DigitalOcean Holdings, Inc.

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 DigitalOcean second quarter 2023 earnings conference call. 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'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 DigitalOcean's second quarter 2023 earnings call. Joining me today is Yancey Sproul, our Chief Executive Officer, and Matt Steinforth, our Chief Financial Officer. Before we begin, I would like to cover our Safe Harbor Statement. During this conference call, we will be making forward-looking statements, including our financial outlook for the 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. 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 Sproul. Yancey?

Thanks, Rob. Good afternoon, and thank you for joining us today. I'm pleased to share the results of another strong quarter for DigitalOcean. As discussed throughout this year, we made it a priority to position the company in 2023 to generate significantly higher pre-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 Paperspace. 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% and delivered healthy free cash flow margins of 27%. on the strength of progress we are making in transforming our cost structure. From a top-line growth perspective, we continue to see slower growth in the core DigitalOcean Cloud business. We saw growth moderate across our diversified customer base with all regions and most industry verticals seeing slower growth, which points to the broad weakness that the technology market faced 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 must stabilize is expansion, which continued to moderate in Q2, although at a decelerating pace. Until we see stability in all three metrics, we can only say that we are bottoming, but have not yet reached a bottom for growth deceleration. With respect to churn, it has been stable in the low double digits about where it was before the broader slowdown occurred, which is a positive indicator of the strength of our value proposition. Contraction also stabilized in the 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, a 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've moved through this year. In 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 bottomed, we are certainly in the process of bottoming. Our lowered revenue outlook announced 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 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 fronts. 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 scalers. Previously launched product capabilities, such as the premium optimized droplet, which are tailored to specific bandwidth intensive use cases, enabled us to increase our ARPU and shareable, while the expansion of our footprint, such physical footprint, such as the new Sydney data center, enabled us to more effectively serve the global market opportunity. Other investments, such as evolving the customer onboarding process, are enabling us to better identify higher growth potential customers early and get them the support they need to accelerate their use of our cloud services, as well as better match them from a product perspective earlier in their lifecycle, which yields higher ARPU. A good example of this is identifying candidates for a managed hosting solution through CloudWaves instead of them self-serving directly onto the DigitalOcean platform with a mismatch of their needs leading to under-optimization 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 on our 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 in the establishment of these new channels and they are not yet material contributors to growth, we continue to see them as important growth levers next year and beyond. On the inorganic investment front, we are very happy with the results we are realizing from the strategic acquisitions that we have made today. We are incredibly excited about the acquisition we recently announced. The Cloudways managed hosting business continues to be a very strong addition to our platform, with performance that exceeds our initial expectations. We've seen net new Cloudways 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. Cloudways revenue, which grew 45% year-over-year in Q2, continues to be a strong contributor to overall growth, company growth, aided by our focus on top of funnel and customer acquisition enhancements. And it's becoming a larger percentage of our revenue mix and therefore an increasingly more meaningful contributor to driving a higher overall company growth rate in 2024 and beyond. Which brings me to the exciting announcement that we made about a month ago that we acquired Paperspace for $111 million. We couldn't be more excited about this highly strategic and synergistic acquisition in the dynamic and explosively growing AI ML market whose impact and opportunity is projected 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. PaperSpace has tremendous potential. We've been very familiar with the team, having tracked them carefully over the years as they have built their business. The addition of PaperSpace to the DigitalOcean platform makes tremendous sense on three key dimensions. First, DigitalOcean and PaperSpace are philosophically aligned both in the segment of the market that we target and in how we differentiate ourselves versus the larger enterprise-focused providers. We are both focused on enabling smaller companies from individual developers to startups to emerging growth S&B customers to leverage technology to grow their businesses. We both win customers in this segment of the market by providing simpler, more cost-effective solutions that can be leveraged on a consumption basis without the constraints of long-term contracts. with a higher level of support than these customers get from the larger providers. We expect AI will be a force multiplier for small and medium-sized businesses. Just as the advent of cloud computing eliminated many of the barriers to entry for developers and startups to create a digital business, allowing anyone in any geography to start a business, we believe that 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. Paperspace's MLOps 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 DigitalOcean's key differentiators. differentiators. With PaperSpace, we will be able to provide multiple products for AI and ML use cases, including compute storage and databases, allowing these customers to scale on DigitalOcean's integrated platform. The second dimension of importance is there are substantial synergies between DigitalOcean and PaperSpace that will accelerate both of our growth rates. PaperSpace serves the fast-growing segment of the market that brings together the combination of AI platforms and accelerated compute, which allows customers to build and maintain AI applications while providing the computational capacity required to do this at scale. Together, IDC estimates that the compound growth of the SMB portion of this market will be 36% over the next three years. Today, PaperSpace has established itself as a leading player serving this market with a proven, differentiated GPU-based AI ML product that serves over 12,000 paying customers today, despite having invested very little in marketing or go-to-market. We will accelerate PaperSpace growth by leveraging DigitalOcean's more scaled marketing and global go-to-market motions to increase the top of the funnel and drive new customers for PaperSpace's business. There is also a significant cross-selling opportunity to sell PaperSpace capabilities to DigitalOcean's 616,000 plus learners, builders, and scalers many of whom are already evaluating how AI ML can be leveraged to accelerate their businesses. In addition, AI use cases clearly drive increased compute requirements. But PaperSpace had no capability to capture those additional production workloads, requiring customers to leverage other cloud platforms. Combined platform of AI ML software and high performance in GPU based compute will enable us to capture more of PaperSpace's current and future customers' broader infrastructure needs for database as a service, high throughput networking, Spaces and Kubernetes, driving higher ARPU and creating more stickiness and loyalty on the DigitalOcean platform. The third dimension that has us so excited is how cleanly it will integrate with our platform and how dramatically it accelerates our time to bring this capability to market. With PaperSpace, 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 PaperSpace team adds more than three dozen employees to the DigitalOcean team and brings significant experience providing AI solutions to thousands of SMB customers. Also, as an active and important player in the AI ecosystem that is not tied up with the hyperscalers that have plans to build their own chips, PaperSpace on its own has strong industry relationships, such as having elite status with NVIDIA. These critical industry relationships will only be strengthened when combined with the larger scale relationships that DigitalOcean has with other players in the market. We are already leveraging these combined relationships to ramp up PaperSpace's investment in GPU capacity. Clearly, we are very excited about the possibilities that PaperSpace brings to us, and you should expect to hear more from us on this potential over the coming quarters. While Matt will walk you through the financial implications of the PaperSpace deal on our overall business later in our discussion, I can say unequivocally that after owning PaperSpace for just a few short weeks, the potential is far greater than we had expected. We acquired a triple-digit growing business that we feel confident we can accelerate from here. And as such, we expect PaperSpace to contribute at least three percentage points towards our total growth rate next year. We are excited to be on a path to deliver a truly differentiated set of capabilities with an aspiration to be the AI cloud for SMDs. With our acquisition of PaperSpace and aggressive entry into the AI ML market, Many of you are likely interested in the implications on our projected cash flow margins and our current capital allocation strategy. While Matt will cover the specific projection 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 for $1.3 billion and lowered our fully diluted shares outstanding well in excess of the shares granted to employees over the same timeframe. When combined with the 6X increase in free cash flow since 2021, our first fiscal year as a public company, 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 our food growth, and meaningfully increased our addressable market. Although we continue to evaluate M&A opportunities that are consistent with our goals of enhancing our market position to drive profitable growth, in the near term, we are prioritizing integration investments in Cloudways and Paperspace, 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 the long-term free cash flow margins required to do so does not change as a result of our entry into the AIML market with PaperSpace. Our growing free cash flow margin and 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 is our first priority use for capital, and that remains true. Given a 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 to balance growth and capital return through share repurchases going forward. I'll close by saying we've made good progress through the first half of 2023. We've 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 Cloudways and Paperspace while we continue to target investment in the highest revenue potential opportunities and optimize profitability as we work to return to higher growth in our core business. We continue to see a material opportunity and an expanding addressable market in the growing $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.