DigitalOcean Holdings, Inc. Q3 FY2023 Earnings Call

Hello and good afternoon. My name is Jeremy and I'll be your conference operator today. At this time, I would like to welcome everyone to the DigitalOcean Q3 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. I would now like to turn the call over to Rob Bradley, Vice President of Investor Relations.

Thank you, Jeremy and welcome, everyone, to DigitalOcean's third quarter 2023 earnings call. Joining me today is Yancey Spruill, our Chief Executive Officer; and Matt Steinfort, our Chief Financial Officer. Before we get started, 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 fourth 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 and reconciliations between our GAAP and non-GAAP financial results can be found in our earnings press release issued earlier this afternoon and in the investor presentation on our Investor website. With that, let me turn the call over to our CEO, Yancey Spruill.

Thanks, Rob. Good afternoon and thank you all for joining us today. I'm pleased to share our solid Q3 results, representing another quarter with an attractive balance of growth and profitability. This afternoon, I'll share an update on the search for our next CEO, some broader macro observations informed by customer and partner interactions, and briefly recap some of the exciting product announcements that we've made recently. I will also highlight a recent customer win that gives us enthusiasm for our product trajectory before turning the call over to Matt to go over the financial results and updated financial outlook. On the CEO transition front, the search process is well underway and the Board is making good progress in our recruitment of a new CEO. There has been strong interest from numerous leading technology executives and we are confident that we will hire an outstanding executive with extensive cloud infrastructure expertise. The Board of Directors is deeply engaged with several candidates and we will continue to move these candidates through the interview process as the search progresses. It is still too early to communicate a specific timeline for the hiring of a new CEO, but the Board is working with focus and deliberate speed to fill this critical role. Third quarter results were encouraging as the business delivered solid performance from both the top and bottom line perspectives. Revenue grew 16% year-over-year to $177 million and our first quarter having lapped the Q3 2022 pricing actions. As we indicated, we had started to see at the tail end of Q2; we continue to see positive signs through Q3 and into early Q4 that there are abating trends from the growth headwinds from our cohort that we have seen over the past 12 to 18 months. Our margin profile for the core DigitalOcean business was very strong for the quarter and enabled us to absorb the incremental costs from our Paperspace acquisition while remaining within our targeted range of adjusted EBITDA and free cash flow margins. The combination of a stabilizing revenue growth rate and the efficiency we have created in our core business is allowing us to deliver robust free cash flow margins. As we look to accelerate our top line growth rate, we continue to build distinct revenue growth drivers through product and infrastructure investments. A big portion of our focus over the past several months has been on our ongoing efforts to deliver on our product roadmap and continue to add critical capabilities that enable our customers to build and scale their own businesses. Through numerous interactions with customers, prospects, and partners, we continue to fine-tune and evolve how we can best serve customers as they navigate the complexities of the cloud markets. The consistent sentiment from our customers is that simplicity is foundational to our value proposition and relying on DigitalOcean to remove the complexities of the cloud is a productivity multiplier for them. We are focused on enhancing our platform's performance, reliability, security, and scalability, which enables us to retain and grow the spend of our customers and positions us to win new customers. Over the past several months, we have delivered an increase in velocity of product releases and announcements as we focus on meeting our customers' evolving needs. In September, we launched Managed Kafka, a new fully managed database service. Managed Kafka is a critical tool for businesses whose model involves significant data streaming. However, for small and medium business customers, it often comes with increased complexity. With our new fully Managed Kafka as a service offering, companies can focus on their development environment and not be slowed down by complex processes. Customers have provided strong positive feedback about Managed Kafka, citing that it is allowing them to focus their time and resources on their customer-facing activities, referring to their increased productivity as a game changer. In September, we also introduced premium to general-purpose droplets, extending the premium features of enhanced CPU, memory, and storage to offer improved performance to a broader way of cloud-native applications. Our first-generation premium dedicated droplets saw broad adoption and drove strong ARPU growth when launched in early 2021, as customers expanded their computing capabilities and migrated certain workloads to this premium compute offering. Now we've taken it one step further and expanded the opportunity for more customers to use these enhanced features with this new premium general-purpose offering. On the Paperspace front, we continue to be very excited by the addition of their AI/ML capabilities and the expanded market opportunity that this business creates for DigitalOcean. While we are still only a few months into the integration process, the demand for Paperspace's services has been very strong and we continue to learn more about the market and how customers are leveraging our capabilities to develop and grow their businesses. To give you a sense for one such use case, I'll provide an overview of one of the exciting customers we recently added to the Paperspace platform. The company is Nomic, which was founded in 2022 to improve the explainability and accessibility of artificial intelligence. To date, Nomic has released two products, an open-source AI model GPT for all, which is the third fastest-growing repository in GitHub history, and Atlas, a tool that allows users to visualize unstructured datasets used to build large language models. Nomic selected DigitalOcean to access High Performance Compute along with our intuitive software, customer support, and reliability. Their Co-Founder was quoted as saying, 'Our team loves Paperspace. It's far more intuitive than other compute providers. It allows us to spend less time managing infrastructure and more time building great products for our customers.' Their testimony to DigitalOcean's combination of simplicity, reliability, and support along with the current demand environment that we see excites us for the opportunity ahead. The RFPs that we are seeing span across multiple verticals for multiple applications and demonstrate the opportunity for new customers to join our platform to not only build their AI applications but also to scale their products while utilizing the breadth of our IaaS and PaaS capabilities. In summary, we're making good progress with our efforts to bring on a new CEO and during this transition, our business is seeing stabilizing revenue trends while continuing to deliver significant free cash flow. We are seeing very encouraging signals that our top line growth rate is stabilizing relative to the last six quarters of deceleration. We continue to work to reaccelerate our growth rate through targeted product and go-to-market initiatives. The improved operating leverage we have created in the business over the past year is enabling us to make strategic investments while still delivering compelling free cash flow margins. We remain excited about our near and long term potential in the large $100 billion addressable market for SMB cloud infrastructure in which we compete. As we approach the end of the year, I'd like to thank each and every member of the DigitalOcean team for their commitment to our customers and for delivering these solid results. With that, I'd like to turn it over to Matt to provide details on our financial results and our outlook for the balance of the year.

Thanks Yancey, and welcome to all of you who are joining us on today's earnings call as we review our solid Q3 results. In Q3, we continued to execute our strategy of accelerating the achievement of our long-term margin targets in the core DigitalOcean business while positioning the company for accelerated future growth through both organic and inorganic investment in our platform despite the ongoing macro headwinds. We have driven these margin improvements by achieving the savings that we had identified at the beginning of this year, which included improvements in our gross margin as we grew into capacity investments made in 2022 and the achievement of identified savings in both headcount and non-headcount related expenses. As we have continued to execute on these savings, we have increased our overall profitability and free cash flow margin significantly allowing us the flexibility to make targeted investments in growth. During the first three quarters, we have continued to invest in organic growth by our product roadmap as Yancey described and in July, we invested inorganically in the acquisition of Paperspace, which meaningfully increases our total addressable market. With our strong balance sheet, our continued focus on improving operating leverage and our commitment to share repurchases, we have made material progress driving earnings per share increasing 22% year-over-year. As we approach 2024, our strategy remains the same. We will continue to drive operating leverage while balancing investment across organic and inorganic growth opportunities and share repurchases. With that context in mind, I will review the highlights in the third quarter. Revenue in the third quarter was $177.1 million, which was an increase of 16% year-over-year and 4% quarter-over-quarter and our first full quarter that lapsed the pricing increase we implemented in early Q3 2022. Contributing to this growth was Cloudways, which grew 11% quarter-over-quarter and the addition of Paperspace, the AI platform we acquired in early July, which contributed $3 million to our results for Q3 and which surpassed the $1 million in monthly revenue mark in September. Profitability was very strong as we delivered $75.8 million of adjusted EBITDA, a 43% margin for the second consecutive quarter. Adjusted EBITDA margin improvements are the result of improving gross margins as we grew into the incremental data center and bandwidth capacity investments that we had made in late 2022 and the ongoing benefit of the efficiency improvements that we had identified in Q1 of this year and have been realizing throughout the year. Free cash flow was also a highlight in the quarter as we generated $56 million which was 32% of revenue. This 500 basis point improvement from Q2 was a result of both lower capital expense and working capital timing. Given the working capital timing dynamics coupled with our anticipated near-term Paperspace investments, we expect free cash flow margin in Q4 to be lower than Q3 levels. While free cash flow margins can be lumpy quarter to quarter, we continue to be confident in our full-year free cash flow margin expectations. Finally, non-GAAP earnings per share was $0.44, which is a 22% year-over-year increase as we increased our profit margins while simultaneously reducing our shares outstanding through our systematic share buyback program. As expected, net dollar retention declined in Q3 to the mid-90s coming in at 96% as we lapped the price increase implemented in July 2022. Fortunately, despite the difficult year-over-year comp in Q3, we continued to see evidence of the ongoing stabilization of market demand that had started to show signs of bottoming in Q2. As it has been for most of 2022, churn remained stable at historical levels around 11% to 12% for each of the months in Q3, which is consistent with historical churn levels in early 2022 prior to the market slowdown. Contraction which has historically been in the 12% range in early 2022 showed improvement as we progressed through the quarter, ending at 15% after starting the quarter at over 16%. We also saw positive signs in expansion in Q3, which was the final metric we said we needed to see for stabilization as it had continued to decline in Q2, albeit at a decelerating rate in Q3, expansion stopped declining for the first time in over a year and was fairly consistent at 23%. While we have not yet seen a meaningful improvement in NDR, we are encouraged by the relative stability of the key component metrics in Q3. We expect NDR to improve in Q4 and early 2024, driven in part by the continued strength of the Cloudways business and more favorable year-over-year comparisons. From a customer perspective, our durable customer acquisition and graduation model remain solid despite the challenging growth environment. We graduated 4,000 builders and scalers on our platform in the quarter and we now have more than 154,000 on the DigitalOcean platform. These customers who spend more than $50 per month with DigitalOcean continue to represent 86% of our overall revenue and remain a key focus of our product, sales, and customer success investments. Average monthly revenue per customer or ARPU was $92.06 which was an increase of 6% year-over-year, which like NDR faced a difficult year-over-year comp as we lapped the price increase from last July. Before providing guidance for Q4 and for the full year 2023, it is important to understand where we are in the 2024 planning process. We are working diligently to finalize our plan and budget for 2024 with a focus on delivering double-digit growth with healthy profit and free cash flow margins. Our strategy will remain the same in 2024. We will continue to drive operating leverage in the core DigitalOcean business while investing to take advantage of the compelling market opportunity we have with Paperspace. As we shared last quarter, despite the continued market pressures, we believe we have a solid foundation for double-digit top line growth for 2024 with our steady self-serve funnel generating around 5% growth, Cloudways generating around 3% growth, and Paperspace producing at least 3% growth. Key to growing faster than this will be getting NDR above 100% at some point in 2024, which we are working aggressively to accomplish. We look forward to providing more specifics on our plan at our next earnings call in February when we report our Q4 and full year results. In terms of financial guidance for Q4 of 2023, we are targeting revenue to be $178 million. For the fourth quarter, we expect adjusted EBITDA margins to be in the range of 36% to 37% and non-GAAP earnings per share to be $0.36 to $0.37 based on approximately 100 million to 101 million in weighted average fully diluted shares outstanding. For the full year, we are targeting revenue to be $690 million. Given the strong performance driving margin improvement in our core DigitalOcean business, we continue to project adjusted EBITDA margins to be in the range of 38% to 39% for the full year despite our increased investment in our Paperspace AI/ML business. We project non-GAAP earnings per share to be in the range of $1.52 to $1.54 with weighted average fully diluted shares outstanding for 2023 of $102 million to $103 million. And finally, given the strong progress we have made on improving margins in our core DigitalOcean business, for the full year 2023, free cash flow will be 21% to 22% of revenue, consistent with our initial February guide, despite the incremental investment we are making into our Paperspace business. That concludes our formal remarks and we'll now open the call up to Q&A.

All right, perfect, thank you. Our first question comes from the line of Raimo Lenschow from Barclays. Raimo, please go ahead.

Thank you and congrats on a great quarter and it's nice to see the stabilization and improvement. My first question is on Paperspace. Can you kind of talk a little bit about what you're seeing in the customer base in terms of how you see the adoption there? Because like at the moment for us AI, there's a lot of like big companies and co-pilots and stuff like that. Can you talk a little bit about like practical use cases for how SMBs are using this and what are you seeing there in terms of excitement about that? And then I had one follow up on financials. Thank you.

The customer base we're observing, particularly with Nomic, illustrates a diverse range of use cases and verticals. Many are focused on developing large language models for specific applications and creating tools that help people utilize AI more effectively. These are tech-enabled businesses that may not strictly fit the SMB label, as they have ambitions for rapid growth while supporting a wide array of use cases. The promising aspect is our value proposition, coupled with the complementary features of the Paperspace platform designed for simplicity, which facilitates easy onboarding for users. This has been a key differentiator for us throughout DigitalOcean's history, and it's encouraging to see this value proposition gain significance as we explore the AI opportunity.

Okay, perfect. And then a question, quick question on the free cash flow. So obviously very strong performance this quarter and you called out CapEx and working capital a little bit as factors here. But how do you think about those two factors that you mentioned in terms of like in theory some of that could be driven forward or was it just timing? Thank you.

Thanks, Raimo. If we are still staying with our full year guide for this year of 21% to 22%, we will have some of the working capital catch up in the fourth quarter. Looking at free cash flow margin on a quarterly basis is tough just because it's a lot influenced by timing of payments. So that will normalize in the fourth quarter. And then in the fourth quarter also given some of the equipment purchases we made when we acquired Paperspace that are coming in, we expect that to hit partially in the fourth quarter as well. So again, the full year guide of 21% to 22% is still the right way to be thinking about it and it's great that we have the margins as high as we do this quarter which is evidence again of the core DigitalOcean business. As we said we were going to drive free cash flow margins into the high 20s and approach 30 by the end of the year and we've done that and we're using that as a means of funding the growth opportunity that we have to drive more revenue in the Paperspace business and yet we're still able to come in at 21% to 22% for the year. So excuse me, and we're really happy with the progress we made.

Yes, excellent. Yes, no, really good performance. Thank you.

All right. Our next question comes from the line of Mike Cikos from Needham & Company. Mike, please go ahead.

Hey, guys. This is Matt for Mike Cikos over at Needham. Thanks for taking our questions. I know you hit on this a little bit, but it's kind of coming from a different angle; is there anything one-time or anything I guess that sticks out as far as shifts and timing of expenses that you would call out in the reduction of the implied 4Q EBITDA guide?

The sequential decline in EBITDA is influenced by the addition of Paperspace, which is creating a slight impact on the margins due to its different scale in the business. As we plan our investments for growth next year in both the core DigitalOcean and Paperspace businesses, there aren't any significant one-time factors at play. The EBITDA guidance of 38 to 39 for the year is a good benchmark to keep in mind. It's important not to focus too much on the quarter-over-quarter margin fluctuations, but rather to consider the broader picture over a longer timeframe.

Got you. That's helpful. Thank you. And then in any way is the customer base showing any potential signs of greater caution given news on the broader macro or digital native pressures in the F&B space?

I think what we said is we're pleased with churn has been relatively stable now for several quarters as we move through the year. We saw improvement in contraction as we moved through Q3 and that continues at a better level than it was six months ago and we're seeing stabilizing signs in expansion. And so I think those are the biggest tell-tale signs for us as it relates to what our customers and new customers and existing customers are seeing that things seem to be stabilized.

Great. Thanks so much for the color.

Our next question comes from the line of Josh Baer from Morgan Stanley. Josh, please go ahead.

Great. Thank you. Congrats on a good quarter. Was hoping you could break out some of the metrics around Paperspace, the contribution to ARR and just how to think about the contribution to the different customer cohorts?

So from an ARR standpoint, I think we said what it was $2.8 million in the quarter, it's going to be just a little over $3 million. We're going to end up around $6 million for the year. So from an ARR standpoint, it's going to be what, north of 12 because that's where the quarter is ending. But from a customer account standpoint, it added about I want to say 12,000 customers in total to the customer base and again the average revenue per customer there is a lot bigger. So it's closer to average is 900-ish. So they tended to be added to the scalers segment and the builder segment.

Great. Thank you and apologies if I missed this. Just looking at CapEx as a percent of revenue is pretty low. I understand that can be lumpy and it is a priority to invest in Paperspace. But how should we think about the trajectory of that CapEx spend and is it a good leading indicator of your demand in top line growth? Thanks.

No, I don't think it's a good leading indicator of the demand because it is lumpy. We were originally tracking to be about 15% for the year. What we said with Paperspace will be closer to 17% in CapEx as a percentage of revenue for the year. Some of that is just it's lumpy. I mean we ordered gear right out of the gate when we bought Paperspace and we increased that amount because we're seeing a lot of really good demand and just the supply chain around GPUs, it's unpredictable. And so we didn't get everything that we ordered in Q3, and we'll start to get some of that in Q4 and then we'll start to get some more of it in early next year. So it’s really is working capital and the timing of that CapEx purchase, but it's not that’s why we're saying for the full year, we're still sticking to the 21% to 22% free cash flow and still the target of around 17% CapEx as a percentage of revenue for the year.

Got it. Thank you.

Our next question comes from the line of Patrick Walravens from JMP. Patrick, please go ahead.

Great. Thank you very much. And it's nice to see the business stabilizing. So my question is on with Paperspace, how are your GPU cloud data centers different than your traditional CPU cloud data centers that you had with DigitalOcean, and what's that GPU cloud data center footprint look like today and where are you going to take it? Obviously, it's been a big issue in the industry lately.

Well, GPU servers have different heat consumption, much higher heat consumption. So the physical footprint is less dense than you might have with standard compute. I think that's one of the principal differences. We're still evaluating, as Matt mentioned, in the 2024 planning process around what the level of investment pacing and that may include how to think about evolving the data center infrastructure for both companies for the combined company and incorporate the fact that it's going to be a mix of GPU and standard compute CPU going forward. I don't think any decisions have been made on that. We've been fortunate that some of the Paperspace data center footprints are very close in proximity, including one particular case in the same building and we'll see how we evolve that as the demand. We're learning a lot. Obviously, the demand is incredibly strong. And we’re seeing where we're playing in that market and how we're going to grow it and how we're going to need to add to the capacity footprint to support that growth, not just in terms of buying servers but the physical imprint. We are looking to make decisions on that as we get into next year.

All right, great. Thank you.

Our next question comes from the line of Jim Fish from Piper Sandler. Jim, please go ahead.

Hey, thanks. This is Quinton on for Jim Fish. Thanks for taking our questions. First, we've seen significant product launches in the, call it non-core compute side of DigitalOcean with storage with and Managed Kafka kind of the most recent ones. Can you talk about how the team is thinking about bundling or potentially packaging those non-core compute with maybe compute and Paperspace coming on and how we kind of can adapt to some of the go-to-market motions with that?

We've integrated various features, security measures, and tools for our combined customers to ensure a seamless experience with both AI and standard products. Bundling the items I've mentioned, like scalable storage and premium droplets, reflects our ongoing discussions with investors about the potential of this approach. As we gain insights into customer use cases across different industries, we recognize the importance of separating compute from network bandwidth and storage, which is a recurring theme. Establishing a solid foundation in standard and AI computing, along with robust bandwidth, security, and storage capabilities, provides us with the necessary building blocks for effective bundling and unbundling to better address our customers' needs, as demonstrated with our recent scalable storage launch. If a use case requires additional storage without needing more compute, we want to offer that choice, creating a more efficient growth path for our customers. This will continue to be a significant focus for us. Looking ahead to next year, we will share more about our integrated product bundling strategies related to both AI and standard compute. Overall, the bundling and packaging process presents a substantial opportunity for us.

Makes sense. And then, obviously, you talked a little bit about wanting in the search for a new CEO, you're wanting a leader that has the kind of core cloud experience. But as you think about kind of the skills of the background, are you looking for someone with more technical background or are you looking for an operational or sales kind of leader? Maybe any sort of color you can give on the fact like underlying skills would be helpful.

The Board is currently very involved in the search for a CEO. As mentioned in the prepared remarks, this is an active process. While it may take some time, we are proceeding as quickly as possible without compromising the thorough evaluation needed to explore the market. There is no specific timeline for an announcement, and we are clearly seeking a candidate with cloud experience. However, I won't provide further details about the process or the pool of candidates at this time.

Got it. Thank you.

Our next question comes from the line of Kingsley Crane from Canaccord Genuity. Kingsley, please go ahead.

Hi, thanks for taking the question. We noticed on Cloudways website that it no longer offers infrastructure services from SMB cloud competitors like Volt only including options for public clouds like AWS and GCP. So are you actively converting customers over DigitalOcean infrastructure? Is this primarily a new business dynamic?

It's mostly a new business dynamic. We still have such to support customers on each of those platforms. But from a go-forward basis, we still offer the options to go multi-cloud through the hyperscalers or through our platform. But we continue to support partners that drive opportunities through some of those other providers. And clearly, we have a healthy installed base of customers that are leveraging other providers as well.

That's a change that was made earlier this year in Q2.

Okay. Very helpful. And the second one would be, how is the momentum behind the Hatch Accelerator program? How important of a customer ramping mechanism has it become for you? And is there an opportunity to include Paperspace as part of the program?

There's certainly an opportunity to include Paperspace as part of the program and the Hatch program is something that's been a part of the company for a long time, and as we look for ways to accelerate the business and drive more adoption through the self-serve funnel, it's certainly one of the areas that we continue to invest in. But it's certainly an opportunity to bring in both Cloudways and Paperspace into that kind of a program.

Our next question comes from the line of Jason Ader from William Blair. Jason, please go ahead.

Yes. Thank you. I just wanted to ask about the go-to-market strategy.

Jason, we can't really hear you. Can you speak a little louder?

Is that any better?

Much.

Okay. Sorry. I was asking about the go-to-market strategy and just as you look out, especially over the next couple of years, how would you frame sort of where you've been, what you're doing now in terms of maybe some changes and then where you want to go just from an overall go-to-market standpoint? Because I know you've been very much kind of bottom-up driven historically.

That's a good question, Jason. The self-serve funnel has been our main method for acquiring new customers when considering new logos. Clearly, the Net Dollar Retention (NDR) contributes to revenue growth from this group. However, in terms of new customer acquisition strategies, we've primarily relied on the self-serve funnel, which is generating a healthy range of approximately $33 million to $35 million in new revenue. Over the last several years, we've invested in expanding our go-to-market channels to include a more direct sales approach. This targets customers on larger cloud platforms, particularly at the smaller end of their customer base, where enhanced customer service and direct exposure to company representatives are appealing. It also provides cost savings and simplicity for them. We believe we are still in the early stages of this effort. One lesson we've learned this year, especially during the slowdown, is the need for product enhancements and capabilities to effectively attract customers from larger hyperscalers. This insight is informing our product roadmap and the capabilities we're currently developing. Additionally, there is an opportunity to grow our partner channel. We currently have many partners on our platform, including web agencies and developers creating websites for others. Historically, we’ve treated them similarly to customers, addressing their unique requirements without differentiating them as partners. We're investing in expanding our approach here because they represent a valuable source for reaching market segments we might not otherwise capture—those who wouldn’t self-identify and come to our platform. Looking ahead to the next several years, it would be ideal to achieve a 50-50 ratio of new sales to self-serve acquisitions, but we have some work to do to reach that goal. We're still in the early stages of developing channels outside of the self-serve model, which has been the foundation of our company's growth.

Great. Thanks for the background. Just one quick follow-up on that. It would be helpful, I think, for investors as you go forward just to provide some proof points on some of those newer channels and maybe anecdotes of customers that you've taken away from the hyperscalers, et cetera, just because I think that would be helpful for everyone to kind of just understand how that motion is working.

Great. It's a good suggestion, Jason. Thank you.

Jaiden: Hey guys. I'm on for Pinjalim Bora. Thanks for taking the question. Any early feedback on the Managed Kafka service, maybe some of the use cases there and do you think it could be a tailwind to growth next year?

The feedback has been very good and positive. We have many businesses on the platform that utilize big data streaming, such as e-commerce, gaming, and others where large amounts of data are processed. This is a key use case that is highly suited and more effective on Kafka compared to other services. As a result, it's a natural fit for our customers. The feedback has been excellent, as it enhances productivity for our customers because they spend less time managing Kafka, which can be more complex with other solutions. This allows them to dedicate more time to customer-facing activities. While we don’t expect a significant impact this quarter since adoption started late last quarter, we anticipate that it will become a more meaningful contributor as we progress through 2024.

Okay. Thank you. And then on Paperspace, it seems like it's doing well. Are you still baking in less than $5 million in contribution for Paperspace for the second half of this year?

I think we've disclosed the actual revenue for the third quarter, and we mentioned that the run rate was 1 million in September. If you extrapolate that, it puts us at about $6.

And our next question comes from the line of Wamsi Mohan from Bank of America. Wamsi, please go ahead.

Hi, this is Mattie Esner taking the question on behalf of Wamsi. Thank you for taking the question. I was wondering if you could talk more about the underlying drivers in terms of the mix, in terms of the ARPU growth, especially for the upsell and the attach? And how are you thinking about like the trajectory for the ARPU growth?

So the ARPU growth, again, year-over-year, we said was 6%, which was low relative to historical based on the difficult comp on even the price changes. But if you look at the products that we announced during this year, you talked to a number of them, but we had launched a number of them earlier this year, and we have a roadmap that is designed to appeal to the larger set of our customers, products and capabilities like integrated – sorry, identity and access management IM or role-based access control virtual private clouds, certain capabilities that really resonate with some of the customers that have gotten to more scale on our platform. That's really where the focus is in our development in the near term. That enables us not only to continue to take a big share of our own customers' workloads as they grow but also enables us, as I mentioned earlier, to accelerate the direct sales. If you're trying to poach customers, longer customers of the larger providers, these are some of the same capabilities you need. So that's really where the focus is on driving ARPU is on being able to provide the capabilities that enable our customers to continue to scale on our platform as we get better meet and deliver on their requirements.

If I could follow up, could you guys talk more about like what's the health of the SMB customer at the moment and if there's any improvement in the usage trend?

Yes. We talked about this earlier. If you look at it from a macro standpoint, you think of what's been going on in the market, our customers have not been growing as fast in their own businesses as they were historically. And we see that through the expansion that they get with us. A year ago, we were seeing expansion from our customers that were growing in the high 30s. We've seen that decline month-over-month for well over a year down into the 22%, 23% range, but that's stabilized.

Thank you. Congrats on the quarter.

All right, perfect. And our final question comes from the line of Michael Turits from KeyBanc. Michael, please go ahead.

Hey guys. This is Billy on for Michael. Just a quick follow-up to that last question. Good to see some of the leading metrics kind of stabilizing in the business. Anything you'd call out as notable in different verticals or customer segments?

No, actually, that's something that we spent a lot of time assessing and the nice thing, one of the nice things about DigitalOcean's customer base is it's so diverse. 70% of the revenue comes from outside the U.S. There's no single vertical, there's no single use case, there's no single region that drives a disproportionate amount of our business. We really track kind of broad SMB and startup and developer trends. And so the recovery and the stabilization has been pretty consistent across all of them. We don't see kind of laggards and we don't see any that have kind of raced ahead. Again, part of the appeal is it's a very, very diverse and distributed customer base. Thank you all for joining us. We're excited to report on a very solid quarter with a lot of encouraging trends and I appreciate your time this evening and hope you have a good night.