DigitalOcean Q4 2023 Earnings Call Transcript

Quartr
Provided by Quartr
February 21, 2024

There are 14 speakers on the call.

Operator

Ladies and gentlemen, good afternoon. My name is Abby, and I will be your conference operator today. At this time, I would like to welcome everyone to the DigitalOcean 4th Quarter 2023 Earnings Conference Call. Today's conference is being recorded and 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

Thank you. And I will now turn the conference over to Mr. Rob Bradley, Vice President of Investor Relations. You may begin.

Speaker 1

Thank you, Abby. Good afternoon, and thank you for joining us today to review DigitalOcean's 4th quarter and full year 2023 financial results. With me on the call today are Patti Srinivasan, our newly joined Chief Executive Officer and Matt Steinfurt, our Chief Financial Officer. After prepared remarks, we will open the call up to a question and answer session. Before we begin, let me remind you that certain statements made on this call today may be considered forward looking statements, which reflect management's best judgment based on currently available information.

Speaker 1

I refer specifically to discussion of our expectations and beliefs regarding our financial outlook for the Q1 and full year 2024. Our actual results may differ materially from those projected in these forward looking statements. I direct your attention to the risk factors contained in the company's annual report on Form 10 ks filed with the SEC and those referenced in today's press release that is posted to our website. DigitalOcean expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward looking statements made today. Additionally, non GAAP financial measures will be discussed on this conference call.

Speaker 1

Reconciliations to the most directly fleet comparable GAAP financial measures are also available in today's press release as well as in an updated investor presentation that outlines the financial discussion of today's call. A webcast of today's call is also available on our website in the IR section. With that, I'd like to turn the call over to Patti.

Speaker 2

Thank you, Rob. Good afternoon and thank you for joining us today. I'm very excited to be here with you on my first call as the CEO of DigitalOcean. As today is my first opportunity to talk to you, I would like to start by sharing a bit about my background, why I was drawn to the DigitalOcean opportunity before providing an overview of our priorities for 2024 and highlighting the focus I will bring to the company. To start, I'm thrilled to be here at DigitalOcean.

Speaker 2

Having worked my entire career in technology companies and having a professional art that spans engineering, product management and C level positions, I have a deep appreciation for the opportunity that DigitalOcean has in front of us and strongly believe that I'm well positioned along with the DigitalOcean leadership team to help the company reach its full potential. I started my career as a developer and spend my formative years of my career at Microsoft, where I worked on various products, including Windows Server, a variety of developer centric distributed technologies, and finally, the Microsoft Office Server team. As I progressed in the leadership ranks at Microsoft, I had hands on experience building platforms aimed at developers, working with independent software vendors and managing businesses with tens of millions of users. From Microsoft, I moved to Oracle to help launch its Asia R and D center focused on innovating products for the unique needs of that market. As an entrepreneur at Oracle, I picked up experience identifying market opportunities and developing platforms like mobile embedded databases with extremely small footprint and near real time performance in a very low bandwidth network environment to meet those unique emerging market requirements.

Speaker 2

After Oracle, I co founded Opsterra, an application monitoring and managed cloud services platform. This experience again reinforced the importance of having a deep understanding of developer needs and using that to drive innovation as we work to keep up with the evolving needs of nearly 500 early adopter cloud companies, including most of Microsoft's top Azure customers at that time. Following the successful sale of Optera, I spent the majority of the last decade at Go to formerly known as LogMeIn, a SaaS pioneer delivering cloud based software applications with a global footprint with a stint of Amazon in between. At LogMeIn, I experienced 10x growth as we took the company from a little over $100,000,000 at the time I joined to over $1,300,000,000 in revenue through both organic and inorganic expansion. As part of this journey, my team built an Internet of Things platform, which was later acquired by Google to form the foundation of its IoT strategy.

Speaker 2

After leaving for Amazon to be the General Manager of the data and machine learning platform that powers Alexa, I returned to Go2 as its Chief Product and Technology Officer before ultimately taking over as CEO. At LogMeIn and Go2, I picked up what it takes to build a product led growth motion and augmented with a high velocity sales and customer success machine to attract, convert and expand 100 of thousands of growing digital businesses at scale. All these roles and experiences have shaped my perspective and have nurtured my passion to understand customer needs, especially those of developers, innovating on their behalf by anticipating their needs, running modern infrastructure platforms to support global scale products, building efficient customer acquisition and expansion engines and delivering value for all stakeholders, customers, employees and shareholders. I'm really looking forward to bringing these experiences, focus and operating discipline to DigitalOcean. Switching gears now, there are a few compelling reasons that drove me to join DigitalOcean, but 3 stand out that I would like to share with all of you today.

Speaker 2

First, it's the market that DigitalOcean is focused on. The cloud computing market and especially the one that serves developers is one of the largest and fastest growing markets in the history of technology. This market consisting of infrastructure as a service and platform as a service is $114,000,000,000 opportunity, which IDC is forecasting to grow in excess of 23% through 2020 7. This growth should continue well beyond the timeframe as the market benefits from ongoing migrations to the cloud, acceleration of new business formation that cloud computing enables and the still very early impact of AI and machine learning and the new generation of applications that these capabilities are all ready unlocking in a variety of different industries. The second reason is the strong position that DigitalOcean has in this market.

Speaker 2

Dio is the cloud leader focused on developers, startups and growing digital businesses. DigitalOcean has more than 640,000 customers and global footprint with revenue in over 190 countries and serves customers across a wide range of industries and use cases. Our brand is beloved with a large and loyal developer community that leverages our extensive library of content, including tutorials, Q and A, product how tos, video guides and articles. DigitalOcean has carved out a compelling segment in this market, providing a simple and easy to use developer cloud with transparent and cost effective billing and a level of support that small growing businesses will not get from the larger hyperscalers. DigitalOcean has also steadily expanded its array of offerings starting with core infrastructure as a service with its compute technology called Droplets, object and block storage and networking capacity with a global footprint to power our customers' apps and services.

Speaker 2

These are complemented and extended by platform as a service products, including managed databases, managed Kubernetes, app platform and managed Kafka for those customers that need to leverage high volumes of data streaming. In addition to our core infrastructure and platform offerings, with cloud based, we offer managed cloud hosting that is used to power digital agencies, e commerce storefronts and a variety of other online businesses. Finally, to take advantage of a generational technology shift, we acquired a leading AI machine learning application development platform, Paperspace last year, increasing our addressable market and adding a very valuable growth lever. This further extends our platform by enabling developers to test, develop and deploy AI and machine learning centric cloud applications that harness the power of GPUs in ways that have been predominantly available only to large enterprises. I just talked about the vast and growing market that DigitalOcean is in and the strong position we have with our platform and customers, customer trust that we have earned over the years.

Speaker 2

But now let me talk about the 3rd compelling reason that drew me to DigitalOcean, the growth and value creation opportunity that is still ahead of us. DigitalOcean has the opportunity to even more developers and expand the services we provide to these customers, driving higher revenue growth while maintaining our strong profitability, enabling us to generate compelling investor returns. The plan for achieving this growth centers on understanding and addressing the needs of developers as they build growing digital businesses. We will achieve our near term growth objectives and position ourselves for higher sustainable long term growth by focusing on these very specific growth levels. First, we are enhancing our platform with global load balancing, data resiliency, granular identity and access management, storage enhancements and many other new features that will enable our customers to operate and scale globally.

Speaker 2

Number 2, we are investing in both network and infrastructure, providing increased diversity, lower latency and enhanced speed on our core IP backbone and edge to enhance the performance of our platform to benefit our customers and allow us to migrate more customer workloads from other providers onto our platform. On top of these product offerings and platform foundation, we will continue to expand our managed services offering to serve customers that want an assisted experience with robust scaling capabilities on our platform. As an example of this, just a few days ago, we announced Autonomous, a new cloud based offering that enables growing businesses to scale their hosting needs dynamically without having to overinvest in infrastructure. Next, building on our recent PaperSpace acquisition, we are investing in our AI and metal strategy to take advantage of this market opportunity by bringing simple, easy to use AIML capabilities on both hardware and software to developers, machine learning engineers and application builders across a broad range of business types as we have done successfully with our core digital ocean cloud services. And finally, point number 5 is we will augment our durable self-service customer acquisition model with direct sales and customer success motions to acquire, retain and expand customers and amplify our reach through our vibrant partner ecosystem.

Speaker 2

For these reasons, I'm very excited to have joined DigitalOcean at this critical time of inflection. The company begins 2024 having weathered a challenging macro demand environment where like many large platform providers, top line growth slowed from historical highs. Recognizing early in 2023 that near term growth could be pressured, we successfully accelerated the attainment of long term target margins to build a durable cost structure that will generate attractive free cash flow. With plans to improve net dollar retention or NDR through increased customer engagement and continued product innovation and driving higher growth opportunities across cloud base and our new AIML platform, we are positioned to establish a foundation to deliver low double digit growth in 2024 while setting ourselves up for the future. Let me now finish by articulating the key focus areas that I'll be driving.

Speaker 2

While I'm excited about the company's long term growth plans, as CEO, I will leverage my product and engineering background and deep cloud experience to bring an elevated focus to 2 critical priorities in the short term, product innovation and efficient go to market. Let me explain quickly. 1st and foremost, we will obsess over the developer experience on our platform. We will develop an intimate understanding of their needs, whether the use case is in SaaS application deployment and scaling, running the back end of web and mobile applications, game development or data streaming, e commerce storefronts, education technology or any other workload and we will be unrelenting in our quest to understand how to make their jobs easier and to be a critical part of their growth through our platform offerings. We will use this understanding to rapidly develop on our product roadmap, which includes several important enhancements in security, resiliency, performance, networking and storage, which are really critical to our customers scaling on our platform.

Speaker 2

We will also increase the pace of identification and development of new capabilities that will drive value to our customers and fuel our growth further. Our ongoing investments in AI machine learning capabilities is a perfect example of this. In addition to driving innovation, we will augment our best in class self-service or product led growth customer acquisition engine with an effective high velocity sales and customer service engine to improve NDR by establishing a trusted relationship with our top customers, drive adoption and visibility into our other offerings in our platform and continue providing world class support and community engagement that these customers have come to expect from DigitalOcean. By obsessing over the developer experience and innovating on their behalf and enhancing our go to market, we will take advantage of the tremendous growth opportunity that is in front of us. Our aim is to cement our position in this $114,000,000,000 addressable market for infrastructure and platform as a service and be be the foundation for developers at startups and growing digital businesses to rapidly build, deploy, host and scale applications that change the world.

Speaker 2

In conclusion, over the 1st several weeks as CEO, I'll spend the majority of my time meeting with customers, employees and investors to gather their feedback and sharpen our understandings of the market we serve. While we will continue incorporating this feedback into our ongoing plans, I'm very confident in the immediate priorities that I just outlined. We will continue to invest in our key revenue growth drivers to achieve our 2024 plan and position the company for further growth in 2025 and beyond. We will obsess over the developer experience and focus on innovating to meet their evolving needs with platform innovation and crisp go to market initiatives. We will reignite growth in our core infrastructure and platform as a service offerings.

Speaker 2

We will leverage the strong margins in the core DigitalOcean business to help fund investment in our strategic long term bets like AI and machine learning centric cloud application development. We will maintain our long term focus on increasing operating leverage and delivering attractive free cash flow margins, creating a compelling return for investors. As you can tell, I am very excited to be here at DigitalOcean. I've got a very busy quarter ahead, but I'm really looking forward to meeting many of you in the upcoming months. With that, I will now turn it over to Matt.

Speaker 3

Thanks, Patti. It's great to have you on board. I can tell you the entire DigitalOcean team and I are excited that you've joined as CEO and we're very much looking forward to working with you to achieve DigitalOcean's enormous potential. In my comments, I will review our Q4 results and cover the full year 2023 financial highlights before sharing our Q1 and full year 2024 financial outlook and our go forward capital allocation strategy. Q4 2023 was a good finish to the year with revenue, adjusted EBITDA and net income per share all exceeding the outlook that we have provided.

Speaker 3

Revenue was $181,000,000 which was up 11% year over year and was $3,000,000 above the high end of our revenue outlook. This performance was driven by the stabilization of net dollar retention within our core business and strong execution on the Cloudways front, and we got some contribution from our recently acquired AI and machine learning solutions. We also delivered strong profitability as we continue to appropriately manage our investments, balancing investment for growth with efforts to improve operating efficiency in our core business, which resulted in adjusted EBITDA of $73,000,000 a 41% margin. Adjusted free cash flow was $29,000,000 representing 16% of revenue due to working capital timing and increased investments in our AIML capabilities in the Q4. Non GAAP fully diluted net income per share was $0.44 which was up 57% year over year as we continue to successfully implement our strategy of increasing operating leverage while executing our ongoing share repurchase program.

Speaker 3

As Patti mentioned, and as it was for many players in the industry, 2023 was a challenging year with slowing revenue growth in the face of persistent macroeconomic headwinds. While top line pressure lasted longer into 2023 than we had originally expected, we saw a bottoming of the headwinds in Q3 and with stable net dollar retention and steady growth in Cloudways in the second half, we exceeded the revised full year revenue outlook. For 2023, total revenue increased 20% year over year to $693,000,000 This growth came from over 18,000 new customers that joined our platform through our durable self serve funnel and that came from increased spending from existing customers as well as overall revenue per customer increased 6% year over year. Growth also came from the steady performance of our managed hosting platform Cloudways, which increased revenue to $80,000,000 growing 43% year over year and from our recently acquired Paperspace AI ML products. On the operating leverage front, acknowledging the growth headwinds early in 2023, we proactively accelerated our long term margin profile, positioning the business to generate attractive free cash flow regardless of the economic growth environment.

Speaker 3

We successfully achieved that objective, increasing adjusted EBITDA margins from 35% in 2022 to 40% in 2023 and free cash flow margins from 13% in 2022 to 22% in 2023. We accomplished this through difficult but necessary cost management of headcount as well as non headcount related spend. And by expanding our global workforce, setting ourselves up structurally to improve margins in our core business as we grow. These strong margins in our core DigitalOcean platform enabled us to absorb Paperspace and invest in the generational growth opportunity that we see in AIML while still exceeding our full year profitability guidance. Now I want to come back to the solid growth foundation that we have established as we launch into 2024.

Speaker 3

We have a high degree of confidence in achieving double digit growth on the back of several growth levers. 1st, we expect new customer revenue, which includes revenue growth from any customer that's still in the 1st 12 months on our platform that's incremental to the 2023 revenue to contribute 8% growth in 2024, with the majority of that growth coming from self serve as we are still in the early innings of our direct and partnership motions. 2nd, we continue to invest in our managed hosting capabilities, having for example recently launched our Cloudways autonomous service that Patty had mentioned, enables customers to automatically scale their businesses on Cloudways. And we anticipate Cloudways contributing 2 to 3 points of growth in 2024. 3rd, our AI and machine learning solutions will be another key growth driver.

Speaker 3

We see tremendous long term growth potential in the AI market, and we are increasing our investment in both operating expenses, adding engineering resource to advance our AI software platform and capital, adding incremental GPU capacity to take advantage of this opportunity. We recently announced initial availability of H100s and expect additional offerings and further capacity to come online over the course of 2024. We anticipate our AI ML solutions contributing 3% revenue growth in 2024. Our 4th and final major lever growth lever is net dollar retention. As we've discussed, NDR declined over the course of 2023 with a bottoming beginning in Q3 at 96% NDR as we lap the 2022 price increase.

Speaker 3

NDR increased several basis points in Q4, but remained at 96% due to rounding. And we anticipate NDR continuing to improve as we move through 2024, as we're working aggressively to return NDR above 100% in the latter half of the year. As an early indicator of our progress on this front, in January, we saw increasing month over month growth in customer usage on the core DigitalOcean platform and we are seeing similar higher usage growth trends in February as well. With that context, I will now share our financial outlook for the quarter and for the year. For the Q1 of this year, we project revenue of $182,000,000 to $183,000,000 with adjusted EBITDA margins of 37 percent to 38% and diluted net income per share of $0.37 to 0 point 39 on a quarter by quarter basis given it's heavily influenced by working capital time.

Speaker 3

With that said, our 2024 plan is front loaded on capital as we navigate a constrained supply chain and build critical mass in our AIML capacity. So we expect free cash flow margin to dip in Q1 and then increase over balance of the year. For the full year 2024, we project revenue between $755,000,000 775,000,000 which represents year over year double digit growth at the midpoint. This range takes into account the early stage of our AIML offerings and the timing related risks of a constrained GPU supply chain, but it doesn't require any further improvements in the broader macro demand environment. With our 2024 investments, we will see modest declines in both adjusted EBITDA and free cash flow margins as we invest to generate a higher growth trajectory as we exit 2024.

Speaker 3

Adjusted EBITDA margin will be in the range of 37% to 38% for the year as improved margins from our core DigitalOcean platform are offset somewhat by increased investment in our AIML capabilities. Non GAAP fully diluted net income per share for the full year will be in the range of $1.60 to $1.67 With our increased investments, we expect to invest north of $50,000,000 alone on the AI and ML machine learning capabilities. Free cash flow margin will be in the range of 19% to 21%. We strongly believe the potential growth opportunity of this new market warrants the near term investment of 1 to 3 points of free cash flow. Before concluding my remarks, I'd like to reiterate our long term capital allocation strategy.

Speaker 3

Growing levered free cash flow per share remains our ultimate goal and what we believe is a primary shareholder value creation lever. In that pursuit, we remain committed to driving top line growth with increasing operating leverage, while continuing to execute a regular stock repurchase program to return capital to our shareholders. Together, we believe these priorities create a compelling return profile for investors. On the buybacks front, the Board has approved a $140,000,000 share repurchase authorization that we will execute over the next 2 years, utilizing the full repurchase authorization by the end of 2025. We made strong progress on our buyback program in 2023, repurchasing $488,500,000 in stock and reducing our weighted average non GAAP fully diluted shares by 11% year over year from 118,000,000 to 105,000,000 shares.

Speaker 3

Stock based compensation expense also declined materially from 18% to 13% of revenue year over year. With respect to leverage, we continue to believe that 2.5x to 3x net leverage is an appropriate long term target. And with our strong free cash flow generation, anticipate being in the low 3s by the end of 2024 based on the guidance that we have provided today. We continue to benefit from the $1,500,000,000 0 coupon convertible debt instrument that does not mature until December of 2026. With that said, we will manage and steadily reduce our net leverage over the remaining 3 years to ensure that we have an appropriate capital structure flexibility and can take advantage of the company's growth potential while increasing our levered free cash flow per share at attractive rates.

Speaker 3

To close my remarks, the company achieved a great deal in 2023 and is well positioned for profitable growth in 2024. We have a tremendous and expanding market opportunity and an actionable strategy to capitalize on it. With Patti now in the seat, we're eager to execute the plan and deliver strong results for our investors. Thank you again for your time today. And I'll now turn it over to the operator for your questions.

Operator

And we will take our first question from Jason Ader with William Blair. Your line is open.

Speaker 4

Yes. Thank you. Good afternoon and welcome aboard, Patty. Wanted to ask you just as you've I know we've been in the seat for a few weeks, but from your perspective and observing the business so far and talking to folks, where do you see the lowest hanging fruit for the company?

Speaker 2

Yes. Hello, Jason. Nice to talk to you and thank you for the welcome. Yes, this is my day 7 on the job. Last week, I spent the whole week in Boulder, Colorado with my management team and just taking stock of where we are and the plan ahead for 2024.

Speaker 2

Yes, I don't want to comment on low hanging fruit. For me, everything looks like great targets to accelerate our product roadmap. And as I was saying in my prepared remarks, I think it all starts with really understanding who our customers are and solving their challenges. So I'm super excited, given the breadth of offerings we have, the how much our product is loved by our customers, the community engagement, all of these things are great foundation for us to build on. And in terms of my priorities, as I outlined, it's really straightforward.

Speaker 2

There are 2 buckets of priorities. 1 is accelerating innovation and delivering on the product roadmap.

Speaker 3

And there are several aspects of that,

Speaker 2

whether it is fortifying our core the exciting world of AIML and everything in between. I think we have so much innovation to do. It's going to be super, super exciting. And the second thing is the experience that I bring in from Go to and other places, which is how can we not only augment our product led growth engine that has gotten digital ocean to where it is, but drive positive NDR by really establishing a great relationship with our top thousands of customers, exposing them to the breadth of offerings that we have in our platform already and building a great drumbeat in terms of engaging with them and exposing them of all the great product capabilities that our teams are going to be rolling out. So all in all, I feel very energized by all of these opportunities.

Speaker 2

And of course, I'm going to be building a series of operational mechanisms to ensure that we are looking at all these initiatives 1 by 1 and driving execution across the board. So I'm super excited to be here. Thanks for the question, Jason.

Speaker 4

Yes. And one quick follow-up on it. Just how long do you think it will take to see the return on some of these initiatives? Do you think it's like 2025? Do you think we could see some actual kind of material impact later this year?

Speaker 4

Just to give us a sense of the timeline that you're thinking about right now.

Speaker 2

Yes. I think many of these initiatives are going to be long running, right. We will never be done with innovation or fortifying and enhancing our performance stability, security kind of a thing. So I think a lot of these things are evergreen initiatives. In terms of when you're going to start seeing results, I hope it is sooner rather than later in terms of the outlook that Matt laid out.

Speaker 2

I think it is a very appropriate outlook for the year given the that we are coming off of. And we will absolutely be laser focused on execution. So there's a great opportunity ahead of us and you can count on us to be very disciplined and be laser focused on execution.

Speaker 4

Thank you and good luck.

Speaker 5

Thank you.

Operator

And we will take our next question from Gabriela Borges with Goldman Sachs. Your line is open.

Speaker 1

Gabriela, we can't hear you.

Operator

Can you hear me now? Yes.

Speaker 6

Okay, great. To Patty, I want to pick up on the comment that Matt made about generating a higher growth trajectory exiting 2024. So Patty, either for you or for Matt, how do you think about what the sustainable growth rate is for this business and the sustainable margin profile that sits alongside of that?

Speaker 2

Yes. Gabriela, thank you for your question and nice to meet you. So you're absolutely right. My overall philosophy is to find the right balance between long term growth and profitability. I'm a firm believer in the concept of growth at a reasonable price with growth being trajectory growth rate.

Speaker 2

I think it is too early for me to do that. But given where our core market is and where our developer customers are going, I think there is a tremendous opportunity in front of us in terms of participating in the AI, ML market and make the right responsible investments to help us accelerate our growth going into next year and beyond. I think you will find us be very active and busy in our product roadmap, not just on the AIML front, but also you saw just in the last few days, we announced the auto scaling capability of cloud based, call autonomous. You will start seeing a string of announcements and string of releases on our core infrastructure and platform as a service offerings. So I think our job is to focus on delivering for our developer customers.

Speaker 2

And then once we do that and we become very disciplined at doing that, I think the rest is going to take care of itself. There's no shortage of growth opportunities here, right? There's just so many different problems that developers face today that I'm super excited to start solving. And I think it's really setting ourselves up for the future. And I think we have the luxury of having such a strong foundational financial profile to be able to make quick, thoughtful, calibrated investments to help us lay the right foundation for next year and beyond.

Speaker 6

Okay. That makes sense. And then the follow-up I have is a strategy question on how you think about AI ML. If I were to oversimplify and think about DigitalOcean's value proposition, so much of it is tied to the bread and butter offerings, the ease of use, the getting SMBs and developers off the ground with straightforward configurations and usability. Help me understand where AI and ML fits into that.

Speaker 6

How do I reconcile the classic value proposition of simplicity with something that could arguably be much more sophisticated and target perhaps a different customer set from where you've traditionally participated?

Speaker 2

Yes, it's a great question, Gabriela. And that's one of the main reasons why I was so excited to come here and work at DigitalOcean because I market is just making it a lot more complicated than it needs to be. And I'm a fundamental believer that, the future of any kind of application development, on the cloud is going to be AI and ML centric for the years to come, right. I've had a lot of background in the last few years, both at Go to as well as at Amazon. And I'm a firm believer that we are in the very early innings in this space.

Speaker 2

And to your point about, hey, this is a market for very sophisticated developers, that's because everyone is talking about large language models and the GPU forms that you need to power them. But I believe that there's a lot more to this than just building and training LLMs. So there is obviously a hardware part to it, but I think the power of this is again going to default back to software. That's where the magic is going to happen. And we at Bitch Solution firmly believe that the durable competitive differentiator for us long term is going to be in the software layer.

Speaker 2

And you rightly mentioned that developers are finding it extraordinarily hard to say, okay, where do I believe or where do I start my AIML application development from? Should I build a model? Should I train a model? What is fine tuning? What is RAG?

Speaker 2

Just so many buzzwords in the market today. We have a phenomenal opportunity to do what DigitalOcean's founding principle was, which is deliver the best cloud computing experience for developers so that they can forget about the infrastructure and worry about the software that is going to change the world. We have that exact opportunity to do it in AIML. And we are going to unleash the same playbook in a different domain of AIML. So having said that, I feel, the Paperspace acquisition is very strategic to us.

Speaker 2

The Gradient experience and I personally played around with Gradient over the last few weeks, it is phenomenal. This is exactly what the market is missing today. And we have a lot of work to do to integrate and we are very busy doing that integration between the Gradient experience and the core DigitalOcean offerings. But as I said, this is super early innings in the world of AIML despite all the hype cycle. So I think, this is an opportunity that we are in the very early innings of and I feel super energized that this is exactly in the wheelhouse of DigitalOcean and every app developer in the world that is going to build a cloud application, will have to consume and make sense of the complex AI machine learning landscape today.

Speaker 2

And that's a great opportunity for us to add value to that.

Speaker 6

Thank you for the thoughts.

Operator

And we will take our next question from Brad Reback with Stifel. Your line is open.

Speaker 7

Great. Thanks very much. Patty, given everything you just laid out there around the opportunity, why not invest more and faster, especially given some of the people you're competing against are investing on for sums that we've never seen before?

Speaker 2

Yes. Thank you, Brad, for the question. That is a really important question. So I'll start and then I would love for Matt to give us a little bit of color as well. As I said, Matt, Brad, it is very early innings, right?

Speaker 2

So and I've only been here for a week. So I think the strategy that we have is a very responsible strategy that balances the right mix of investing for our future while not being carried getting carried away by the hype cycle of today. And as I said, our long term competitor differentiator is going to be in the software experience we provide to the developers. And we absolutely have to invest responsibly in the hardware that powers this experience. But we have to be careful not to try and become a hardware provider, which is not our long term strategy.

Speaker 2

But we have to find the right balance and I am a firm believer that we are going to be very focused on looking at our value proposition, how developers are consuming our services and we have the ability to calibrate the investment as we go along the year. So that's those are my early thoughts. But Matt, why don't you chime in?

Speaker 3

Yes. I completely agree that it's a very similar model to the model that we have versus the scalars today. I mean, we have a very small footprint of locations and a very small capital budget relative to any of the 3 hyper scalars. I mean, it's because we target a different market that doesn't require that level of sophistication or that level of scale. And what you're seeing when you see a lot of these companies raising massive dollars, they're basically just providing bare metal solutions of renting the GPUs and in some case, renting them to the hyperscalers.

Speaker 3

That's not a model that we'll ever compete in at scale. It's just we don't have the cost structure for that. What we do have is what Patty described is we have differentiation in the target market and we have differentiation in the software layer and that's where we're going to devote our investment. So we're investing more in R and D and in the software layer We clearly need GPU capacity. And as I said, we'll spend $50,000,000 this year in GPU alone in 2024, which is a big third of our capital budget.

Speaker 3

And that's an appropriate amount, I think, given that we think that we're taking a slightly different angle that we think is perhaps, I don't want to say more durable, but it certainly got a long a lot of legs from our perspective and we see a lot of long term growth potential in that strategy.

Speaker 1

That's great. And then

Speaker 7

just one quick follow-up, Matt. It may be sort of splitting hairs, but the Cloudways contribution, I think you said 2% to 3% for next year. I believe last quarter you put it at 3%. So any specific changes there or is it just rounding? Thanks.

Speaker 3

Brett, it's just rounding. We were, as you would expect, coming out of the year, we wanted to establish a baseline growth rate that we and everyone can count on and we're going to build from there. And we've tried to be real clear on that and we're not expecting any kind of major recoveries in the market. So when you look at the exit growth rates of the various businesses and products we have, that's kind of what you get. And again, the NDR that's assumed in the guide is we're not assuming any macro improvement, that all the NDR improvement that we have, which is still not much, We won't get in the baseline plan to above 100 NDR to the latter part of the year.

Speaker 3

It's all tied to discrete products and initiatives that we're driving. So I'd just say it's there's no message in that number. It's a little bit of rounding and it's based on the December ish exit run rates that we're seeing.

Speaker 7

Perfect. Thank you very much.

Operator

We'll take our next question from Raimo Lenska with Barclays. Your line is open.

Speaker 5

Hey, thank you and all the best from me as well, Teddy. I just wanted to ask more about expansion into new areas and how you think about that. I mean, if you look at the last few quarters, it was more over M and A to get you into AI with Paperspace and Cloudways, etcetera. Like how do you think about that balance of kind of having internal product development and you talked that you've been at AWS and Microsoft versus kind of buying expertise from the outside. Can you talk speak to that, please?

Speaker 5

Thank you.

Speaker 2

Yes. Hello, Raimo. Nice to be here. And I think my philosophy is we have to do both. And in a market that is evolving quickly And I don't want to make this sound like it is all about AIML.

Speaker 2

I think we have a lot of core innovation left, both in our infrastructure platform as a service as well as in our cloud based hosting offering. I think we have a lot of innovation left within the core digital ocean. And also, as I mentioned, we are still building the bridge between the gradient experience at Paperspace and the core DO offering. So we have enough to keep us very busy organically, but as you would expect, we are very diligent in scanning the landscape, whether it is to buy talent as you're talking about or buy new capabilities, which our customers will appreciate, expand from a geographical footprint perspective. There's so many dimensions that we could add inorganic capabilities into our offering.

Speaker 2

So I'm super excited and having the financial structure that we have gives us the opportunity to make the right responsible bets to accelerate our growth.

Speaker 5

Okay, perfect. Thank you. And Matt, one for you. If you think about the environment out there, you mentioned in your plans, there's no assumption of things getting better. But if you think about the linearity in the quarter and the different geographies as well, what has been your observation this quarter?

Speaker 5

Thank you.

Speaker 3

Yes. So, it's again, one of the things I love about this business is how the lack of concentration we have in any vertical or in any industry or use case or country. And so we're pretty diversified on that front. And we haven't seen any kind of one sector or region performing materially different than the rest. But what I would say is, while the NDR was still 96% in the 4th quarter, we are seeing increased usage on the core deal platform.

Speaker 3

We saw that continue into January, it's continued into February. And we're seeing we are seeing signs of like we said, we expect NDR to improve over the course of the year. And we're seeing good leading indicators at this point as customers are starting to pick up their activity on the core deal platform itself, which has been kind of the real headwind of growth over the last several quarters.

Speaker 5

Okay, perfect. Thank you. And

Operator

we'll take our next question from Patrick Walraven with Citizens JMP. Your line is open.

Speaker 8

Great. Thank you. And let me add my congratulations, Patty. So my question is really basic. What is your philosophy of leadership?

Speaker 2

Patrick, thank you for your question. So my philosophy leadership all starts with the customers we serve. I think our purpose of existence as a company is to serve our customers. And if we do that well and if we understand their needs and we deliver at a brisk pace and solve their problems, I think the rest is going to take care of itself. And I think, as I mentioned, those are the couple of things that really excite me here.

Speaker 2

It's a large market and we already have a very, very strong foundation. And it is a market in which our core customers, which are the developers, have an emerging set of very complex problems that are worth solving for. So my leadership philosophy starts with that. Number 2 is we need to have we are a tech business, so our technology has to be world class. So that's something that I'm going to be super focused on.

Speaker 2

And number 3 is technology has to come from world class world class technology should come from world class people. I've been very impressed with the caliber of talent we have here at DigitalOcean. And we are really excited to get to work. And my job as the CEO is to A, help us understand our customers very deeply and B, put the right people in the right jobs to deliver innovation to help take care of our customers. So hopefully that gives you an answer which is not super fluffy or high level, but you will hopefully I will back up these things over the next several quarters with product innovation and delivery that backs up my leadership principles.

Speaker 8

Awesome. Thank you.

Operator

We will take our next question from Josh Bair with Morgan Stanley. Your line is open.

Speaker 9

Great. Thanks for the question and welcome, Patty. I was hoping you could give an update on the revenue composition between products, like how much mix is droplets or infrastructure as a service versus platform as a service, what products are contributing most in platform? And I guess I'm wondering if with the net retention rate below 100, like looking at the average revenue per customer, if some of the adoption of multiple products is sort of masked by lower consumption overall bringing that average revenue per customer keeping that more modest growth?

Speaker 3

Hey, Josh, it's Matt. We don't disclose the mix of the IaaS and PaaS solutions. But what I'd tell you is the PaaS solutions are growing faster than the core kind of infrastructure as a service offering. So database and some of the other products and Kubernetes are all growing at a more rapid clip than is the core kind of droplet and compute business. And that's so the take rate of those services is very healthy.

Speaker 3

I think when you see that again, the big driver in the NDR challenges that we've had has been, as I've said multiple times over the last several calls, its expansion has slowed, right? The churn has not changed. It's right around where it was even a year ago. The contraction is a little bit elevated, but it's been fairly stable over the last now 7, 8 months. Where we saw the most pressure year over year last year was in expansion.

Speaker 3

And that expansion was customers' own businesses just weren't growing fast and so they didn't need more compute. And so we didn't see as much growth in the core kind of droplet part of the business. And so I think that I'm very excited by the product roadmap that we have and with Patty coming on the ability to even more focus on driving adoption and increased kind of take rate of our existing products into the installed base. Most of the headwind that we've seen though has been in kind of just the core droplet core compute.

Speaker 9

Great. And just wondering, Patty, if you're thinking about all the opportunity in front of you, all the growth levers available to you, how are you thinking about potential for future pricing increases over the medium term? And Matt, just wondering in your breakdown of growth drivers for the year, is there any contribution from pricing embedded in those different categories? Thanks.

Speaker 3

Yes. Hey,

Speaker 2

Josh. There's no factored in price increase as part of our outlook. And just my philosophy is, we will continue to have packaging changes and lineup changes and we will introduce new products and premium capabilities and things like that. But nothing which is already baked into our outlook for this year. And my philosophy is we'll continue we have to innovate and try new packages and different thresholds and things like that.

Speaker 2

So it's an ongoing thing. And as with any other technology vendor, we will pay close attention to what our customers are asking for. So that's my overarching philosophy.

Speaker 5

Perfect. Thanks.

Operator

And we will take our next question from Piyush Limbura with JPMorgan. Your line is open.

Speaker 10

Great. Thanks for taking the questions and welcome, Patty. Just a 2 part, one question on Paperspace. Any way to understand kind of the adoption of the MLOps platform versus the IAS side of Paperspace? Is the MLOps platform landing with customers?

Speaker 10

Are they using that more versus the IaaS side of things? And Matt, maybe help us understand you are, I think, assuming about $6,000,000 from Paperspace this year, was that did that land at that point, about $6,000,000 or was it more?

Speaker 3

I can start. Thanks, Pindjal. I'll start. It's Matt with the latter question. Yes, we came in right exactly what we had expected.

Speaker 3

We had signaled, I think, around 5 and we came in around 6 for the year and clearly on an ARR basis it's higher than that. That was just the last 6 months of the year. And we think that again that that business should give us 3 points of growth on the entire business. So it's more than doubling on an ARR basis over the course of this year.

Speaker 2

Yes. And to answer your first part of your question, I think it is it's a mix of both, right? So the machine the MLOps platform needs a steady dose of infrastructure. And as we go into this year, as we start bringing the 2 platforms closer together, we expect a lot of our PaperSpace or AIML customers to start consuming more of the DigitalOcean compute capabilities as well. So it's still early days.

Speaker 2

It's a little, so there are customers that are very heavy users of the AIML stack and they might use a little bit of compute on an as needed basis. But then there are other customers who are in a steady state inferencing type of workload. So it is still a little training heavy as you would expect, given the nature of what customers are trying to do with AIML and many of our customers are in core use cases like text to image generation or text to video generation and those kinds of things. So it's a very heavy training oriented mode where it is lot more of the AI machine learning ops, marshaling data, getting the data set organized and just training the data set is what we are seeing a lot more of now. But once you get to the steady state is where the spillover to the compute side is about to happen in the inference stage.

Speaker 2

So that's why we're getting ready with our integration of the core DEO infrastructure.

Speaker 10

Thank you.

Operator

And we will take our next question from Tim Horan with Oppenheimer. Your line is open.

Speaker 11

Thanks. Just a few clarifications. Matt, I think you said $50,000,000 on GPUs this year, it's 1 third. So are you guiding to CapEx closer to 150,000,000 dollars for the year? And if so, how does that square with 20% free cash flow margins?

Speaker 11

Or maybe I'm just missing some adjustments. And can you just give us some color on the outload, the demand for GPUs? How confident are you that you can utilize that $50,000,000 in GPUs? Thanks.

Speaker 3

Yes. So the guide for the year for free cash flow is $19,000,000 to $21,000,000 so kind of $20,000,000 in the middle. It's consistent with we're not guiding to CapEx. I gave you general parameters of it, so you can kind of sort it out. But we're pretty confident in our ability to hit that 19% to 21% free cash flow margin.

Speaker 3

As we demonstrated this year, we have the opportunity to drive material kind of leverage in the core deal platform and we can use that to offset the incremental investments that we're making in both OpEx and CapEx in the paper space business. From a demand standpoint and this gets back to I think pendulum's question before, which is, did we exceed what we thought we would do in revenue for AIML in 2023? Part of this is, it's a there's supply constraints. So you have to order the gear 6, 9 months in advance to be able to get GPU capacity. And even when you do that, the vendors and these are major kind of Tier 1 distributors not going to small shops.

Speaker 3

Even then they can't guarantee that you get it all and you get it all at the right time and you get it all with all the right parts. And so there's more of a it's more of a supply challenge right now, to be honest with you, than a demand challenge. It's like can we get it installed? Can we get it up and running? And we're also, again, very focused on the software side of things, which is an integration that we're doing with between our platforms.

Speaker 3

And so it's we're not worried at all about the demand. We're worried about how quickly we can get it turned up and available. And when you're starting again a business from this small size when we acquired Paperspace, if you turn something up 2 months later in the month than you had anticipated, that's a big hit on the in year revenue, which we're not fussed about. But that's why we're I think being conservative in terms of the amount of revenue that we're going to drive off that capital in 2024.

Speaker 2

And then Patty, can you and

Speaker 11

all the due diligence you did, can you talk about who you think your primary competitors are? And Akamai acquired Linode and they seem to be more focused in R and D and enterprise than SMB. Do you think competitive intensity is decreasing or do you expect it to or do you expect it to increase?

Speaker 2

Thanks. Yes. That's a good observation. So yes, I think the competitors are who, all of you can guess, right? And I feel, when we are looking at our competitive posture, I'm always I have a very healthy dose of founders paranoia.

Speaker 2

So I feel like every dollar has to be earned, every customer has to be earned. So we will go with the assumption that all of our competitors are fiercely coming after our customers. So I think that's the way, I like to operate and push our teams to make sure that our innovation, a, outpaces our competition and also out delivers in terms of ease of use and the ability of our platform to stand on its own and impress our customers. So yes, Akamai, Linode, I have also heard what you just said, but that's not to say that they might not change their strategy in the next few quarters. So, we like to operate or I like to operate with that philosophy.

Speaker 2

So and same thing for AIML. It's everyone is throwing the kitchen sink at this problem. But as Matt and I have been repeating ourselves over the last hour, we'll focus on, yes, hardware is an essential means to an end, but our long term durable differentiator is going to be on the software stack.

Speaker 5

Thank you.

Operator

And we will take our next question from Jim Fish with Piper Sandler. Your line is open.

Speaker 12

Hey, this is Quintin on for Jim Fish. Thanks for taking our question and Patty look forward to working with you. Patty maybe for you, you, you talked about a focus on augmenting this self-service motion, investing more in a direct customer relationship. Is that something that's going to require a further increase in the sales rep headcount as we look to 2024? Or is this more of a rebalance of the existing resources within the sales team?

Speaker 2

Yes. So it is it's all factored into the outlook that Matt gave. So yes, it is a rebalance and we are not talking about building an army of sales people, right. So our customers are developers and we have to this is again going back to my core philosophy of we really need to be world class in understanding our customers and their preferences and how they want to be reached. And so we're not going to start dialing for dollars and call our customers day in and day out.

Speaker 2

That's not what I'm talking about at all. But there are customers that are reaching a certain point in time of sophistication and requirement from our platform, which a, requires the platform to be rich and number 2 is tasteful customer success and ongoing relationship to make sure that they're getting the best value from our platform. And many of our customers don't even know the breadth of or how much we have evolved since they started their journey with us. So I think it's a great opportunity for us to wave the flag and make sure that we are engaging with them in a very scaled manner. So and also using technology to make sure that we are establishing that relationship at the right time with the right set of tools to raise the visibility and offer them help on an as needed basis.

Speaker 2

Matt, I don't know if you wanted to add any color on the actual expense outlays.

Speaker 3

You nailed it, Patti. The plan we have already factors in the refactoring and kind of investment in the sales and marketing engine as part of the guidance.

Speaker 12

Very helpful. Then maybe a quick follow-up. Matt, I think it's for you. We've talked about in the past crypto being a headwind to top line. We've seen a little bit of improvement in the underlying pricing.

Speaker 12

Has that correlated to any sort of return in usage on the platform? Or maybe what are you seeing from that specific vertical? Thank you.

Speaker 3

Yes. We've looked exactly at that for the reasons that you described and we haven't seen nearly the kind of surge that we had seen in the past that we are seeing, as I said, more usage on the platform and we saw increasing kind of use patterns in January. We're seeing that increase in February, but it's not coming disproportionately from crypto. As we had said previously last year, crypto was down to like 2% of revenue. So it's not by itself a needle mover at this point.

Speaker 12

Appreciate it. Thank you.

Operator

And we will take our next question from Mike Sciacop with Needham and Company. Your line is open.

Speaker 8

Hey, thanks for getting me on and taking the questions here guys. I wanted to start first, I know that you guys are talking to some of these investments in direct sales and customer success. Wanted to get a sense here, can you remind us what is the time to maturity for these reps? And also what's the profile of the customer that you're looking to invest in as far as taking them through these solutions to increase attach rates or better serve those customers?

Speaker 2

So, yes. So, first of all, it's not that we are starting from a clean slate. So we do have people in roles that are already engaging with customers both on the customer success side and sales perspective. So I'm too new to answer your question in terms of what the ramp up time is going to be for new reps, but I just want to make sure that I'm not inadvertently signaling that, oh, we have to start from scratch and nobody has thought about this so far in the company. So in terms of just the types of customers we'll go after, it's both a looking at the top consumers of our platform with an implicit nod to the fact that the more you consume, the more you would want to have a trusted relationship with your biggest platform provider.

Speaker 2

So that's 1. Number 2 is, we are also investing in we already have technologies that we have invested in that gives us great visibility into customers, that are about to hit a certain threshold of usage and consumption that we can get ahead of and be proactive in building a relationship with. So that's more of a technology enabled engagement, if you will, to augment building this relationship to drive expansion and reduce churn with some of our top consuming customers.

Speaker 3

And I would add that the 3rd kind of leg of that is as customers, we get millions of visitors to our site every month and tens of thousands of those sign up as customers and 3, 4 months later you get kind of shake out which ones are viable customers and which ones are grow and part of that sales motion is taking those customers as they come on and trying to figure out which ones have growth potential. And is it they may only be spending a little bit as they're dabbling with our platform, but they might be part of a bigger company and there's a bigger workload that they could bring. And so part of that go to market motion is triaging those customers and figuring out which ones are the higher value prospects and then making sure that you're disproportionately helping them through the onboarding and trying to understand what their potential is.

Speaker 8

Understood. Thank you for that guys. And then for the follow-up, I know last quarter, Matt, you had given us some great parameters around that retention. I remember churn had been relatively stable at 12%, contraction had improved entering the quarter at the September quarter at 16% and you exited at 15%. Based on your comments today, is it fair to assume that churn and contraction were stable and then the big overhang on that 96% NRR we're seeing today really ties to the expansion rates?

Speaker 8

Or is there anything else to consider?

Speaker 3

No, no. I think you've got it. I mean, this is frustrating because it's a rounding. But we actually saw improvements in all three over the course of if you look at like July to January. It's actually it's a much better than it appears improvement.

Speaker 3

Part of the problem is the way we define NDR, it's averaged over the month. So it's the July the Q3 number was the average of July, August and September and the Q4 number is the average of the 3 months. But if you look at the actual months, which you can't because we don't disclose that, but there's actually more kind of steady progress. It's still modest. So it's clearly if it's rounding as an issue, it's not massive improvements.

Speaker 3

But we have modest progress on each of the three dimensions over that period. And as I said, January was a strong month in terms of usage and NDR for the month. February is looking good as well. So I'm confident that it will continue to steadily go up and I would expect it to go up at a faster clip than clearly what it did in the 3rd to 4th quarter.

Speaker 8

Makes sense. Thank you for the color there, Matt. And looking forward to working with you as well, Patty.

Speaker 2

Thank you, Mike.

Operator

And we will take our final question from Wamsi Mohan with Bank of America. Your line is open.

Speaker 13

Yes. Thank you so much. Patty, congrats on the role. Look forward to working with you as well. Patty, you mentioned focus on product innovation, enhancing developer experience.

Speaker 13

But as Matt mentioned, you have very diversified customer base. So how are you thinking about prioritizing across these use cases? I know you've mentioned several including SaaS or back end of web game development, e commerce, a bunch of those. And is there a specific maybe intersection of that with the product roadmap that you mentioned between security, resiliency, storage, networking, etcetera, that really stands out or jumps out as the area that you would tackle first? Or how are you thinking about prioritizing these?

Speaker 2

Hi, Vamsi. Very nice to meet you and look forward to working with you again. I think in terms of the workloads themselves, the workloads might be very diverse. Yes, you're right. But the core capabilities that most of these workloads need are fairly finite.

Speaker 2

So you have the core network, core compute, different types of storage. And even in AI and machine learning, again, it's a very finite number of work capabilities that they need to power whether it is a classification type of workload or a large language model or a large language model or any other type of AI machine learning workload. It is about making sure you have the data curation right and figure out the data pipeline and you have the right training and right inference infrastructure. So I feel fairly confident having dug into some of the platform capabilities that we have and also spent a bulk of my time last week going into the customer feedback and looking at what our customers have been asking us for. I think the priorities are very overlapping between these workloads.

Speaker 2

So I think if and I think we have enough to keep us super busy over the next several quarters in terms of product innovation and the prioritization of the roadmap. And I think most of what we are going to be doing and most of what we have actually released, like for example, I mentioned the cloud based autonomous functionality, regardless of whether you're an e commerce store or any other kind of web hosting customer, auto scaling and sophisticated rules based configuration are universal more or less. So I feel fairly confident that our innovation is going to impact multiple customers across different workloads. So as we go along, I'm pretty sure that we will find ways by which we can accelerate specific workloads as we get into the later part of this year. But I feel fairly confident that we have a robust roadmap that addresses a broad set of functionality.

Speaker 13

Okay. Thanks, Patty. That's helpful. As a follow-up, Matt, the incremental quarter on quarter growth of learners and builders seems to have decelerated a bit in Q4. How are you thinking about the trajectory of growth in customers over the next few quarters just directionally over the course of the year maybe?

Speaker 3

Yes. That's a good question, Wamsi. I'd say one of the things that I've been paying attention to is the incremental ARR. Clearly, I'm looking at the customer count. I'm less worried about the customer count because it's such a broad set of customers that we have.

Speaker 3

And again, churn is not a factor. So I feel like there's a lot of opportunity for us to accelerate the growth of the customer base. And as we drive these new capabilities into the market or into our platform, that's where we're assuming the growth comes from. Not that we suddenly drive tons and tons of new customers on the platform, it's more growing the existing customers. But when you look at the ARR growth and you take out paper space from the Q3, clearly the first and the second quarter were really light in terms of incremental ARR growth.

Speaker 3

But then in 3rd Q4, we got back to closer to kind of historical levels at around $18,000,000 in incremental ARR $17,000,000 in the Q4. And with the increase in usage that we're seeing, it's not again, it's not being driven by we have tons of more new customers, it's because the customers we have are starting to spend more. That's what is giving us optimism as we go into the beginning of this year.

Speaker 13

Great. Thank you so much.

Operator

And there are no further questions at this time. I will now turn the call back to Mr. Paddy Srinivasan for closing remarks.

Speaker 2

Thank you all for your time and really excellent questions and great engagement. As you can tell, I'm super excited to roll up my sleeves and get to work. A lot of great opportunities to innovate, enhance our product offerings and really augment our great product led growth motion. I'm looking forward to working with all of you and meeting many of you over the next few months. Thanks and have a good rest of the day.

Operator

And ladies and gentlemen, this concludes today's call and we thank you for your participation. You may now disconnect.

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Earnings Conference Call
DigitalOcean Q4 2023
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