DigitalOcean Holdings, Inc.

Good day and welcome everyone to the Digital Ocean second quarter 2022 earnings conference call. Please note today's conference is being recorded. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, press star followed by the number one again. Thank you. At this time, I will turn the call over to Rob Brantley, Vice President of Investor Relations.

Thank you and welcome everyone to DigitalOcean's second quarter 2022 earnings call. Joining me today is Yancy Sproul, our Chief Executive Officer, and Bill Sorensen, our Chief Financial Officer. Before we begin, I want to cover our Safe Harbor Statement. During this 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 in 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. Also, we will be discussing non-GAAP financial measures on our call. And reconciliations between our GAAP and our non-GAAP financial results can be found in our earnings press release, which was issued earlier this afternoon, and in the investor presentation on our IR website. With that, I'd now like to turn the call over to our CEO, Yancey Spruill. Yancey?

Thanks, Rob. Good afternoon, and thank you for joining us today. I am pleased to review a quarter that had its share of challenges where, nonetheless, we demonstrated our ability to deliver against our financial targets despite the macro headwinds we are all facing. Our performance alongside our improved financial outlook for the balance of the year highlights that we are positioning DigitalOcean for strong revenue growth coupled with rapidly scaling pre-cash flow despite operating within an uncertain and challenging economic environment. The durability and resiliency of our business is prominently on display right now. The simplicity of our business, including our consumption revenue model, allows our customers to automatically align strength or weakness in their business to what they pay us. For the market segment we serve, we believe that this is a critical strength as it supports our early stage business customers through good times and bad. with a highly transparent economic model that builds loyalty with them. A validation of that premise is that despite a challenging environment, churn last quarter remained at similar levels to prior recent quarters. The global nature of our customers and the diversity of industries we serve, while not fully immunizing us from macroeconomic trends, does make us less vulnerable to a material change in our business since we aren't dependent on one type of industry, one set of large customers, or a particular region of the world. The key growth drivers in our business are being somewhat offset by macro weakness, which has resulted in a reduced expansion spend rate on our platform, particularly in Europe and Asia, and principally for customers operating in the blockchain vertical. That is to say, in aggregate, customers continue to grow on our platform, but in certain regions and use cases, they're growing more slowly than we have seen in prior quarters. The traction we are seeing in Q3 gives us confidence to project at least 30% revenue growth for Q3 and maintain our revenue outlook for the year. And given actions we have taken to drive efficiency in our spend, we are increasing our outlook for Q3 operating margins, and both operating margins and free cash flow for the full year. To be clear, the approach to our forecast update today, we are being cautious setting near-term expectations, reflecting uncertainties not within our control. Revenue in the quarter was $133.9 million of 29% year over year. We came in at the midpoint of our Q2 revenue guide while significantly outperforming on operating income and free cash flow. Our focus on simplicity, community, support, and open source software that is value priced are enabling our customers to grind through this tough environment and for us to do so with operating leverage. ARR was up 28% year over year and ended the quarter at $544 million. as we added $20 million in net new ARR in the three months ending June 30. Q2 had a 100 basis point growth headwind from Q2 last year from the launch of our premium droplet, and the expected impact from Russia-Ukraine also represented another 100 basis point headwind to our Q2 growth rate. The balance of the sequential slower ARR growth is due to lower net expansion. Another point to make is that we bill our customers and they pay us in U.S. dollars. Although we don't have a direct way to tie FX impacts to our revenue, we can't ignore the likely headwind on our customers' businesses due to the significant strengthening of the U.S. dollar in the first half of 2022. We added nearly 3,000 high spend customers that are spending more than $50 per month. In total, they now number just over 105,000. and generate 85% of total revenue, which is up 300 basis points from a year ago. Importantly, revenue from this cohort of customers grew 34% year over year, continuing to pull up our overall growth rate. Despite the weaker environment in the quarter, revenue from these customers is growing significantly faster than GDP in the markets in which we operate. As we moved through Q2, we managed our business prudently. We slimmed our spending to focus on a critical few initiatives that we expect to have the greatest impact on growth, delivered on operational improvements that drove efficiencies, and put our procurement engine into full gear, driving further leverage in core areas of third-party spend. These focus areas will pay dividends well beyond the near-term economic challenges driving operating leverage as we continue our progress to 20% or better free cash flow margins as we achieve our first billion dollars of revenue. The results of our managing spend were strong operating margins of 17% of revenue. We also demonstrated the powerful cash generation capabilities of the company in the quarter with free cash flow that was 10% of revenue. Given this period of uncertainty, we will be very cautious in adding new spend and will prioritize delivering strong margins and free cash flow until we have better clarity about the growth outlook. The key takeaway from our Q2 results is that in a challenging environment, we delivered a solid top line and continued accelerating margins and free cash flow. One last thing about Q2. We've now bought approximately 15.5 million shares back since our March 2021 IPO. Make no mistake, we are principally focused on investing to drive revenue growth while generating meaningful free cash flow leverage. However, we are also focused on doing so with an efficient balance sheet that provides flexibility to achieve our long-term strategic goals while also honoring our deep commitment for driving value for our shareholders. Driving significant leverage to earnings and free cash flow while maximizing shareholder value are highly compatible goals, and this is how we will always run this business. As we share at our investor day in June, we have a number of growth initiatives that help us achieve our higher revenue outlook for 2022, despite the macroeconomic challenges. I'd like to share some insights into each of them now. Beginning with the pricing changes that we announced in May and that went into effect last month, we are already seeing meaningful impact today in Q3. A few early indicators of the impact of our recent changes to pricing. First, since the announcement and since July 1st effective date for new pricing, we have seen dramatically lower churn than we accounted for in our base case, and that new customer acquisition has been unaffected. Second, downgrades to our $4 droplet remain modest and much less than anticipated, with roughly half of new $4 droplets being used in complement with the new $6 droplets. Finally, our large customer usage has remained in line with historical averages, with the exception of the prior mention of blockchain customers. I'm excited about these pricing changes. They have created a new dialogue with our customers in the broader market that clarifies our value proposition. That is to say, we offer a highly performing cloud computing platform with simplicity community support, a commitment to open source software as core differentiators, enabling a great customer experience. And our service remains value price when factoring what you get versus what it costs. Our platform is tailor-made to serve the $70 billion SMB and developer cloud market. Next, we continue to see strong results from our sales investments. As we mentioned in May, in Q1 we exceeded our plan nicely, and we're pleased to see that trend continue in the second quarter with average ARPU and Q2 deals just below $20,000, which is up approximately 50% year-over-year. Obviously, this is highly accretive to our total company ARPU, and with the continued progress we are making in Q2, we prioritize additional investment to continue to drive growth acceleration. through our sales channels. We remain confident that accelerating growth from our sales channels is on track, as it represented 5% of total revenue in Q2, up from just over 3% of revenue in the first quarter. Finally, we continue to make investments to drive our top-of-funnel customer acquisition. In June, we acquired the website Journal Dev. This developer-rich resource has tutorial content for Java and Python, along with other web development frameworks. Content from JournalDev will soon be found on our community site where millions of learners visit monthly to find quality content from a source they trust. We're thrilled to expand the breadth of our content offering to help even more developers benefit and continue building a community that leads to highly efficient customer acquisition. I want to make a critical point regarding the efficiency of our go-to-market model. Let's look at the payback period for customer acquisition. Using Q1 2022 non-GAAP sales and marketing expense of $15.7 million and net new ARR in Q2 of $20.5 million, combined with improving gross margins to 65% of revenue, we are paying back our customer acquisition costs in less than six months. And that's happening while we are ramping spend to build our sales capabilities. This efficiency is paramount in our ability to sustain our revenue growth targets and drive margins higher over the course of not just this year, but for years to come.