DigitalOcean Holdings, Inc. Q1 FY2022 Earnings Call

Hello. My name is Stephanie, and I will be your conference operator today. At this time, I would like to welcome everyone to the DigitalOcean First Quarter 2022 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. Thank you. Rob Bradley, Vice President of Investor Relations. You may begin your conference.

Thank you, and welcome, everyone, to DigitalOcean's First Quarter 2022 Earnings Call. Joining me today is Yancey Spruill, our Chief Executive Officer; and Bill Sorenson, 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. Reconciliations between our GAAP and non-GAAP financial results can be found in our earnings press release, which was issued earlier this afternoon and in the investor presentation on our IR website. With that, let me turn the call over to our CEO, Yancey Spruill.

Thanks, Rob. I apologize for the slight delay in kicking this off. Good afternoon, everyone, and thanks for joining us. I'm pleased to share the details of another strong quarter for DigitalOcean. Q1 demonstrates that we are building a highly efficient business that combines strong revenue growth with significant free cash flow generation. Despite an increasingly uncertain macro environment, we are proving the strength of the DigitalOcean business model quarter-after-quarter and beating our top-line guidance once again. We are maintaining our previous revenue outlook for the full year 2022. While there is some near-term global economic uncertainty, especially in Eastern Europe, we have a number of initiatives that give us confidence that we will manage through near-term macro challenges and have another strong year of growth and free cash flow. Bill will walk you through those details in a few minutes. But first, I want to address some of the key developments from the quarter. We're pleased with our Q1 performance as we continue to see exciting developments in product. We released the beta version of our serverless function into customers' hands and are on track to make a generally available release to all customers very soon. We saw a dramatic increase in the unique visitors to our website with visits up over 70% year-over-year in the first quarter. That's before the recent acquisition which will significantly boost monthly visitors as we move through this year. As I will share in the customer story shortly, bringing developers and businesses onto DigitalOcean early in their journey is a vital component to our strategy to drive sustainable growth, and website visits are a strong proxy for the health of that part of our customer acquisition strategy. Customers that come through this channel are presenting us with modest near-term revenue but are a highly valuable option for their eventual uplift, and in the meantime, we nurture them on their journey. Finally, we continue to make progress building an inbound and outbound sales capability, which contributed 3 percentage points of revenue in Q1, up more than 200 basis points from Q1 of last year. This area complements our self-service revenue motion because these customers start substantially larger, roughly $5,000 to $6,000 per month in revenue relative to our self-serve customers at $15 to $20 per month from day one. This sales-sourced ARPU is also up 180% year-over-year, a strong demonstration of the potential for this route to market. Revenue in the first quarter was $127.3 million, up 36% year-over-year and a 700 basis point improvement compared to Q1 of last year when we grew 29%. We ended the quarter with $524 million in ARR, which is up 35% year-over-year, a 500 basis point improvement from Q1 of last year. Net dollar retention and revenue per customer were both significant contributors to our top-line growth. Once again, NDR improved and was 117% in the quarter, a 1,000 basis point increase from Q1 of last year. Importantly, the churn portion of NDR has been stable at roughly 10% for consecutive quarters now. We continue to invest to improve the entire customer experience to help our customers develop, build, grow and scale on our platform. This investment in the customer experience along with targeted product and infrastructure investments that ensure a relevant and growing set of capabilities will continue to be essential to sustaining NDR at current levels or better. ARPU was up 28% in Q1, driven by our customers' own organic growth. We accelerate their spend by providing them other offerings beyond core infrastructure that they consume as they scale, including managed databases, Kubernetes, serverless in our marketplace. Operating margin and free cash flow improvements were also reflected in our Q1 performance. Our non-GAAP operating margin was 11% in Q1, in line with the prior year. Our operating margins are typically lowest in Q1, given certain typical front-loaded costs, such as benefits and related taxes. We will deliver ramping margins progressively through this year as revenue grows sequentially throughout the balance of 2022. We are committed to generating positive and ramping free cash flow in Q1, despite seasonal challenges. We believe that a defining differentiator of DigitalOcean's investment thesis is our ability to grow fast while generating free cash flow. In the past, we have referred to the company becoming a free cash flow machine, and we are confident that we are on track to deliver on our targeted revenue growth of 20% or more in the next couple of years as we approach and exceed our first $1 billion of revenue. In Q1, we generated free cash flow of 4% of revenue or $5 million. This was a strong performance as our team is managing our capital spending very well, both in terms of generating operational efficiencies and better management. Similar to our operating margin profile, we expect free cash flow to ramp through the year and margins to increase significantly by year-end. Finally, customer additions were also key contributors to our Q1 growth. We had 14,000 total customers and more than 3,000 of those are customers spending more than $50 per month. This higher spending cohort now numbering 102,000 in total, grew 20% year-over-year, and their revenue represented 84% of total company revenue. Even better, their revenue grew 43% year-over-year, much faster than overall company growth. We believe there are many more customers that fit this high customer spend profile that we can attract and cultivate this year and in the years ahead. We break down customer size because it's a more relevant indicator in terms of what is fueling our revenue base since we simply don't have an average customer. Most of our customers start at $15 to $20 a month and over time and at their own pace, they grow to greater than $50 per month, which is a point where we typically see lift off. This unique focus on supporting our customers through a journey is a defining differentiator for DigitalOcean in the marketplace. As you can see, the business is on firm footing, and we are well positioned to continue to grow into this immense market opportunity. I'd like to turn your attention to some specific steps we are taking in product development and marketing to continue to execute against our ambitious growth objectives. One of the many growth levers that we have is expanding our product set to serve our customers' changing needs as they experience their own organic growth. A key request from our customers is a serverless offering, and that is why we acquired Nimbella last year. In Q1, we introduced the beta version of our serverless offering, which will become generally available in a few weeks. Serverless is a rapidly growing adjacent market opportunity that extends and complements our infrastructure and platform offerings and is foundational to our Functions as a Service strategy. Our serverless product is cloud native and allows builders to create and manage applications without having to allocate time and resources to server selection, geography, and performance. Instead, builders and developers can choose DigitalOcean to provision servers to meet their needs based on consumption and other factors while they can focus on coding and development. This has been one of our top product launches for 2022, and serverless should help propel customer acquisition, ARPU growth, and NDR while also laying the groundwork for future product expansion plans. Efficient customer acquisition has always been one of the hallmarks of our business, as best evidenced by low sales and marketing costs. Few companies in software are growing their top line 36% with sales and marketing expenses as low as ours. In Q1, non-GAAP sales and marketing spend was only 12% of revenue. And yet, our largest customers grew 20% and their revenue grew 43%. Expanding our community content is an essential element of our customer acquisition strategy; we use this content to drive millions of people to our website each month. In Q1, we made an acquisition that significantly increased our content library. We also launched a refresh of our brand to be more balanced in our positioning to who we serve across developers and SMBs. In March, we acquired CSS-Tricks, a learning site with 6,500 articles, videos, guides, and other content focused on front-end development. This nicely complements our existing library of content, furthering our reach with both front-end and full-stack developers. We now have over 7,000 tutorials to complement the 32,000 other documents on our site, contributing to the rapidly growing website visits and allowing us to sustain an efficient customer acquisition motion as we scale the business. When we went public a little more than a year ago, we were averaging roughly 5 million unique visitors to our website each month. Thanks to the leverage we are realizing from significant changes in our self-serve marketing motions and the addition of CSS-Tricks in Q1, we delivered an average of over 9 million unique visitors in the quarter, representing over 70% year-over-year growth. We will continue to look for high-quality content sites that can expand the top of the funnel to increase the base of potential customers and enhance the brand around the world. With respect to enhancing our strong brand, which supports increasing organic traffic, we launched a new campaign in Q1 targeting customers that can build their businesses with us, leveraging the product portfolio we offer and increasing their spend as they scale. We want to be the cloud platform of choice for innovative digital SMBs anywhere in the world, and our branding will help promote to that growing audience. Next, I'd like to highlight one of our 102,000 high-spend customers who drive 84% of our revenue, which provides yet another demonstration of the organic tailwinds driving our business. One customer's mission is focused on engaging experiences for people to meet online. They do this via a video chat platform that makes virtual introductions and interactions more human. The company started only two years ago and has experienced exponential growth and now has more than 10 million people using their platform. The online platform caters to individuals, teams, and companies. More than 10,000 teams have adopted their platform for virtual office space, and they have hosted over 20,000 professional events, including job fairs, academic events, conferences, and media releases. The company was started by a group of friends after they graduated from college. They were aware of DigitalOcean due to our vast library of technical tutorials and selected DigitalOcean for our simplicity and pricing. As a start-up, they needed an easy way to build and test ideas quickly and with minimal overhead. Our low-cost outbound data transfer is an incredibly valuable asset for network-intensive loads, which rely heavily on streaming video to large numbers of users. They started on DigitalOcean in May 2020 as part of our start-up accelerator, which we call Hatch. They received infrastructure credits and dedicated technical support to build their business. Once they completed the Hatch program, they decided to continue to build their business on DigitalOcean. When they started on DigitalOcean, their monthly recurring revenue was just under $300. As of March of this year, their monthly spend has jumped to more than $190,000 or over $2 million of ARR. As we have seen time and time again, this dramatic growth in spend has been paired with the adoption of additional products in our portfolio. They started with droplets and have now added our managed Kubernetes, managed databases, our platform, our spaces and volume storage, our load balancers, and container registry projects across five of our global data centers to deliver great experiences to their customers. This customer offers another example of the journey that businesses take on DigitalOcean, demonstrating how and why we cultivate a large use of developers and early-stage businesses, even if at lower dollar values initially, and reap the benefits as many of them lift off and experience rapid growth while using the increasing mix of our products and services. Last, but certainly not least, I want to share an exciting recent development that highlights our mission to grow together with our customers and the broader developer community. When we went public last year, we planned to contribute 1% of our valuation at the time of the IPO or $50 million to charitable initiatives over the ensuing decade. Last month, we announced the cornerstone of that initiative, DO Impact, a global social impact program aimed at empowering technology innovators through the donation of DigitalOcean infrastructure, philanthropic grants, and employee volunteering. We are supporting organizations that we believe are making interesting and important impacts, such as facilitating technology literacy to communities who haven't historically been part of the broader tech ecosystem, efforts that help tech-enabled non-profits better use technology to support their missions, and many other specific use cases. Supporting innovation like this is core in our mission to simplify cloud computing so builders can create software that changes the world. I'm very proud of this effort because it expands access to cloud computing technology, creates more opportunities for people around the world, and will be a feeder for DigitalOcean's business over the long term. We look forward to expanding our DO Impact program in the coming years. We truly believe that our community is bigger than just us. DO Impact runs how we live our values and will be an important element of our company as we continue to grow and achieve our first $1 billion of revenue in 2024. In summary, we're off to a good start despite the global challenges we all find in 2022. I'm proud of our team for their accomplishments. I would like to thank each of them for their efforts on behalf of our customers. We are well positioned for continued and durable growth along with ramping free cash flow generation across the balance of this year. 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 Q1 and our updated outlook for this year.

Thanks, Yancey. Good afternoon, everyone, and thanks for joining us today to discuss another quarter of strong results that produced revenue and free cash flow that exceeded expectations. Yancey captured much of the positive momentum we are seeing across the business, so I'll keep my remarks fairly brief. I'm going to focus on some top-line numbers, customer dynamics, free cash flow and CapEx, along with our financial outlook before turning it over to the operator to take your questions. For the first quarter, revenue grew 36%, which represents our fourth consecutive quarter of revenue growth greater than 35%. This was driven by 117% net dollar retention, the highest we have ever reported as a public company. Revenue per customer improved 28% and 20% growth in the number of high-spend customers with total customer growth of 6%. We also had healthy cash from operations of $30 million and free cash flow that was 4% of revenue. Once again, our results demonstrate DigitalOcean's superb product-market fit. DigitalOcean's combination of customer growth, ARPU growth, and high-teens NDR are proving to be a valuable mix and continue to be the foundation for durable 30% plus revenue growth. Providing some more context on our customers, we see ongoing success in attracting and onboarding high-spend customers, those who spend more than $50 per month with DigitalOcean. This cohort is now more than 102,000 strong and grew by 20% year-over-year, up from 85,000 in Q1 2021. In many regards, these customers, which typically use multiple products and services, have been critical to the improvement in NDR that we've experienced over the last two years. In Q1, revenue from these customers grew 43% and now represent 84% of our total revenue, up from 80% last year. The increasing percentage of revenue indicates their value to our financial performance as their revenue is growing faster than the company overall. We are pleased to add 3,000 of these customers in Q1, and we're very focused on deliberate strategies to increase these customers by nurturing our very large base of smaller customers as they themselves scale their businesses and by bringing in higher-spend customers at the outset. Efforts include targeting potential customers in specific verticals and use cases that are good fits with our platform offerings and pricing model, including video, streaming, media, managed service providers, and web agencies. Additionally, we are working to increase our top-of-funnel. As you heard from Yancey, our unique visitors have grown by over 70% year-over-year. At the same time, we are continually improving our funnel dynamics to activate and convert the potential higher-spend customers more rapidly. Lastly, we also have sophisticated data analytics triggers to help us facilitate these customers being offered and purchasing additional products from us as they scale. Our goal is very straightforward. We want to significantly increase the number of high-spend customers, drive their NDR higher through customer success best practices, and grow their revenue faster than the company average. We think in our massive and growing market opportunity, there are many more high-spend customers that we can attract, convert, grow, and retain. Our continued focus on customer support, targeted sales outreach, and our product efforts in areas such as serverless will help us accelerate the growth in these customers. Q1 is the first quarter where we report solely on non-GAAP operating income as a measure of profitability versus adjusted EBITDA, which we had used historically. For the quarter, this metric was $13.6 million, reflecting 11% of revenue, which fell short of our guidance target previously provided of 12% to 13%. The primary driver of this variance was payroll taxes related to stock-based compensation that were previously forecasted over the course of the year, but that had a greater impact in Q1. Without that impact, we would have met guidance as we continue our focus on operating efficiency while at the same time increasing spend in marketing and customer success. We remain solidly on track to improve profitability over the course of 2022, driven in part by continued improvements in gross margin and overall spend efficiency, and are confident in our full-year guidance, which I will address shortly in my remarks. Next, I want to share some exciting news on our expanding global footprint, which we believe will help us accelerate our growth in an important geography for us. We are on track to open a new data center in Australia in Q4 of this year. As we have shared previously, we plan and manage our capital expenditures with a six to eight-quarter horizon. The launch of this new data center was planned within our continually improving capital expenditure targets. As a result, even with this investment, we expect to deliver a further reduction in CapEx as a percentage of revenues this year. We still project that CapEx will be approximately 22% of revenue for the calendar year 2022 and remain confident that we can lower that further into the teens over time. This CapEx improvement over the past few years is one of the changes we are very proud of, as it is an improvement from Q1 2020 when CapEx was 44% of revenue and even last year's Q1 of 25% of the revenue, which allows us to drive growth in free cash flow. Free cash flow is the beneficiary when you prioritize efficient growth and manage capital expenditures. We are very pleased to deliver $5 million of free cash flow in Q1, or 4% of revenue, especially considering that Q1 is usually our most modest in terms of free cash flow as we have a number of significant cash outlays at the start of the year, the largest being the bonus payments to our employees. We expect to build our free cash flow as we progress through the year, and we maintain our outlook for 8% to 10% of revenue for 2022. As you know, back in February, our Board approved a $300 million share repurchase program. During Q1, we used $150 million of that approval to repurchase 2.6 million shares. As Yancey shared on our previous call, we view this buyback as a commitment to our investors that they will not experience dilution from any equity we may use over the next few years to attract and retain our best-in-class employees. We expect to repurchase the remaining $150 million in Q2. Now I'd like to provide our Q2 and full-year outlook. The war had minimal impact on our Q1 results. And while we do not have employees or operations in Russia or Ukraine, we do have customers who do business in these countries. Historically, revenue from Russia and Ukraine combined has been approximately 3.5% of our total revenue, but we have seen a marked decline in our Russia-source revenues over the last three months, which is not surprising given the financial sanctions that hinder payment processing. While sanctions are not impacting payment processing in Ukraine, hardships and disruption from the war may affect some of our customers there. While we are maintaining and are confident in our full-year revenue guidance, we also need to be prudent with our Q2 outlook to take into account the potential for disruption to revenue that is directly exposed as a result of this conflict. For the second quarter, we expect revenue to be in the range of $133 million to $135 million, which reflects the potential loss of approximately $3 million of revenues from Russia and Ukrainian customers. We expect Q2 non-GAAP operating margin to be in the range of 10% to 11% as we complete the bulk of our 2022 hiring by the end of Q2. For the full year, we are maintaining our revenue guidance to be in the range of $564 million to $568 million, which at the midpoint represents 32% growth. Please keep in mind that at the time we issued that guidance, we had not factored in the impact of the war. However, even with the potential loss of between $8 million and $10 million of revenues related to Russia and Ukraine, we are still confident in achieving that revenue growth due to the number of efforts underway that will offset the potential war-related losses. The continued outperformance of our outbound sales efforts, further improvements in the funnel to drive self-serve revenue ahead of plan, and the launch of our new serverless product in a few weeks. Lastly, we see opportunities around the way we package and price our product portfolio, which we have discussed with you all before. With all of these efforts, we are very confident in our full-year revenue outlook, despite the near-term macro uncertainty and also believe these efforts will provide a material carryover benefit into 2023. We expect full-year non-GAAP operating margins to be in the range of 13% to 15%, which is also consistent with our previous guidance. Lower margins were anticipated early in the year as we made a number of investments, particularly in people that will impact profitability in the first half of the year. Margins will improve over the second half of the year, as revenue growth will outpace spend. In 2022, we expect free cash flow as a percentage of revenue to be in the range of 8% to 10%. The combination of continued revenue growth and increasing cash flow generation puts us on track for the continued achievement of the Rule of 40. That concludes my remarks. Now let's turn it over to Q&A.

Your first question comes from Michael Turits with KeyBanc Capital Markets. Your line is open.

Hi, this is Billy on for Michael. Good to see customer ads get back to the mid-teens level. I guess, how should we think about the sustainability of that mid-teens level to drive customers' growth to your goal of 10%? Thanks.

Well, our longer-term target remains 10% for year-over-year net logo adds, customer adds. And we're making very good progress. We talked about the growth in our website visits. Our conversion rates have been good, where the net new customers we're adding have been very strong, as has the dollar per revenue out of the box as we've talked about. And then we're complementing that with our sales efforts. So we feel very good about where we are today in terms of customer additions. We're going to continue to invest in that. As Bill noted, we are outperforming our initial plans this year in this area, and we're going to continue to focus on it. So 10% is our longer-term goal, and we should start to edge up to that over time. We're very pleased with the performance in the first quarter and our current outlook for this part of our customer acquisition motion.

Your next question comes from Mark Murphy with JPMorgan.

Thank you very much. Yancey, Europe is a significant concern for many, and we understand you have considered it in your guidance. I would like to know, aside from any direct exposure to Russia and Ukraine, how would you describe the situation in the rest of Europe regarding business confidence, usage trends, and retention rates? When you notice an impact, how does that present itself for you? I also have a quick follow-up.

Yes. As we discussed in our outlook and considering the impacts we've experienced over the last 60 to 70 days due to the unfortunate situation, we are noticing some effects in the areas we mentioned. There is certainly broader uncertainty. However, regarding our business trajectory, we are largely meeting expectations at this point. Of course, things could change. It's clear from the previous pandemic and severe recession that our customers remained resilient. We were able to execute effectively, acquire customers, and reduce churn. The small and medium-sized business marketplace has proven to be very resilient, as shown through various financial crises and disruptions. Additionally, a report highlights that customers using DigitalOcean experience 200% internal rate of return. This demonstrates that we provide a very cost-efficient solution for our customers, reflected in the cost of sales on their income statements. We are an essential part of their service operations and one of the last expenses they would cut. In terms of value proposition, we represent approximately 2% to 2.5% of our customers' cost of goods sold. Overall, we offer a highly effective capability. We believe we have shown resilience during the pandemic, particularly in the first two years. We are confident in our value proposition and the enhancements we are incorporating into our platform, such as the upcoming launch of our serverless functions in the next couple of weeks. What we are currently seeing aligns with our expectations, and we will monitor how things develop as the year continues.

Your next question comes from Raimo Lenschow with Barclays. Your line is now open.

Thank you. Could you provide an update on new products like serverless and the recent launch of MongoDB as a service? What are the price points for these offerings? Additionally, how significant do you believe these higher value-added products could become for the organization over time? Thank you.

Yes. So those are modest uplifts in terms of depending upon the volume and the types of use cases the customers have. They tend to be uplifts in terms of ARPU adds to existing customers. And what I would say is when we launch a product, our expectation is that three-plus years out, we're going to be at least 300 basis points contribution to growth to give you a sense of size and scale. It takes a while for those customers, given the nature of our revenue model, our subscription, to offer the number of customers to build on the platform. We're now seeing Mongo getting into that critical mass that will be a material contributor at really high growth rates. We'll expect serverless to build during the course of this year, contribute to revenue growth, and be an outsized driver of pushing revenue supporting our 30% or more growth targets over time. We're targeting new products to contribute 300 basis points two-, three-plus years out as a criteria for when and how we decide to launch products.

Your next question comes from Tim Horan with Oppenheimer & Company. Your line is open.

Thanks, guys. Just two follow-ups. On the new products, can you maybe just talk about how many major new products you think you can launch a year at this point? And just maybe some color on what areas make the most sense. And then just following up on your comments on maybe further thinking about what a recession might mean for you guys? Can you give any metrics on what happened two years ago when we had a slowdown? I know it was a different world, but did you see much impact to trends at all at that time? Thanks.

Well, our recent cadence is sort of one major new product a year plus a number of feature enhancements on existing capabilities. We've made some significant changes in our product and technology innovation capability over the last six months. We're starting to execute on change in the first half of this year, which I’m really excited about. The designation of that change is to give us greater velocity. So we'd like the capacity to do more than one major new product a year and more than a handful or a couple of handfuls of feature enhancements. So we're in the motion here while expecting in the second half of this year and certainly next year to significantly improve our velocity, quality, and transparency of our execution because what we've seen in the last two to three years is the launch of managed databases, Kubernetes, our first foray into the app platform of services, and obviously, serverless functions are coming this month. Our marketplace has substantially added to the revenue growth because per the customer journey in the case we just shared, as customers build out their capabilities in their businesses, they consume more PaaS or SaaS offerings. To the extent we give them relevant SaaS offerings, that's going to be a strong contributor to growth. I'm excited about the changes we've made and the investments we're making in product and innovation are key fuels of our growth and of our reputation and relationship with our customers. We think we can sustain that growth even during a time of uncertainty that we're all seeing right now. In terms of the first question about a recession two years ago, I hope we never see a more severe recession than when we went into the pandemic. I'll say this: churn was approaching 20% when we went into the pandemic, and as you said earlier, it's now cut in half. Obviously, net dollar retention was just under 100%; it’s in the mid-to-upper teens today. Customer acquisition was relatively flat, and it is now upper single digits. Growth was in the low 20s; now it has moved to the mid-to-high 30s. I think we were able to endure through a significant revamp and focus on our support going back, doubling down on simplicity, and our support model. We made significant investments in the tutorials and our digital content. I think we went into the pandemic with 2.5 million to 3 million website visitors a month, and we've tripled that. We're going to continue to double down on the customer experience. We've demonstrated that getting closer to our customers and building an intimate understanding of what they need is a key differentiator for us. That's what's going to enable us to sustain above 30% growth during tough economic times.

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

This is Quinton on for Jim Fish. Thanks for taking my question. Just a quick one on net large customers added in the quarter. We did see a slight downtick compared to prior levels. Is there higher churn here, or anything to call out that was kind of one-time in nature? Or was this kind of the 3,000 level the way to think about it as a little bit more sustainable moving forward? And then we do have a quick follow-up.

I believe revenue growth was essentially consistent with last quarter. While customer growth may fluctuate slightly each quarter, it remains robust. It's crucial to highlight that we anticipate customer growth to significantly exceed the overall company growth rate because, as we mentioned, many customers are moving into higher spending categories as their businesses gain traction. This is an important point. We expect to attract more new customers as our inbound and outbound sales efforts strengthen. Therefore, I wouldn't concentrate too much on the 400 basis point change from one quarter to the next. Instead, I'd emphasize revenue growth and the increasing percentage contribution to revenue. These are trends to watch. Specifically, customer growth will be stronger in the $50 and up category, revenue growth will surpass the overall company growth, and the revenue mix percentage will continue to rise. These three aspects are key. While there may be some variability from quarter to quarter, we expect these metrics to remain stable in the near term.

Got it. Yes, that makes total sense. And then maybe touching more on the launch for the serverless. Can you talk about your strategy here? Is the goal in Q2 and Q3 to drive adoption first and then monetization kind of in the back half of the year? Or is it kind of monetization along with adoption? Maybe any sense of motion that is going to move would be helpful?

We aim for awareness and adoption, which will lead to monetization as our customers increase their usage. We launched the product because it interests customers and aligns with our growth goals of 30% or more. However, this growth is gradual. When we acquire customers, we typically recognize one-twelfth of their annual revenue each month. We are driving customer growth by focusing on month-over-month trends in customer additions and their usage of the product. We expect to see very strong growth rates in customer acquisition and revenue shortly. As this revenue starts to become significant, it will meaningfully influence our overall growth, which we anticipate will contribute 300 basis points to our overall revenue mix in the next two to three years for serverless.

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

Thank you. My question is about the revenue growth trajectory. You're slightly below 30% at the midpoint for Q2. However, the comparisons are going to be more challenging moving forward, especially in Q3 and Q4. Can you clarify what additional factors might help you achieve over 30% growth in Q3? Will you reach 30% growth in Q3 according to your full-year guidance, or do you expect a significant increase in Q4? How should we assess the growth trajectory considering your new product launches and initiatives? I also have a question regarding operating margin.

Well, I'll let Bill address the operating margin. It's quite simple. Our job is to set expectations that we meet and beat. I know there's a lot of gamesmanship on the beats in the guidance. We’ve just set expectations we intend to meet. We said there is some near-term, and we're taking the near-term impact from Russia, Ukraine, etc., this quarter. So we expect to start normalizing against that because of the outperformance we're seeing in our go-to-market motions on sales and self-serve. We have the launch of serverless and some packaging and pricing monetization initiatives that we're taking a very hard look at right now. That’s how we lap that. You're right; we were accelerating through last year, and that creates tougher comparisons. At the same time, this year we have initiatives to help us offset the impact of that to continue supporting a 30% or better growth rate. We set expectations that we intend to be in that range.

Okay. Thanks, Yancey. And Bill, maybe on the operating margin and free cash flow commentary, I think you guys said Q1 is typically the bottom and then you sort of build from there, both for operating margin and free cash flow. I think you called out some hiring initiatives in Q2 that are going to pressure operating margins sequentially here into Q2. So as we think about that free cash flow profile as well, how should we think about the cadence of that? And then you guys actually did have a slight miss on your operating income that you called out in the quarter as well. So the ramp to the second-half profitability, is that all just revenue leverage coming on higher revenues, or is there anything else happening on the cost line as well? Thank you.

Well, it's a variety of things. But first, one other thing on the revenue front, we took $3 million out of Q2. If you didn't take $3 million out of Q2, you're at 32% plus. We have a near-term hit from some macro factors that we're going to outgrow as we move through the year. In terms of the margin, we see sort of a flat margin in Q2, and that's largely because we're doing the bulk of our hiring by June 30. After that, we don't see any incremental ramp in spend through the year. As you know, Q3 and Q4 are our two largest quarters of the year. Spending growth will slow greatly, and you will see our margins improve into the mid- to high-teens as you move into Q3 and Q4. Even in Q2, where we're around 10% to 11%, we're still forecasting positive free cash flow. As we move through the year and margins improve, we'll see bigger contributions than the 4% or so that we had in Q1, but we expect our CapEx generated per quarter to continue growing quarter-on-quarter.

Your next question comes from James Breen with William Blair. Your line is open.

Thanks for taking my question. Just can you talk about DBNR 117 and how you think about that moving up as you add products and given the existing growth in your customer base? Thanks.

As we look at net retention, we're definitely going to have a challenge in Q2. The $3 million of revenue coming out of the top line for us as a result of what's going on in Eastern Europe is clearly going to have a near-term impact on NDR. We see, though, as we move forward in the back half of the year, moving back up towards the high teens. The question that we continue to work on is where can we drive it to? Our goal would be to drive it over 120%. We have a massive customer base, as you know. Part of what we're doing is focusing on those $50 and greater customers who are demonstrating 117%, 118% NDR. After a tough comp in Q2, our expectation is to move back up to the 116%, 117% range. Our hope is that new products will drive new net dollar retention as customers buy additional products which generates incremental usage of their base infrastructure. We think serverless will be another step towards that goal while driving greater ARPU and greater NDR from our customers, especially those spending over $50 a month.

Your next question comes from Josh Baer with Morgan Stanley. Your line is open.

Thanks for the question. Two quick ones. I know the CSS-Tricks content is and will remain free and open, but I was just wondering if there's any advertising or other revenue streams associated with that acquisition?

Nothing that's material, nothing that's meaningful. No.

Okay. Great. And then I was hoping you could talk a little bit more about the brand relaunch. I was just wondering what were some of the changes that were made and what you are looking to achieve?

If you look historically at DigitalOcean, we have this dynamic where 500-plus thousand customers generate 15% of our revenue, and 15%, which we put more in the developers or early-stage startups. We spent a lot of our effort just on the brand there. But 15% of our customers, 100,000, 102,000 last quarter generate nearly 85% of our revenue. We weren't spending a proportionate effort in communicating and speaking to that constituency. I think we're balancing it now, and it's about speaking to the journey and helping customers grow with us. That’s the principal focus: ensuring that we're aligning who we serve, how we serve them, and at what stages we serve them in our messaging. This is especially important as we've nurtured customers through the years and, in the case study we just discussed, we are seeing customers come from hyperscalers. The reason they come to us is that we have a highly performing set of capabilities at half the price. We want to make sure our brand resonates and speaks to those customers as they're considering switching from being underserved with other platforms. That’s what we aim to accomplish as part of repackaging the brand. I want to thank you all for joining us. As you can tell, we're very excited about our Q1 results, and despite the uncertainty we face, we feel confident about our ability to flow through given the assets, the brand, and the team we have here at DigitalOcean. We look forward to continuing our conversation with you and our investors in the weeks, months, and years ahead, and we're working hard to realize the limitless potential of DigitalOcean. Thank you so much, and have a great rest of the day.

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