DigitalOcean Holdings, Inc. Q2 FY2021 Earnings Call

Thank you for standing by, and welcome to DigitalOcean's Q2 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Rob Bradley, Vice President of Investor Relations. Thank you. Please go ahead, sir. Thank you, and welcome everyone to DigitalOcean's earnings call. Today, we will be highlighting our results for the second quarter of the fiscal year 2021. With me on the call today is Yancey Spruill, our Chief Executive Officer; and Bill Sorenson, our Chief Financial Officer. As we did last quarter, we will begin with commentary from Yancey and Bill, and then we'll answer questions we've received from our analysts. Our goal, as always, is to help investors understand our business model and outlook in the most efficient way possible. After we address those questions, we will turn the call over to the operator to manage an open Q&A period. Turning now to our safe harbor statement. I'd like to remind everyone that during this conference call, we will be making forward-looking statements, including our financial outlook for the third quarter and full year of 2021 as well as statements about goals and business outlook and industry trends and market opportunities, expectations for future financial performance and similar items, all of which are subject to risks, uncertainties, and assumptions. You can find more information about these risks and uncertainties 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. And finally, we will be discussing non-GAAP financial measures today. Reconciliations between our GAAP and non-GAAP financial results and discussions of the limitations of our non-GAAP financial measures can be found in our earnings press release, which was issued earlier this morning. With that, let me turn the call over to our CEO, Yancey Spruill.

Thanks, Rob. Good morning, and thank you for joining us today. We are excited to review our strong second quarter results with you. A quarter in which we saw acceleration across all key metrics. We see continued opportunity to accelerate revenue growth. As importantly, we believe we will sustain a 30%-plus growth rate in the near to medium term. Now let's turn to our second quarter results. Simply put, it was an outstanding quarter. Total revenue was just under $104 million and grew at 35%, a 1,000 basis point improvement year-over-year and 600 basis points sequentially. ARR was up 36% to $426 million, a 1,200 basis point improvement year-over-year and 600 basis points improvement sequentially. And importantly, it was higher exiting the quarter, pointing to continued growth acceleration in the second half. We generated $31.4 million of adjusted EBITDA, which represents a 30% margin and continues to highlight our ability to generate strong margins even as we invest to accelerate growth. We will continue to drive operating leverage in adjusted EBITDA while continuing to make targeted investments to sustain our strong growth rate. I'd like to share some insights into our revenue performance as well as highlight a customer example that demonstrates how we enable entrepreneurs to build their businesses on DigitalOcean. Three pillars to accelerating and sustaining our business trajectory are customer growth, net dollar retention, and average revenue per customer. In Q2, we increased total customers by 9% year-over-year to 602,000. We see customer growth as key to setting the table for robust long-term growth as we bring in thousands of customers per month who start relatively small in terms of revenue, but they test and learn over time and grow. Having a healthy and steady supply of customers is a very good indicator of the sustainability of our high-growth expectations. We are working deliberately to engage our customers early as they join DigitalOcean to ensure that they have an excellent experience and stay on our platform. Historically, the overwhelming majority of our churn occurs within the first 12 months in a customer's journey with DigitalOcean. And within that first year, mainly during the first 90 to 120 days. We have focused our teams specifically on improving the onboarding experience of customers. We are leveraging data science and proactive measures in order to identify improvement opportunities in how, when, and the frequency with which we interact with newly onboarded customers. Next, I'd like to turn to net dollar retention, a critical indicator of the value proposition we offer our customers and the durability of our higher growth rate targets. NDR measures revenue efficiency across customers that are part of the one-year and older cohort who typically represent more than 80% of total revenue in any given period. We are managing specific initiatives to improve retention and expansion, and we saw excellent progress in Q2. Beyond the quarter, it was 113%, which was an improvement of 1,100 basis points year-over-year and 600 basis points sequentially over Q1. The expansion of existing customer spend and the improvement in churn were the key drivers of the significant improvement that we saw quarter-over-quarter. While we are extremely proud of the progress we have made in improving NDR, we still see near-term opportunity to meaningfully improve from the level reported today. The final pillar supporting our revenue growth acceleration is average revenue per customer, or ARPU. ARPU is driven by organic growth inherent within developer, startup, and SMB customers who are early in their life cycle, and who are realizing significant growth. We saw a robust increase of 25% in Q2, resulting in ARPU of $58.07. In summary, across the three major pillars of revenue growth, we are near our minimum target of 10% for customer growth and see a path to attain that. We've made enormous progress in NDR improvement and still see more meaningful near-term growth in NDR, and we are in our targeted range for ARPU growth. Collectively, delivering on these metrics gives us confidence that we will sustain a 30%-plus growth rate for the rest of 2021 and into 2022. At our recent Deploy conference, we announced the launch of Managed MongoDB, a new, fully-managed database-as-a-service offering in partnership with and certified by MongoDB. This new product offering is consistent with our strategy to routinely enhance our core infrastructure and managed services offerings to provide relevant choices for our customers as their businesses evolve. Now I'd like to share a customer story to highlight how we are a destination for developers and entrepreneurs to learn, grow, and ultimately launch their ideas into businesses. This customer is a global online education platform that is both free and open-source, serving both K-12 educational institutions and higher education universities, and they have been a customer of DigitalOcean since 2013. They are on our platform for many years testing and refining their ideas, ultimately leading to the launch of their business, which began ramping a few years ago and is growing rapidly today. When the pandemic kicked in, their business experienced hypergrowth, and with it, their usage of DigitalOcean's infrastructure. This is a great example of a customer starting out small while testing their ideas on our platform and generating revenue for a period of time. Then a catalyst occurs, and they quickly evolve into a rapidly growing business. Our platform is fully capable of supporting the early phases of discovery and the later phases of rapidly scaling businesses. So why did they stay with us for so long before seeing lift-off? It's because of our simple, easy-to-use technology. It's because we provide documentation and support to help them get unstuck when they encounter difficulties. It's because we support open-source software, so we never force their technology decisions and enable them to have flexibility to build their applications. And finally, we are competitively priced. I'm so proud of our entire DigitalOcean team for our accomplishments so far this year. We are poised and excited for additional growth acceleration in the second half of this year, coupled with accelerating free cash flow. I'm confident in our ability to create a durable, high-growth, and highly profitable business serving developers and entrepreneurs throughout the world. I'd now like to turn the call over to Bill Sorenson, our Chief Financial Officer, who will provide details on our financial results in Q2 and our updated outlook for this year.

Thanks, Yancey, and good morning, everyone. We appreciate you joining us today as we review our strong second quarter performance and our first full quarter as a public company. We continue to be pleased with the progress we're making against both our 2021 plan and our medium-term objectives. At DigitalOcean, we're convinced that the strength of our offering is perfectly suited to address the needs of developers and SMB users of the cloud, and we look to capitalize on the massive global market in front of us. To that end, I want to elaborate on some of the key points within Yancey's remarks and share with you additional detail on the progress we're making in the key areas of our company. At DigitalOcean, we track our progress by focusing on key indicators that Yancey mentioned: ARR, NDR, and ARPU, along with free cash flow. In each of these key metrics, we've made material improvements and see continued improvement ahead. At DO, annual recurring revenue, ARR, is the leading indicator of the company's trajectory. In Q2, ARR grew 36% year-over-year, up meaningfully from the 30% growth in the prior quarter and 24% growth in Q2 of last year. Through another lens on a sequential dollar perspective, ARR increased $38 million from Q1. Looking back over the last two years, this is by far the largest sequential dollar increase we've had. Key to the acceleration in ARR is another important indicator, net dollar retention, NDR. NDR in Q2 was very healthy. In Q2, we reported NDR of 113%, which was meaningfully higher than last year and last quarter. In Q2 of 2020, net dollar retention was 102%, and last quarter was 107%. Driving this improvement are customers expanding their utilization of DigitalOcean. Our customers increase their infrastructure use plus their expansion into our other offerings, both benefiting net dollar retention. While driving adoption of our core and newer products are critical to our NDR improvement, continued retention of our customers as they grow is critical as well. We've made progress in this area as we saw a further reduction in churn and improvement in our service levels and response times. While we're very pleased with NDR progress, particularly when considering the SMB market that we service, we aim to continue to drive this metric higher with a continued focus on customer service and new product introductions like Managed MongoDB. Another clear indicator of progress is the continued growth in ARPU, average revenue per user, which reached $58.07 in Q2 and was up 25% compared to the second quarter of 2020. Driving ARPU higher is customer usage growth, broadening our product set, and retaining those customers as they grow. The combination of improved procurement and capacity utilization, coupled with growing EBITDA, has allowed us to become cash flow positive. For the quarter, we had cash flow from operations of $40 million, up from $20 million in Q1, and CapEx of $26 million. As a result, we were free cash flow positive in the quarter and expect that trend to continue. For the third quarter, we expect revenue to be in the range of $106 million to $109 million. We expect adjusted EBITDA margin to be in the range of 30% to 31%. For the full year, we expect revenue to be in the range of $419 million to $423 million. We expect adjusted EBITDA margin to be in the range of 30% to 31%, and we expect CapEx as a percentage of revenue to be between 25% and 26%. I want to thank you all for your continued support and for joining us today. And now I'd like to turn it back over to Rob.

Thank you, Bill, and thank you all for joining us again today as we go over this strong second quarter performance. Our first question is from Tim Horan at Oppenheimer, who asked to know more about DigitalOcean's typical customer and how that is changing and some of the details on how we grow ARPU as well as an update on our success adding and retaining larger customers.

Thanks, Tim, for the question. A couple of points. First, we add thousands of customers per month through our self-serve channel and our sales effort. It's hard to characterize a typical customer given that we don't target specific industries and geographies. But I'll outline two types. About 80% of our customers by logo are early in their journey, similar to the customer example we cited earlier. They are testing, learning, and spending low levels of dollars while consuming our infrastructure and trying to gain traction. They represent under 20% of our revenue. About 15% of our customers by logo have been on the platform for several years and are experiencing rapid growth as they manage their businesses on DigitalOcean. They represent about 85% of our revenue. Our business is built to handle the lifecycle of our customers, from developer to entrepreneur and then to a larger-scale business. In terms of our sales effort, we're making very good progress in terms of the contribution that they're providing to our revenue growth. They tend to bring in much larger customers that have higher ARPU. That was about 2% of revenue last year and will be over 3% of our total revenue this year. We are investing in adding capabilities globally to direct sales, support, and solutions engineers to help our customers onboard existing businesses.

The next question is from Brad Reback at Stifel, who asked what percentage of DigitalOcean's revenue comes from premium products and how much larger this can become on a percentage basis over the next few years?

Currently, just over 90% of our total revenue comes from our core infrastructure as a service. Under 10% comes from our managed services, and that is growing very rapidly. We expect this mix to gradually shift toward 80% infrastructure and 20% managed services over time.

Our next question is from Josh Baer at Morgan Stanley, who asked about differentiation, which is obviously key to DigitalOcean. He asked about faster time to deployment due to ease of use and platform simplicity. How do you maintain this differentiation even as you add more features and products to your platform?

It's definitely a balance. We can't compromise on simplicity. Our customers demand it as they often lack extensive IT resources. We focus on where we expect workflow to evolve and ensure that the addition of new capabilities does not compromise the ease of use that our customers expect.

Next is Pat Walravens at JMP Securities, who asked about our pricing strategy, especially regarding newer product offerings like managed Kubernetes, managed database, and our app platform service.

Our pricing strategy focuses on our differentiation relative to the competition. We provide easy-to-use service and community support while allowing customers flexibility in their technology choices, which further enhances our pricing strategy.

Investors often ask about churn. Pat also asked for an update on customer retention and churn, how to think about those dynamics, and the main reasons for customer churn.

We're excited about our quarterly results, particularly in net dollar retention. The vast majority of our improvement came from expansion as our larger customers grow. Churn dynamics are now down in the lower double digits, and we can still improve further. Mark Murphy at JPMorgan asked about core differentiation and our data center strategy, focusing on video streaming and gaming performance. The foundation of our offerings is built on high-performance infrastructure with a network of global data centers. We provide capabilities at competitive prices, and our customers value predictability in pricing.

Now I'll open the line for Q&A and provide instructions.

Yancey, Bill congrats. Great set of numbers here. Maybe this one is for Bill. Can you help me understand the delta between 25% ARPU growth and 113% net revenue retention? I just wouldn't expect that gap to be that wide.

Good question, DJ. The reality when dealing with 600,000 customers is there's very broad dispersion relative to what they're paying. We are seeing higher entry points and quicker spending from higher spend customers, contributing to the uplift.

We are investing in sales to add regional capabilities to support more directly and more volume from new customers. As we've added capability over time, both to the core infrastructure and our managed services, we see progress.

Can you share more color about this core droplet uplift? What type of workloads are using this enhanced offering? Where are you in terms of penetration?

There’s a diversity of use cases. The uplift is allowing early-stage companies access to the processing performance they need at a lower price point without cannibalizing other parts of the business. We're learning and optimizing.

When you reported your quarter, you showed strong acceleration in customer adds. Do you think that correlates with your Deploy conference?

We're targeting 10% year-over-year customer growth. We're seeing significant results from improving self-serve outcomes, scaling sales efforts, and enhancing customer experiences in their first year.

Can you talk about the trajectory for NDR going forward? Do you see it rising above 115% on a sustainable basis?

We are incredibly excited about the progress in net dollar retention. We expect a sustainable growth of 115% or better soon, continually improving through customer success initiatives.

I think the slides show that the world is heading towards 45 million developers by 2030. How many do you think you can address with your core platform?

It's a massive opportunity with tens of millions of software developers and over 100 million SMBs globally. We focus on supporting these early-stage use cases and believe we are relevant within this market opportunity. We want to thank everybody for joining our call this quarter. We're excited about the progress we're making, and we look forward to continuing our conversation with each of you. We're working really hard to realize the incredible potential of this business. Enjoy the summer, and we look forward to speaking with many of you at the upcoming investor events.

This concludes today's conference call. You may now disconnect.