Thank you for standing by, and welcome to the DigitalOcean First Quarter 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] And finally, I would like to advise all participants that this call is being recorded. Thank you. I'd now like to welcome Rob Bradley, Vice President, Investor Relations to begin the conference. Rob, over to you.

Thanks, Paulie. And thank you and welcome everybody to DigitalOcean's First Quarter 2023 Earnings Call. Joining me today is Yancey Spruill, our Chief Executive Officer; and Matt Steinfort, our Chief Financial Officer. Before we begin, I want to cover our Safe Harbor statement. During this conference call, we will be making forward-looking statements, including our financial outlook for the second 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 GAAP and non-GAAP financial results can be found in our earnings press release, which was issued earlier this morning and in the investor presentation on our IR website. With that, let me turn the call over to our CEO, Yancey Spruill.

Thanks, Rob. Good morning and thank you for joining us today. I'm pleased to share the results of another strong quarter for DigitalOcean. We made solid progress on our key priorities of adding valuable services for customers on our platform and reshaping our cost structure to accelerate our long term free cash flow margin objectives. And despite the challenging macro environment, we met or exceeded all of our financial targets. Our first quarter financial results were strong across the board. We delivered year-over-year revenue growth of 30%. As projected, our quarter-over-quarter revenue growth was more muted, given the near term macroeconomic headwinds we are experiencing. These headwinds have resulted in modest net expansion from our customer cohorts as their businesses have seen their own growth deceleration. And they have continued to focus on managing their spend in the midst of the ongoing economic uncertainty. While it is unclear how long these macroeconomic headwinds will persist, we remain committed to achieving our financial targets this year. Matt will provide more detail on our Q1 results and Q2 and full year outlook later on the call. Stepping back for a second from the current market conditions, I've reflected that we just recently crossed the two year anniversary of our IPO. Over the course of these two years, we have become a much stronger and durable company. We added significantly to our platform's capabilities and have enabled our customers to grow their businesses. We dramatically improved our financial profile or the doubling revenue from 2020, the full year prior to our IPO to this year. And improved adjusted free cash flow from negative 18% in 2020 to 21% plus this year. We've added a number of valuable offerings for our customers like serverless functions, premium droplets, tiered support, significant additions to our tutorial…

Thanks, Yancey. Good morning, everyone and thanks for joining us today to discuss another quarter of strong results with revenue, margins, earnings and free cash flow that continue to demonstrate the resilience and growth potential of our business model. I will focus my remarks today on our first quarter results, on our progress on several key initiatives and on our updated financial outlook. We delivered revenue of $165.1 million in the first quarter, which was 30% growth year-over-year and 1% growth sequentially from the fourth quarter of 2022. We saw resilience in our cohort performance despite the ongoing headwind of continued cloud optimizations by customers, with an NDR of 107% for the quarter. Churn continues to hold steady, which is a great accomplishment in this lower growth environment with top line pressure coming instead from lower expansion and elevated contraction that continued through the quarter. In the current environment, holding churn at historical levels is a testament to both the value of our platform and the loyalty of our customer base even as they focus on optimizing their spend. And retaining our customers will position us for success when they themselves return to growth. Our resilient customer graduation model continues be a source of strength and durability in the face of the challenging macroeconomic environment. Fed by our extensive pool of learners that spend less than $50 per month, we saw a net sequential increase after both graduation and churn of close to 2,000 new builders who spend between $50 and $500 per month and more than 350 new scalars who spend more than $500 per month. Builders and Scalars continue to be the drivers of our growth, representing 86% of revenue and growing ARR at 41% and 24%, respectively, despite together being only 24% of our customer base. Our…

[Operator Instructions] And your first question comes from the line of Wamsi Mohan from Bank of America. Your line is open.

Yes. Thank you so much. Yancey, the larger hyperscalers are all noting deceleration, so did [OVH] (ph) and your NDR decelerated in 1Q, ARR growth was slowest sequentially. Clearly, there are all these macro headwinds. You're still maintaining your revenue guide for the year? Can you talk about maybe what is giving you the confidence in your fiscal year guide and how the weaker macro is changing customer behavior that you're seeing? And I have quick second part, if you could, on just your AI comments. We did run a survey of DigitalOcean users that reflected of the positive elements of differentiation that you called out. We also noticed AI became a top tier for workload case at your Scalars and Builders. Any color on if these are all inferencing use cases and already the customers that are asking for the GPU clusters you referenced and how that might impact your CapEx profile? Thank you so much.

Just first on the AI dynamics. We have businesses running AI based models and businesses on our platform today and they've been doing it for many years. We've always from the founding invested in really high performance computing. And so although GPUs offer some differentiation in enhancing that compute, we still offer very high performance compute, strong bandwidth capability. So, we're looking at product extension and, yes, GPU tends to be capital intensive, but we, obviously, know capital intensity very well and expect our foray into this area over time to be well within our previously made comments about long term free cash flow margins, CapEx as a percentage of revenue. But we do think it will enhance our addressable market with some of the newer business models that are emerging and give some of our existing customers more options beyond just, for example, our premium dedicated droplet product is very compelling for bandwidth intensive. And computational intensive use cases that could be AI, but we will create broader offerings and have more to say about as we go into the near term. On the first comment, I think what we're seeing in the broader environment is, first off, we're very excited about the fact that our churn has been very stable over this past year. Ticked up a little bit, but we know we've noted with some of the blockchain and the dynamics in Russia mainly causing that. But we did see churn even improved -- decline as we move through Q1 and into Q2. So that's a very strong thing that we focused on, because weakening environment, you want to keep your customers. And I think our team is doing a very good job of that. Secondly, what we're seeing is that, our customers are -- we have…

Thanks, Yancey.

Your next question comes from the line of Michael Turits from KeyBanc. Your line is open.

Hey, guys. Congratulations on stability and then certainly on the margin efficiency expansion. Matt, I wonder if you could add in, Yancey as well, I guess, could you just talk about the -- your thoughts on gross margins and CapEx for the year. Obviously, you've done a great job on the OpEx side with a little bit of pressure on gross margins and then you're benefiting it seems from some timing but also some efficiency on CapEx.

Yes, I'll start in reverse on that with the CapEx. CapEx came in at 15% of revenue for the quarter and that's generally consistent with what we expect kind of for the full year. So while I mentioned timing, we don't expect that CapEx as a percent of revenue is going to increase in any material way from the first quarter. On the gross margin front, that's something that we had known is coming, right? We signaled [indiscernible] we have made investments in our data center footprint. We've added the Sydney data center. We've expanded some capacity in certain markets. And that causes a near term kind of increase in the cost structure. It was about 350 basis points impact around colocation year-over-year. We also invested in some upgrades around bandwidth to improve some performance of our network, that was about 125 basis points. And then there was another 125 basis point impact from the European utility cost, which we don't think persist much longer than 2023. But the important thing is that, despite the increase in the cost -- on the gross cost side. We were able to effectively manage and exceed the EBITDA margins and the free cash flow margins. And by the end of the year, we expect to be north of 60% on the gross margin front, but it's just a really temporal challenge on the gross margins.

Great. Thanks for that detail and color and congrats on the stability and then the efficiency.

Your next question comes from the line of Raimo Lenschow from Barclays. Your line is open.

Hey, thank you. My question was more on the optimization or the end demand signals you're seeing, Yancey. Obviously, like if you think about like the big enterprises, they would renegotiate the clouds raise and the renewals in Q3, Q4 and then you kind of done what you're dealing with. How do you see the picture playing out for you? Is that kind of an ongoing rolling kind of optimization that is going on there? And what are the segments that you're looking for to see if there's a change? Or are you just kind of basically plainly wherever the cycle goes you go? Thank you very much.

Yes. So we've now been about 12 months into this lower growth dynamic as our businesses, our customers have been expanding slower. Again, with the consumption based model, it corrects immediately. So we've been living with this again for a year. I think a key signal and importantly, as I pointed out, the churn has been stable and is actually proving right now. Those are two really important -- that's a really important side for us. The second is for the turn, we'll be looking at for expansion to begin -- the fact that our customers are actually consuming more cloud because their businesses begin to expand again. That will be a key signal for us. It's relatively stable but slower than it was certainly a year or two ago and that explains the lower NDR and the overall growth rate. As it relates to optimizations, I would say the consumption based model kind of builds in optimization because as their business slows, they pay for what they use. So their customers are consuming less, they consume less bandwidth, et cetera, they just spend less. They're built corrects immediately. So we have a built in optimization if you will into our model, which is why we saw this earlier than some of the people with one or longer year contracts. What I would say about the conversations we've been having with our customers is, as their businesses have slowed and typically our small businesses tend to have really rapid growth rates. They're taking a pause and they're looking at architecture, they're looking at longer term or intermediate term dynamics around how they run cloud. And they've led to some great conversations with us putting customers in different packaging that actually gives them a more efficient growth path similar to the case I just cited with the premium dedicated droplets. So this has been a great opportunity for us in a challenging environment where our customers are nervous for us to work with them to put them on a more efficient path that they feel better about so that they can manage through the current period of time. And be poised when they do accelerate to have a more efficient growth path. That's going to see growth for us, but also more peace of mind for them. So we're taking this opportunity to get closer to our customers, which I think in a recession or certainly a super low growth environment which the tech industry or our industry is in is the approach that we've decided to take.

Yes. Okay, perfect. Thank you.

Your next question comes from the line of Mike Cikos from Needham. Your line is open.

Hey, guys. Thanks for taking the questions here. I wanted to cycle back to Matt's prepared remarks. I think to open up, you had cited these elevated contraction rates. And I just wanted to see if we could get a better sense of the shape of those rates. How did 1Q play out as far as those contractions we were seeing? With April now behind us, was there any change there? And then the second question was, I know that you guys reiterated the calendar 2023 guidance, but at the end of February, you had also announced a price increase for Cloudways. Can you give us a sense of what's embedded in your guidance based on that Cloudways price increase or was that already in some way incorporated in your previous thinking? Thank you.

Thanks, Mike. Yes, just to close out on that one, the Cloudways price increase was contemplated in the guide. So that was baked into our plan. We made the decision at the time we acquired Cloudways, which was right when we were just recently done the price increase for [indiscernible] that we would wait until we closed that transaction and got a little further in and did some analysis before we just blanket increase the prices at Cloudways. But -- so we did that, it took effect in April. But it was -- that we knew that going into the planning process and into the guidance. On the contraction, as Yancey said that, if you think of what NDR, NDR is a function of three things, its churn, its expansion and its contraction and the net of all those three gives you your NDR. And so, if you look at the decline in the NDR from first quarter or from fourth quarter to first quarter, churn didn't contribute in a negative way to that reduction, churn held flat. In fact, as Yancey said, we've seen kind of month-over-month through the course of 2023 an improvement in the churn rate, modest improvement in the churn rate. So the delta that you're seeing in the NDR is driven almost entirely by the combination of lower expansion and more contraction which is very consistent with the optimization and kind of the pause that Yancey just described in our customer base. So if you're trying to get a math kind of view of it, just look at the NDR and assume churn is flat kind of quarter-over-quarter, that will give you the result for expansion and contraction.

Awesome. Thank you for the color. And did you guys quantify the benefit from the Cloudways price increase for this guidance we have now? I'm done.

No, we did not.

Okay, all right. Thank you. I'll turn it back to my colleagues.

Your next question comes from the line of Brad Reback from Stifel. Your line is open.

Great. Thanks very much. So with the current guide sort of pointing towards the mid to upper teens exit growth rate for the year and the CapEx growing at 15%. Should we think about that being the long term sustainable organic growth rate for the business? We're -- our guidance reflects their outlook for the year. And we aren't commenting on longer term growth expectations for the business. We continue to invest to drive growth that's higher than what you just cited. But at the same time, there's things that we can't control beyond and so we're focusing on what we can control, which is why we made it a very strategic decision months ago to accelerate to longer term free cash flow margins today. And as Matt just cited, we'll be approaching those even in this quarter, but certainly as we exit this year. And what that positions us for is, in an area of lower growth, this is the growth rate that persists with attractive margins and returns on capital. If growth reaccelerates and we are investing in new products as we cited today to do that, we'll have more investment capacity as well as deliver more leverage in the operating model. So we're pleased to reiterate the guidance for the year. We're pleased actually with quite a few of the trends that we saw as we moved through Q1 and as we're into Q2 year. And as we get to the back half of this year and certainly in early next year, we'll have more to say about 2024 and perhaps beyond depending upon how the macro is shaping up.

Great. Thanks very much.

Your next question comes from the line of Pinjalim Bora from JP Morgan. Your line is open.

Hey, guys. Thanks for taking the question. Yancey, maybe could you talk about the Cloudways performance, especially around the multi cloud adoption that you were talking about. I'm assuming Cloudways will be a beneficiary of that. How are you driving that motion? And secondly, it seems like the pricing increase in Cloudways is proportionally higher with some of the competitive offerings, some of your peers. What are you hearing from those customers on that price increase? And how do you think that plays out?

Well, Cloudways is performing very well. There's been a slight uptick in the growth rate since the close, really owing to a lot of the acceleration and new customers is incredibly exciting. Those customers who were coming to DigitalOcean had a mismatch expectation before the close of the deal. That they were expecting a more managed experience, many of them churned. And we've done a great job in saving those customers and getting them into Cloudways out of the box and they're going to be long term customers. So we're materially increasing value as a result. So really excited to have a bullet -- first bullet on the synergies of the complementary platforms and actually realizing those synergies so early and so significantly. And so, we're really excited as we continue to look at other areas on the sales and marketing side to better match customers whether it's at Cloudways or at DigitalOcean into the right fit, either it's day one or overtime. So we feel very good about that. In terms of the pricing change. It's early, six weeks after it's gone effective. We feel good about the early returns on that. And as Matt cited that had been baked in, that was put on pause as we closed the acquisition last year. So it was contemplated earlier this year. And it -- Cloudways had got a previous price increase four or five years ago and it was time. And feel good about the early feedback and what we're seeing in terms of demand on the platform since that announcement and it's gone into effect.

Got it. Thank you.

Your next question comes from the line of Gabriela Borges from Goldman Sachs. Your line is open.

Hi. Good morning. Thank you. Yancey, I wanted to ask how you think about the impact of AI on the Cloudways business in particular. One of the risks that I'm trying to understand is, to what extent Cloudways is helping bridge what may be a technical gap to help get your customers on DigitalOcean software. And to what extent that bridging essentially gets potentially extracted away by other AI tools? Would love to hear how you think about it. Thank you.

Well, I think in the bigger picture AI is a very compute intensive, storage intensive, bandwidth intensive products that, however, the ultimate products are successful products shakeout. And so, i.e. infrastructure is a service intensive. So I think overall, AI tools, applications will ultimately be a tailwind for our business. And as I cited earlier, there are already businesses who are running AI models that are whole premise as artificial intelligence that are serving customers at reasonable size on our platform today and have been for years. So as it relates to sort of the core compute, what we would be looking to offer is capabilities that allow our customers to leverage AI tools, our build language models or run complex compute algorithms beyond what they can do today on our platform, which is why we also acknowledge that we're looking at GPUs. So not sure I understand specifically your question or that's something that we are necessarily concerned about in terms of the infrastructure part of our business, because we think infrastructure enables AI applications. And frankly, we should be a beneficiary over time. We've already been a beneficiary from AI models businesses running on our platform as of today.

Thank you for the detail.

Your next question comes from the line of Jim Fish from Piper Sandler. Your line is open.

Hey guys. This is Quinton on for Jim Fish. Thanks for taking our question. With another quarter of learnings behind the team following the Cloudways deal, has there been any changes in the other managed service provider's willingness to offer DigitalOcean just due to your accelerated investments in Cloudways? Or have those channel relationships remained relatively unchanged following Cloudways? Thank you.

So the managed hosting, managed services business is very large and very fragmented around the world. This was, obviously, a key diligence concern for us as we were going through the negotiations and the conversations with Cloudways a year ago. And the sentiment was that it would not be an issue and the reality is that it is not an issue. We are not seeing other managed service and hosting providers that have been meaningful customers on DigitalOcean. We have not seen them move volumes away. In fact, one of the larger ones on our platform that is a multi-cloud managed hoster moved cloud services onto our platform as a part of the optimizations in Q1. So the direct answer to your question is, we have not seen it. We weren't concerned going into the deal after diligence and it's not something we've seen in this two plus quarters that we've owned the company.

Got it. Helpful. Thank you.

And that concludes our Q&A session for today. I would like to turn the call back over to Yancey Spruill for closing remarks.

Thank you all for joining us. We truly appreciate the opportunity to update you on our progress and in transforming our business into a durable high growth business and a free cash flow machine in both good times and in bad. We look forward to continuing the conversation in the weeks and months ahead as we work hard to realize this limitless potential of this opportunity we call DigitalOcean. Have a great rest of the day.

This concludes today's conference call. Enjoy the rest of your day. You may now disconnect.