Q3 2022 DigitalOcean Holdings Inc Earnings Call
Good afternoon, and welcome to the digital Ocean good quarter 2022 earnings conference call all.
All lines have been placed on mute to prevent any background noise.
After the Speakers' remarks, there will be a question and answer session. If you'd like to ask a question. During this session. Please press star one on your telephone keypad.
To withdraw your question Press Star one again, thank you I will now turn the call over to Rob Bradley Vice President of Investor Relations. Please go ahead.
Thank you and welcome everyone to digital Oceans third quarter 2022 earnings call. Joining me today is Yancey Spruill, our Chief Executive Officer, and Bill Sorenson, Our Chief Financial Officer.
Before we begin I want to cover our Safe Harbor statement. During this conference call, we will be making forward looking statements, including our financial outlook for the third quarter fourth quarter 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 you can review more information about these and the risk factors section of our filings with the SEC, we remind everyone that our actual results may differ and we undertake no obligation to revise or update any forward looking statements.
We will be discussing non-GAAP financial measures on our call and reconciliations between our GAAP and non-GAAP financial results can be found in our earnings press release, which was issued earlier. This afternoon and is also in the investor presentation on our IR website.
With that let me turn the call over to our CEO Yancey Spruill.
Nancy.
Thank you Rob.
Thank you all for joining us as we review our strong third quarter results.
Another quarter, and our ongoing commitment to delivering robust revenue growth.
And improving profitability and free cash flow.
I'm proud of the entire digital ocean team for delivering these results given the challenges in the operating environment. This year.
Yeah.
I'd like to begin today by framing where our business stands in the context of where we've been.
And how we are set up for durable profitable growth.
Even in these times of uncertainty.
I will then share some insights on our growth and profitability priorities as we close out this year and work our way towards 2023.
I'll, specifically address the early indicators, resulting from our recent pricing initiatives and discuss our exciting <unk> acquisition, which we closed on September one.
Bill will then provide more details on our financial results our financial outlook for Q4, and then turn to your questions.
Yeah.
Yeah.
We have a highly resilient business due to several key factors and they've been clearly on display this year.
First we have a truly global geographic footprint with our revenue and customer base spread across 185 countries in.
In similar proportion to global GDP.
So we are not dependent on any one region or country.
Second.
We have customer diversity with our top 25 customers representing less than 10% of total revenue.
So our revenue is not concentrated in a small number of customers.
Third we serve a wide range of industry verticals and use cases for E Commerce web and mobile applications website hosting media and gaming publishing AD Tech and many more.
So we aren't overly reliant on any industry or our business model.
Finally, we also have a consumption based revenue model, which creates the flexibility for our customers to pay for what they need.
As they scale their business, but.
But also to adjust their use to address any equity.
The economic headwinds they are facing.
This customer centric model with simplicity at its heart.
Builds customer loyalty that historically has been a great benefit to us.
As demonstrated in our low churn levels.
And we will pay long term dividends as we exit this turbulent environment.
Collectively these factors position us well when there is an economic downdraft like we have seen this year.
And allow us to achieve continued strong revenue growth coupled with improving profitability.
With our consumption based model, we were early and seeing the impact of the economic downturn during the first half of 2022.
These economic headwinds, which include a global economic slowdown and high inflation in U S dollar strength.
The Russia, Ukraine War and the decline in blockchain continued in the third quarter.
Undoubtedly these factors contributed to slower growth within our cohort than we had forecast at the beginning of the year.
Along with the reduction of revenue in Russia, and Ukraine, and significantly lower blockchain customer spend has resulted in a 900 basis points.
Headwinds in Q3 to our stated goal of 30% growth.
Importantly, churn within our cohort has remained flat during this period.
And our customer engagement remains strong.
So we are very optimistic when things turn in the broader economy.
We will be well positioned for expansion across our cohort.
To be a tailwind on our top line growth rate as it was throughout 2021 and even Q1 this year.
Despite these unforeseen challenges, we managed through it to deliver 37% total revenue growth with 33% organic growth.
We arent ready to call a bottom in terms of a lower growth across our cohort and given the number of uncertainties in the broader macro we will remain cautious in our planning.
And in setting expectations.
Q3 marks my three year anniversary at digital Ocean is a good time for me to reflect on our progress.
In the summer of 2019, we inherited a business growing revenue in the mid in the low to mid Twenty's with negative 25% free cash flow.
We set a goal of getting the growth rate above 30% by focusing on the most impactful opportunities we saw.
From improving the customer experience to reducing churn, which was upper teens driving expansion in our cohorts through adding relevant products and features such as managed databases and <unk> and building a sales capability to better penetrate.
The $70 billion addressable market.
This strategy was successful as we generated 35% growth in 2021 and will be above 30% this year.
So we expect to grow at least 30% next year from the midpoint of the 2022 guidance we're issuing today.
<unk> has improved from below 100% to the mid teens as we cut churn in half and ARPA growth has improved for the mid teens up to.
The mid to high <unk>.
Our second goal is to dramatically improve the profitability.
Cash flow profile of the business.
Those that know me well can confirm the free cash flow has always been an obsession for me not a revelation made in 2022, when the world started seeing signs of economic turmoil.
We saw an opportunity here is capital intensity was too high operating costs were too disconnected from revenue and the resulting operating and free cash flow margins were significantly negative, which simply was not acceptable.
Today, our non-GAAP operating margins are about 20% of free cash flow margins are double digits, both with plenty of upside from here.
This work over the past three years has created a powerfully efficient high growth business model built around simplicity.
With incredibly attractive customer lifetime value to acquisition costs.
A modest requirement for incremental product investment in an increasingly capex efficient footprint to deliver value to our customers.
These characteristics when combined are driving 30% growth rate this year before cloud ways with the strong and ramping free cash flow generation, we are seeing today.
We remain committed to our combined goals with annual revenue growth of 30% ramping free cash flow and starting in 2020 for free cash flow margins of 20% or better.
Our $70 billion market opportunity is projected to continue to grow in coming years.
The SMB economy is roughly 50% of global GDP if.
It's not going anywhere and although it is not immune from the broader trends impacting our economy smaller businesses are demonstrating how nimble and resilient. They are during this period.
There is a perception that SMB is subject to a more significant impact than enterprise from weak macroeconomic conditions.
Facts suggest otherwise as the Hyperscale cloud providers and other software companies, who are principally focused on enterprise customers have reported similar levels of declines to their growth rates as us during this year.
We believe having an SMB focused business with geographic industry and business model diversity in a consumption based model is a key strength of our company.
Plan to exit this turbulent economic period with a stronger set of capabilities grounded in an even better customer experience, resulting in greater market share.
The levers we use the next few years will be somewhat different from those we pulled the last three years.
The revenue and profitability targets, including achieving our first $1 billion of revenue 2024.
Change.
First targeted product enhancements that represent large revenue opportunities will be one area of focus.
This may come from internal development work or through acquisitions like our recent cloud waste transaction.
Which I'll address in a bit more detail shortly.
One specific area of focus for us will be enhancing our storage offerings for SMB customers.
Our storage revenue currently is high single digits as a percentage of our total revenue and we believe based upon benchmark and customer surveys that we can double the revenue mix percentage for storage related capabilities over the next few years.
Providing a more performance feature rich storage platform more specifically tailored to our SMB customers.
Also drive growth across droplet database coover days and service products.
<unk> from our customers that use our object and block storage products as more than 25 times the <unk> for customers that do not use them.
Many of our SMB customers may use us for compute with go multi cloud for storage.
Being able to capture the full compute and storage suite from current and new customers is a big opportunity for us.
Second we see opportunities to better align our product pricing and packaging models with the differing needs and wants of our diverse customer base.
We took the first step here earlier this year.
Which I'll address in a few moments.
But there are other opportunities, we see to optimize our monetization approach.
With the specific and different needs of our customers.
One example of a packaging the various security protections, we provided on our platform to address specific customer needs.
Third we will continue to expand our sales and marketing engine around the world.
This effort is working well, but it is still early and.
And we see a significant opportunity to sell more to our existing customer base as well as targeting new customers.
We recently announced the launch of our partnership program called partner pod.
As part of this program our partners receive free training and enablement on sales products and other topics co marketing opportunities and market development funds. So they can get help running their campaigns and bring in new customers.
We think a robust partner program is an essential part of the go to market approach for our global SMB business.
Growth from our sales efforts was up 225% year to date and the mix as a percentage of total sales was just over 5% in Q3 up from 4% in Q3, 2021, and essentially zero three years ago.
We're making very good progress in building our sales capability that will continue to generate an increasing component of our overall revenue mix in the coming years.
Lastly, we expect to expand our global infrastructure in the coming years to better capture more localized customer set in key markets.
Our new data center in Australia will be launching this quarter.
This has been a consistent asked from our customers and we are pleased to offer this expanded capability to our infrastructure footprint.
We are in the planning phase for additional locations and expect to broaden our footprint to address other important regional markets as.
As well as to enhance the performance of our entire network for our global customer base.
At the same time on the expense side, we will continue to focus on operational excellence, optimizing our processes and deploying our capital efficiently.
Which will help us to continue to drive operating and free cash flow margin leverage regardless of the economic environment.
We have made great progress over the past few years on improving our profitability profile.
There is more we will do here as well.
I would like to provide a bit more color on the two levers we pulled in Q3 that I just referenced first and action on the pricing of our portfolio of products, followed by our largest acquisition today.
This provides critical insight into how we manage our business consistently.
Consistently working on opportunities to grow faster, while also growing free cash flow.
Effective July one we introduced our new pricing model, which we had been developing since last fall into 2021.
This new framework, which we announced in May incorporated higher prices for some of our products, including our flagship drop later as well as the introduction of a lower price droplet SKU.
The rationale had two main components first to have our pricing reflect the tremendous value we have added to our portfolio over the years.
In terms of reliability performance security and support and second to align our pricing structure to the different needs of individual developers and SMB customers.
Broadly speaking after one quarter of operating under this new pricing framework.
A positive impact on our business has exceeded our expectations.
Despite weaker macro trends that offset some of the benefits of the pricing changes.
Specifically, both customer churn and the number of customers downgrading to lower priced SKU have been less than we forecast.
Pricing initiatives generated a 200 basis point benefit to year over year growth in Q3.
The same time the headwinds that we've discussed dilutive the impact of those pricing changes in the quarter.
But as those dissipate.
Our new pricing framework is going to endure as we continue to lead in the SMB cloud with a differentiated platform.
I'd also like to note.
That other players in the SMB segment of cloud infrastructure have followed us and introduced price increases subsequent to our analysis.
These results have confirmed our thesis that our customer base sees tremendous value from the platform improvements. We have made across time, we're still roughly half the cost of the hyperscale or pricing and are prices still constitute a small expense as a percentage of their revenue for our SMB customers that view.
As a critical requirement to run their entire business.
These pricing actions have created a tailwind to other key performance indicators as well.
Including net new annual recurring revenue, which was up 41% to $641 million.
Net dollar retention, which was 118% and revenue per customer or <unk>, which was up 28%.
Perhaps the most important measure of the durability of our growth that also saw a dramatic uplift was with our highest spend customers.
Excluding <unk>, our highest spend customers those who spend at least $50 per month grew 29% year over year to 122000 and.
And now represent 86% of total revenue.
Up 300 basis points from Q3 2021.
Including the 20.
Greater than $50 customers within cloud ways, our total high spend customer count increased to $142.
A 50% increase year over year.
Again these customers are fueling our revenue growth in.
And our ability to grow this business to greater than a $1 billion in revenue and beyond is critically dependent on growth from this customer cohort.
Next I'd like to speak to cloud ways.
We are very excited about the cloud ways acquisition and frankly, our conviction has grown stronger in the two months since we have been integrating our two companies.
Our excitement is predicated on our shared passion for serving the SMB opportunity.
The significant expansion of our serviceable market and increased benefit we will realize from the deep customer insights that the cloud waste team possesses which will accrue to our entire business as we build a unified go to market motion.
As investors view, our $70 billion market opportunity consists of infrastructure and platform as a service for businesses that have fewer than 500 employees that is to say SMB. They often think that the customers. We serve are all the same.
But in reality that is not the case, while these customers represent a vast array of industry verticals geographies and use cases, perhaps the most critical distinction is between customers that seek to manage the experience versus a more do it yourself model for their cloud investments.
Bright as the historical business model for digital Ocean has been the target the do it yourself customers, who have both the internal expertise and desire to handle their infrastructure.
As we have scaled our business over the last several years. It has become very clear that there is a large universe of technology, smbs and a corresponding large market opportunity for us.
Likely as large as our core market that want to manage the experience.
So often we see the customer churn in the first few months on our platform decides that they were looking for a managed experience.
Something that we have not offered until now.
With a more complete suite of offerings become an attractive provider to an even larger number of the $100 million global Smbs looking for a cloud solution.
We are very optimistic about the potential for significant revenue synergies.
And the early proof points are very encouraging.
Cloud ways brings deeper SMB customer insights to digital ocean as a managed service entails a deeper relation with end customers that provides value added valuable insights about the opportunities and challenges businesses are facing as they grow.
As a good indicator of the value of this customer intimacy cloud waste generates two X the pricing for a similar sized customer footprint.
Obviously this creates a big opportunity for us over time, given the scale of our customer base.
We are already acting on this opportunity by moving to improve customer monetization and to make our product development and go to market efforts are much more integrated.
Cloud waist deep customer understanding and intimacy is a key ingredient to digital oceans aspiration to become the SMB cloud provider.
The final piece of the puzzle with cloud ways as Theyre very attractive revenue growth and free cash flow profile.
They're growing faster with free cash flow margins in line with ours, and we will invest to keep it that way and leverage <unk> capabilities to accelerate growth across the business by better placing customers into the service profile that best meets their needs.
We are already realizing some of the significant opportunity for revenue synergies for cloud waste as we matched customers on our combined platform with the best outcome for their objectives.
The <unk> acquisition and these synergies will certainly be a critical contributing factors to sustaining our 30% annual revenue growth target.
In summary, Q3 demonstrated our ability to operate in a challenging environment, we delivered 37% growth, while delivering free cash flow margins of 15%. We achieved this in the face of significant macro headwinds.
Very proud of these results and what it says about the durability and resilience of our business in tough times and speaks loudly about the power of our business model and better times.
Most exciting of all despite the uncertain economy, we took decisive action that meaningfully increased our business capabilities with the cloud ways acquisition.
Which will help us better address the $70 billion SMB cloud market, which positions us for both self serve and managed services customers.
We will end 2022 of our larger and more profitable business setting us up for continued success in 2023 and beyond.
With that over to bill to provide details on the quarter. Thanks, C&C and thanks to all of you for joining us today to review, our very solid third quarter results.
Before we begin I would like to review the fundamental elements of our operating strategy, which have not changed since becoming a public company and we will continue to guide our efforts for the years ahead.
At our core we focus on three key areas revenue growth in excess of 30% faster than the SMB cloud market growth rate, increasing profitability and growing free cash flow for shareholders.
Those fundamentals have not changed and will not change as we go forward.
Also we've frequently articulated that a variety of levers would be used to achieve those three objectives, including pricing and packaging evolving our go to market strategy from purely self serve to more direct customer outreach and interaction and finally accretive M&A opportunities that either expand and enhance our go to market.
Capabilities or accelerate our product innovation.
Entering the year with over $1 billion of cash on our balance sheet provided us with real opportunities to execute this strategy.
Pulling the right levers and executing well has been critical this year over the past few quarters, we've experienced the mooring Europe , a global economic slowdown a strengthening dollar and the collapse of the bitcoin market all of which had put pressure on our top line. Despite these developments we have delivered another quarter of better than 30 <unk>.
<unk> growth, coupled with improving profitability and cash flow margin and going forward. We will continue to do the same.
Today I'm going to use my remarks to provide more color on the drivers of our top line revenue performance in the quarter. The gross margin impact from the adoption of the lease accounting standard ASC 842, which we are required to do by the end of this fiscal year.
And the contributors to the profitability, we demonstrated in Q3 as well as our expectations for the remainder of the year.
Following that I'll share our outlook before turning it over to the operator to take your questions.
I wanted to begin with revenue, which came in at $152 million in the quarter, an increase of 37% year over year and the fifth out of seven reported quarters, where our growth exceeded 30%.
Q3 does includes a net revenue contribution from our <unk> acquisition, but even excluding that our revenue grew 33% year over year and exceeded the guidance we provided prior to the acquisition by $1 million.
Several initiatives helped us achieve these strong results. The first of those initiatives focused on pricing and packaging, which we've consistently discussed as an opportunity Q3 benefited from the implementation of increased pricing to reflect the improvements we've made in the product over the past several years, we strongly believe our new pricing model.
Provides incredible value to our customers with our learners builders or scalar and based on the customer reaction our customers are seeing this value.
And our price increase was not unique to the industry as we've seen other cloud providers, both big and small follow our lead.
As we've long hypothesized our product offerings were priced too wide a gap to the digital ocean value proposition and the results that we've seen through the first three months of the new pricing taking effect is that our hypothesis was correct. Since July one we've had lower customer churn, we had assumed lowered downgrades to the $4.
Droplet and lower negotiated discounts with our larger customers.
In total the price increase provided approximately $13 million of additional revenues in the quarter.
And in order to learn more about the reasons for customer churn, whether pricing macro factors or other we conducted a survey with customers who spend contracted since the price changes took effect. The results of our survey were and likely more than half of those surveyed cited needing fewer resources as the main driver of their decreased spin.
<unk>, suggesting that our customers demand environment is reduced which is not surprising given the global backdrop.
In addition, less than a quarter of survey respondents cited digital oceans increased price as the reason for their spend reduction.
This gives us confidence that the value proposition of our offering endures and we will have an ongoing benefit through the subsequent quarters.
Another initiative was in the area of go to market with long shared that a central component of our strategy has been to enhance our distribution capabilities to extend our customer reach and expand our serviceable market.
Cloud ways accomplishes these objectives and helps us accelerate our revenue growth in.
In the two months since we've acquired cloud ways. We've been pleased to see that their leadership team and business processes are even stronger than we expected and importantly, a key strategic benefits from the acquisition will be our ability to leverage the customer intimacy that cloud wages nurtured for years to help us get closer to our sizes.
<unk> customer base in order to improve our service offering and capabilities and prioritizing our product roadmap.
And finally, we've continued to increase our investment in the digital Ocean go to market team. So we can focus on our largest customers during the quarter. The contribution from this group continued to beat plan and we will continue to be a focus area. In the years ahead. All told these initiatives contributed more than $17 million to our top line.
Q3, and sets of sets us up well for continued strong revenue performance in the year ahead.
Despite several material headwinds that we've discussed we delivered 37% revenue growth for Q3 and will deliver 30% plus revenue growth for this year and 2023 as well I will address our guidance in a bit more detail in a few in a few moments now.
Now that we've talked about our top line and I'd like to move to profit and loss beginning with gross margin.
As many of you know we will be adopting ASC 842, the accounting standard for leases in Q4, which applies to our colocation contracts that contain both data center cage and power components.
ASC 842, resulting companies straight lining lease obligations over the respective lease terms for both these components in anticipation of the full adoption of this standard we adjusted the straight line treatment for the cage component during Q3.
This negatively impacted gross margin by roughly 1% in the quarter.
As our datacenter agreements are frequently multiyear arrangements, where the payments increase over the term.
In Q4, the impact of adopting the new standard will straight line, both our cage and power cost and will result in a onetime charge of roughly $7 million. This is a noncash charge that will not impact our free cash flow, but will put pressure on margins. In Q4. However, we have taken numerous steps to limit.
Our overall operating expense growth during the quarter. So even with this adjustment we will still deliver a further improvement in our overall <unk> for the year more on that in our guidance discussion.
And just noted this accounting standard does not change our free cash flow expectations, and we remain on track and committed to delivering free cash flow margins of 20% in 2024.
In addition to the new accounting standard we expect data center power pricing to increase as of January one, particularly in Europe .
Been in discussions with our vendors and have factored this impact into our planning process for 2023, we're confident that we can manage price increases from power against our portfolio of other colleagues spend where we are driving efficiency, including but not limited to better pricing on non power aspect of our data center vendor.
<unk> chips and for next year, we expect to generate gross margins of 65% or better even with the noncash impact of the lease accounting standard treatment.
Next I'll turn to operating margin, which was very strong in Q3, as we delivered $40 million of non-GAAP operating income representing a 26% margin on a consolidated basis, we significantly exceeded the high end of our outlook by 800 basis points driven principally by compensation.
During Q3, there was a onetime bonus accrual reversal that contributed 600 basis points to this pete but even adjusting for that our margin was 20% 200 basis points above the outlook we provided in August .
This bonus reversal reflects our current expectation for 2022 relative revenue relative to the original internal plan.
The additional outperformance for profitability resulted from our continuing discipline to prioritize hiring against the key initiatives that either generate revenue or improve efficiency in the near term and at the same time limiting limiting spending growth overall to only those elements needed to meet our operating goals.
<unk> were maintaining lower spend levels on longer term products projects that we can then dedicate incremental resources too as they become available.
Next I wanted to share some of the drivers of our very strong free cash flow that we delivered in the quarter, which was $22 million and represented 15% of revenue.
The improvement in cash flow was driven by the substantial improvement in non-GAAP operating income and adjusted EBITDA, which reached 42% in the quarter and helped by better working capital performance from our prior plan as payments came in lower than expected either due to negotiated reductions with different payment timing.
Several payments are scheduled for Q4 and are fully reflected in our Q4 forecast I do want to reiterate that the new accounting standard will have no impact to our free cash flow targets and similar to operating income we will be increasing our target for 2022.
Which brings me to our financial outlook.
For the quarter, we expect revenue to be in the range of $160 million to $162 million, which.
<unk>, 35% growth at the midpoint.
We expect fourth quarter non-GAAP operating margins to be 16%, which is below Q3 levels principally due to the onetime charge of approximately $7 million for the adoption of the new leasing standard in higher compensation levels.
For the full year, we expect revenue to be in the range of $573 million to $575 million.
Which at the midpoint represents 34% growth. This range includes approximately $16 million of net revenue contribution cloud ways for 2022.
From a profitability standpoint, once again, we are increasing our expectations and are targeting full year non-GAAP operating margins to be 17%.
And finally, we are increasing our 2022 free cash flow outlook as a percentage of revenue to between 10, and 11%, which is the second consecutive 50 basis point increase from our previous call at the midpoint.
With regard to 2023, we expect to grow at least 30% over reported 2022 revenue targeting $746 million in total revenue based upon the midpoint of our guidance range as we will benefit from product enhancements pricing strategy cloud ways and our expanding go to market effort.
We expect all of these to yield results even in the face of the broader macro uncertainties.
That concludes our remarks and now let's turn to Q&A.
Thank you at this time I would like to remind everyone in order to ask a question Chris Star one on your telephone keypad, we'll pause for just a moment compile the Q&A roster.
Your first question comes from Raimo <unk> from Barclays. Please go ahead.
Thank you congrats.
Congrats that's really good quarter in this environment.
Just.
Two quick questions one is.
If you think about the behavior, you're seeing from clients and the macro downturn you saw at <unk>.
They were kind of putting less workloads on they were looking to optimize their cloud spending.
And because they had committed to over committed that seems like less of a problem for you like what are you seeing there in terms of behavior.
Coming out there and then I had one follow up.
Yes, so what we're seeing.
And when we engage with customers and the conversations I've had the feedback from our support our broader teams that engage with customers.
They are very happy with our service I think bill referenced the survey we did just to check in with customers a few months ago to learn more about contraction our customers are simply seeing a weaker operating environment and a number of them Express.
Appreciation to us for this fact that we have this consumption based model because it allows them to adjust without calling us up and trying to renegotiate et cetera. So what we're seeing is just a reflection of what they're seeing.
And not a them trying to shift things around it et cetera. So.
None of US are happy with the World we're living in today for <unk> reasons.
But I think our engagement with our customers and.
Where our customer sentiment the positive sentiment they've had with us.
Has continued throughout this year and frankly, even despite the pricing increase the number of comments you've had from customers.
Understand they get it they still see lots of value and.
And we continue to work with them helped.
Help them through this but we feel very good about the relationship we have and are building with our customers in this environment.
Hey, yes, it makes it a lot of sense and then the.
The second question was more on cloud ways and now that you own the asset like how would you think about it more in the long run because it does offer a much much deeper relationships in the <unk>.
We see much broader in terms of offering Blake.
And that perspective, there's almost like a questions like how do you see digital ocean in the long run as a vendor in terms of ies versus being a much broader provider for the SMB have you kind of started thinking about that already.
Well, we think a lot about that and what we.
The comment in the script was.
We are more bullish today than when we signed the contract or when we first approached them earlier this year about this combination.
We're still learning as we dissect.
The opportunities between the combined companies, but one thing is pretty clear there's a ton of synergies in this transaction both in terms of us better matching customers stay one.
To a managed service we have I won't quantify it here, but we've had a decent amount of churn in our first 60 90 days for customers, who come to digital Ocean. We've got millions of people coming every month they re tutorials.
Line up for an account and then they leave us in the first 60 to 90 days and a lot of them say, we were hoping for more more of a managed experiences we like digital ocean, but it's just not for us and obviously, we've closed that gap here similarly from their side and we've already seen its early so we won't give a lot of stats hopefully over the next call we'll give more.
But theres such a.
The opportunity I think to give the market a more integrated view and.
That's why we're planning to integrate much more in terms of our go to market.
Just a lot of opportunity here and as it relates to what digital ocean represents versus the broader market.
Sort through that but it's really about giving customers and what we're learning is a lot of smbs.
Don't want to manage infrastructure, they love the cloud because of the pricing and flexibility, but they actually just don't they don't have the desire.
And Thats not how we were operating pre the deal and I think when you start to think about <unk> the price uplift for someone using six dollar droplet.
Good ways versus what they pay us because of the more managed experience there is a lot of upside opportunity.
For us when you look at our broader customer cohort.
Yes, it sounds exciting thank you.
Your next question comes from Gabriela Borges from Goldman Sachs. Please go ahead.
Hi, good afternoon, Thanks for taking my question.
Can see on this.
Sure Optionality that you talked about in the prepared remarks.
Do you think about your customers and what that was.
Looking for in order to get that strong revenue doubling essentially as a percentage of sales what do you think needs to be better from that standpoint.
Standpoint in terms of functionality.
I think when we look at the breadth of our customers and they are truly is a cutover. What somebody is sub 50, and then they get to 200 301100, <unk>, there's a pretty broad diversity and so what we'll be looking to add capability is to support the growth of scale of larger customers.
Who who's on use of objects and blocked depending upon the industry type of the use case.
In terms of more speed of performance.
Their features et cetera, we have a very clear roadmap on this frankly cloud ways opening cloud ways, having them in the mix is very clarified given they serve the SMB market.
<unk> will help us with product roadmap, but we have a very clear area. We've been investing in this area haven't been talking about it much over the last call it six quarters, or so and have been improving and adding to the capabilities, but we're going to look to really focus our efforts in the near term in this area because of the unlocking.
So substantial when you look at the multi product adoption and also just the.
Doubling the revenue as a proportion of mix. So it's really features.
Functionality and performance to span a broader array of customers than than what.
The capability is today.
That's helpful and as a follow up if I may on the E Commerce medical in particular, we've seen trends there a little bit different Shanker, then where end market presidents talk about E. Commerce normalizing back to trend line curious when you look at the cloud Lane fitness and then you're a broadest set of e-commerce customers.
Would you describe the trend there or is it still deteriorating do you feel like it's stable is there a path that may be accelerating.
A little bit on the E Commerce medical specifically thank you.
Well given the high leverage so wordpress at cloud ways. It's a good proxy for your question, what I would say, we've seen with cloud ways throughout this year.
Is.
They have been impacted but not to the same degree that we have.
In terms of their growth rate.
Yes.
Is lower than what.
They would have expected coming into this year I don't know that there is anyone in the world. If that's not the case, but theyre much closer meaningfully closer to their plan then.
Coming into the year than today than what they would have expected.
First as us so I do think.
To some of the trends youre seeing in other areas of E Commerce.
Very resilient.
As it relates to and their new customer ads also very strong as well so.
I think that aspect again.
In an environment, where you have to devote resources to do it yourself, even though you may have a higher uplift there.
Given the fact that you don't have you can devote your other resources to your core activities.
Yes.
We're learning more and more about that being a value so.
I think that sort of speaks to the question.
Thank you.
Your next question comes from Jonathan borrow from J P. Morgan. Please go ahead.
Oh, great Hey, thanks for taking the questions.
Wanted to continue its solid ways I guess Owen.
Can I ask you.
What are you hearing from customers, who are using a competitive solution in terms of the likelihood of moving over are you having those discussions and are you are you.
What are you thinking in terms of pricing I guess on cloud wins versus the increase that you did for digital ocean.
Well cloud ways as a managed hoster uses other providers, we haven't seen a change in the conversations are customers wanting to switch one are there any other we haven't adjusted our prices.
Since our announcement on sideways and we will continue to evaluate opportunities. There. We're really focused now on how do we direct customers who come into our funnel.
Give them an option minute one.
In terms of whether they want to have a more do it yourself legacy deal versus a cloud ways.
But haven't seen any change in traction any change in the conversation customer.
Customers with us.
There's been no real change even during the course of this year on us versus someone else in the pricing.
Other issues I think the conversations with our customers are very healthy around how do we help them manage through this environment.
In terms of best practices other other areas that we can help them operate better.
As I mentioned earlier and this is really important given.
Some of the uncertainty our churn levels remain consistent throughout this year, and frankly, where they've been.
Since.
Early last year, and I think thats very comforting.
Because when things do turn they are here and the consumption pricing model, although it's a headwind in the near term.
There will be a tailwind as they resumed growth.
Yes understood one question for Bill on the <unk>.
IRR the sequential growth of $97 million I think you gave us an idea of cloud wins, which is about $4 million. We can we can try to annualize and look at any IRR number I guess.
You gave us a little bit of an idea about the pricing of $13 million I wanted to ask you what how should we think about the headwinds on that number at about $97 million sequentially, how should we think about the headwinds.
While the $97 million has been.
Accelerated by the contribution of cloud wins, but it still was a massive quarter for us in terms of <unk>.
Picked up quarter over quarter so.
The combination of cloud weighs into that number along with the benefit of.
The additions from the price increase gave us a pretty strong uplift.
Going forward the headwind calculation frictionless is anyone's guess at this point I mean, we certainly are.
Mindful and watching every month in terms of what we're seeing I don't think we're necessarily out of the woods. We still are encouraged by the uptake that we're getting particularly in the bigger customers.
What we're seeing the areas are greater than 50, and even our greater than 250 customers are still showing resilience.
But it's hard to basically estimate what we think the impact would be going forward.
I think we still think we are still addressing 30% plus growth we have a number of levers to get there and we hope that the economic headwinds will turn to tailwind that will give us further acceleration relative to the seeds we planted.
In terms of cloud ways with its managed service, providing and also what we're doing here in terms of the customer enablement.
And our go to go to market initiatives through sales so.
We continue to be cautious, which I think.
<unk>, followed us over the past three quarters thats been the tone of our calls.
So we'll have to see what happens, but the multiple levers gives us confidence is still point towards 30% plus growth.
Okay. Thank you.
Your next question comes from James Breen from William Blair. Please go ahead.
Thanks for taking the question can you talk a little bit about the impossible pricing keeps them hard and did it did mainly come within this quarter or is there a sort of a tail to that as we move over the next couple of quarters and then the <unk>.
Just on the cost side.
I understand that margins will tick down in the fourth quarter.
How do you sort of see that moving from there.
We will stay sort of at this lower level for a while we see a rapid improvement. Thanks.
No we're continuing to to basically focus on expense improvements one of the things <unk> said in our year end result, we may not be able to control revenue in this environment, but we certainly can control spend and the trajectory, we see going forward will be increasing profitability next year and improving cash flow.
We're still on target.
For 2020 for targeting 20% free cash flow as we move forward.
Expenses will be the the key part here that we can continue to control and we do see room for upside and greater efficiency, particularly as we target our initiatives against the bigger customers and we're able to monitor payback. So if we're not getting payback, we certainly can pivot as needed and Jim Im sorry.
The first part of the question was revenue related.
Just on the price increases that you put in place in July .
Is there a long tail to that all the customers immediately go to the higher price point or are there. Some that are gradually moving to the higher price points over the over a couple of quarters.
Well not over a couple of quarters, we did provide discounts to some of our larger customers, which are basically starting to mature during this quarter, but we do anticipate that the net pricing will continue to impact the next two or three quarters before we get to the anniversary of the price increase we do think that will be.
An important accelerated relative to our growth and helped offset the impact of the economic headwinds.
Great. Thanks.
Your next question comes from Tim Horan from Oki CEO . Please go ahead.
Thanks, guys. Just two questions do you think the free cash flow improvement from 10% to 20% is that relatively linear I guess, how should we be expecting like 15% next year or is it more backend loaded.
And then secondly on the price increases by your peers.
Was it both hyperscale as well as small providers like yourself or is it weighted more towards the other end, what's the magnitude or do you think the magnitude is that youre seeing now in line with what you did thank you.
Yes, so on the last question.
All the Hyperscale is of race pricing. This year I was not referring to them I was referring to folks who are competing in the SMB segment of the cloud and I would say their pricing.
<unk> were similar.
And again were announced after us.
After our may announcement.
So.
I think the competitive positioning in the market is neutral to positive which is also going to be a tailwind as the market flips.
In terms of the uncertainty.
As for free cash flow.
Whether it's linear or not youre going to see significant leverage next year from this year's full year.
As a result.
We're going to get to 20% or better in 2024, which is only 14 months away and so we can control a lot of that and we've taken up expectations. This year. Despite massive headwinds in terms of top line.
And if you think about three years ago being negative 25%.
Free cash flow margin.
And we flipped at 3500 basis points in less than 36 months.
And so.
Rest assured.
We will be hitting 20% or better free cash flow when the when the calendar flips to 2024.
Thank you.
Your next question comes from Pat Walraven from JMP Securities. Please go ahead.
Oh, great. Thank you and congratulations you guys on the way you're managing SaaS business, Hey, Bill can we talk a little bit about the convert so it comes due at the end of 'twenty, six 1 billion and a half.
Conversion price is $1 79.
Are you just going to generate enough cash to close the gap would you refinance it how do you think about it.
Well I think we have a number of opportunities Pat.
In terms of where we see ourselves being out there.
Talked about as a $1 billion by 2024, we certainly look to continue that trend from there at that 30% type of growth rate and a continued improvement in overall margin, which the mantra for us is free cash flow improvement.
DMT is challenging us to 20% plus as we move forward that's not a number were putting out officially anywhere because we have work to do there, but when you look out two to three years from here on our trajectory and relative to the financial model. We think we're going to be eminently re financeable.
<unk> also came down portions of that conferred or.
Potentially looking at repurchasing portions of those notes over time as things become more clear from a macro perspective. So when we got here we were faced with limited capital availability, we manage to increase.
Bank loans Fortuitously, we're able to manage our way through that and then reduce that debt. We've used the public markets for both equity and debt. So we think we'll have a lot of levers relative to our business two to three years from now and if you look at the majority of these converged most of them are basically addressed.
18 months to 24 months before maturity.
So we'll keep looking at our options, but we feel very comfortable that we will have a number of them over the next several years.
That's great. Thank you and then you answered can I ask you it seems like in software.
Where a lot of the acquisitions fell apart during the pandemic was just.
It turns out you can't really retain talent over zoom what are you doing to make sure that you keep the way's team.
Well frankly, our attrition employee attrition has come down since the pandemic. So.
We've leaned into remote tours of engaging with our team.
<unk>, our employee attrition is actually lower.
Pleased that in the first few months since the announcement of cloud ways. Their retention has been very strong.
And we're very highly engaged with them they have critical roles in driving our business. There is a lot as I mentioned earlier theres a lot of synergies.
Here, which gives it from both sides and so.
So there's a lot of collaboration a lot of engagement.
Folks on the ground visiting with them.
And so this isn't a we bought something its in the back corner acquisition. This.
We're focused on deeply integrating the two companies we also share.
A similar vision.
That's not an exact a similar vision for the SMB opportunity, we share a vision for the heart of the value proposition around serving Smbs is simplicity.
And so.
Like I said, we're very bullish and we're taking a very tight pulse to make sure. We're doing a good job of integrating we've taken feedback and adjusting where we need to so.
Obviously, we're buying.
An acquisition in this in this industry as you suggest is about the people and we're prioritizing in accordance with that.
Great. Thank you.
Your next question comes from James Fish from Piper Sandler. Please go ahead.
Okay.
Hey, guys wanted to go back to actually get realized question more on the go to marketing side rather than the product.
What point does it actually start to make sense to bundle more of the compute and storage products together rather than try to sell them individually.
Is it possible that you guys could give us an update on the NR for just large.
Greater than $50 a month cohort I think it was.
113 last quarter.
I'll address the first question Bill can address the second one.
Mentioned.
One of the levers that we will evolve going forward.
What we've done really in the first couple of years here.
We're not done on pricing and packaging.
We're going to learn and we are learning a ton.
Customer behavior in response to the pricing changes, we made a few months ago.
And we're going to take those learnings plus other things that we're looking at.
But the concept of packaging I.
I think all too often in the tech world. They think of product management is just technology products reality is there's four piece of that and product packaging.
<unk> is a critical aspect of that so we see a lot of opportunity.
And so.
I want to make sure people look at the actions. We took earlier this year is a one off.
There is more opportunity and frankly, our customers would prefer I think for us to simplify the options for them.
And offer them packages versus having them take Ala Carte Ala carte and that sort of speaks to this despite vacation as customers grow as theyre running businesses.
An aspect of simplicity, we will be pricing and packaging and so we see opportunity so more on that to come but.
The premise of your question is absolutely we see opportunity there.
And on the MTR greater than 50% $50 we've seen.
A nice pop back up as we expected we would as a result of the pricing improvements.
And we're continuing to see that group hold in there it is.
Interesting to us that as you move up the spectrum.
To higher dollar value customers, we are seeing.
Better <unk>, we're seeing faster growth rate and this speaks to we believe the opportunity for the bigger customers, who present to a foundational opportunity for us to accelerate growth from here once we get a little bit of benefit on the tailwind or the headwinds rather but it also speaks to the sticky.
This is a product.
We are being used for a lot of these businesses to drive the foundations of their their businesses and what they do regardless of whether they are SaaS providers or digital agencies or mom and pop retail shops. So we're encouraged by what we're seeing there in terms of that.
Them holding up and part of our go to market initiatives are all around <unk>.
Driving the MBR that group, even higher Nancy mentioned earlier that when we see our teams interacting with our customers. We're looking at our <unk> that are multiples of where we are today. They are accelerating the growth of those cohorts. So we think thats the opportunity to be interacting more with these customers and <unk>.
Again, not to beat the same drum, but cloud ways in how they interact with their customers provides a lot of learning for us. So a lot of opportunity for us across the board self serve has been tremendous for us, but when you get over 500 million Bucks.
Got to start looking at other ways to drive revenue growth. If you want a three handle on it and Thats what were doing.
Thanks, guys.
And our last question for today comes from the line of Glenn.
<unk> Mohan from Bank of America. Please go ahead.
Yes. Thank you sorry, I was jumping between calls so apologize if you already answered this but can you talk about.
What you saw in terms of linearity of demand in the quarter and any difference that you can maybe highlight across the various cohorts of spending and perhaps touch on how that trajectory might have changed or not in October versus the prior few months and I will follow up.
Obviously, we did if prices went up and jet July one.
And so I would say is we saw some.
Some noise in July and August tied to that September started to normalize as did October .
So.
We feel pretty good about the trajectory half coming into.
Q4.
Okay, Thanks for that and.
Just to clarify I'm not sure if you quantified.
What is the impact of cloud weighs in your at least 30% guide in fiscal 'twenty, three and Bill. If you could just maybe also address what is the impact from energy costs on your gross margin that you anticipate looking into 2023. Thank you so much.
So the second one one stay tuned we will come back quantifying that we do have a range we have factored that in which is how we're driving our assumptions around 65% growth.
In terms of in terms of where we're going.
We think that that.
That's something that we're going to have to manage through a lot of people are going to be impacted by that but but we think thats going to be.
This is something that we can manage and as part of our overall efficiencies.
The first part of your question was with Nexgen cloud ways next year. So this year, we've talked to around $15 million to $16 million of contribution for cloud ways cloud ways CAGR over the past few years has been in the 40% to 50% range been growing very very quickly obviously it's office.
Smaller base.
But again the management team there are dialogues with them they understand their end markets very very well they understand the verticals that they are selling into them. They understand how they are managing their offering delivers against the requirements for those verticals. So we hope with those learnings.
They can help accelerate our growth as well, but they have been growing very very nicely over the past three years. They certainly are feeling a bit of the headwinds that everyone is feeling.
But they are continuing to power through those.
And as we get into next year, we'll be really talking about all of this in a consolidated way, but we're very very optimistic and bullish bullish about what they can bring.
Not only are rapidly increasing their base, but helping us monetize our 600000 customers even more.
Thank you.
This is all the time that we have for today I will turn the call back over to the presenters for closing remarks.
Just wanted to thank everybody for joining us today.
We're grateful for your support.
Especially in these tough times, our goal is to be as transparent and communicative with you as we can.
We look forward to speaking with you in the coming days or weeks to months.
And of course of the years ahead.
Have a great evening.
And this concludes today's conference call you may now disconnect.
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