DigitalOcean Holdings, Inc. (NYSE:DOCN) Q3 2023 Earnings Call Transcript
DigitalOcean Holdings, Inc. (NYSE:DOCN) Q3 2023 Earnings Call Transcript November 2, 2023
DigitalOcean Holdings, Inc. beats earnings expectations. Reported EPS is $0.44, expectations were $0.36.
Operator: Hello and good afternoon. My name is Jeremy and I'll be your conference operator today. At this time, I would like to welcome everyone to the DigitalOcean Q3 2023 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. [Operator Instructions] I would now like to turn the call over to Rob Bradley, Vice President of Investor Relations.
Rob Bradley: Thank you, Jeremy and welcome, everyone, to DigitalOcean's third quarter 2023 earnings call. Joining me today is Yancey Spruill, our Chief Executive Officer; and Matt Steinfort, our Chief Financial Officer. Before we get started, I would want to cover our Safe Harbor statement. During this conference call, we will be making forward-looking statements, including our financial outlook for the 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 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 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 in the investor presentation which can be found on our Investor website. With that, let me turn the call over to our CEO, Yancey Spruill. Yancey?
Yancey Spruill: Thanks, Rob. Good afternoon and thank you all for joining us today. I'm pleased to share our solid Q3 results, representing another quarter with an attractive balance of growth and profitability. This afternoon, I'll share an update on the search for our next CEO, some broader macro observations that have been informed by customer and partner interactions and briefly recap some of the exciting product announcements that we've made recently. I will also highlight a recent customer win that gives us enthusiasm for our product trajectory before turning the call over to Matt to go over the financial results and updated financial outlook. On the CEO transition front, the search process is well under way and the Board is making good progress in our recruitment of a new CEO.
There has been very strong interest from numerous leading technology executives and we are confident that we will hire an outstanding executive with extensive cloud infrastructure expertise. The Board of Directors is deeply engaged with several candidates and we will continue to move these candidates through the interview process as the search progresses. It is still too early to communicate a specific timeline for the hiring of a new CEO, but the Board is working with focus and deliberate speed to fill this critical role. Third quarter results were encouraging as the business delivered solid performance from both the top and bottom line perspective. Revenue grew 16% year-over-year to $177 million and our first quarter having lapped the Q3 2022 pricing actions.
And as we indicated, we had started to see at the tail end of Q2 we continue to see positive signs through Q3 and in early Q4 that there are abating trends from the growth headwinds from our cohort that we have seen over the past 12 to 18 months. Our margin profile for the core DigitalOcean business was very strong for the quarter and enabled us to absorb the incremental costs from our Paperspace acquisition, while remaining within our targeted range of adjusted EBITDA and free cash flow margins. The combination of a stabilizing revenue growth rate and the efficiency we have created in our core business is allowing us to deliver robust free cash flow margins. As we look to accelerate our top line growth rate, we continue to build distinct revenue growth drivers through product and infrastructure investments.
A big portion of our focus over the past several months has been on our ongoing efforts to deliver on our product road map and continue to add critical capabilities that enable our customers to build and scale their own businesses. Through numerous interactions with customers, prospects and partners, we continue to fine tune and evolve how we can best serve customers as they navigate the complexities of the cloud markets. The consistent sentiment from our customers is that simplicity is foundational to our value proposition and relying on DigitalOcean to remove the complexities of the cloud is a productivity multiplier for them. We are focused on enhancing our platform's performance, reliability, security and scalability, which enables us to retain and grow the spend of our customers and positions us to win new customers.
Over the past several months, we have delivered an increase in velocity of product releases and announcements as we focus on meeting our customers evolving needs. In September we launched Managed Kafka, a new fully managed database service. Managed Kafka is a critical tool for businesses whose model involves significant data streaming. However, for small and medium business customers, it often comes with increased complexity. With our new fully Managed Kafka as a service offering, companies can focus on their development environment and not be slowed down by complex processes. Customers have provided strong positive feedback about Managed Kafka, citing that it is allowing them to focus their time and resources on their customer facing activities, referring to their increased productivity as a game changer.
In September, we also introduced premium to general purpose droplets, extending the premium features of enhanced CPU, memory and storage to offer improved performance to a broader way of cloud native applications. Our first generation premium dedicated droplets saw broad adoption and drove strong ARPU growth when launched in the beginning of 2021, as customers expanded their computing capabilities and migrated certain workloads to this premium compute offering. Now we've taken it one step further and expanded the opportunity for more customers to use these enhanced features with this new premium general purpose offering.
PostgreSQL: On the Paperspace front, we continue to be very excited by the addition of their AI/ML capabilities and the expanded market opportunity that this business creates for DigitalOcean. While we are still only a few months into the integration process, the demand for Paperspace's services has been very strong and we continue to learn more about the market and how customers are leveraging our capabilities to develop and grow their businesses. To give you a sense for one such use case, I'll provide an overview of one of the exciting customers we recently added to the Paperspace platform. The company is Nomic, which was founded in 2022 to improve the explainability and accessibility of artificial intelligence. To date, Nomic has released two products, an open source AI model GPT for all, which is which is the third fastest growing repository in GitHub history, and Atlas, a tool that allows users to visualize unstructured data sets used to build large language models.
Nomic selected DigitalOcean to access High Performance Compute along with their along with our intuitive software, customer support and reliability. Their Co-Founder was quoted as saying. Our team loves Paperspace. It's far more intuitive than other compute providers. It allows us to spend less time managing infrastructure and more time building great products for our customers. Their testimony to DigitalOcean's combination of simplicity, reliability and support along with the current demand environment that we see excite us for the opportunity ahead. The RFPs that we are seeing span across multiple verticals for multiple applications and demonstrate the opportunity for new customers to join our platform to not only build their AI applications, but also to scale their products while utilizing the breadth of our IaaS and Paas capabilities.
In summary, we're making good progress with our efforts to bring on a new CEO and during this transition, our business is seeing stabilizing revenue trends while continued to deliver significant free cash flow. We are seeing very encouraging signals that our top line growth rate is stabilizing relative to the last six quarters of deceleration. We continue to work to reaccelerate our growth rate through targeted product and go to market initiatives. The improved operating leverage we have created in the business over the past year is enabling us to make strategic investments while still delivering compelling free cash flow margins. We remain excited about our near and long term potential in the large standing $100 billion addressable market for SMB cloud infrastructure in which we compete.
As we approach the end of the year, I'd like to thank each and every member of the DigitalOcean team for their commitment to our customers and for delivering these solid results. With that, I'd like to turn it over to Matt to provide details on our financial results and our outlook for the balance of the year.
Matt Steinfort: Thanks Yancey, and welcome to all of you who are joining us on today's earnings call as we review our solid Q3 results. In Q3, we continued to execute our strategy of accelerating the achievement of our long-term margin targets in the core DigitalOcean business while positioning the company for accelerated future growth through both organic and inorganic investment in our platform despite the ongoing macro headwinds. We have driven these margin improvements by achieving the savings that we had identified at the beginning of this year, which included improvements in our gross margin as we grew into capacity investments made in 2022 and the achievement of identified savings in both headcount and non-headcount related expenses.
As we have continued to execute on these savings, we have increased our overall profitability and free cash flow margin significantly allowing us the flexibility to make targeted investments in growth. During the first three quarters, we have continued to invest in organic growth by our product roadmap as Yancey described and in July, we invested inorganically in the acquisition of Paperspace, which meaningfully increases our total addressable market. With our strong balance sheet, our continued focus on improving operating leverage and our commitment to share repurchases, we have made material progress driving earnings per share increasing 22% year-over-year. As we approach 2024, our strategy remains the same. We will continue to drive operating leverage while balancing investment across organic and inorganic growth opportunities and share repurchases.
With that context in mind, I will review the highlights in the third quarter. Revenue in the third quarter was $177.1 million, which was an increase of 16% year-over-year and 4% quarter-over-quarter and our first full quarter that lapsed the pricing increase we implemented in early Q3 2022. Contributing to this growth was Cloudways, which grew 11% quarter-over-quarter and the addition of Paperspace, the AI platform we acquired in early July, which contributed $3 million to our results for Q3 and which surpassed the $1 million in monthly revenue mark in September. Profitability was very strong as we delivered $75.8 million of adjusted EBITDA, a 43% margin for the second consecutive quarter. Adjusted EBITDA margin improvements are the result of improving gross margins as we grew into the incremental data center and bandwidth capacity investments that we had made in late 2022 and the ongoing benefit of the efficiency improvements that we had identified in Q1 of this year and have been realizing throughout the year.
Free cash flow was also a highlight in the quarter as we generated $56 million which was 32% of revenue. This 500 basis point improvement from Q2 was a result of both lower capital expense and working capital timing. Given the working capital timing dynamic coupled with our anticipated near-term Paperspace investments, we expect free cash flow margin in Q4 to be lower than Q3 levels. While free cash flow margins can be lumpy quarter to quarter, we continue to be confident in our full year free cash flow margin expectations. Finally, non-GAAP earnings per share was $0.44, which is a 22% year-over-year increase as we have increased our profit margins while having simultaneously reduced our shares outstanding through our systematic share buyback program.
As expected, net dollar retention declined in Q3 to the mid-90s coming in at 96% as we lapped the price increase that was implemented in July of 2022. Fortunately, despite the difficult year-over-year comp in Q3, we did continue to see evidence of the ongoing stabilization of market demand that had started to show signs of bottoming in Q2. As it has been for most of 2022, churn remained stable at historical levels around 11% to 12% for each of the months in Q3, which is consistent with historical churn levels in early 2022 prior to the market slowdown. Contraction which has historically been in the 12% range in early 2022 showed improvement as we progressed through the quarter ending at 15% after starting the quarter at over 16%. We also saw positive signs in expansion in Q3, which was the final metric we said we needed to see for stabilization as it had continued to decline in Q2, albeit at a decelerating rate in Q3, expansion stopped declining for the first time in over a year and was fairly consistent at 23%.
While we have not yet seen a meaningful improvement in NDR, we are encouraged by the relative stability of the key component metrics in Q3. We expect NDR to improve in Q4 and early 2024, driven in part by the continued strength of the Cloudways business and more favorable year-over-year comparisons. From a customer perspective, our durable customer acquisition and graduation model remained solid despite the challenging growth environment. We graduated 4000 builders and scalers on our platform in the quarter and we now have more than 154,000 on the DigitalOcean platform. These customers who spend more than $50.00 per month with DigitalOcean continue to represent 86% of our overall revenue and remain a key focus of our product, sales and customer success investments.
Average monthly revenue per customer or ARPU was $92.06 which was an increase of 6% year-over-year, which like NDR faced a difficult year-over-year comp as we lapped the price increase from last July. Before providing guidance for Q4 and for the full year 2023, it is important to understand where we are in the 2024 planning process. We are working diligently to finalize our plan and budget for 2024 with a focus on delivering double digit growth with healthy profit and free cash flow margins. Our strategy will remain the same in 2024. We will continue to drive operating leverage in the core DigitalOcean business while investing to take advantage of the compelling market opportunity we have with Paperspace. As we shared last quarter, despite the continued market pressures, we believe we have a solid foundation for double digit top line growth for 2024 with our steady self-serve funnel generating around 5% growth, Cloudways generating around 3% growth and Paperspace producing at least 3% growth.
Key to growing faster than this will be getting NDR above 100% at some point in 2024, which we are working aggressively to accomplish. We look forward to providing more specifics on our plan at our next earnings call in February when we report our Q4 and full year results. In terms of financial guidance for Q4 of 2023, we are targeting revenue to be $178 million. For the fourth quarter we expect adjusted EBITDA margins to be in the range of 36% to 37% and non-GAAP earnings per share to be $0.36 to $0.37 based on approximately 100 million to 101 million in weighted average fully diluted shares outstanding. For the full year, we are targeting revenue to be $690 million. Given the strong performance driving margin improvement in our core DigitalOcean business, we continue to project adjusted EBITDA margins to be in the range of 38% to 39% for the full year, despite our increased investment in our Paperspace AI/ML business.
We project non-GAAP earnings per share to be in the range of $1.52 to $1.54 with weighted average fully diluted shares outstanding for 2023 of $102 million to $103 million. And finally, given the strong progress we have made on improving margins in our core DigitalOcean business, for the full year 2023, free cash flow will be 21% to 22% of revenue, consistent with our initial February guide, despite the incremental investment we are making into our Paperspace business. That concludes our formal remarks and we'll now open the call up to Q&A.
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