DigitalOcean Holdings, Inc. Q3 FY2021 Earnings Call

Good day and thank you for being here. Welcome to the DigitalOcean Q3 '21 Earnings Conference Call. All participants are currently in listen-only mode. Following the speaker's presentation, there will be a question-and-answer session. Now, I would like to turn the conference over to your first speaker today, Rob Bradley, Vice President of Investor Relations. Thank you. Please proceed.

Thank you and welcome, everybody, to DigitalOcean's third quarter 2021 earnings call. With me on the call today is Yancey Spruill, our CEO; and Bill Sorenson, our CFO. Today, we will start the commentary from Yancey and Bill and then we will answer questions we 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'll turn the call over to the operator to manage an open Q&A period. Turning 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 fourth quarter and full year as well as statements about goals and business outlook and industry trends, market opportunities and 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. Finally, we'll be discussing non-GAAP financial measures today and reconciliations between our GAAP and our non-GAAP financial results 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 pleased to share our very strong third-quarter results with you, where we again delivered acceleration in revenue growth, adjusted EBITDA and growing cash flow. As a result, we are increasing our outlook for the balance of 2021 and reiterating our confidence in sustaining 30% or better growth in 2022. The transformation of DigitalOcean is well underway and we remain laser-focused on achieving our first $1 billion of revenue in 2024. For the second consecutive quarter, we saw a significant improvement in revenue growth versus the year-ago period and an acceleration from Q2. Relative to Q3 of 2020, top-line growth improved nearly 1,300 basis points and accelerated more than 200 basis points from the prior quarter. This continued growth acceleration results from strength across our key growth drivers: number of customers, net dollar retention and revenue per customer, or ARPU. I will dive into each a bit more in a moment. ARR increased 36% year-over-year to $455 million. This represents a 1,200 basis point uptick relative to Q3 last year. ARR was flat on a sequential basis to Q2, largely due to lapping the step-up in September 2020 revenue from new products. We are off to a strong start in Q4 and we are confident in our outlook for the rest of the quarter and feel great about our momentum heading into 2022. Our profitability is an attractive differentiator for a company whose growth rate continues to accelerate. In Q3, we generated $36 million of adjusted EBITDA which represents a margin of 33%, underscoring the efficiency of DigitalOcean's business model. Investors often ask whether we would be willing to invest even more into the business to grow even faster. The answer is we are doing so today. In fact, our margins could have been higher in Q3 but we see opportunities to invest that will enhance our growth in 2022 and are more than happy to hold back on current adjusted EBITDA margins in order to give us a head start on product innovation and go-to-market initiatives, driving growth acceleration into 2022. Now that I've shared the headline results for Q3, I'd like to take this opportunity to provide more granular insight into our customer base. We have a large customer base with a very long-tail dynamic, where a large percentage of our customers are testing ideas, learning how to code and are in the idea formation stage of launching a business. A small percentage of our customers emerge to launch and build rapidly growing small and medium-sized businesses. One of the key drivers of our faster revenue growth is that we are nurturing and attracting increasingly larger and more rapidly growing businesses to our platform, what we would consider the typical SMB. These larger customers represent roughly 15% of our total customer base, yet generate roughly 85% of our total revenue. They grow substantially faster than our reported top-line growth with ARPU growth of over 50%. NDR of 118% in Q3, also better than our company average and up meaningfully from 104% in Q3 of 2020. These customers have a higher net expansion rate as many of them buy multiple products and churn at a much lower rate, in the mid-single digits versus low double digits for the entire company. Importantly, the number of larger customers is growing several times faster than our overall customer growth rate. We expect these trends to continue where these larger customers grow faster, have a higher NDR and therefore will represent a larger share of our total revenue mix over time. Our continued investment in product, direct sales and focus on customer support is paying off as the size of our customer base gets bigger and we attract more of the SMB market. Many of these fast-growing customers have incubated on our platform for a period of time before their businesses launch and they ramp. We have an incredible customer ecosystem where we nurture early-stage developers and entrepreneurs until they get lift-off of their ideas and support the growth of rapidly growing start-ups and SMBs as they get traction. To boot, we do this at a very low customer acquisition cost and at increasingly compelling unit economics, as expressed by our NDR results. With that context on the nature of our customer mix, let's discuss our Q3 performance levers to drive sustained revenue growth, that is: customer growth, net dollar retention and average revenue per customer. Beginning with customer growth; we ended Q3 with 598,000 customers, an increase of 7% year-over-year. The slight sequential decline from Q2 was the result of our implementing enhanced security protocols to remove certain low-value customers from our platform. Importantly, although these actions reduced reported customer count by roughly 150 basis points, they had no material impact on our reported revenue. On the contrary, revenue growth, ARPU and NDR all accelerated and improved sequentially from Q2. I'm very proud of our team for leading in the area of trust and security. It's vitally important to our customers as they look to us to be the platform to build their relationship and business with their customers. We are making DigitalOcean a more robust and secure platform for all of our customers to have confidence on which to build their businesses while not impacting our ability to accelerate revenue growth. Next, let's focus on the strong improvement we saw in net dollar retention in Q3. We believe that NDR is one of the most important gauges of the health of our business and a critical driver of near-term and enduring growth potential. Our 12-month and older cohort of customers in the NDR calculation have historically represented over 80% of reported revenue. So we are very focused on sustaining this improved NDR as it is a key pillar to our overall growth acceleration. In Q3, NDR was 116%, as we continue to see customers stay on the platform, consume more product, and churn less. The expansion of existing customer spend and reduced churn combined to drive the improvement in NDR in the third quarter. We have dramatically reduced churn. And by keeping more customers on the platform, we are now set up for net expansion to continue to drive NDR acceleration. Finally, a key contributor to our strong results in Q3 was a 28% year-over-year improvement in ARPU. As I mentioned earlier, our larger customers are doing well and experiencing their own robust organic growth. This success not only leads them to consume more DigitalOcean infrastructure but also drives them to purchase additional products from us, particularly our Platform-as-a-Service offerings that are well suited for these growing SMBs. This dynamic will continue as we broaden our product offering for SMBs, creating a stickier customer experience and giving us confidence we can sustain these current levels of growth. To illustrate, just a little over two years ago, we had roughly zero revenue from products outside of our Infrastructure as a Service. Yet today, we're at roughly 10% of total revenue and solidly on track to achieve our target of 20% of total revenue when we generate our first $1 billion of revenue in a few years. This is not coming at the expense of growth in our infrastructure revenue. Rather, our customers' inherent organic growth helps increase their infrastructure spend while they also spend more on our relevant platform services. Turning to our product strategy; there were two developments since our last earnings call that we are very excited to highlight today. First, we hired a new Chief Product Officer, who started a few weeks ago. Gabe Monroy joined us from Azure and will lead our product development strategy. Given his expertise in the infrastructure and Platform as a Service markets and experience helping significantly scale revenue on those platforms, we are confident that product innovation will be a much more prominent lever as a component of our growth strategy in the years ahead. We are excited to have Gabe aboard and look forward to sharing more of our plans for product innovation as we move into 2022. The second piece of exciting news on the product front occurred with our acquisition of Nimbella. This expands our Functions as a Service or FaaS offerings. FaaS is a rapidly growing adjacent market opportunity that complements our IaaS and PaaS offerings. Nimbella is a cloud-native offering that allows developers to build and run applications without having to manage servers, delegating that to DigitalOcean in the background so they can focus even more on their customers and application development. Serverless has been a top five customer request and closely aligns with our mission to simplify cloud computing and will attract customers' focus on increasing their agility and productivity. Additionally, serverless will be a driver of both NDR and ARPU growth as it will create a net new revenue stream as well as increased usage of DigitalOcean's infrastructure services given the complementary nature of serverless with our other offerings. Our team is busy integrating Nimbella on our platform and we are excited to get this product into our customers' hands next year. In sum, we were pleased with the strong momentum with all three of our growth drivers as well as progress on the product front which we expect to increase as we get into 2022. These moves continue to give us confidence in our positive trajectory, and in our ability to sustain top-line growth greater than 30% for the balance of 2021 and in 2022. Next, I want to highlight one of our 600,000 customers that exemplifies all these growth drivers in action, that is: an SMB customer who has scaled on our platform and is using a breadth of our offerings. And as a result, their increased spend is contributing to our accelerating ARPU and NDR. This customer offers advanced training for IT security professionals and hackers through gamified hands-on learning experiences, including hacking methodology, penetration testing and vulnerability research. The training is self-driven and users advance by completing a series of challenges where points and rankings are garnered by users' ability in solving progressively complex scenarios. Over the last four years, they have grown from three employees to more than 100 and their user base exceeds 750,000 platform members, representing more than 800 organizations. Driven by the need for simplicity and performance, the customer engaged DigitalOcean. Their platform was running on a hyperscaler with virtual machines and a relational database. But their CTO was familiar with DigitalOcean and appreciated our focus on simplicity, community support and our highly performing capability. They conducted benchmarking tests which confirmed our ability to manage their workloads and migrated them over to DigitalOcean. Today, the customer takes full advantage of our product portfolio and runs approximately 95% of their infrastructure on DigitalOcean. As they continue to grow, they are leveraging our managed Kubernetes, our Database as a Service, and app platform in their architecture as well. 10% of their overall spend is coming from our platform services and 90% from our infrastructure, similar to our overall company product mix. They spend over $220,000 in annual run rate today and that's up from zero since launching our platform just three years ago, a powerful demonstration of how we help developers and early-stage businesses get lift-off and then ramp up their businesses with our set of relevant products that support their rapid growth. This is just one example of a customer leveraging DigitalOcean's platform and quickly scaling as they experience rapid growth. This is a perfect illustration of the customers driving our accelerating revenue and the supporting metrics. There are tens of thousands more just like this and I look forward to sharing more about others in the quarters ahead. In summary, the third quarter was strong across the board, as we are transforming DigitalOcean into a durable, high-growth and free cash flow-generating business in a massive $50 billion market growing to over $100 billion in the next few years. We are confident in our trajectory and we expect a strong finish to this year that will take us into 2022 with a great deal of momentum. I wish to express my thanks and gratitude for the hard work of each member of our DigitalOcean team, who is driving this success. I'd now like to turn the call over to Bill Sorenson, our Chief Financial Officer, who will provide details on our Q3 financial results and our updated outlook for the balance of this year.

Thanks, Yancey. Good morning, everyone and thanks for joining us today to discuss yet another quarter of strong revenue growth and continued acceleration in our key operating metrics. The initiatives that our management team undertook for this fiscal year are clearly paying off and showing continued traction. This provides a great foundation for next year as we look to continue to deliver our sustainable and durable 30%-plus revenue growth. Yancey covered many of the key points in his remarks but I'd like to provide some additional detail on the results and the key drivers of our growth. Following that, I will provide our financial outlook before taking your questions. Management is keenly focused on the three levers of growth that Yancey highlighted which really are the most critical metrics in our monthly dashboard: revenue growth, ARPU, and NDR. Each of these metrics clearly demonstrate the progress that we have and continue to make. In the last four quarters, all indicators have shown consistent and meaningful improvement. For the third quarter, revenue grew by more than 37%, up from 35% growth in Q2 and up over 1,000 basis points from last year when we grew 24%. ARPU was $61.97, up 28% year-over-year and up from $58.07 just last quarter, and NDR continues to grow. We averaged 116% in Q3, up from 113% just last quarter; these results clearly reflect the strength of our offering in both infrastructure and managed services, giving our customers easy access to the tools and technology that they need to grow their business. What is particularly exciting for us is the growth we see in our larger customers, those who spend multiples of our average ARPU and many of whom consume several of our products. Investors have heard us discuss this trend before. But as these consumers consume more of our managed service products, database, and Kubernetes, they in turn consume more of our core infrastructure product as well. These customers are spending more, expanding at a faster rate, and are churning substantially less than our average customers. And with the development of additional offerings, such as App Platform, MongoDB, and the future launch of our recently acquired serverless offering Nimbella, we see the opportunity for further growth. This trend is driving healthy growth in ARPU and as importantly, NDR, because if these customers grow and expand with us, they stay with us, driving the expansion side of the NDR equation and reducing the churn side. And that was clearly evident in the third quarter as NDR accelerated further to 116%. This was a 300 basis point improvement from Q2 and is a critical component for durable 30%-plus revenue growth. We’re seeing this uplift in NDR coming from a combination of net dollar expansion and a reduction of overall churn, particularly in the larger customers I just mentioned. While we remain focused on the customer and their experience, we've also continued to focus on further improvements in terms of profitability and capital efficiency, while at the same time, investing for the future to capitalize on the large growth opportunity in front of us. Cost control, along with a focus on return on investment, has allowed us to maintain adjusted EBITDA margins above 30%. In Q3, adjusted EBITDA reached 33% due to our revenue and gross margin overperformance but we expect that will moderate in Q4. We will continue to invest across our business, focusing on new customer acquisition, both from self-service and increasingly through direct sales, in onboarding and customer support; and finally, in new product development. One item to note is that during the quarter, we were able to release that liability of $3.2 million. The elimination of this reserve increased operating income in the quarter but is excluded from the adjusted EBITDA calculation. This reserve was established over three years ago. And after discussions with European tax authorities, it was determined that no additional liability was outstanding. Also during the quarter, as part of our ongoing security best practices, we removed the number of low-value customers from the platform which slightly reduced total billable customers. Our security measures have allowed DigitalOcean to achieve a meaningful reduction in bad debt while improving the value and quality of our customers overall, as reflected in our continued growth in ARPU and NDR. Customer growth is continuing in Q4 with early indications that recent investments in paid advertising or refreshed brand campaign and the introduction of additional payment options are accelerating customer acquisitions. Given our improved operating performance, we've been accelerating investments this year in order to get ahead of '22. By investing in people as well as the systems needed to support our growth, we want to hit the ground running for fiscal 2022. As noted, adjusted EBITDA in Q3 came in slightly above plan at 33%. For Q4, we anticipate that increased hiring will result in EBITDA of approximately 31%, in line with our initial guidance. Finally, we continue to invest in CapEx to support our growth and as importantly, to upgrade our existing fleet. For 2021, we're planning for CapEx to be between 25% and 26% of revenue, consistent with the guidance we provided at the beginning of the year. In Q3, CapEx represented 24% of revenue or $26.3 million. This was a significant improvement from Q3 of 2020, where CapEx was 32% of revenue. This number is slightly lower than our guidance for the full year as a result of some shipment delays which have since been rectified. It's important to note that in 2021, we will have invested $100 million in our global infrastructure footprint. We've made material investments to support our rapid growth while also modernizing our existing fleet. Fleet modernization, combined with the optimization of our infrastructure architecture, is increasing our return on investment as these efforts increase the revenue-generating capability per server. Our disciplined and ongoing investment in infrastructure, however, has not reduced our commitment to generating cash flow. In the quarter, DigitalOcean generated just over $40 million in cash flow from operations, 36% of revenues, which is up more than 70% year-over-year. Now, I'd like to provide our Q4 and full year outlook. For the fourth quarter, we expect revenue to be in the range of $117 million to $119 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 $426 million to $428 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%. Our forecasted results for 2021 provide a great foundation for '22. At this time, we're targeting approximately 31% growth for fiscal 2022. In closing, I want to remind investors that DigitalOcean is well positioned to take advantage of the exciting and large opportunity we have ahead of us. We have a product offering that is delighting SMB customers in virtually every country in the world. We have a brand name that is recognized and respected and we're a major player in the fast-growing global developer community, that along with improving profitability, increasing cash flow combined with no debt. With all of this, we intend to further expand our product set and pursue aggressive growth.

Thanks, Bill. And thank you for joining us today as we go over these strong Q3 results, where we saw acceleration across the board. As is our process, we've asked for some questions ahead of time which will address some thematic issues and then we'll open up Q&A with the operator. The first question today came from Tim Horan at Oppenheimer. And he asked, is there some color you can provide on the small competitor landscape? How many companies have a focus on your niche? And are they catching up with you or falling behind?

Good morning. Thanks, Tim, for the question. I'd say there's a small handful of sort of Infrastructure as a Service providers who compete in the small and in the developer and the SMB space. What I would say is we're playing in a $50 billion market targeting SMBs and developers. That market is growing 27%. We are now growing substantially faster than our market for cloud, SMB and developer cloud. And so we're pulling away from the competitive set as we see it. And that's happening from a combination of our go-to-market initiatives to drive more customer conversion, expansion and retention and then our product strategy to give customers who are scaling on a platform more options to do more with us. So we're excited about where we are. We feel like we are well-positioned and accelerating into 2022 and are really well positioned vis-à-vis the competitive landscape and feel like we're pulling away at this point in time.

Great. The next question came from Brad Reback at Stifel. And he asked, are there any supply chain constraints to purchasing new CapEx?

This is Bill Sorenson. Good morning, everyone. As we've talked about repeatedly, we take a view for the next six to eight quarters in terms of our requirements for both investing in growth as well as upgrading our overall fleet. We did reference that we had a slight delay in one of the projects we had scheduled for this year, which meant that our CapEx in Q3 was a little bit lower. But across the board, we have not experienced any material delays. Again, because we plan so far in advance, we feel that we're in a very good position relative to what our needs are. We are mindful of constraints that are being suffered by a number of industries. We're in pretty regular conversation with our major suppliers. We give them visibility into what our ongoing requirements are going to be, again, with that 6- to 8-quarter-type horizon. So given that visibility that they have with us, we think it puts us in a pretty good position that if they do indeed experience any potential delays, we're well ahead of that and we can adjust accordingly. So I feel like we're in a very good position. We never want to be in a spot and we'll not be in a spot where we are caught out relative to meeting the accelerating growth that we're experiencing. We'll continue to invest there as we move forward.

The next question comes from Pat Walravens at JMP Securities. And he asked, can you talk about the hiring of your new Chief Product Officer, Gabe Monroy? What about his background stood out most? And what did he bring to the table? How might this change the product strategy, if at all?

Thanks, Pat. Well, we're excited to have Gabe aboard. He's a builder, an entrepreneur, started a company, was able to sell it to Azure. And then stayed at Azure and has had significant success in leading teams there, leading product and building a really large business sort of on the same trajectory that we're on, understands developer in that migration, that journey that developers take to start a business and then scale. And so we're excited about the relevant experience and the scale. And we just can't be more delighted to have him come in here with a very strong point of view already on our marketplace, our customer base, our market opportunities. And he'll be responsible for helping us lay out the future product roadmap, the priorities and we look forward to sharing that with you all as we get into next year. But we ran a search. We had an incredible amount of people interested in the role which is particularly exciting as a validation of where we're taking our business. And I think Gabe is going to be an incredible driver of value for our customers and our investors over the next several years.

Thank you. And the next question came from Michael Turits at KeyBanc. And he asked, investors are still trying to understand how customers evolve and grow with DigitalOcean. Could you help us understand how, as they grow, mature and have more requirements, how does DigitalOcean support those customers? Do you ever see customers as they become larger, either move existing workloads or add net new workloads to one of the major public cloud vendors?

Thanks, Michael. We have this unique ecosystem where we attract tens of thousands of customers every month who are just here to test ideas, test code, learn how to code, learn and grow as developers and entrepreneurs. We have a very low acquisition cost, very low friction to get those customers here. We generate nearly five million visitors to our website. We are seeking to read our tutorials and other documentation. And they say come here, they test, they learn. They could be here for a month, two months, eight months. In the last earnings call, we gave an example of a customer who was doing that for five years before they launched their business. And then we have that unique ability to support their scale as they go from zero customers to 10 customers, thousands of customers, etc. And well, if the infrastructure scales, we have a global network of infrastructure services that support their needs. And then increasingly with our managed databases, our managed Kubernetes, our App Platform, soon to be our serverless, our marketplace, we have incremental applications that as their workflows evolve, their customers grow, their product sets grow, their geographies grow, their number of employees grow, we have incremental tools and services on the software platform side that enable us to grow with them. And an example of the customer we just cited is a powerful demonstration of how we can serve those customers on their journey. And we're really excited about the opportunity to do that and that's driving ARPU, that's driving our net dollar retention and that those customers are driving our revenue growth. And at the front end, we have this engine that's fueling long-term revenue growth by having customers come in here in a very low-friction, low-cost way and then we can nurture those customers over time.

Thank you. The next question comes from Q - Wamsi Mohan at Bank of America. And he asked, your growth has been accelerating well beyond 25% over the last few years, now over 10 points better than that. Can you talk about the drivers of growth as a function of, one, how penetrated you are in the target customer base? And two, opportunity to drive blended ASPs double digits?

Thanks, Wamsi. Well, first and foremost, we're playing in a massive market. There are 30 million software developers going to 50 million by the end of this decade. There's 100 million small- and medium-sized businesses in the world today, 14 million new are added each year. Collectively, those groups spend about $50 billion in the cloud today and that is heading to $120 billion by 2024. So a massive market opportunity. And given our penetration, 600,000 customers, roughly $450 million of run rate, we're really early in the journey here and the opportunity in terms of penetration. And our go-to-market strategies and our product strategies are designed to help us attach at really high growth rates, at great unit economics and to sustain better than double-digit revenue growth per customer at really strong expansion net of churn rates expressed in NDR and a robust customer growth rate over time. So we're early. And we've made a lot of progress in improving the core metrics and the attractiveness of our business in terms of growth rates, in terms of unit economics on ARPU and NDR and operating margin, free cash flow. And we just have an incredible sea of opportunity ahead of us. So early in the opportunity and excited and well positioned to go grab a big chunk of that. And again, we've said we're on track for that first $1 billion of revenue by 2024 and see a sea of opportunity beyond that as well.

Excellent. And the last question we have before we open up the line is from Q - Raimo Lenschow at Barclays. He asked, your pricing has consistently been cheaper than Amazon Lightsail and Microsoft Azure. How can you afford to keep prices lower given the scale advantages that hyperscale cloud providers offer? Is lower pricing the primary reason an SMB chooses DigitalOcean over the hyperscale providers?

Thank you, Raimo. We have a distinctly unique set of capabilities. However, the main reason customers choose to join and continue with us is our simplicity. During this earnings call, you could have already started as a customer. It's straightforward and intuitive. Even as we expand our products and services, simplicity remains a core value, which is crucial for early-stage small businesses that don't have extensive teams for IT solutions. It has to be user-friendly. Our community investment includes tens of thousands of tutorials and digital documentation that attract millions to our website. We support individuals in learning and growing, whether they are large customers or just starting their business journey. Our focus is on customer success, which is central to our value proposition. Additionally, we provide human support to every customer, regardless of their size, which sets us apart from many alternatives. We embrace open source. We recently wrapped up Hacktoberfest, the largest hackathon globally, with over 150,000 participants. We promote open source software as a significant advantage for early-stage entrepreneurs to acquire code and launch businesses affordably, enhancing their speed to market. Our ecosystem supports and empowers entrepreneurs. Our differentiation lies in this approach, along with offering a relevant set of services. We’re not innovating for the broad complexities of enterprise; instead, we focus on simplicity, providing the essential tools our customers need. This allows us to deliver compelling value. Ultimately, our simplicity, community engagement, support model, and commitment to open source principles are why customers choose to join, remain, and grow with DigitalOcean.

Great. Thank you very much. And Paul, if you could open up the line for instructions in Q&A, we'd appreciate that.

Your first question is from Mark Murphy with JPMorgan. Your line is open.

Thank you, everyone, and congratulations. I wanted to touch on something.

Mark, we cannot hear you.

Paul, it sounds like they have a problem maybe with their connection. Why don't we go to the next question and then get back in the queue?

Our next question is from DJ Hynes with Canaccord. Your line is open.

Hey, good morning, guys. Thanks for taking my questions. Yancey, I want to point a finer point on the customer account dynamics. That's where I'm getting some questions this morning. So you mentioned a 150 basis point headwind to customer count based on the enhanced security protocols we put in place. If my math is right, that's about 8,400 customers that were churned off the platform. Maybe just talk about what the issue was with those customers. Was this a one-time thing? Could we see more impact in Q4? And then I have a follow-up.

The Internet is a place where people engage in both positive and negative activities, and we must continuously monitor our platform for customer behavior. In Q3, we took the chance to adjust certain aspects, which resulted in an increase in the number of first-month customers. This did not significantly impact our revenue but affected our customer count. We do not make daily changes to our parameters; instead, we periodically review the landscape of the Internet and our platform and regularly remove certain users. Typically, we exit many customers each month, but this time was slightly higher due to a protocol change. We plan to modify some of the market locations to attract users, as Bill mentioned earlier. We expect to overcome this situation relatively soon. We are off to a strong start in terms of growth, with new initiatives aimed at expanding our customer base. This is all part of operating a business on the Internet. We are enthusiastic about taking a proactive approach because trust is essential to what we offer. Whether individuals come to test ideas or develop businesses, they must trust that our platform is secure and that their IT reputations are protected. This necessitates managing the customer base to exclude those who might engage in undesirable practices on DigitalOcean.

Yes. Okay, makes sense. The follow-up would be like even if we normalize for that change, I get net new customer adds that are kind of below the run rate we've seen over the last year or so. And again, I realize customer adds are not the relevant metric. It's ARR from these customers but folks pay attention to this metric. So maybe just talk a little bit about what you're seeing in terms of top of the funnel in conversion? And maybe you could bridge that to kind of what your expectations are for Q4. I think there was a comment in there that mentioned some potential acceleration. Anything along those lines would be helpful.

Yes. First, I want to reiterate that we aim for a 10% annual customer growth and we are committed to that goal. While we've made some short-term adjustments, we believe we will begin to see customer growth accelerate next year. Our lead generation remains strong, and we are focusing on improving conversion rates as customers move through our sales process. We are enhancing the customer experience and their journey by adding new products and payment options, which we believe will help improve mid-funnel conversion. The core of our strategy remains unchanged. We have adjusted a few factors leading to the removal of some customers from the platform, but we consistently renew a significant number of customers. This doesn't typically affect revenue significantly; it's more about customer count. I would emphasize focusing on ARPU and net dollar retention. Our retention and expansion metrics have shown significant improvement compared to previous quarters or even a year ago. This progress is due to our efforts in nurturing the customer experience and guiding them from their initial engagement throughout their relationship with us. These metrics are pivotal for our near-term economics. As we've mentioned, customer growth is a longer-term indicator of our business health. We onboard thousands of self-service customers each month, many of whom start small while learning and testing our offerings. Over time, some of these customers will scale their businesses, and we are here to support that growth. We are confident in our ability to reach and maintain a 10% customer growth rate in the long run. In the meantime, you can look to net dollar retention and ARPU for indicators of near-term revenue growth and performance.

Yes, I would like to add that it's early in the quarter, but our performance in the first month aligns well with our historical trends from the past three to four quarters. Some of the strategies Yancey highlighted, especially regarding the payment methods we are introducing for developing economies, are definitely starting to show positive effects. We feel optimistic about this.

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

Thank you, Yancey. I have a couple of questions. First, can Bill or Yancey provide specific details on the expected net additions for next quarter? Additionally, are you finished with what we can refer to as involuntary churn?

Well, what I would say is the last couple of quarters, we've been about 8% to 9% customer growth annualized. This quarter, 7% net of 150 basis point impact. So in the near term, we're going to lap this and start to ramp as we get through this quarter and into next year. And again, we expect to get back to or get to and then sustain a 10% annualized year-over-year customer growth. So you should see customers ramping this quarter off of the bounce off of last quarter and we'll take that into next year. And we feel very good about what we're doing, both top and bottom of funnel, what we're doing on direct sales, inside sales and outbound sales, what we're doing on the product side to attract customers, etc. And again, 28% ARPU growth and net dollar retention of 116%. I'd remind you that was in the low hundreds just this time last year. So we're nurturing customers, we're driving expansion, we're fulfilling a much higher level of customer support and success with them today that's driving the cohort. And we still grew customers 7% year-over-year despite increasing the dials last quarter and I feel confident we'll get back to 10% or get to 10% and then sustain it. So you should start seeing us ramp from Q3 back to where we were in recent quarters and then get above that hump at 10% in sustainment.

Okay. My follow-up is about investment. You mentioned investing for opportunities and addressed the question of whether you could increase your spending. You're currently around a 10% sales and marketing margin. Could that margin increase? It seems stable at the moment. What are your expectations for the sales and marketing margin as we move into next year?

At this growth rate, our sales and marketing expenditure can increase by 37% and still remain at 10% of revenue. We are making significant investments in sales and marketing and are eager to grow at a rate faster than our revenue increase. As an executive team, we continuously discuss potential opportunities and assess them. We are inclined to grow at a faster pace and believe we can surpass the 37% growth target. We are allocating resources to achieve this, focusing on both sales and marketing strategies and product development. There is ample room to increase our spending beyond 10% of revenue, especially when we compare ourselves to other companies in our sector. We appreciate that our EBITDA margins are strong and that we are generating free cash flow at this growth rate. Our approach ensures that we will consistently generate cash flow since that is part of our philosophy. However, it's not necessary for us to focus on optimizing free cash flow and EBITDA right now. We plan to invest some of those funds when the opportunity arises to promote an accelerated and sustained growth rate. This is our strategy, and it will remain our focus.

Your next question is from the line of Wamsi Mohan with Bank of America. Your line is open.

Hi, guys. Thank you. Yes. Your ARPU growth was very strong in the quarter. And I think in your comments, you noted that the increase in ARPU, there was a significant contribution, obviously, from your larger customers. Any way to disaggregate how much of this ARPU growth came from the 15% of the customer base that's driving the 85% of revenue and sort of how much is coming from the remaining? And what are sort of the underlying product consumption trends? Is it more usage? Or is it more sort of increased usage just like higher configurations? What is sort of the underlying trend that you're seeing within those customers?

Thanks, Wamsi. There are a few key points to highlight. The 15% of our logo customers, which contribute around 85% of our revenue growth, are expanding at a much faster rate than our overall company growth of 37%. Their customer growth is significantly higher than the 7% annualized run rate, so we are acquiring more of these customers. These customers are progressing through our ecosystem, launching businesses, and experiencing a rapid increase in their revenue per customer. This growth is organic; for instance, a new business might grow from $100,000 to $500,000 to $1 million and beyond. While these figures may not seem large in total, they represent considerable percentage growth. This indicates increased usage of Infrastructure as a Service as they add customers and products globally. As they hire more employees, they require additional services—deployment tools for their software teams, App Platform, Kubernetes, and soon our serverless capabilities. They also need to manage their customer ecosystem with analytics, databases, and other marketplace tools. Our Software as a Service offerings, which now account for 10%, enable customers to engage more with DigitalOcean as they ramp up. This results in strong organic growth. The synergy between Infrastructure as a Service and Platform as a Service is evident, with both segments growing robustly thanks to this organic expansion. We're adding to the small group of customers who are thriving; every month, we see teams transitioning from initial development to launching and quickly scaling their businesses. This dynamic drives ARPU growth, providing a solid foundation due to the natural expansion of our rapidly scaling SMBs. We can further enhance ARPU by offering them additional products and services, which is critical to maintaining the high growth rates we are currently achieving.

Okay. Thanks, Yancey. And can you also talk about the Nimbella acquisition? You said serverless is a top five customer request. Conceptually, what percent of your user base is asking for this or likely to utilize this? And what are some of the other top customer requests?

Yes. What I would say is Nimbella represents this generic theme around the simplifying software development, making it more application configurable. App Platform was a product that we launched a year ago that fits in that category. We have a number of our customers who want this flexibility. They want the functions capability. And I'll give you another example. Mongo was another top request for our customers that we launched earlier this year. So you're seeing us be much more responsive to customer needs for scaling on our platform. We're two months into the Nimbella integration. It's going very well. We're really excited to have the team on board and we're really excited to get this product into our customers' hands as we get into next year. We think that serverless will be a core pillar of our Platform as a Service capabilities like Kubernetes and like our managed databases. And we have a lot of expectation that's going to contribute meaningfully to growth as that product starts to get in the customer hands in the first half of next year.

Real quick, thank you. One quick question and one more longer one. The quick one for Bill. If you look at the ARR growth, it was the same level as last quarter and you mentioned some reason for that. Could you just kind of go into a little bit more detail there? And then for Yancey, if you think about the product expansions that you talked about, like at the moment, you seem only at the very beginning of that journey with like Mongo, serverless, etc. Like how do you think that this will play out over the next few years? Because if I look at the portfolio from like an AWS, Azure is by now like more tens and hundreds of different versions, you don't want to go that far because you kind of create too much complexity. But what you have at the moment seems like the very, very beginning of a journey to kind of differentiate the product more. Thank you for that and congrats on the good numbers.

Okay. Quick on the ARR. Remember, right now, this is a monthly number. So it's taking a look at September. We had a very strong September last year. We had a number of improvements relative to the offerings to customers that basically improve our actual pricing per tier in a way. We eliminated some tiers. And effectively, what we saw was that customers were purchasing up, so that was very, very beneficial for us. So we're lapping that. We would expect that number is going to be accelerating along with revenue as we move forward. But it is a monthly count, and so just to lap against a very good September a year ago.

Yes. Regarding our long-term product strategy, I am excited to have Gabe on board as we assess the landscape. The simplicity you mentioned is crucial and remains at the forefront of our thinking. We will introduce relevant features to our existing services, both on the infrastructure side and in our software offerings, ensuring that simplicity is a core element. Our customers, primarily small and medium-sized businesses with fewer than 500 employees, have a simpler set of needs compared to enterprise clients, who often require more complex, customized solutions. As these smaller customers grow from $1 million to $2 million in revenue and expand their clientele, they can no longer rely on tools like Excel for their needs; they require a database service. This early stage in their journey means they face far less complexity than enterprises, which simplifies our innovation strategy. Even when we roll out new capabilities like database functions or serverless architectures, we don't need to build in as much complexity because these customers seek simplicity. We are committed to innovation and will share more specific plans as we move into next year. Our rapid growth from zero to 10% of revenue in databases, Kubernetes, and our App Platform over the past two years demonstrates our ability to add relevant capabilities to the platform. We aim to replicate this success in the coming years, which will strongly support the growth rates we are currently experiencing.

Yes, thank you. Well done.

And that concludes the question-and-answer session for the call. I will now hand the conference back to Yancey Spruill for closing remarks.

I want to thank everybody for joining us today. As you can tell, we are incredibly excited about our results and about the opportunity in front of us. We look forward to continuing this conversation in the weeks, months and years ahead. And we're working incredibly hard to realize the limitless potential here at DigitalOcean. And it's a potential that's driven by enabling developers and entrepreneurs to test their ideas, build their businesses and realize their dreams. Have a great rest of the day.

This concludes today's conference call. Thank you for joining. You may now disconnect. Have a great day. Stay safe.