it will integrate with our platform and how dramatically accelerates our time to bring this capability 2. With Paperspace, we immediately have a proven AIML offering that has demonstrated clear product market fit And it comes with a team with valuable experience operating in this dynamic market.

Speaker 2

The talented and entrepreneurial Paperspace team adds more than 3 dozen employees to the DigitalOcean team and brings significant experience providing AI solutions to thousands of SMB customers. Also as an active and important player in the AI ecosystem that is not tied up with the hyperscalers that have plans to build their own chips, Paperspace on its own has strong industry relationships such as having elite status with NVIDIA. These critical industry relationships will only be strengthened when combined with the larger scale relationships that DigitalOcean has with other players in the market. We are already leveraging these combined relationships to ramp up PaperSpace's investment in GPU capacity. Clearly, we are very excited about the possibilities that PaperSpace brings to us and you should expect to hear more from us on this potential over the coming quarters.

Speaker 2

While Matt will walk you through the financial implications of the Paperspace deal on our overall business later in our discussion, I can say unequivocally that after owning Paper Space for just a few short weeks, the potential is far greater than what we had expected. We acquired a triple digit growing business that we feel confident we can accelerate from here. And as such, we expect Paper Space to contribute at least 3rd cash flow margins and our current capital allocation strategy. While Matt will cover the specific projections in his commentary, I'd like to share my thoughts on how we view the economic impact on our business at a strategic level and how this translates our go forward capital allocation framework. We have demonstrated a clear focus on driving attractive returns on invested capital since going public.

Speaker 2

With that as our guiding principle over the past 2 years, We have repurchased more than 27,000,000 shares for $1,300,000,000 and lowered our fully diluted shares outstanding well in excess of the shares granted to employees over the same timeframe. When combined with the 6x increase in free cash flow since 2021, our 1st fiscal year as a public company. Through these actions, we have increased free cash flow per 2. As another part of this capital allocation strategy, we have invested nearly $500,000,000 on 2 Content Technology and Capability acquisitions, which have bolstered customer acquisitions, driven ARPU growth and meaningfully increased our addressable market. Although we continue to evaluate M and A opportunities that are consistent with our goals of enhancing Our market position to drive profitable growth.

Speaker 2

In the near term, we are prioritizing the integration investments in Cloudways and Paperspace, Both of which are growing substantially faster than the core DigitalOcean business. Our commitment to driving attractive shareholder returns under any market conditions delivering the long term free cash flow margins required to do so does not change as a result of our entry into the AIML market with PaperSpecs. Our growing free cash flow margin and the $551,000,000 on the balance sheet afford us the flexibility to both invest appropriately in this exciting new market and at the same time maintain focus on delivering profitable growth across our entire business and delivering capital return to our investors. We have consistently said that investing in organic and inorganic growth is our first priority use for capital and that remains true. Given the significant opportunity we are looking at with key growth levers, we may moderate the magnitude of buybacks from 2023 levels.

Speaker 2

However, we will remain committed to managing the portfolio of balanced growth and capital return through share repurchases going forward. I'll close by saying we've made good progress through the first half of twenty twenty three. We've dramatically improved our financial profile by driving greater We will invest in 2 of our fastest growing segments in cloud waste and paperspace. While we continue to target investment in the 2 highest revenue potential opportunities and optimize profitability as we work to return to higher growth in our core business. We continue to see a material opportunity in an expanding addressable market in the growing $100,000,000,000 plus market for SMB Cloud Infrastructure and are increasingly well positioned to capture our fair share.

Speaker 2

Now over to Matt to provide details on our financial results and our outlook for Q3 and for the balance of this year.

Speaker 3

Thanks, Jansy. Good afternoon and thank you for joining us today to discuss another solid quarter that highlighted the material progress we have made towards 2. We are now achieving our long term profitability targets, delivering solid revenue growth in the quarter while meaningfully improving our margins. We continue to deliver durable and attractive free cash flow growth regardless of the macro growth environment. In my commentary today, I 2.

Speaker 3

I will review our Q2 financial results, provide additional insight into Paperspace's anticipated impact on our financials Over the past several months, we have made meaningful upgrades to our tax capabilities and expertise. With new tax leadership recently in place 2 in the context of Section 174. The error had an immaterial impact on our full year 2022 financials, But did have a material impact on our reported Q1 2023 financials and rose to the level of a material weakness in both periods. 2nd quarter share in Q1 of 2023 and will result in a lower net operating loss balance as of December 31, 2022. We are confident that our new tax leadership, the incremental internal and external resources we have added and other changes we have made 2.

Speaker 3

The finance organization will enable us to remediate this issue and to provide more confidence in our tax estimates going forward. Turning to our Q2 performance. Revenue in Q2 was $169,800,000 2, which was 27% year over year growth and 3% growth sequentially over the Q1 of 2023. Net dollar retention was 104% for the quarter. NDR declined 300 basis points from Q1 of 2023, which was a deceleration from the 500 basis point decline we saw from Q4 of 2022 to Q1 of 2023.

Speaker 3

NDR has 3 main components: expansion, contraction and churn. As discussed in our last call, We have also seen a deceleration of contraction in the past 3 months, which is a positive signal that customers may be reaching the end of their optimization cycles. With these two components either flat or decelerating, we are looking to see a similar flattening or deceleration of the slowdown in expansion before we will be able to conclude 2nd quarter 2020. On the customer graduation front, we saw continued growth in our higher spend customers as our builders and scalers represented 86% of total revenue in Q2. We added more than 3,600 builders and scalers in Q2 versus the approximately 2,300 we added in Q1, bringing our total to more than 150,000.

Speaker 3

These customers are collectively growing revenue 28% year over year and are a key driver of overall ROE, which increased 14% year over year to $90.84 The addition of PaperSpecs, Profitability was very strong in Q2 as a result of our disciplined execution and the good progress we have made on our cost savings initiatives. GAAP gross margin improved from 56% in Q1 to 60% in Q2 as we both grew into the colocation and bandwidth capacity increases Adjusted EBITDA was 43%, which was significantly above the 34% that we delivered in Q1. This 900 basis point increase was driven by continued cost management, the full quarter impact of the cost reductions we announced in February And the structural impact of shifting more of our employee base to our global capability centers in India, Pakistan and Mexico. Roughly 2 thirds of that margin increase was driven by people related cost savings, with the remaining third driven by efficiencies and cost of goods sold and other expense reductions. Free cash flow was very strong at $45,000,000 representing 27% of revenue.

Speaker 3

This 1100 basis point sequential improvement from Q1 resulted from higher gross margin, higher adjusted EBITDA margin and the continued discipline we have shown in our capital investment program with capital expenditures remaining at 15% of revenue consistent with Q1 levels. Given the approximately $18,000,000 overstatement tax expense in Q1 of 2023 that I mentioned earlier on the call, We're still finalizing non GAAP diluted net income per share for Q1 and Q2 2023. We do, however, anticipate that the correction will increase our previously reported Q1 non GAAP diluted net income per share. And looking forward, Q2 2023 non GAAP diluted net income per share will be above our previously guided $0.40 to $0.41 per share. Contributing to at an average price of $37.08 per share.

Speaker 3

We ended Q2 with fully diluted shares outstanding of 105,000,000 shares, down from $120,000,000 in Q2 of 2022. On the operational front, we made substantial progress locking in $60,000,000 run rate 2nd quarter cost savings opportunity that we had disclosed in Q1. And based on that progress, we expect to exceed our initial full year savings estimates, which will give us cushion in the face of ongoing top line pressure. Our strong balance sheet and healthy profitability levels give us significant flexibility to invest to accelerate the faster growing segments of our business without materially impacting our ability to achieve our long term profitability targets. Before providing our financial outlook for Q3 and the full year, I will provide some additional financial details on the exciting Paperspace acquisition that we announced in early July.

Speaker 3

As Yancey shared, we believe that the AIML market is a tremendous growth opportunity for DigitalOcean. Paperspace is a great fit as it is very highly aligned with our existing target customer profile and the acquisition expands our total addressable market within the large and growing SMB cloud market. Given DigitalOcean's proven and efficient go to market model and sizable customer base, we believe that we can accelerate Paperspace's already 100% plus growth rate and that Paperspace will begin to contribute meaningfully As previously disclosed, Paperspace will have an immaterial impact on DigitalOcean's revenue in 2023, contributing less than $5,000,000 in the second half. Despite the modest 2023 revenue impact, we expect it to contribute at least 3 points of growth for overall DigitalOcean in 2024 based on the known and growing demand in our funnel. To facilitate this growth and to keep up with the rapidly increasing demand we have seen in the short time that

Speaker 4

we have owned them, we have

Speaker 3

already accelerated planned investment in Paperspace's GPU capacity. Turning towards our financial guidance for Q3 of 2020 3. We expect revenue to be in the range of $172,500,000 to $174,000,000 which implies roughly 13% to 14% year over year growth for Q3. NDR for the Q3 will decline to the mid-90s as we lap 2,000,000,000 and a 10% price increase that took effect in July of 2022. On our current trajectory, NDR will increase steadily over the back half of twenty twenty three as we reach the 1 year anniversary of our Cloudways acquisition and Cloudways higher growth begins to contribute within our MDR coverage.

Speaker 3

We estimate 105,000,000 to 106,000,000 weighted average fully diluted shares will be outstanding to $680,000,000 to $685,000,000 This 3% to 5% reduction in our full year projection is driven by a weaker than anticipated outlook for cohort growth in the second half of twenty twenty three. We've seen steady and durable performance on net new customer revenue from our self serve funnel. Cloudways continues to grow faster than it was growing before we acquired to be in the range of 38% to 39% for the full year, thanks to our strong execution driving operational efficiencies. We estimate that our investment in PaperSpace will have a $15,000,000 to $20,000,000 impact on free cash flow in 2023, excluding the roughly $4,000,000 to $6,000,000 in one time integration expenses that will be excluded from our non GAAP metrics. Despite this investment, we remain confident in delivering our previously guided 21% to 22% full year free cash flow margin 2.

Speaker 3

Despite an estimated 3 to 4 percentage point impact on longer term free cash flow margins from PaperSpace and despite becoming federal cash tax payer in the U. S. Beginning in 2023. We continue to target long term free cash flow margins in EBITDA high 20s as we see additional opportunities to drive incremental operating leverage in our core business. We estimate that we will have Between 105,000,000 to 107,000,000 weighted average fully diluted shares outstanding for the full year 2023.

Speaker 4

People are kind of doing more work with it. Is this going to be like a very broad based adoption product or is this going to be some specialized guys that are going to spend a lot with you? And then I had one follow-up for Matt, please.

Speaker 2

Well, I think as we've said before, we've been participating in the portion of AI that's in the inference aspect. What PaperSpace brings to us is large language models and other complex machine learning algorithms and applications that require or utilizing GPU capacity versus The standard high performance compute. What we've seen with our customers is that and really a rising tide potential for investment in AI capabilities. And so again, we serve a long tail of use cases, Industry Verticals, etcetera. And so I think everybody across the SMB landscape and our customer base, like everywhere else in the world is Trying to figure out how to get most leverage, where to get most leverage.

Speaker 2

And we're really excited that We now can bring this capability that's consistent with our historical process and capabilities around simplicity. And I could tell you the inquiries have accelerated since we've made the acquisition a month ago In terms of our sales folks, our customer success folks engaging with customers, educating them on what Paperspace brings. So I would expect to see broad adoption not necessarily tied to any particular industry really as people start to really want to invest real resources to build out use cases to help them drive productivity, whatever the case may be. And they came out of synergy on top line synergies in both directions here. And again, really excited about that.

Speaker 4

Yes. Okay, perfect. That makes sense. And then one for you, Matthew. Obviously, changing full year guidance in the middle of

Speaker 3

the year is always like It's tough to share

Speaker 5

the decision for a management team. If you think about it

Speaker 4

like as you pointed that decision, What was for you like the driving thing to say like, okay, I need to change it and how did you come up with the new level? What are kind of the puts and takes in there? Thank you.

Speaker 3

Yes, it's always a tough decision. I think as everyone saw in our guidance, We had expected moderate growth, only moderate growth in the first two quarters, which we delivered pretty much as expected. But embedded in the second half increase was 2 things. 1, we needed to see a flattening of the at least the flattening of the cohort and they couldn't get worse and we talked about that. And then we needed to see the ramp of the monetization initiatives and some of the other investments we made.

Speaker 3

And the The good news is we are seeing the ramp around the monetization initiatives and some of the new products we launched, the Sydney data center, etcetera, are growing Kind of generally in line with what we thought, but what we missed was that the cohort is just continuing to see pressure longer than we had anticipated. And as we sat here in July, I mean, clearly, we would have liked to beat the revenue guidance For the Q2 and as we saw that coming into in line with the expectations instead of being ahead of it and we saw The continued kind of deceleration of or the continued slowdown of expansion, even though we're seeing some green shoots around contraction is decelerating. We just didn't think it was appropriate to hold that out there still. So what we've done is we've given a range which is fairly tight And it's reflective of kind of if it doesn't change from where it is today, it continues at the current improvement in the rates of 2. Growth around our monetization initiatives, around the go to market initiatives.

Speaker 3

It assumes a very modest impact from The paper space at less than $5,000,000 So we believe that we rotated to a, I'd say, a reasonably conservative view of what The potential is for the second half. And I think that's appropriate until we see a bottom, because we can't keep hoping every month that it's at a bottom. We have to Except the reality that it may not for a couple more months or quarters.

Speaker 4

Okay, perfect. Hey, thank you very much.

Speaker 6

Great. Thank you. Maybe Paperspace first. Just, so I saw that, just this morning, Yancey, There's a company called Coreweave that I think did a $2,300,000,000 debt financing secured in part by the NVIDIA. It seems like with Paper Space, you're entering that same general area.

Speaker 6

How are these businesses similar and how are they different?

Speaker 2

Well, 2. As I mentioned on the prepared comments, we Paperspace has a sort of a delivered product with an API that Makes it simple and easy for people to build applications on top of the GPU capability for language models and I think other folks who are sort of in the focusing on essentially renting GPU for hire for and don't have the other applications, don't have the other build outs. And So for our customer base, we think they're going to need that because again, our customers don't have big DevOps, IT, development capabilities and whatever they have, they want to dedicate that to their end products. And I think what we have is an offering tailored towards developers, startups and small businesses. And I think other folks in the space are catering to the large enterprise opportunity.

Speaker 2

We think our opportunity is large as 2. Well, so I don't know if it's a winner take all. I think it's a lot of people are going to win in this market. We think we'll be one of them. And we're sticking to our knitting, which is focusing on the Our end of the market where people need the core value differentiators we have, which is support, our community investment And simplicity.

Speaker 6

All right, great. Thanks. And then Matt, I think you addressed it, but just to be really explicit about it. Are you seeing higher churn?

Speaker 3

No. The churn as we talked about, Sure, we saw elevate over the balance of last year, but then moderated in the beginning of the year 2. It's been relatively steady. So it's not customers that has been of the 3 drivers, Probably the biggest headwind for us over the 1st 6 months of this year. And it's as Jensy said in his remarks, 2.

Speaker 3

Several hundred basis points higher than it has been historically, but it's moderating the it's not getting worse. It's 2. At an elevated level, but it's not increasing. But what we've seen is that expansion still continues to come down a bit. So the customers just aren't growing as fast as they were a year ago and we've seen kind of month over month that that has continued to get A little bit worse.

Speaker 3

And so when we say that we're looking to see deceleration, we've seen stability in churn, which is in a good spot. We've seen stability recently in contraction, but it's still elevated. And we've seen a continued kind of decline in the rate of expansion. And that last one, the decline in the rate of expansion, That's what you need to see flatten or turn in other direction before you're going to be able to say, okay, we're at the bottom and now we're going to start to pick growth up as contraction moderates more. I mean contractions stable, but it's at an elevated level and expansion is continuing To weaken, but churn has been fine this year.

Speaker 7

Okay, great. Thank you.

Operator

Your next question comes from the line of Michael Turits with KeyBanc Capital Markets. Please go ahead. Hi.

Speaker 2

This is Billy on for Michael. You talked about how potentially there was some indication that optimizations are moving behind us. So When you speak about optimizations in your customer base, kind of what does that look like? Is it more or less what we've heard from the hyperscalers? Are there differences in how customers optimize spend at DigitalOcean?

Speaker 2

Just some more color on that would be great. Thanks. Well, There's two points to that. 1, because we have a consumption based model, as we saw last year, as weaker demand happened in the macro, We saw much faster growth deceleration because as our customers' business has slowed dramatically, they're slowing less today than they were a year ago. Their spend corrects immediately.

Speaker 2

So there's that aspect. There's a second aspect about them. So versus the longer term contract model that others have where volumes might be lower than committed payments and people need to just correct. That's not what we saw because we have 30 day contracts and so our customers correct on spending for what they're buying. What we've been seeing sort of late last year, early this year, a pickup in customers calling saying, am I using this the right way?

Speaker 2

How do I use less, but still satisfy my current demand? Did I activate too many compute instances, too many droplets, am I in too many different locations? Can I use Kubernetes to potentially have a more efficient deploy For my cloud infrastructure, that is the optimization we've been seeing? And I would say The first couple of earnings calls this year, we talked about pretty active customer conversations. That has really slowed In terms of our support and customer success engagements with customers, I think they're in a good spot and we're seeing that as we talked about The contraction is flat over a quarter, flattened or stable, let's say.

Speaker 2

It's at a higher level, which I as I mentioned, I think we're in a different time. As people are in a lower growth environment, they're going to be much more vigilant 2. Our customers tend to be bootstrap companies. So they a dollar saved is a dollar earned for them. So I think that aspect Is here to stay.

Speaker 2

And that plays really into a key strength of ours, which is high support, high touch. We engage with our customers on how to best use the cloud. Our community investment, our tutorials are also involved in that. And so I think the churn that's why I'm so heartened by churn being flat relative to when this whole slowdown started because it reflects The fact that our value proposition is very high, even in a challenging environment, we're able to help our customers through it And they're sticking with us, which is going to be critical. We said we're seeing their slowdown in their growth.

Speaker 2

The deceleration in our growth has really slowed and it's not at a point where we're going to call a bottom, it's flat, but it is clearly Slowing at a much more dramatically slower rate than it was the beginning of this year or this time, certainly this time last year. And having that stable churn, for me, is a leading indicator that when things bounce, we're going to see a significant bounce As the recovery ultimately happens, we don't know when that's going to happen, which is why we've changed the outlook as reflected today. But we're positioned well for that because we've been helping our customers through this process and the consumption based model sort of immediately corrects their spend So they can focus on operational efficiency and we can help them do that. Helpful color. Thanks, Yancey.

Operator

Your next question comes from the line of Mike Sicos with Needham and Company. Please go ahead.

Speaker 7

Hey, guys. Thanks for getting me on here. I just wanted to circle up on some of the earlier comments, but I guess take it from a different angle. I know you guys have been talking about course of the June quarter and even into July now that the month is behind us. Can you discuss how things trended as we went from April to May to June?

Speaker 7

Just to give us a sense of what's going on inter quarter, for some of those real time data points that you're seeing.

Speaker 3

Yes. So this is Mike. Thanks. It's Matt. When you look at each of those metrics, clearly, we look at them on a monthly basis in addition to a quarterly basis, Sure.

Speaker 3

It stayed relatively flat. It's in the kind of low double digit and 11% range and it stayed there, Hasn't gotten any worse. What we saw though was a continued kind of an increase in contraction, Which means people taking money off of our platform and a decrease in expansion, meaning the amount of people are adding year over year Each month as I look at it is getting smaller. But what we said is the rate of change of contraction Has moderated, so it's decelerating. It's not getting worse as fast as it was Yes, as it was earlier this year.

Speaker 3

And in fact, in the last month that we've seen it actually flipped the other direction and we saw it go back on an absolute basis. It actually is the amount of contraction we saw went down in the last month, which is a really positive sign. So multiple months in a row of 2. Acceleration and actual flip in the other direction. But the expansion, which is the other driver has just continued to kind of get smaller.

Speaker 3

And so that's why we're saying, when we're looking at this, as we looked at that over the course of those months, We couldn't call the bottom and we can't say whether expansion is going to continue to get smaller in the coming months. And 2. And is contraction going to stay at the level it is or is it going to continue the 1 month trend we have of moderating. And with that level of uncertainty, we just couldn't continue to go into the second, the third and fourth quarter without providing an update on the guidance because it's providing enough of a headwind that it's offsetting the other good growth that we're seeing through our self serve funnel and through the other initiatives that we've been Pursuant.

Speaker 7

I appreciate the color, Matt, and I really appreciate the transparency there as well. I just wanted to be crystal clear then when we turn to the outlook, again, it seems like you guys are juggling a number of different pieces all in real time. But as far as those assumptions that you have is I don't want to characterize, but like between churn, contraction and expansion, what are the assumptions that you're embedding in your guidance today, Which give you confidence in your ability to achieve the numbers that we're communicating to the Street investors?

Speaker 3

I'd say we're assuming that nothing gets better than what we're currently seeing. So the rates have declined and the level of That we're landing on the things that stabilized, stay the same. We don't see an improvement in any of those, which would imply we're not forecasting a bottom In our guidance.

Speaker 2

That's great. Thank you

Speaker 7

for that. That's exactly what I wanted to clear up with my understanding. Thank you so much.

Operator

Your next question comes from the line of Pinjalim Bora with JPMorgan. Please go ahead.

Speaker 8

Great. Thanks for taking the questions. Yancy, can you talk a little bit more about Paperspace? Can you talk about maybe the customers that Paperspace brings to And as I look at the numbers, I think you're saying 5,000,000 For the second half, so call it $10,000,000 $10,000,000 $12,000,000 for the year, 12,000 customers. So is it something like $1,000 ACV about help me understand through that.

Speaker 8

And then Lastly, what portion of DataSpace's customers are on the MLOps platform versus kind of the core infrastructure?

Speaker 2

I think we'll provide more detail around some of that as we sort through some of the analytics on the business in terms of the mix, etcetera, At a subsequent call, what I would say is their customers are very similar to ours. They're small emerging startups, Many names you would have never heard of, similar to our customer base from all over the place. Lots of different use cases. Obviously, language models is a big growth driver in the near term. Generative Media is a very interesting one that's very dynamic advertising, media, video, etcetera based upon whatever the vertical or use case.

Speaker 2

So it's a lot of people taking a lot of data And leveraging that for outcomes and it's very exciting. What I love about it is that The fact is you can look at the logos, you can look at the names in terms of the customers and like our business, It's long tail. It's we enable people all over the planet to leverage their ideas in the cloud. And now we have the ability to do that in AIML. And so I think the ARPU is higher Then I think our average customer will give more specifics later than that.

Speaker 2

And But it's that's what we said earlier. It's a really hand in glove fit in so many dimensions. And I think I'm excited to get this in the hands of our DigitalOcean customers and vice versa to give the PaperSpace customers the same A similar kind of experience they've had building their AI apps. Once they get those over the hump and are running a business around that application, they can run on our platform and have the same experience in terms of ease of use, simplicity, the support model, our community investment And the low cost.

Speaker 8

Understood. Thank you very much.

Operator

Your next question comes from the line of Jim Fish with Piper Sandler. Please go ahead.

Speaker 5

Yes. This is Quintin on for Jim Fish. Thanks for taking our questions. Yancey, maybe first for you. I'd like to touch a little bit on the timeline side of coming to this Paperspace deal.

Speaker 5

Thinking back to Q3, Q4, We talked a little bit about how CPUs would be able to support AI workloads. And then kind of Q1, we transitioned to GPUs are probably an attractive expansion to the platform. And then obviously now we have the PaperSpace offering. Can you talk through what trends or maybe inputs changed from 2Q3, Q4 to Q1, Q2 where now you know you need this kind of GPU as a service offering. And then, any color you can provide around position process of paper space, whether it was competitive bidding or anything would be helpful.

Speaker 3

Yes. So I don't know

Speaker 2

that we ever never We ever said, I ever said that we didn't need GPUs. What I think we were clarifying is that there were a number of AI based 2. The algorithmic type business models that we're running on our platform because high performance compute was fine. I think that tended to be more in the inference Market versus the Language Model market. So I just want to be clear.

Speaker 2

We have always said that 2. We wanted to build a GPU capability and AI ML platform capability certainly since we've been public. We've known PaperSpace for years. I've stayed very close to the founders since I became CEO in 2019. So we're excited to let's say finally have them part of the DigitalOcean family.

Speaker 2

But we certainly saw with late last year, early this year, a pickup in the threshold level of capability and market perception and interest in the language model opportunity, which Yes, the market wants to use GPUs for those. Certainly to get the model up and running, Maybe not to operate the model once it is running in customers' hands. Certainly, the level of compute needs change And we'll see how that plays out. We're learning a lot very rapidly. But we're excited to have this new dimension of compute now on the platform.

Speaker 2

And I think whether that was accelerated or not, this is a capability We wanted to add and excited to be able to get this done here in the middle of this year. Not going to comment on the process that led to the conversations and what led to our announcement with Paper Space a month ago.

Speaker 5

Yes, understand. Thank you. And then, Matt, maybe for you. As I look at the customer segments, it looked like really the scalars is the segment of the business that saw some deceleration in ARR growth and I think you've been pretty clear that it's really not churn. So is it fair to think that the optimizations hit This segment of your business the heaviest compared to maybe some of the builders or learners?

Speaker 5

Thank you.

Speaker 3

Yes, that's Very accurate. The larger the customer, the more opportunity for optimization. And we got the examples Yancey gave a few, but Example, we're a customer, a large customer that's storing a fair bit of data on our platform might change a policy and say, what we used to store 60 days of data and now we've kind of We've rethought it and we think we can get away with 15 and we just don't need as much given the consumption model. They can just make that happen. But that typically happens in the larger customer base.

Speaker 3

That's why you've seen the slowdown in The ARPU growth in the scalars versus some of the others, but it's not the scalars have the lowest churn of all of our segments. 2. The bigger the customer gets on our platform and the more that they consume and the more products that they use, the lower their churn. So the churn in Scalars is incredibly Attractive churn level, just we're seeing more contraction in that area as you expect.

Operator

And our final question will come from the line of Tim Horan with Oppenheimer. Please go ahead.

Speaker 9

Thanks guys. Yancey, can you talk about how you balance free cash flow generation with growth here? And I think you said high 20% on the free cash flow, maybe some timing there. I only mentioned because it's basically insatiable demand for GPUs. If you doubled your CapEx spend, you could probably double your revenue growth.

Speaker 9

So And it seems like now is the opportunity to do that. So can you just walk us through how you're thinking about balancing that out?

Speaker 2

Well, I think what we've reflected today is what we see. I will say this, in the month that we've acquired Paper Space, The potential growth that we see is significantly higher than we saw a month ago. I'm not going to put a quantitative on it, but It's pretty significant and we've already stepped up capital purchases ahead of what we thought a month ago to get us through this year and to support acceleration of the growth rate, which again, to triple digit growth rate, we already see our ability to accelerate that month in. And we're getting very focused right now on what's the 2024 opportunity. I think one of the reasons We are sort of reframing expectations around capital allocation is this issue.

Speaker 2

Because to your point, if we can grow 500%, we will look to do that. We'll just see what the opportunity presents itself. And we're very focused on that. And I know we've talked a lot about free cash flow this year, Any year where the growth was uncertain, weakening. And I think I hope people did misread that as we were allergic to growth.

Speaker 2

We've always said we want to invest our primary uses of capital are whether it's internal or externally 2. We generated growth and we're demonstrating that now and we're excited. And I remember when we had the conversation with the Board that we're going to take margins Down from what they could have been to invest more in paper space and there was all hands in the air. So we're excited about this And we'll see where it plays out. Obviously, we'll have more of an update, a formal update at the next earnings call on what we're seeing.

Speaker 2

But I'll just say that if the pace of this opportunity continues as it has in the 1st 30 days, We'll continue to see a lot of money going into paper space because it's a really exciting opportunity we have.

Speaker 9

Congratulations on developing an AI strategy and expense reductions looks really impressive.

Speaker 3

Conference Call.

Operator

I'll now hand the conference back over to Yancey Spruill for closing remarks.

Speaker 2

Thank you. And thanks everybody for joining us today. 2. As usual, we really appreciate your support and we're looking forward to talking with you over the coming weeks months about where we are and where we're heading. And we hope that you all have a good rest of the day.

Speaker 2

Thank you so much.

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Earnings Conference Call
DigitalOcean Q2 2023
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