DigitalOcean Holdings, Inc. Q1 FY2023 Earnings Call

Thank you for standing by, and welcome to the DigitalOcean First Quarter 2023 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. And finally, I would like to advise all participants that this call is being recorded. Thank you. I'd now like to welcome Rob Bradley, Vice President, Investor Relations to begin the conference. Rob, over to you.

Thanks, Paulie. And thank you and welcome everybody to DigitalOcean's First Quarter 2023 Earnings Call. Joining me today is Yancey Spruill, our Chief Executive Officer; and Matt Steinfort, our Chief Financial Officer. Before we begin, I want to cover our Safe Harbor statement. During this conference call, we will be making forward-looking statements, including our financial outlook for the second quarter and full year, as well as statements about goals and business outlook, industry trends, market opportunities and expectations for future financial performance and similar items. All of these statements are subject to risks, uncertainties and assumptions. You can review more information about these in the Risk Factors section of our filings with the SEC. We remind everyone that our actual results may differ and we undertake no obligation to revise or update any forward-looking statements. Finally, we will be discussing non-GAAP financial measures on our call today. Reconciliations between our GAAP and non-GAAP financial results can be found in our earnings press release, which was issued earlier this morning and in the investor presentation on our IR website. With that, let me turn the call over to our CEO, Yancey Spruill.

Thanks, Rob. Good morning and thank you for joining us today. I'm pleased to share the results of another strong quarter for DigitalOcean. We made solid progress on our key priorities of adding valuable services for customers on our platform and reshaping our cost structure to accelerate our long-term free cash flow margin objectives. Despite the challenging macro environment, we met or exceeded all of our financial targets. Our first quarter financial results were strong across the board. We delivered year-over-year revenue growth of 30%. As projected, our quarter-over-quarter revenue growth was more muted, given the near-term macroeconomic headwinds we are experiencing. These headwinds have resulted in modest net expansion from our customer cohorts as their businesses have seen their growth deceleration. They continue to focus on managing their spend in the midst of the ongoing economic uncertainty. While it is unclear how long these macroeconomic headwinds will persist, we remain committed to achieving our financial targets this year. Matt will provide more detail on our Q1 results, Q2, and full year outlook later on the call. Stepping back for a second from the current market conditions, I've reflected that we just recently crossed the two-year anniversary of our IPO. Over the course of these two years, we have become a much stronger and more durable company. We added significantly to our platform's capabilities and enabled our customers to grow their businesses. We dramatically improved our financial profile or the doubling revenue from 2020, the full year prior to our IPO to this year. We improved adjusted free cash flow from a negative 18% in 2020 to over 21% this year. We've added a number of valuable offerings for our customers like serverless functions, premium droplets, tiered support, significant additions to our tutorial content, and additional database engines, to name a few, and expanded our total addressable market through our Cloudways acquisition last year, which brings us managed hosting capability. Collectively, the improvements we've made to our offerings and our go-to-market have improved ARPU by more than 70%. We've also returned significant value to our shareholders since Q2 2021, repurchasing 26 million shares for a total of $1.3 billion. While we are proud of these accomplishments, we will continue to remain focused on delivering new offerings, significant operational improvements in the business, allocating capital to accelerate growth both organically and through M&A, and delivering capital back to shareholders through a regular buyback program. We remain bullish on our incredible market opportunity and we know we are still early with plenty of room for significant growth in the years ahead. Shifting back to our near-term plan, I’d like to reiterate our key priorities for 2023, which we believe will enable us to deliver our 2023 targets and position us for accelerated growth when the macro environment improves. As shared at our last earnings call, we have prioritized three growth initiatives that underpin our 2023 revenue targets. These are focused on sales and go-to-market, product monetization, and delivering the synergies from our Cloudways acquisition. Each of the initiatives will build on the $660 million annual recurring revenue foundation we had entering 2023. First, we will continue to strengthen our go-to-market capabilities. Over the course of the company's more than 11-year history, our highly efficient self-service go-to-market motion has been the primary source of new customers. People leverage our platform and become paying customers because of the simplicity and ease of use of our cloud tools, documentation, and support we provide to all customers, the openness of our platform, and the attractive price-to-value we offer for our services. Collectively, we are focused on building an ecosystem of learners, builders, and scalers. We're investing to attract more learners, providing an environment to nurture and launch an idea into a business. We're extending our product capabilities to enable the long-term successful growth of the builders and scalers on our platform. I like to think of our self-service model as one of the world's most efficient lead generation engines. Customers pay small amounts to learn and test in our platform, representing the right opportunity to foster their development so that over time they become rapidly growing businesses on our platform. Importantly, the cost to acquire these customers is very low. Our ability to track learners who have high intention to become builders and scalers has been an important evolution of our self-service go-to-market strategy. We are evolving our tools and upfront content to attract higher spending customers, and we are also changing our onboarding process to better serve these high intent customers early in their DigitalOcean journey, reducing the time they spend as learners and enabling them to become higher spending customers sooner. Additionally, we have invested significantly in enhancing our ability to engage with a higher percentage of the 146,000 builders and scalers on our platform. We are seeing good traction from leveraging data analytics to help our sales teams better target candidates for upgrades or additional product adoption, including moving their multi-cloud workloads to DigitalOcean from other providers. This expanded customer engagement effort is bearing fruit as our legacy cohorts of builders and scalers continue to increase spending at robust rates and we continue to add to these cohorts at strong rates of growth. Our second key initiative is to continue to deploy new capabilities or new bundles that both increase the value we provide to customers and drive up ARPU and our share of wallet. These product monetization efforts are focused primarily on our fast-growing builders and scalers customer segments as we listen closely to their feedback and extend our capabilities in response to help them continue to scale their businesses. As an example of a recent monetization initiative, we launched a premium dedicated droplet in Q1, which targets bandwidth-intensive applications such as video streaming and ad tech businesses. We’ve seen strong adoption of this product extension as it improves the ability of our customers to scale efficiently. In other words, it enables cloud optimization for our customers. The premium dedicated droplet serves as a prime example of packaging our existing capabilities to better serve the needs of a specific customer application, providing additional value for which our customers are willing to pay. We were already an attractive destination for bandwidth-intensive use cases due to our capabilities and value pricing. However, bandwidth-intensive customers had to customize our base service through additional software to configure into their specific use case, which added time, complexity, and cost to their use of our platform. Based on their feedback, we launched this new tailored solution, which speeds up their deployment and reduces their costs to maintain and grow their business, offering them a more efficient path for growth. This new product SKU exemplifies how we create higher ARPU opportunities for customers through packaging our services rather than outright price increases. We believe we have opportunities to enhance the customer experience with other examples like this on an ongoing basis. Another example of extending our platform to meet the needs of larger customers was the expansion of our backup storage capabilities. In this case, we augmented our platform by acquiring a complementary early-stage product company, SnapShooter, in Q1 to add backup and snapshot storage features. This acquisition is part of a broader initiative to augment our overall storage capabilities, and we expect to continue enhancing functionality across our storage portfolio over the next several quarters into 2024. Looking ahead at the product roadmap for the rest of 2023, we will continue to invest to enhance our storage offerings to meet the needs of our builders and scalers customers. By addressing a broader set of storage use cases at larger scales, we will make it attractive for existing customers to put more of their cloud workloads on DigitalOcean and for builders and scalers on other cloud platforms to bring their workloads to DigitalOcean. We are also evaluating other strategic platform extensions, such as the introduction of GPU and AIML offerings, which would be a strong complement to our existing capabilities and expand our total addressable market. Although we are refactoring our cost structure in 2023 to deliver significantly better margins into cash flow, we don't want this year to be solely focused on efficiency. We are positioning ourselves for faster growth in the future, and the opportunity to enhance our offerings with GPU and AIML services is a focus. The ongoing organic and inorganic investment in our platform through product expansion and monetization efforts is key to driving long-term growth. We’re leveraging the numerous customer conversations we have during this challenging market environment both to educate customers on how they can leverage our existing products and services differently to help them optimize their spend, and to understand how to prioritize our product development roadmap. Our focus on the large SMB customer segment that has traditionally been underserved by more enterprise-focused technology companies is a direct contributor to the stable churn we've seen over the last year, even as our growth has decelerated. Our commitment to simplicity, higher touch support, extensive relevant content, and direct engagement with our customers is a key differentiator for DigitalOcean and has created a very loyal customer base. Remaining close to our customers while their own businesses see a slowdown in growth is going to position us well to capture more than our fair share of revenue opportunities as growth rates normalize and accelerate over time. The third growth initiative involves continued investments in our recently acquired Cloudways managed hosting capabilities. The Cloudways business continues to perform well, managing its growth despite the weaker macro environment and accelerating our overall growth expectations for the balance of this year. We are pleased with the progress we've made on integration in our first six months post-acquisition, having seen a 46% increase in new Cloudways customers in Q1 2023 compared to Q1 last year. Some of that increase is due to how we have leveraged our well-established self-serve funnel to drive customer leads to Cloudways. We are encouraged by the early results of the recent addition of product capabilities and pricing changes we announced for Cloudways, which has strongly validated their brand and value proposition. We continue to be very optimistic about the long-term potential of Cloudways as a driver of value for our customers and investors. Before I conclude, I want to take a moment to address changes that we've made to our leadership team. Just as we've focused on aligning our operating model, cost structure, and investment priorities toward achieving our long-term growth and free cash flow initiatives, we’ve worked to build a leadership team that can scale and help us deliver on these objectives. To that end, we’ve made several changes this year to augment our team. First, we’ve created an important new role, Senior Vice President of Communications, to bring additional focus and expertise to our efforts to connect with our customers and support them along our journey. Nancy Coleman, a seasoned executive with experience in technology businesses at similar stages of size and scale, has taken this role to drive communications to our stakeholders as we increase awareness of the company's capabilities and elevate our storytelling across our customers, employees, and investors. The addition of this role is another important step in our effort to upgrade our go-to-market capabilities, which started with the integration of our sales, customer success, and marketing efforts under our Chief Revenue Officer at the beginning of 2023. We have also taken steps to better align our client development investments with our key growth priorities. With the Q1 departure of our Chief Product Officer, we took the opportunity to consolidate product development under our COO, combining our infrastructure and new product development teams to drive better coordination and synergies and moving product strategy under our Chief Strategy Officer to ensure that our product development efforts are tightly aligned with our overall corporate strategy and long-range plan. This creates a simpler and more efficient organizational structure and will drive improved development execution and tighter alignment across our broad set of strategic priorities. To further augment our go-to-market capabilities, we also announced the addition of Chris Merritt to our Board of Directors. Chris is an accomplished sales executive with a rich history across multiple business models and technology, including both self-service and direct sales motions. He most recently spent 10 years as the Chief Revenue Officer at Cloudflare and helped them scale their business from $1 million to $1 billion in annual recurring revenue during his tenure. We look forward to adding Chris' perspective to our Board and Executive leadership team. Collectively, these recent changes support our strategy to become the preeminent cloud infrastructure provider to small and medium-sized businesses. In summary, we're very pleased with our progress early in 2023, delivering against our revenue growth and free cash flow targets and our ability to maintain the 2023 targets set during our last earnings call, despite the ongoing macroeconomic challenges. We continue to invest across an array of product, infrastructure, and go-to-market areas while refactoring our cost structure to position the company for durable profitable growth in the growing $98 billion annual market for developer and SMB cloud infrastructure. I will now turn the call over to Matt to provide details on our financial results and our outlook for the balance of the year.

Thanks, Yancey. Good morning, everyone, and thank you for joining us today to discuss another quarter of strong results with revenue, margins, earnings, and free cash flow that continue to demonstrate the resilience and growth potential of our business model. I will focus my remarks today on our first quarter results, our progress on several key initiatives, and our updated financial outlook. We delivered revenue of $165.1 million in the first quarter, which was a 30% growth year-over-year and 1% growth sequentially from the fourth quarter of 2022. We saw resilience in our cohort performance despite the ongoing headwind of continued cloud optimizations by customers, with a net dollar retention of 107% for the quarter. Churn continues to hold steady, which is a great accomplishment in this lower growth environment, with top-line pressure coming instead from lower expansion and elevated contraction that continued through the quarter. In the current environment, holding churn at historical levels is a testament to both the value of our platform and the loyalty of our customer base, even as they focus on optimizing their spend. Retaining our customers will position us for success when they themselves return to growth. Our resilient customer graduation model continues to be a source of strength and durability in the face of the challenging macroeconomic environment. Fed by our extensive pool of learners spending less than $50 per month, we saw a net sequential increase after both graduation and churn of close to 2,000 new builders spending between $50 and $500 per month and more than 350 new scalers spending more than $500 per month. Builders and scalers continue to be the drivers of our growth, representing 86% of revenue and growing ARR at 41% and 24%, respectively, despite being only 24% of our customer base. Our go-to-market and product monetization initiatives remain largely focused on meeting the needs of these growing customers. We exceeded our outlook on both adjusted EBITDA and free cash flow margins in the first quarter through disciplined management of our expenditures and the swift execution of our previously announced cost reduction initiatives. Adjusted EBITDA was 34% of revenue, which compared favorably to 29% in Q1 of 2022. The improved margin was driven by a 22% year-over-year decrease in sales and marketing expenses and a 2% year-over-year decrease in R&D expenses as we reshaped the cost structure to align with the lower market growth expectations and accelerated our timeline to reach our long-term free cash flow margin target. Adjusted free cash flow margin was 16% of revenue, up 4% from Q1 of 2022. This strong result was due to both the higher adjusted EBITDA margins and the timing of several capital projects that we expect will occur later in 2023. Q1 2023 will be the low point in 2023 for margins. The first quarter of each year includes the cash flow impact of annual bonuses as well as higher payroll taxes and other seasonal cash impacts. Additionally, our cost savings actions occurred in the middle of the first quarter, meaning savings were only partially realized in the period. As we progress through 2023, we expect to steadily improve profitability and to exit the year with adjusted EBITDA margins in the low 40s and with adjusted free cash flow margins approaching 30%. Our strong adjusted EBITDA and free cash flow margin results came despite the anticipated near-term pressure on gross margin, which on a GAAP basis came in at 56% in the first quarter compared to 63% in Q1 of 2022. The year-over-year decline in gross margin is the expected result of the previously discussed increase in colocation expenses following the expansion of several facilities, including the new Sydney data center and the short-term impacts of higher power costs in Europe. Data center expansion is a key element of our growth strategy as we increase our footprint to meet growing customer demand. While margins are initially impacted with these expansions, we will grow into the new capacity over the coming quarters, improving their utilization and margin profile. We also expect to see flat to declining power costs in Europe over the course of 2023, which will provide additional margin improvement. Despite the gross margin pressure, we effectively managed our overall operating expenses to exceed our profit outlook for the first quarter, and we are on track to achieve our margin goals for the full year. Our non-GAAP earnings per share of $0.28 was within our guidance range, but was impacted by a one-time international tax expense from the Cloudways acquisition in 2022 that reduced our non-GAAP earnings per share by $0.03. As we shared on our last call, we identified a total of $60 million in annualized cost savings, $25 million of which were related to headcount and $35 million non-headcount related, that would enable us to accelerate our long-term cash flow margin targets into 2023. We have made good progress on these savings and optimization initiatives, with our February reduction in force and the rationalization of expenses in direct marketing, software licenses, travel and entertainment, and other third-party spending. We are pleased with our progress so far this year and we are confident that we will be able to achieve the full targeted 2023 savings. In addition to our strong margin performance, we also made meaningful progress on our ongoing share buyback program. We are highly focused on driving outsized growth in both earnings and free cash flow per share as the long-term drivers of shareholder value creation through continuous improvement in operating margins, coupled with our commitment to return capital to shareholders. During Q1 of 2023, we made meaningful progress on the share repurchase front, repurchasing 7.8 million shares for a total of $266 million at an average share price of $34.27. As of the end of last week, we had approximately $175 million remaining of our $500 million approved repurchase program, and we expect to deploy the full remaining balance of the authorized repurchases over the course of 2023. The company's strong balance sheet and significant free cash flow generation enable us to invest in growth initiatives, continue to make acquisitions, and repurchase shares on an ongoing basis. We expect to continue our repurchase program of up to 125% of free cash flow in 2024 and beyond. Given our progress to date on the buyback and our anticipated utilization of the remaining balance over the course of 2023, we expect to end the year with approximately 103 million to 105 million in weighted average fully diluted shares outstanding for 2023. It's important to note that our fully diluted shares outstanding include 8.4 million shares associated with our convertible debt, which has a conversion price of $178.51. We anticipate that the combination of our ongoing buyback program and the eventual resolution of our convertible debt will more than offset any dilution from stock-based compensation and will result in a 15% to 20% decrease in our share count over the coming years. Turning towards our financial guidance for Q2 2023, we expect revenue to be in the range of $169.5 million to $170.5 million. For the second quarter, we expect adjusted EBITDA margins to be in the range of 37% to 38%, and non-GAAP earnings per share to be $0.40 to $0.41 based on approximately 103 million in weighted average fully diluted shares outstanding. For the full year, while we continue to see headwinds from customer optimizations and we are still early in our go-to-market and product monetization efforts, we are comfortable with our previously provided guidance and expect revenue to be in the range of $700 million to $720 million. With our strong margin performance in Q1 2023 providing room for incremental growth investments, we continue to expect adjusted EBITDA margins to be in the range of 38% to 39% for the full year. Having better visibility into the impact of our share repurchase program, we now expect non-GAAP earnings per share to be in the range of $1.70 to $1.73. For the full year 2023, free cash flow will increase as a result of our improved profit margin and lower capital expenditures, driving a 21% to 22% free cash flow margin. Excluding the one-time cost associated with our workforce reduction and transaction costs, like adjusted EBITDA, free cash flow will ramp throughout the year, and we expect free cash flow margin to approach 30% by the fourth quarter. That concludes our prepared remarks and we will now open the call up to Q&A.

And your first question comes from Wamsi Mohan from Bank of America. Your line is open.

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

Just first on the AI dynamics. We have businesses running AI-based models and businesses on our platform today and they've been doing it for many years. We've always, from the founding, invested in really high-performance computing. And so, although GPUs offer some differentiation in enhancing that compute, we still provide very high-performance compute and strong bandwidth capability. So, we're looking at product extension and, yes, GPU tends to be capital intensive, but we, obviously, know capital intensity very well and expect our foray into this area over time to be well within our previously made comments about long-term cash flow margins and CapEx as a percentage of revenue. We do think it will enhance our addressable market with some of the newer business models that are emerging and give some of our existing customers more options beyond just, for example, the premium dedicated droplet product which is compelling for bandwidth-intensive and computationally intensive use cases that could be AI. We will create broader offerings and have more to say as we go into the near term. Regarding the first comment, I think what we're seeing in the broader environment is, first off, we're very excited about the fact that our churn has been very stable over this past year. It ticked up a little bit, but we noted with some of the blockchain dynamics in Russia mainly causing that. We did see churn even improve as we moved through Q1 and into Q2. So that’s a very strong point that we focused on because in a weakening environment, you want to keep your customers, and our team is doing a very good job of that. Secondly, what we're seeing is that our customers operate on a consumption-based model. What's driving the lower NDRs and slower growth is the fact that their expansion has slowed significantly over the last year. That’s the main driver for why NDR has contracted and why our growth rate has contracted. We talked with them anecdotally with our sales, our customer success teams, and formal surveys. The sentiment continues to be that our customers' demand environment is weakening. They really appreciate the consumption-based model because it allows them to adjust accordingly. But we are deeply focused on them and we've made significant progress in certain instances even with our customers that have multi-cloud workloads on DigitalOcean and others in talking with them about moving their workloads from other cloud providers to us. It’s a difficult environment in terms of things we can’t control. However, I think our engagement with our customers, support focus, customer success, and our compelling differentiated product packaging is helping us work through these challenges. We reaffirmed the revenue range because if you go back to how we discussed our guidance at the beginning of the year, the low end of the range contemplated no real change from additional initiatives and a slight weakening in the macro. We didn’t see a drastic change in the macro. As you recall, our Q1 guidance anticipated a relatively flat sequential result from Q4, so it was well within our expectations. Our Q2 and what we're seeing now with the initiatives we've launched, both concerning go-to-market and products already in market, is seeing traction. Getting to the high end of the range depends on the success of those products. So, we’re comfortable holding the range, given the downside of the low end reflecting what we believe is a slightly better outlook than when we set that several months ago. These initiatives are clearly seeing traction as customers look for more value. So, that's our reasoning behind maintaining our guidance for this year.

Thanks, Yancey.

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

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

Yes, I'll start in reverse on that with the CapEx. CapEx came in at 15% of revenue for the quarter, and that's generally consistent with what we expect for the full year. While I mentioned timing, we don't expect that CapEx as a percentage of revenue will increase materially from the first quarter. On the gross margin front, that’s something we had anticipated. We signaled we were making investments in our data center footprint. We’ve added the Sydney data center and expanded some capacity in certain markets. This causes a near-term increase in the cost structure. It was about a 350 basis point impact around colocation year-over-year. Also, we invested in some upgrades around bandwidth to improve network performance, that contributed about 125 basis points. There was another 125 basis point impact from the European utility cost, which we don’t think will persist much longer than 2023. The important thing is that, despite the increase in gross costs, we were able to effectively manage and exceed the EBITDA margins and free cash flow margins. By the end of the year, we expect to be over 60% on gross margin, but it’s a temporal challenge on the gross margins.

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

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

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

Yes. So we've now been about 12 months into this lower growth dynamic as our customers have been expanding slower. With the consumption-based model, spend adjusts immediately. We’ve lived with this again for about a year. I think a key signal, importantly, is that the churn has been stable and has actually improved in some areas. Those are really important sides for us. The second is for growth to resume; we need our customers to consume more cloud based on their business expansion again. That will be a crucial signal for us. It's relatively stable but slower than it was certainly a year or two ago, and that explains the lower NDR and overall growth rate. As for optimizations, I would suggest the consumption-based model inherently builds in optimization. If their business slows, they pay for what they use—so they consume less, which results in lower spending. They’re built to adjust accordingly. We’ve seen this earlier than some of the others on longer contracts. What I’ll point out from our conversations with customers is that as their businesses slow, our small businesses typically experience rapid growth and are opting to pause—they’re reassessing architecture, and the dynamics of how they run cloud. We’ve been able to foster great conversations with them, placing them in different packages that provide a more efficient growth path similar to the premium dedicated droplets case I cited. This has allowed us to take advantage of this challenging environment to work with customers toward a more efficient growth path, yielding benefits for us and more peace of mind for them. So this focus on getting closer to our customers is what we’ve decided to do in this current environment.

Yes. Okay, perfect. Thank you.

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

Hey, guys. Thanks for taking the questions here. I wanted to cycle back to Matt's prepared remarks. I think to open up, you had cited these elevated contraction rates. I wanted to see if we could get a better sense of those rates. How did Q1 play out as far as those contractions we were seeing? With April now behind us, was there any change there? And then the second question was, I know that you guys reiterated the calendar 2023 guidance, but at the end of February, you had also announced a price increase for Cloudways. Can you give us a sense of what's embedded in your guidance based on that Cloudways price increase or was that already in some way incorporated into your previous thinking? Thank you.

Thanks, Mike. Yes, to close out on that one, the Cloudways price increase was contemplated in the guidance. That was baked into our plan. We made the decision at the time we acquired Cloudways, which was right when we had just recently raised prices for DigitalOcean, to pause on that front until we closed that transaction and did further analysis before blanket increasing prices at Cloudways. So we did that, and it took effect in April. But it was something we had anticipated during the planning process. Regarding contraction, as Yancey mentioned, if you think of NDR, NDR is a function of three things: churn, expansion, and contraction. The decline in NDR from Q4 to Q1 was predominantly not driven by churn, which remained flat. In fact, as Yancey stated, we’ve seen month-over-month improvement in churn. The decline in NDR resulted from lower expansion and an increase in contraction, which aligns with the optimization and pause we see in our customer base. For a numeric view, just look at NDR; assume churn is approximately flat quarter-over-quarter—that'll give you the metrics for expansion and contraction.

Awesome. Thank you for the color. Did you guys quantify the benefit from the Cloudways price increase for the guidance?

No, we did not.

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

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

Great. Thanks very much. With the current guide pointing towards the mid to upper teens exit growth rate for the year and the CapEx growing at 15%, should we think about that being the long-term sustainable organic growth rate for the business?

Our guidance reflects the outlook for the year, and we aren't commenting on longer-term growth expectations for the business. We continue to invest to drive growth higher than what you just cited. But at the same time, there are factors beyond our control. So we’re focusing on what we can control, which is why we made a strategic decision months ago to accelerate achieving long-term free cash flow margins today. As Matt highlighted, we'll approach those even in this quarter but certainly as we exit this year. In an area of lower growth, this is the growth rate that persists with attractive margins and returns on capital. If growth reaccelerates, we are investing in new products as we cited today to support that growth and will have more investment capacity as well as deliver more leverage in the operating model. We're pleased to reiterate our guidance for the year and have confidence in the trends we've seen as we moved through Q1 into Q2. As we get to the back half of the year and into early next year, we'll have more to say about 2024 and potentially beyond, depending on how the macro environment shapes up.

Great. Thanks very much.

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

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

Cloudways is performing very well. There's been a slight uptick in the growth rate since the close, owing largely to acceleration and new customers which is incredibly exciting. Those customers who were coming to DigitalOcean had mismatched expectations before the close of the deal; many of them churned. We've done a great job saving those customers and getting them into Cloudways out of the box. They're going to be long-term customers. We're materially increasing value as a result. So, we’re first bullet on realizing the synergies of the complementary platforms and achieving those synergies early and significantly. We’re excited as we continue to look at other areas in sales and marketing to better match customers at either Cloudways or DigitalOcean. We feel good about that. In terms of the pricing change, it’s early—six weeks since it went active. We feel good about the early returns. As Matt mentioned, that had been baked in; it was on pause as we closed the acquisition last year. Cloudways had its previous price increase four or five years ago, and it was due for an update. We feel positive about early feedback and what we're observing in demand on the platform since the announcement took effect.

Got it. Thank you.

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

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

I think, in the bigger picture, AI is a compute-intensive, storage-intensive, and bandwidth-intensive arena that fundamentally leverages infrastructure as a service. Overall, AI tools and applications will ultimately act as a tailwind for our business. As I noted earlier, we have businesses running AI models on our platform today and have done so for years. From a core compute perspective, our goal is to provide capabilities that allow customers to leverage AI tools, build language models, or run complex compute algorithms beyond their current capabilities on our platform. This is why we acknowledge we’re looking at GPUs. I’m not sure I completely understand your question; however, we are not concerned specifically about the infrastructure part of our business because we firmly believe infrastructure facilitates AI applications. Frankly, we should benefit over time, and we have already witnessed benefits from businesses running AI models on our platform as of today.

Thank you for the detail.

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

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

The managed hosting and services business is very large and fragmented globally. This was an essential diligence concern for us when negotiating and conversing with Cloudways a year ago. The sentiment indicated it would not be an issue—and the reality is that it has not been. We are not seeing other managed service and hosting providers that were meaningful customers on DigitalOcean move volumes away. In fact, one of the larger ones on our platform, a multi-cloud managed host provider, moved cloud services onto our platform as part of optimization in Q1. So, the direct answer is we have not seen any significant changes; we had no concerns going into the deal, and it hasn't been an issue in the two-plus quarters since we acquired the company.

Got it. Helpful. Thank you.

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

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

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