DigitalOcean Holdings, Inc. (NYSE:DOCN) Q4 2023 Earnings Call Transcript
DigitalOcean Holdings, Inc. (NYSE:DOCN) Q4 2023 Earnings Call Transcript February 21, 2024
DigitalOcean Holdings, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Ladies and gentlemen, good afternoon. My name is Abby and I will be your conference operator today. At this time, I would like to welcome everyone to the DigitalOcean Fourth Quarter 2023 Earnings Conference Call. Today's conference is being recorded and 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] Thank you and I will now turn the conference over to Mr. Rob Bradley, Vice President of Investor Relations. You may begin.
Rob Bradley: Thank you, Abby. Good afternoon and thank you for joining us today to review DigitalOcean's fourth quarter and full year 2023 financial results. With me on the call today are Paddy Srinivasan, our newly joined Chief Executive Officer; and Matt Steinfort, our Chief Financial Officer. After prepared remarks, we will open the call up to a question-and-answer session. Before we begin, let me remind you that certain statements made on this call today may be considered forward-looking statements, which reflect management's best judgment based on currently available information. I refer specifically to discussion of our expectations and beliefs regarding our financial outlook for the first quarter and full year 2024. Our actual results may differ materially from those projected in these forward-looking statements.
I direct your attention to the risk factors contained in the company's annual report on Form 10-K filed with the SEC and those referenced in today's press release that is posted to our website. DigitalOcean expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements made today. Additionally, non-GAAP financial measures will be discussed on this conference call. Reconciliations to the most directly comparable GAAP financial measures are also available in today's press release, as well as in an updated investor presentation that outlines the financial discussion in today's call. A webcast of today's call is also available on our website in the IR section. With that, I'd like to turn the call over to Paddy.
Paddy Srinivasan: Thank you, Rob. Good afternoon and thank you for joining us today. I'm very excited to be here with you on my first call as the CEO of DigitalOcean. As today is my first opportunity to talk to you, I would like to start by sharing a bit about my background, why I was drawn to the DigitalOcean opportunity before providing an overview of our priorities for 2024 and highlighting the focus I will bring to the company. To start, I'm thrilled to be here at DigitalOcean. Having worked my entire career in technology companies and having a professional art that spans engineering, product management, and C-level positions, I have a deep appreciation for the opportunity that DigitalOcean has in front of us and strongly believe that I'm well positioned along with the DigitalOcean leadership team to help the company reach its full potential.
I started my career as a developer and spent my formative years of my career at Microsoft, where I worked on various products, including Windows Server, a variety of developer-centric distributed technology, and finally the Microsoft Office Server team. As I progressed in the leadership ranks at Microsoft, I had hands-on experience building platforms aimed at developers working with independent software vendors and managing businesses with tens of millions of users. From Microsoft, I moved to Oracle to help launch its Asia R&D center focused on innovating products for the unique needs of that market. As an entrepreneur at Oracle, I picked up experience identifying market opportunities and developing platforms like mobile embedded databases with extremely small footprint and near real-time performance in a very low bandwidth network environment to meet those unique emerging market requirements.
After Oracle, I co-founded Opstera, an application monitoring and managed cloud services platform. This experience, again, reinforced the importance of having a deep understanding of developer needs and using that to drive innovation as we worked to keep up with the evolving needs of nearly 500 early adopter cloud companies, including most of Microsoft's top Azure customers at that time. Following the successful sale of Opstera, I spent the majority of the last decade at GoTo, formerly known as LogMeIn, a SaaS pioneer delivering cloud-based software applications with a global footprint with a stint of Amazon in between. At LogMeIn, I experienced 10x growth as we took the company from a little over $100 million at the time I joined to over $1.3 billion in revenue through both organic and inorganic expansion.
As part of this journey, my team built an Internet of Things platform, which was later acquired by Google to form the foundation of its IoT strategy. After leaving for Amazon to be the general manager of the data and machine learning platform that powers Alexa, I returned to GoTo as its Chief Product and Technology Officer before ultimately taking over as CEO. At LogMeIn and GoTo, I picked up what it takes to build a product-led growth motion and augment it with a high-velocity sales and customer success machine to attract, convert, and expand hundreds of thousands of growing digital businesses at scale. All these roles and experiences have shaped my perspective and have nurtured my passion to understand customer needs, especially those of developers, innovating on their behalf by anticipating their needs, running modern infrastructure platforms to support global scale products, building efficient customer acquisition and expansion engines, and delivering value for all stakeholders, customers, employees and shareholders.
I'm really looking forward to bringing these experiences, focus and operating discipline to DigitalOcean. Switching gears now, there are a few compelling reasons that drove me to join DigitalOcean, but three stand out that I would like to share with all of you today. First is the market that DigitalOcean is focused on, the cloud computing market, and especially the one that serves developers, is one of the largest and fastest growing markets in the history of technology. This market, consisting of Infrastructure-as-a-Service and Platform-as-a-Service is a $114 billion opportunity, which IDC is forecasting to grow in excess of 23% through 2027. This growth should continue well beyond the timeframe as the market benefits from ongoing migrations to the cloud, acceleration of new business formation that cloud computing enables, and the still very early impact of AI and machine learning and the new generation of applications that these capabilities are already unlocking in a variety of different industries.
Second reason is the strong position that DigitalOcean has in this market. DO is the cloud leader focused on developers, startups, and growing digital businesses. DigitalOcean has more than 640,000 customers, a global footprint with revenue in over 190 countries, and serves customers across a wide range of industries and use cases. Our brand is beloved with a large and loyal developer community that leverages our extensive library of content, including tutorials, Q&A, product how-tos, video guides, and articles. DigitalOcean has carved out a compelling segment in this market, providing a simple and easy-to-use developer cloud with transparent and cost-effective billing, and a level of support that small growing businesses will not get from the larger hyperscalers.
DigitalOcean has also steadily expanded its array of offerings, starting with core infrastructure-as-a-service with its compute technology called Droplets object and block storage, and networking capacity with a global footprint to power our customers' apps and services. These are complemented and extended by platform-as-a-service products, including managed databases, managed Kubernetes, app platform, and managed Kafka for those customers that need to leverage high volumes of data streaming. In addition to our core infrastructure and platform offerings, with cloud base, we offer managed cloud hosting that is used to power digital agencies, e-commerce storefronts, and a variety of other online businesses. Finally, to take advantage of a generational technology shift, we acquired a leading AI machine learning application development platform, Paperspace, last year, increasing our addressable market and adding a very valuable growth level.
This further extends our platform by enabling developers to test, develop, and deploy AI and machine learning centric cloud applications that harness the power of GPUs in ways that have been predominantly available only to large enterprises. I just talked about the vast and growing market that DigitalOcean is in and the strong position we have with our platform and customers – customer trust that we have earned over the years. But now let me talk about the third compelling reason that drew me to DigitalOcean, the growth and value creation opportunity that is still ahead of us. DigitalOcean has the opportunity to reach even more developers and expand the services we provide to these customers, driving higher revenue growth, while maintaining our strong profitability, enabling us to generate compelling investor returns.
The plan for achieving this growth centers on understanding and addressing the needs of developers as they build growing digital businesses. We will achieve our near-term growth objectives and position ourselves for higher sustainable long-term growth by focusing on these very specific growth levers. First, we are enhancing our platform with global load balancing, data resiliency, granular identity and access management, storage enhancements, and many other new features that will enable our customers to operate and scale globally. Number two, we are investing in both network and infrastructure, providing increased diversity, lower latency and enhanced speed on our core IP backbone and edge to enhance the performance of our platform to benefit our customers and allow us to migrate more customer workloads from other providers onto our platform.
On top of these product offerings and platform foundations, we will continue to expand our managed services offering to serve customers that want an assisted experience with robust scaling capabilities on our platform. As an example of this, just a few days ago, we announced Autonomous, a new cloud-based offering that enables growing businesses to scale their hosting needs dynamically without having to over-invest in infrastructure. Next, building on our recent Paperspace acquisition, we are investing in our AI/ML strategy to take advantage of this market opportunity by bringing simple, easy to use AI/ML capabilities on both hardware and software to developers, machine learning engineers, and application builders across a broad range of business types as we have done successfully with our core DigitalOcean cloud services.
And finally, point number five is we will augment our durable, self-service customer acquisition model with direct sales and customer success motions to acquire, retain, and expand customers and amplify our reach through our vibrant partner ecosystem. For these reasons, I am very excited to have joined DigitalOcean at this critical time of inflection. The company begins 2024 having weathered a challenging macro demand environment where, like many large platform providers, top line growth slowed from historical highs. Recognizing early in 2023 that near-term growth could be pressured, we successfully accelerated the attainment of long-term target margins to build a durable cost structure that will generate attractive free cash flow. With plans to improve net dollar retention, or NDR, through increased customer engagement and continued product innovation and driving higher growth opportunities across Cloudways and our new AI/ML platform, we are positioned to establish a foundation to deliver low double-digit growth in 2024, while setting ourselves up for the future.
Let me now finish by articulating the key focus areas that I'll be driving. While I am excited about the company's long-term growth plans, as CEO, I will leverage my product and engineering background and deep cloud experience to bring an elevated focus to two critical priorities in the short term, product innovation and efficient go-to-market. Let me explain quickly. First and foremost, we will obsess over the developer experience on our platform. We will develop an intimate understanding of their needs, whether the use case is in SaaS application deployment and scaling, running the back end of web and mobile applications, game development or data streaming, e-commerce storefronts, education technology, or any other workload, and we will be unrelenting in our quest to understand how to make their jobs easier and to be a critical part of their growth through our platform offerings.
We will use this understanding to rapidly develop on our product roadmap, which includes several important enhancements in security, resiliency, performance, networking, and storage, which are really critical to our customer scaling on our platform. We will also increase the pace of identification and development of new capabilities that will drive value to our customers and fuel our growth further. Our ongoing investment in AI machine learning capabilities is a perfect example of this. In addition to driving innovation, we will augment our best-in-class self-service or product-led growth customer acquisition engine with an effective high-velocity sales and customer service engine to improve NDR by establishing a trusted relationship with our top customers, drive adoption and visibility into our other offerings in our platform, and continue providing world-class support and community engagement that these customers have come to expect from DigitalOcean.
By obsessing over the developer experience and innovating on their behalf and enhancing our go-to-market, we will take advantage of the tremendous growth opportunity that is in front of us. Our aim is to cement our position in this $114 billion addressable market for Infrastructure and Platform-as-a-Service and be the foundation for developers at startups and growing digital businesses to rapidly build, deploy, host, and scale applications that change the world. In conclusion, over the first several weeks as CEO, I'll spend the majority of my time meeting with customers, employees, and investors to gather their feedback and sharpen our understandings of the market we serve. While we will continue incorporating this feedback into our ongoing plans, I'm very confident in the immediate priorities that I just outlined.
We will continue to invest in our key revenue growth drivers to achieve our 2024 plan and position the company for further growth in 2025 and beyond. We will obsess over the developer experience and focus on innovating to meet their evolving needs with platform innovation and crisp go-to-market initiatives. We will reignite growth in our core Infrastructure and Platform-as-a-Service offering. We will leverage the strong margins in the core DigitalOcean business to help fund investment in our strategic long-term bets like AI and machine learning-centric cloud application development. We will maintain our long-term focus on increasing operating leverage and delivering attractive free cash flow margins, creating a compelling return for investors.
As you can tell, I'm very excited to be here at DigitalOcean. I've got a very busy quarter ahead, but I'm really looking forward to meeting many of you in the upcoming months. With that, I will now turn it over to Matt.
Matt Steinfort: Thanks, Paddy. It's great to have you on board. I can tell you the entire DigitalOcean team and I are excited that you've joined as CEO, and we're very much looking forward to working with you to achieve DigitalOcean's enormous potential. In my comments, I will review our Q4 results and cover the full year 2023 financial highlights before sharing our first quarter and full year 2024 financial outlook and our go-forward capital allocation strategy. Q4 2023 was a good finish to the year with revenue, adjusted EBITDA, and net income per share, all exceeding the outlook that we have provided. Revenue was $181 million, which was up 11% year-over-year and was 3 million above the high end of our revenue outlook. This performance was driven by the stabilization of net dollar retention within our core business and strong execution on the Cloudways front, and we got some contribution from our recently acquired AI and machine learning solutions.
We also delivered strong profitability as we continued to appropriately manage our investments, balancing investment for growth with efforts to improve operating efficiency in our core business, which resulted in adjusted EBITDA of $73 million, a 41% margin. Adjusted free cash flow was $29 million, representing 16% of revenue due to working capital timing and increased investments in our AI/ML capabilities in the fourth quarter. Non-GAAP fully diluted net income per share was $0.44, which was up 57% year-over-year as we continued to successfully implement our strategy of increasing operating leverage while executing our ongoing share repurchase program. As Paddy mentioned, and as it was for many players in the industry, 2023 was a challenging year with slowing revenue growth in the face of persistent macroeconomic headwinds.
While top line pressure lasted longer into 2023 than we had originally expected, we saw a bottoming of the headwinds in Q3, and with stable net dollar retention and steady growth in Cloudways in the second half, we exceeded the revised full year revenue outlook. For 2023, total revenue increased 20% year-over-year to $693 million. This growth came from over 18,000 new customers that joined our platform through our durable self-serve funnel, and that came from increased spending from existing customers as well, as overall revenue per customer increased 6% year-over-year. Growth also came from the steady performance of our managed hosting platform Cloudways, which increased revenue to $80 million, growing 43% year-over-year, and from our recently acquired Paperspace AI/ML products.
On the operating leverage front, acknowledging the growth headwinds early in 2023, we proactively accelerated our long-term margin profile, positioning the business to generate attractive free cash flow regardless of the economic growth environment. We successfully achieved that objective, increasing adjusted EBITDA margins from 35% in 2022 to 40% in 2023, and free cash flow margins from 13% in 2022 to 22% in 2023. We accomplished this through difficult but necessary cost management of headcount as well as non-headcount related spend and by expanding our global workforce, setting ourselves up structurally to improve margins in our core business as we grow. These strong margins in our core DigitalOcean platform enabled us to absorb Paperspace and invest in the generational growth opportunity that we see in AI/ML while still exceeding our full year profitability guidance.
Now I want to come back to the solid growth foundation that we have established as we launch into 2024. We have a high degree of confidence in achieving double-digit growth on the back of several growth levers. First, we expect new customer revenue, which includes revenue growth from any customer that's still in their first 12 months on our platform that's incremental to the 2023 revenue, to contribute 8% growth in 2024, with the majority of that growth coming from self-serve as we are still in the early innings of our direct and partnership motions. Second, we continue to invest in our managed hosting capabilities, having for example, recently launched our Cloudways autonomous service that Paddy had mentioned, which enables customers to automatically scale their businesses on Cloudways, and we anticipate Cloudways contributing two to three points in growth in 2024.
Third, our AI and machine learning solutions will be another key growth driver. We see tremendous long-term growth potential in the AI market, and we are increasing our investment in both operating expenses, adding engineering resource to advance our AI software platform, and capital, adding incremental GPU capacity to take advantage of this opportunity. We recently announced initial availability of H100s and expect additional offerings and further capacity to come online over the course of 2024. We anticipate our AI/ML solutions contributing 3% revenue growth in 2024. Our fourth and final major growth lever is net dollar retention. As we have discussed, NDR declined over the course of 2023 with a bottoming beginning in Q3 at 96% NDR as we lapped the 2022 price increase.
NDR increased several basis points in Q4 but remained at 96% due to rounding, and we anticipate NDR continuing to improve as we move through 2024 as we are working aggressively to return NDR above 100% in the latter half of the year. As an early indicator of our progress on this front, in January, we saw increasing month-over- month growth in customer usage on the core DigitalOcean platform, and we are seeing similar higher usage growth trends in February as well. With that context, I will now share our financial outlook for the quarter and for the year. For the first quarter of this year, we project revenue of $182 million to $183 million with adjusted EBITDA margins of 37% to 38% and diluted net income per share of $0.37 to $0.39. As you may recall, we do not provide free cash flow guidance on a quarter by quarter basis given it’s heavily influenced by working capital time.
With that said, our 2024 plan is front-loaded on capital as we navigate a constrained supply chain and build critical mass in our AI/ML capacity. So we expect free cash flow margin to dip in Q1 and then increase over the balance of the year. For the full year 2024, we project revenue between $755 million and $775 million, which represents year-over-year double-digit growth at the mid-point. This range takes into account the early stage of our AI/ML offerings and the timing-related risks of a constrained GPU supply chain, but it doesn’t require any further improvements in the broader macro demand environment. With our 2024 investments, we will see modest declines in both adjusted EBITDA and free cash flow margins as we invest to generate a higher growth trajectory as we exit 2024.
Adjusted EBITDA margin will be in the range of 37% to 38% for the year as improved margins from our core DigitalOcean platform are offset somewhat by increased investment in our AI/ML capabilities. Non-GAAP fully diluted net income per share for the full year will be in the range of $1.60 to $1.67. With our increased investments, we expect to invest north of $50 million alone on the AI/ML machine learning capabilities, free cash flow margin will be in the range of 19% to 21%. We strongly believe the potential growth opportunity of this new market warrants the near-term investment of one to three points of free cash flow. Before concluding my remarks, I’d like to reiterate our long-term capital allocation strategy. Growing average free cash flow per share remains our ultimate goal and what we believe is a primary shareholder value creation lever.
In that pursuit, we remain committed to driving top-line growth with increasing operating leverage while continuing to execute a regular stock repurchase program to recurrent capital to our shareholders. Together, we believe these priorities create a compelling return profile for investors. On the buybacks front, the Board has approved $140 million share repurchase authorization that we will execute over the next two years, utilizing the full repurchase authorization by the end of 2025. We made strong progress on our buyback program in 2023, repurchasing $488.5 million in stock and reducing our weighted average non-GAAP fully diluted shares by 11% year-over-year from 118 million to 105 million shares. Stock-based compensation expense also declined materially from 18% to 13% of revenue year-over-year.
With respect to leverage, we continue to believe that 2.5 to 3 times net leverage is an appropriate long-term target. And with our strong free cash flow generation anticipate being in the low 3s by the end of 2024 based on the guidance that we have provided today. We continue to benefit from the $1.5 billion zero coupon convertible debt instrument that does not mature until December of 2026. With that said, we will manage and steadily reduce our net leverage over the remaining three years to ensure that we have an appropriate capital structure flexibility and can take advantage of the company’s growth potential while increasing our levered free cash flow per share at attractive rates. To close my remarks, the company achieved a great deal in 2023 and is well-positioned for profitable growth in 2024.
We have a tremendous and expanding market opportunity and an actionable strategy to capitalize on it. With Paddy now in the seat, we’re eager to execute the plan and deliver strong results for our investors. Thank you again for your time today and I’ll now turn it over to the operator for your questions.
Operator: Thank you. [Operator Instructions] And we will take our first question from Jason Ader with William Blair. Your line is open.
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