Q2 2023 DigitalOcean Holdings Inc Earnings Call
Hello, and thank you for standing by my name is Regina and I will be your conference operator today at this time I would like to welcome everyone to the digital Ocean second quarter 'twenty twenty-three earnings conference call. All lines have been placed on mute to prevent any background noise.
After the Speakers' remarks, there will be a question and answer session. If you'd like to ask a question. During this time simply press Star then the number one on your telephone keypad to withdraw your question Press Star One again I would now like to turn the conference over to Rob Bradley Vice President of Investor Relations. Please go ahead.
Thank you Regina and welcome everybody to digital Ocean second quarter 2023 earnings call. Joining me today is yes, he sproule, our chief Executive Officer, and Matt <unk>, Our Chief Financial Officer before we begin I would like to cover our safe Harbor statement during.
During this conference call, we will be making forward looking statements, including our financial outlook for the third 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.
Finally, we will be discussing non-GAAP financial measures on our call today.
Reconciliations between our non-GAAP and GAAP financial results can be found in our earnings press release, which was issued earlier this afternoon and the investor presentation on our IR website.
With that let me turn the call over to our CEO Yancey Spruill Nancy.
Thanks, Rob Good afternoon, and thank you for joining us today.
I'm pleased to share the results of another strong quarter for digital Ocean.
As discussed throughout this year.
We made it a priority to position the company in 2023 to generate significantly higher free cash flow margins to create a durable platform that generates compelling shareholder returns regardless of the challenges of the macro growth environment.
We have also been focused on leveraging our balance sheet to accelerate our business with the acquisition of paper space.
Which positions us with immediate offerings in the rapidly growing market for artificial intelligence and machine learning application development.
In Q2, we delivered a quarter with an attractive combination of growth and profitability.
Revenue grew a solid 27% year over year.
We delivered strong adjusted EBITDA margins of 43%.
Levered healthy free cash flow margins of 27%.
On the strength of progress we are making in transforming our cost structure.
From a topline growth perspective, we continue to see slower growth in the core digital Ocean cloud business.
We saw growth moderated across a diversified customer base with all regions and most industry verticals seeing slower growth.
Which points to the broad weakness, but the technology market space during the quarter.
We expect these ongoing headwinds to put further pressure on our second half growth.
Although we saw positive signs of stabilization across churn and contraction.
Both of which have been stable during Q2.
The third piece of the cohort performance puzzle that less stabilized as expansion.
Which continued to moderate in Q2, although at a decelerating pace.
Until we see stability in all three metrics, we can only say that we are bottoming, but not had that have not yet reached a bottom for growth deceleration.
With respect to churn it has been stable in the low double digits about where it was before the broader slowdown occur which is a positive indicator of the strength of our value proposition.
Contraction also stabilized in the second quarter.
Potentially indicating that optimizations are moving behind us, although it remains several hundred basis points higher than when the slowdown began.
This reflects a change in our customers' practices.
They have been much more disciplined about managing their cloud usage that trend that we expect may be with us for a while.
As for expansion, we have been pleased to see the sequential deceleration of the declines.
As we move through this year.
And speaking with our customers they remain optimistic.
Even though they are growing more slowly than they were previously they are still growing.
This provides us with optimism that although we have not bottoms we.
We are certainly in the process of bottom.
Our lowered revenue outlook.
Alex today reflects our expectation that the bottoming process continues in the second half.
We continue to deliver on the transformation of our cost structure, which we announced in Q1.
There are several components to this transformation, including prudently managing our third party spend.
Leveraging our strong procurement capabilities.
Operating our capital infrastructure more efficiently and shifting our talent mix to be more global.
We made significant process progress in the quarter driving towards our longer term target free cash flow margins.
Doing so provides us the flexibility to invest both organically and inorganically to accelerate future growth.
We have taken advantage of this flexibility by investing on both the organic and inorganic growth.
Internal investment is focused on expanding our capabilities to better meet the needs of our customers as they grow their own businesses and expand on our platform graduating from learners to builders to scalar.
Previously launched product capabilities, such as the premium optimized droplets, which are tailored to specific bandwidth intensive use cases enabled us to increase our fluid share role, while the expansion of our footprint such physical footprint such as the new Sydney datacenter enabled us to do more to more effectively.
We serve the global market opportunity.
Other investments such as evolving the customer onboarding process are enabling us to better identify our higher growth potential customers early.
And give them the support they need to accelerate their use of our cloud services as.
As well as better match them from a product perspective early in their lifecycle, which yields higher ARPA.
A good example of this is identified candidates for our managed hosting solutions through cloud growth instead of them self serving directly onto the digital ocean platform with the mismatch of their needs leading to under optimizations of their experience.
The newer capabilities that we've introduced over the past 10 months are growing significantly faster than is our overall company.
We expect these offerings and the other capabilities that are second half roadmap, such as enhancements to our storage capabilities.
To be more material drivers of our future growth.
We also continue to invest to build out direct sales and partner channels to augment our proven self serve go to market motion.
While it is early innings and the establishment of these new channels and they are not yet material contributors to growth.
We continue to see them as an important growth levers next year and beyond.
Okay.
On the inorganic investment front, we are very happy with the results. We are realizing from the strategic acquisitions that we have made to date.
But we are incredibly excited about the acquisition, we recently announced.
The cloud based managed hosting business continues to be a very strong addition to our platform with performance that exceeds our initial expectations.
We have seen net new cloud waist customers grow rapidly since the time of acquisition.
Benefiting from both our cross selling activities and the strength of our highly efficient self serve model.
<unk> revenue, which grew 45% year over year in Q2 continues to be a strong contributor to overall growth company growth aided by our focus on top of funnel and customer acquisition enhancements and is becoming a larger percentage of our revenue mix and therefore, an increasingly more meaningful contributor to drive.
A higher overall company growth rate in 2024 and beyond.
Which brings me to the exciting announcement that we made about a month ago that we acquired paper space for $111 million.
We couldnt be more excited about this highly strategic and synergistic acquisition and the dynamic and explosively growing AI ml market who's impacted opportunities protected to transfer to be transformative to how the technology sector is driving the global economy.
We are very focused on building an AI platform that enables developers and smbs to leverage the power of these technologies to build and run applications.
While maintaining our differentiation of simplicity in how we deliver these capabilities.
Paper space has tremendous potential.
We have been very familiar with the team having track them carefully over the years as they have built their business.
The addition of paper space to the digital Ocean platform makes tremendous sense on three key dimensions.
First digital Ocean, a paper space are philosophically aligned both in this segment of the market that we target and how we differentiate ourselves versus the larger enterprise focused providers.
We're both focused on enabling smaller companies from individual developers to startups to emerging growth SMB customers to leverage technology to grow their businesses. We both wind customers in this segment of the market by providing simpler more cost effective solutions that can be leveraged on a consumption basis without the constraints of long term.
<unk> with a higher level of support than these customers get from the larger providers.
We expect AI will be a force multiplier for small and medium sized businesses just as the advent of cloud computing and.
Eliminated many of the barriers to entry for developers and startups to create a digital business, allowing anyone in any geography to start a business. We believe that AI ml will provide a similar accelerant to new SMB creation and their subsequent growth as it will enable them to scale more efficiently to create new and innovative solutions.
And to compete in novel and dynamic ways.
Paper spaces MLR software layer allows smbs to execute AI ml use cases simply rather than just providing access to physical gpus on demand.
This simplicity strategy fits very well with digital <unk> key differentiators.
Differentiators with paper space, we will be able to provide multiple products for AI and ml use cases, including compute storage and databases, allowing these customers to scale and digital oceans integrated platform.
The second dimension of that.
Of importance as there are substantial synergies between digital issued a paper space that will accelerate both of our growth rates.
Paper space serves the fast growing segment of the market that brings together the combination of AI platforms, and accelerated compute which allows customers to build and maintain AI applications, while providing the computational capacity required to do this at scale.
Together IDC estimates that the compound growth of the SMB portion of this market will be 36% over the next three years.
<unk> paper space has established itself as a leading player serving this market with a proven differentiated GPU based AI ml product that serves over 12000 paying customers today, despite having invested very little in marketing our go to market.
We will accelerate paper space growth by leveraging digital options more scale marketing and global go to market motions.
We increased the top of funnel and drive new customers, who pay per spacing business.
There is also a significant cross selling opportunities sell paper space capabilities to digital oceans, 616000, plus learners builders and scalar.
Many of whom are already evaluating.
AI ml can be leveraged to accelerate their businesses.
In addition, AI use cases, clearly drive increased compute requirements. The paper space had no capability to capture those additional production workloads requiring customers to leverage other cloud platforms.
And buying platform of AI ml software at high performance in GPU based compute will enable us to capture more paper space as current and future customers broader infrastructure needs for database as a service.
Networking spaces and <unk>.
Driving higher <unk>, and creating more stickiness and loyalty and digital Ocean platform.
The third dimension that has us. So excited is how cleanly it will integrate with our platform and helps dramatically accelerates our time to bring this capability to market.
With paper space, we immediately have a proven AI ml offering that has demonstrated clear product market fit and it comes with a team with valuable experience operating in this dynamic market.
The talented and entrepreneurial paper sales team adds more than three dozen employees to the digital ocean team and brings significant experience, providing AI solutions to thousands of SMB customers.
Also as an active and important player in the ecosystem that is not tied up with the hyperscale <unk> that have plans to build their own chips.
Per space on its own has strong industry relationships, such as having a lead status with Nvidia. These.
These critical industry relationships will only be strengthened when combined with the larger scale relationships that digital ocean has with other players in the market.
We are already leveraging these combined relationships to ramp up paper spaces investments in GPU capacity.
Clearly we are very excited about the possibilities that paper space brings to us and you should expect to hear more from us on this potential over the coming quarters.
While Matt will walk you through the financial implications of the paper space deal on our overall business later in our discussion I can say unequivocally that after owning paper space for just a few short weeks the potential is far greater than what than we had expected.
We acquired a triple digit growing business that we feel confident we can accelerate from here.
As such we expect paper space to contribute at least three percentage points towards our total growth rate next year.
We are excited to be on a path to deliver truly differentiated set of capabilities with an aspiration to be the AI cloud for Smbs.
With our acquisition of paper space and aggressive entry into the AI ml market.
Many of you are likely interested and the implications on our projected cash flow margins and our current capital allocation strategy.
While Matt will cover the specific projects in his commentary I'd like to share my thoughts on how we view the economic impact on our business at a strategic level and how this translates our go forward capital allocation framework.
We have demonstrated a clear focus on driving attractive returns on invested capital since going public.
With that as our guiding principle over the past two years, we have repurchased more than 27 million shares.
The $1 3 billion.
And lowered our fully diluted shares outstanding well in excess of the shares granted to employees over this same timeframe.
When combined with a <unk> increase in free cash flow since 2021, our first fiscal year as a public company due.
Through these actions, we have increased free cash flow per share by more than 590%.
As another part of this capital allocation strategy.
We have invested nearly $500 million on content technology and capability acquisitions, which have bolstered customer acquisitions, driven <unk> growth and meaningfully increased our addressable market.
Although we continue to evaluate M&A any M&A opportunities that are consistent with our goals of enhancing our market position and drive profitable growth in the near term, we're prioritizing the integration investments in cloud weighs in paper space.
Both of which are growing substantially faster than the core digital ocean business.
Our commitment to driving attractive shareholder returns under any market conditions and to delivering our long term free cash flow margins required to do so does not change as a result of our entry into the AML market with paper States are.
Our growing free cash flow margin in the $551 million on the balance sheet afford us the flexibility to both invest appropriately in this exciting new market and at the same time maintain focus on delivering profitable growth across our entire business and delivering capital return to our investors.
We have consistently said that investing in organic and inorganic growth as our first priority use for capital and that remains true.
Given the significant opportunity we are looking at with key growth levers, we may moderate the magnitude of buybacks from 2023 levels. However, we will remain committed to managing the portfolio of balanced growth and capital return.
Share repurchases going forward.
I'll close by saying we have made good progress through the first half of 2023.
We have dramatically improved our financial profile by driving greater efficiency in our core business, while maintaining the flexibility to aggressively invest in several attractive growth opportunities.
We will invest in two of our fastest growing segments in cloud weighs in pay per space, while we continue to target investments in the highest revenue potential opportunities.
<unk> optimized profitability as we work to return to higher growth in our core business.
We continue to see a material opportunity in an expanding addressable market and the growing $100, a $100 billion plus market.
For SMB cloud infrastructure.
And are increasingly well positioned to capture our fair share.
Now over to Matt to provide details on our financial results and our outlook for Q3 and for the balance of this year.
Thanks Nancy.
Good afternoon, and thank you for joining us today to discuss another solid quarter that highlighted the material progress we've made towards achieving our long term profitability targets.
Delivering solid revenue growth in the quarter, while meaningfully improving our margins.
We continue to deliver durable and attractive free cash flow growth, regardless of the macro growth environment.
In my commentary today, I will review, our second quarter financial results.
Provide additional insight into paper spaces anticipated impact on our financials and share our updated financial outlook for both Q3 and for the full year.
Before I begin that commentary I'd like to provide some context on the material weakness and the tax expense are described in the 8-K, we filed earlier today.
Over the past several months, we have made meaningful upgrades to our tax capabilities and expertise.
With new tax leadership recently in place and with the support of incremental third party tax advisors, we identified an error in our tax expense calculation related to the treatment of R&D expense in the context of section 174.
The error had an immaterial impact on our full year 2022 financials, but did have a material impact on our reported Q1 2023 financials and rose to the level of a material weakness in both periods.
The correction of the roughly $18 million overstatement of Q1 tax expense will result in lower net loss and higher non-GAAP earnings per share in Q1 of 2023.
And will result in a lower net operating loss balance as of December 31, 2022.
We are confident that our new tax leadership, the incremental internal and external resources, we have added.
And other changes we have made the finance organization will enable us to remediate this issue and to provide more confidence in our tax estimates going forward.
Turning to our Q2 performance revenue in Q2 was $169 8 million, which was 27% year over year growth and 3% growth sequentially over the first quarter of 2023.
Net dollar retention was 104% for the quarter.
And Dr declined 300 basis points from Q1 of 2023, which was a deceleration from the 500 basis point decline. We saw from Q4 of 2022 to Q1 of 2023.
And Dr has three main components.
Expansion contraction in churn.
As discussed in our last call churn has been stable since early in Q1 as customers remaining are remaining on our platform at near historic levels.
We have also seen a deceleration of contraction in the past three months, which is a positive signal that customers may be reaching the end of their optimization cycles.
With these two components either flat or decelerating, we're looking to see a similar flattening or deceleration of the slowdown in expansion before we will be able to conclude that we have reached the bottom of the macro growth headwinds.
On the customer graduation front, we saw continued growth in our higher spend customers as our builders and scalar is represented 86% of total revenue in Q2.
We added more than 3600 builders and scalar was in Q2 versus the approximately 2300, we added in Q1.
Bringing our total to more than 150000.
These customers are collectively growing revenue of 28% year over year, and our key driver overall of our which increased 14% year over year to $90.
The addition of eight persons with visibility to cross sell our new EMI AI ml capabilities into our builder and steel earnings gives us another further increased our pool going forward.
Profitability.
<unk> was very strong in Q2 as a result of our disciplined execution and the good progress we have made on our cost savings initiatives.
GAAP gross margin improved from 56% in Q1 to 60% in Q2 as we both grew into the co location and bandwidth capacity increases that we had made in late 2022 in early 2023, and we drove efficiency into our cost structure.
<unk> EBITDA was 43%, which was significantly above the 34% that we delivered in Q1.
This 900 basis point increase was driven by continued cost management.
A full quarter impact of the cost reductions, we announced in February and the structural impact of shifting more of our employee base to a global capability centers in India, Pakistan and Mexico.
Roughly two thirds of that margin increase was driven by people related cost savings with the remaining third driven by efficiencies in cost of goods sold and other expense reductions.
Free cash flow was very strong at $45 million, representing 27% of revenue.
This 1100 basis point sequential improvement from Q1 resulted from higher gross margin higher adjusted EBITDA margin and the continued discipline. We have shown on our capital investment program with capital expenditures remaining a 15% of revenue consistent with Q1 levels.
Given the approximately $18 million overstatement tax expense in Q1 of 2023 as I mentioned earlier on the call. We're still finalizing non-GAAP diluted net income per share for Q1, and Q2 2023, we.
We do however, anticipate that the correction will increase and our previously reported Q1 non-GAAP diluted net income per share and that looking forward Q2, 2023, non-GAAP diluted net income per share will be above our previously guided 40 to 41 per share.
Contributing to the anticipated growth in earnings per share for Q1 to Q2 was the repurchase of two 8 million shares in Q2 for a total of $103 million.
At an average price of $37 eight per share.
We ended Q2 with fully diluted shares outstanding of 105 million shares down from $120 million in Q2 of 2022.
On the operational front, we made substantial progress locking into $60 million run rate cost savings opportunity that we have disclosed in Q1 and based on our progress we expect to exceed our initial full year savings estimates, which will give us cushion in the face of ongoing top line pressure.
Our strong balance sheet and healthy profitability levels give us significant flexibility to invest to accelerate to faster growing segments of our business without materially impacting our ability to achieve our long term profitability targets.
Before providing our financial outlook for Q3, and the full year I will provide some additional financial details on the exciting paper space acquisition that we announced in early July .
As Nancy shared we believe that the AI ml market as a tremendous growth opportunity for digitalization.
Paper space is a great fit as it is very highly aligned with our existing targeted customer profile and the acquisition expands our total addressable market within the large and growing SMB cloud market.
Given digital oceans proven and efficient go to market model and sizeable customer base. We believe that we can accelerate paper spaces already 100% plus growth rate in that paper space will begin to contribute meaningfully to overall <unk> and Dr and topline revenue growth as early as 2024.
As previously disclosed paper space will have an immaterial impact on digital oceans revenue in 2023, contributing less than $5 million in the second half despite.
Despite the modest 2023 revenue impact we expect it to contribute at least three points of growth for overall digital Ocean in 2024 based on the known and growing demand in our funnel.
To facilitate this growth and to keep up with the rapidly increasing demand we have seen in the short time that we've owned them. We have already accelerated planned investment in paper spaces GPU capacity.
Turning towards our financial guidance for Q3 of 2023, we expect revenue to be in the range of $172 5 million to $174 million.
Which implies roughly 13% to 14% year over year growth for Q3.
<unk> for the third quarter will decline to the mid nineties as we lap the approximately 10% price increase that took effect in July of 2022.
On our current trajectory MTR will increase steadily over the back half of 2023 as we reached the one year anniversary of our cloud with the acquisition and cloud weighs higher growth begins to contribute within our MD archives.
For the third quarter, we expect adjusted EBITDA margins to be in the range of 38, 39%.
We estimate 105 to 106 million weighted average fully diluted shares will be outstanding at the end of Q3.
We will provide an estimate of Q3 non-GAAP diluted net income per share in the coming weeks. After we finalize our directions and file a revised financials.
Given the continued pressure we're seeing on net expansion, we are updating our full year 2023 revenue guidance to be between $680 million to $685 million.
This 3% to 5% reduction in our full year projection is driven by a weaker than anticipated outlook for cohort growth in the second half of 2023.
We've seen steady and durable performance on net new customers revenue from our self serve funnel cloud waste continues to grow faster than it was growing before we acquired and.
And we have made solid progress on the planned monetization efforts that were part of our original 2023 guidance, but as we look ahead. These contributions are not projected to offset the shortfalls, we expect from lower than anticipated growth in our program.
Despite the lower projected revenue and the additional costs, we're taking on from a paper space acquisition. We continue to expect adjusted EBITDA margins to be in the range of 38% to 39% for the full year, thanks to our strong execution driving operational efficiencies.
We estimate that our investment in paper space will have a $15 million to $20 million impact on free cash flow in 2023, excluding the roughly $4 6 million in one time integration expenses that will be excluded from our non-GAAP metrics.
Despite this investment we remain confident in delivering our previously guided 21% to 22% full year free cash flow margin as we leverage our improving core digital ocean margins to fund our paper space growth investments.
Despite an estimated 3% to four percentage point impact on longer term free cash flow margins from paper space and despite becoming a federal cash taxpayer in the U S. Beginning in 2023, we continue to target long term free cash flow margins in the mid to high <unk> as we see additional opportunities to drive incremental operating leverage in our <unk>.
Our business.
We estimate that we will have between $105 million to $107 million and weighted average fully diluted shares outstanding for the full year 2023.
As I indicated for Q3, we will provide an estimate for full year non-GAAP diluted net income per share in the coming weeks. After we finalize our calculations and file our revised financials.
That concludes our prepared remarks, and we will now open up the call to Q&A.
As a reminder to ask a question simply press star followed by the number one on your telephone keypad. Our first question will come from the line of Raimo <unk> with Barclays. Please go ahead.
Thank you.
<unk> hundred <unk>.
Yeah.
Obviously, it's a V.
The exciting one.
He is coming into.
It's a topic for everyone.
About your installed base.
And what clients are doing with them like what do you see as kind of uptick use cases.
People are kind of doing more work with that it is going to be like a very broad based adoption product or is this going to be some specialized guys tend to want to spend a lot with you and then I had one follow up on that please.
Well I think as.
We've said before we've been participating in the portion of AI, that's in the insurance aspect.
What paper space brings to us.
As.
Large language models and other sort of complex machine learning algorithms and applications that require.
Or utilizing GPU capacity versus the standard high performance compute.
What we've seen with our customers is that.
And really a rising tide of.
Inquiries over the last year.
Related to <unk>.
AI and our potential for investment in AI capabilities and so.
Again, we serve a long tail of use cases industry verticals et cetera, and so I think everybody.
Cross the F&B landscape at our customer base like everywhere else in the world is trying to figure out how to get most leverage where to get most leverage.
We're really excited that.
We now can bring this capability.
Consistent with our historical process and capabilities around simplicity.
And I can tell you the inquiries of accelerated since we've.
Since we've made the acquisition a month ago in terms of our sales folks our customer success folks engaging with customers.
Educating them on what papers basically so I would expect to see.
Our broad adoption not necessarily tied to any particular industry.
Really as people start to really want to invest real resources.
To build out and use cases to help them drive productivity whatever the case may be.
And they can do that on our platform and likewise with the paper space customer base. Your paper space has had a very narrow just so the ml and.
And AI capabilities for application development when they are our customers have historically wanted to leverage that on the broader compute platform. Once the applications were developed they'd have to go elsewhere and now we can we can serve those customers. So we see a lot of synergy.
Topline synergies in both directions here.
Again really excited about that.
Yes, okay, perfect that makes sense.
One for you Matt.
Obviously changing full year guidance in the Midland is always like a tough decision for our management team.
Think about it Mike.
As you pull net debt position.
For you like to driving thing to say like Okay, I need to change it and how did you come up with a new level what are kind of the puts and takes and Jim. Thank you.
Yes, it's always a tough decision I think.
Everyone saw in our guidance we.
We had expected moderate growth only moderate growth in the first two quarters, which we've delivered pretty pretty much as expected, but embedded in the second half increase was two things one.
We needed to see a flattening of the at least the flattening of the.
The cohort and they couldnt get worse than we even talked about that and then we needed to see the ramp up the monetization initiatives and some of the other investments we've made in and the good news is we are seeing the ramp around the monetization initiatives and some of the new products, we launched the city data center et cetera are growing.
Kind of generally in line with what we thought but what we missed was that.
The cohort is just continuing to see pressure longer than we had anticipated as we sat here in July I mean, clearly we would have liked to have beat the revenue guidance for.
During the second quarter and as we saw that coming in in line with.
The.
Expectations instead of being ahead of it and we saw that.
The continued kind of deceleration of or the continued slowdown of expansion, even though we're seeing some green shoots around contraction is decelerating, we just didn't think of it as appropriate.
Hold that out there still so what we've done is we've given a range, which is fairly tight and it's reflective of kind of if it doesn't change from where it is today. It continues at the current.
The decline rate of decline that.
<unk> been about net 90.
While at the mid nineties here in the second half Thats, what youll see and so that doesn't assume any improvement in the cohort it doesn't assume any dramatic improvement in the.
And the rates of.
Gross around our monetization initiatives or any go to market initiatives and assumes a very modest impact from from a paper space at less than 5 million. So we believe that.
We rotated to a I'd say a reasonably conservative view of what the.
The potential is for the second half and I think thats appropriate until we see a bottom because.
We can't keep hoping every month that at a bottom.
Except the reality that it may not for a couple more months or quarters.
Okay perfect Hey, Thank you very much.
Your next question will come from the line of Patrick <unk> with JMP Securities. Please go ahead.
Oh, great. Thank you.
Maybe paper space versus just so I saw that.
Just this morning Nancy.
There is a company called <unk>.
At $2 $3 billion.
<unk>.
Debt financing secured in part by the Nvidia.
And it seems like with paper space Youre entering that same general area.
How are these businesses similar inherently different.
Well.
As I mentioned on the <unk>.
Repaired comments, we paper space.
Sort of a delivered product with an API that.
It makes it simple and easy for people to build applications on top of the GPU capability for language models.
<unk> learning applications what have you.
And it's a traditional or cloud service.
I think other folks.
Who are sort of in that.
Focusing on essentially renting.
GPU for higher for <unk>.
And don't have the other applications don't have the other build outs and so for our customer base, we think theyre going to need that because again, our customers don't have big Dev ops development capabilities and whatever they have they want to dedicate that to their end products and so.
Think what we have is an offering tailored towards developers.
Startups and small businesses and I think other folks in this space are catering to the large enterprise opportunity. We think our opportunity is large as well and so I don't know if its a winner take all I think it's.
A lot of people are going to win in this market. We think will be one of them and we're sticking to our knitting, which is focusing on our end of the market where people need the core value Differentiators, we have which is support our community investment.
And simplicity.
Alright, great. Thanks, and then Matt I think you addressed it but just to be really explicit about it.
Are you seeing higher churn.
No that churn.
We talked about churn we saw elevated over the balance of last year.
But that moderated in the beginning of the year to more historical levels of expense, it's been relatively steady so it's not customers leaving us.
The combination of <unk>.
Higher contraction, which is really customers that are staying on our platform, but optimizing that.
That has been of the three drivers probably the biggest headwind for us over the first six months of this year.
And she said in his remarks, several hundred basis points higher than it has been historically, but it's moderating it's not getting worse.
<unk> level, but it's not it's not increasing but what we've seen is that expansion still continues to come down a bit. So the customers just aren't growing as fast as they they were a year ago and we've seen kind of month over month that has continued to get.
A little bit worse, and so when we say that we're looking to see deceleration we've seen stability in churn, which is in a good spot we'd seen stability recently in contraction, but it's still elevated and we've seen a continued kind of decline in the radar.
Expansion in that last one the decline in the rate of expansion. That's what you need to see flatten or turnaround of directions before youre going to be able to say, okay. We're at a bottom and now we're going to start with.
Going to start to pick growth up as as contraction moderates more and contractions stable, but it's at an elevated level and expansion is continuing to grow.
To weakened but churn is has been fine this year.
Okay, great. Thank you.
Your next question comes from the line of Michael <unk> with Keybanc capital markets. Please go ahead.
Hi, This is Billy on for Michael.
You talked about how potentially there is some indication that optimizations are moving behind us. So when you speak about optimizations in your customer base, what does that look like and is it more or less what we've heard from the hyperscale or are there differences in how customers optimize spend with inflation just just more upon that would be great. Thanks.
Well.
There is two points of that one because we have a consumption based model as we saw last year.
Weaker demand happened in the macro we saw a much faster growth deceleration because as our customers' business has slowed dramatically. They are small slowing less today than they were a year ago.
Their spend.
Correct immediately so theres that aspect, there's a second aspect of bottle so versus the longer term contract model that others have where volumes might be lower than committed payments and people need to just correct. That's not what we saw because we have <unk>.
30 day contracts and so our customers correct on spending for what they are buying what we've been seeing in sort of late last year early this year, a pickup in customers, calling us saying.
Am I using the right way, how do I use less but still satisfy current demand.
Did I activate too many <unk>.
<unk> instances too many droplet to my end too many different locations can I use <unk> to potentially have a more efficient deploy.
For my my cloud infrastructure that is the optimization, we've been seeing and I would say.
The first couple earnings calls this year, we talked about.
Pretty active card customer conversations that has really slowed.
In terms of our support and customer success.
Engagements with customers I think they are in a good spot and we're seeing that as we talked about the contraction.
As flat over a quarter flattened stable, let's say.
It's at a higher level, which I as I mentioned I think we're in a different time as.
As people are in a lower growth environment theyre going to be much more vigilant about any new instance, or how they are executing operationally because they want to be as efficient as possible our customers tend to be bootstrap company. So.
One dollar saved is a dollar earned for them.
So I think that aspect is here to stay.
And that plays really into a key strength of ours, which is high support high touch.
We engage with our customers on how to best use the cloud our community investment our tutorials.
Are also involved in that and so I think the churn thats why im so heartened by churn being flat relative to where it was this whole slowdown started because it reflects the fact that our value proposition is very high even in a challenging environment, we're able to help our customers through it and they're sticking with us which.
Is going to be critical we said we're seeing.
Slowdown in their growth.
Deceleration in our growth has really slowed and it is not at a point, where we're going to call a bottom it's flat, but it is clearly slowing at a much more dramatically slower rate than it was the beginning of this year or this time, certainly this time last year and having that stable churn.
For me as a leading indicator that when things bounce, we're going to see a significant bounce.
As the recovery ultimately happens, we don't know when thats going to happen, which is why we've changed the outlook is reflected today, but we're positioned well for that because we've been helping our customers through this process and the consumption based model sort of immediately corrects their spend.
So they can focus on operational efficiency and we can help them do that.
Uh huh.
Helpful color. Thank you Anthony.
Your next question comes from the line of Mike <unk> with Needham <unk> Company. Please go ahead.
Hey, guys. Thanks for getting me on here I, just wanted to circle up on.
Some of the earlier comments, but I guess take it from a different angle I know you guys have been talking about churn and contraction and expansion if I tie all those up and just think about.
So linearity played out over the course of the June quarter and even into July now that the month is behind US can you discuss how things trended as we went from April to May to June just.
Just to give us a sense of what's going on each quarter.
For some of those real time data points that youre seeing.
So this is Mike Thanks, Matt.
When you look at each of those metrics, we look at it on a monthly basis. In addition to our quarterly basis churn stayed relatively flat.
And.
Kind of low double digit 11% range and it stayed there hasnt.
Hasn't gotten any worse, what we saw though was a continued.
Kind of an increase in contraction, which means people taking money off of our platform and a decrease in and expansion, meaning the amount people are adding year over year.
Each month as I look at it is getting smaller.
But what we said is the rate of change of contraction has moderated so it's decelerating, it's not it's not getting worse as fast as it was.
And.
As it was earlier in this year and in fact in the last month that we've seen it actually flipped the other direction and we saw it go back on an absolute basis.
It actually is the amount of contraction we saw went down.
In the last month, which is really positive signs over multiple months in a row of deceleration in actual flip in the other direction, but the expansion which is the other driver is just continue to kind of.
Get smaller and so that's why we're saying well look we are looking at this as we looked at that over the course of those months.
Couldnt, we couldnt call the bottom and we can't say whether expansion is going to continue to get smaller and in the coming months.
As contraction can stay at the level that it is or is it going to continue that.
One month trend we have.
Of moderate and with that level of uncertainty.
We just couldnt continue to go into the second third and fourth quarter without providing an update on the on the guidance because it's it's providing enough of a headwind that is offsetting the other good growth that we're seeing through our self serve funnel and through the other initiatives that we've been pursuing.
And I appreciate the color, Matt and I really appreciate the transparency there as well.
Wanted to be Crystal clear then when we when we turn to the outlook.
Again, it seems like you guys are juggling a number of different pieces all in all in real time, but as far as those assumptions that you had.
I don't want to characterize but like between churn and contraction and expansion what are the assumptions that you're embedding in your guidance today.
Which gives you confidence in your ability to achieve the numbers that we're communicating.
To the street and investors.
I'd say were.
We're assuming that nothing gets better than what we're currently seeing so the rates the rates of decline in the level of that.
We're landing on the things that stabilized stayed the same we don't see an improvement in any of those which would imply we're not forecasting a bottom.
Our.
In our guidance.
That's great. Thank you for that that's exactly what I wanted to clear up with my understanding. Thank you so much.
Your next question comes from the line of pendulum Baugh with J P. Morgan. Please go ahead.
Oh, great. Thanks for taking the questions can you talk a little bit more about paper space.
Can you talk about maybe the customers that <unk> brings to the table. Some of the use cases those customers are working on and as I look at the <unk>.
But as I think you're saying 5 million.
For the second half so call it $10 million 10 $10 million to $12 million.
For the year.
12000 customers.
Is it something like $1000 ACB.
Help me understand that.
And then lastly, what portion of <unk> customers are on the envelopes platform versus kind of the.
Core infrastructure.
I think we will provide more detail around some of that as we sort through.
Some of the analytics on the business in terms of the mix et cetera at a subsequent call what I would say as their customers are very similar to ours there.
Small emerging startups.
Sure.
Many names you would have never heard of.
Similar to our customer base.
From all over the place.
Lots of different use cases, obviously language models is a big growth driver in the near term.
Generative media is a very interesting one that very dynamic advertising media video et cetera, based upon whatever the verdict or use case so.
That's a lot of people, taking a lot of data.
And leveraging that for outcomes.
It's very exciting.
What I love about it is that the fact is we can look at the logos you can look at the names.
In terms of the customers in like our business its long tail.
We enable people all over the planet to leverage their ideas in the cloud and now we have the ability to do that in AI and ml and.
So I think.
<unk>.
Is higher.
And I think our average customer will give more specifics later than that.
But.
That's what we said earlier its a really hand in glove fit in so many dimensions.
And I think I'm excited to get this in the hands of our.
Digital ocean customers and vice versa to give the papers based customers the same or similar kind of experience they've had building their AI apps once they get those over the hump and are running a business around that application. They can run it on our platform and have the same experience in terms of ease of use simplicity.
The support model or a community investment.
And the low cost.
Understood. Thank you very much.
Your next question comes from the line of Jim Fish with Piper Sandler. Please go ahead.
Yes. This is quentin on for Jim Thanks for taking my questions.
Maybe first for you I'd like to touch a little bit on the timelines items coming to this paper space deal thinking back to Q3, Q4, we talked a little bit about how Cpus would be able to support AI workloads and then Q1, we transitioned to Gpus are probably an attractive expansion to the platform.
And then obviously now we have the papers based offering can you talk to you what trends or maybe inputs changed from Q3 Q4 to Q1 Q2, where now you know you need this kind of GPU as a service offering and then any color you can provide around the acquisition process of paper space, whether it was competitive bidding or anything would be helpful.
Yeah. So I don't know that we ever never we ever said I ever said that we didn't need Gpus. What I think we were clarifying is that there were a number of AI based algorithmic type business models that were running on our platform because high performance compute was fine I think that tended to be more on the entrance.
Market versus the language model.
Market so.
To be clear, we have always said that we wanted to build a GPU capability in AI.
Our platform capability certainly since we've been public.
We've known paper space for years I have stayed very close to the founders since I became CEO in 2019.
So.
Sure.
We're excited to let's say finally have them part of the digital Ocean family.
But.
We certainly saw with late last year early this year a pickup in the threshold level of capability in the market.
Perception.
Interest in the language model opportunity, which.
The market wants to use Gpus for those.
Certainly to get the model up and running.
Maybe not to operate the bottle once it is running in customers' hands.
Certainly the level of compute chain needs change.
And we will see how that plays out we're learning a lot we're very rapidly.
But we're excited to have this new dimension of compute now on the platform.
And I think whether that was accelerated or not this is a capability.
We wanted to add.
Excited to be able to get this done here in the middle of this year.
Not going to comment on the process that.
That led to that.
The conversations and what led to our announcement with paper space a month ago.
Yes.
Stan Thank you and then Matt maybe for you as I look at the customer segments. It looks like really the scalar.
Segment of the business that saw some deceleration in the IRR growth and I think you've been pretty clear that it's really not churn. So is it fair to think that the optimizations segment.
Segment of your business that have yet compared to maybe some of the builders are learners. Thank you.
Yes.
That's very accurate.
Largest customer the more opportunity for optimization and we've got examples of anti gain a few but examples where a customer a large customer that.
Storing a fair bit of data on our platform might change of policy and say, what we used to store 60 days of data and now we've kind of we've rethought. It and we think we can get away with 15, and we just don't need as much given the consumption model. They can just make that they can make that happen.
But that typically happens in the larger and larger customer base, that's why you've seen the.
The slowdown in that.
The ARPA growth.
Scalar versus some of the others, but it's not.
Scalar has have the lowest churn of all of our segments. The bigger the customer gets on our platform and the more that they consume and the more products that they use to lower their churn so the churn and scalar is incredibly.
Attractive churn level.
We're seeing more contraction in that area as you would expect.
And our final question will come from the line of Tim Horan with Oppenheimer. Please go ahead.
Thanks, guys.
Can you talk about how you balance free cash flow generation with growth here.
I think you said high 20% on the free cash flow, maybe some timing there.
I mean, I only mentioned because it's basically.
In Satiable demand for Gpus, if you doubled your Capex spend you could probably double your revenue growth so and it seems like now is the opportunity to do that so can you just walk us through how you're thinking about balancing that out.
Well I think what we've reflected today is what we see.
I will say this.
In the month that we've acquired paper space.
The potential growth that we see as well.
Significantly higher than we saw month ago, I'm not going to put a quantitative on it but it's it's pretty.
Significant and we've already stepped up capital purchases ahead of what we thought a month ago.
To get us through this year and to support the acceleration of the growth rate, which again to triple digit growth rate, we already see our ability to accelerate that month in and we're getting very focused right now on what's the 'twenty 'twenty.
For opportunity I think one of the reasons.
We.
Our.
<unk>.
Reframing expectations of our capital allocation is this issue.
Because to your point, if we can grow 500%.
We will we will look to do that we'll just see what the opportunity presents itself.
We're very focused on that.
No.
Talked a lot about free cash flow this year and a year, where the growth was uncertain.
The weakening and I think I hope people didn't misread that as a we were allergic to growth.
We've always said we want to invest our primary uses of capital are or whether it's internal or externally generated growth and we're demonstrating that now we're excited and I remember when we had the conversation with the board that we're going to take margins down.
Down to what they could have been to invest more in paper space and there was an all hands in the air. So we're excited about this and we'll see where it plays out obviously, we will have we will have more of an update a formal update at the next earnings call, what we're seeing but I'll just say that.
The pace of.
This opportunity continues as it has in the first 30 days.
We'll continue to see a lot of money going into paper space because it's.
Really exciting opportunity we have.
Congratulations on developing an NII strategy and expense reductions it looks really impressive.
Got it.
I will now hand, the conference back over to Yancey Spruill for closing remarks.
Thank you and thanks, everybody for joining us today.
As usual, we really appreciate your support.
<unk>.
We're looking forward to talking with you over the coming weeks and months about where we are and where we're heading and we.
We hope that you all have a good rest of the day. Thank you so much.
That will conclude today's conference call. We thank you all for joining and you may now disconnect.
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