Earnings Call Transcript - DOCN Q2 2023

Operator, Operator

Hello and thank you for joining us. My name is Regina, and I will be your conference operator today. I would like to welcome everyone to the DigitalOcean Second Quarter 2023 Earnings Conference Call. I will now hand the conference over to Rob Bradley, Vice President of Investor Relations. Please proceed.

Rob Bradley, Vice President of Investor Relations

Thank you, Regina and welcome, everyone, to DigitalOcean's second-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 would like to cover our safe harbor statement. During this conference call, we will be making forward-looking statements, including our financial outlook for the third 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 non-GAAP and GAAP financial results can be found in our earnings press release which was issued earlier this afternoon and the investor presentation on our IR website. With that, let me turn the call over to our CEO, Yancey Spruill. Yancey?

Yancey Spruill, CEO

Thanks, Rob. Good afternoon and thank you for joining us today. I'm pleased to share the results of another strong quarter for DigitalOcean. As discussed throughout this year, we made it a priority to position the company in 2023 to generate significantly higher free cash flow margins to create a durable platform that generates compelling shareholder returns regardless of the challenges of the macro growth environment. We have also been focused on leveraging our balance sheet to accelerate our business with the acquisition of Paperspace which positions us with immediate offerings in the rapidly growing market for artificial intelligence and machine learning application development. In Q2, we delivered a quarter with an attractive combination of growth and profitability. Revenue grew a solid 27% year-over-year. We delivered strong adjusted EBITDA margins of 43% and delivered healthy free cash flow margins of 27% on the strength of progress we are making in transforming our cost structure. From a top-line growth perspective, we continue to see slower growth in the core DigitalOcean cloud business. We saw growth moderate across our diversified customer base with all regions and most industry verticals experiencing slower growth which points to the broad weakness that the technology market faced during the quarter. We expect these ongoing headwinds to put further pressure on our second half growth. Although we saw positive signs of stabilization across churn and contraction, both of which have been stable during Q2. The third piece of the cohort performance puzzle that must stabilize is expansion which continued to moderate in Q2, although at a decelerating pace. Until we see stability in all three metrics, we can only say that we are bottoming but have not yet reached a bottom for growth deceleration. With respect to churn, it has been stable in the low double digits about where it was before the broader slowdown occurred which is a positive indicator of the strength of our value proposition. Contraction also stabilized in the second quarter, potentially indicating that optimizations are moving behind us, although it remains several hundred basis points higher than when the slowdown began. This reflects a change in our customers' practices. They have been much more disciplined about managing their cloud usage, a trend that we expect may be with us for a while. As for expansion, we have been pleased to see the sequential deceleration of the declines as we've moved through this year. In speaking with our customers, they remain optimistic. Even though they are growing more slowly than they were previously, they are still growing. This provides us with optimism that although we have not bottomed, we are certainly in the process of bottoming. Our lowered revenue outlook announced today reflects our expectation that the bottoming process continues in the second half. We continue to deliver on the transformation of our cost structure which we announced in Q1. There are several components to this transformation, including prudently managing our third-party spend, leveraging our strong procurement capabilities, operating our capital infrastructure more efficiently and shifting our talent mix to be more global. We made significant progress in the quarter driving towards our longer-term target free cash flow margins. Doing so provides us the flexibility to invest both organically and inorganically to accelerate future growth. We have taken advantage of this flexibility by investing on both the organic and inorganic fronts. Internal investment is focused on expanding our capabilities to better meet the needs of our customers as they grow their own businesses and expand on our platform, graduating from learners to builders to scalers. Previously launched product capabilities, such as the premium optimized droplet which are tailored to specific bandwidth-intensive use cases, enabled us to increase our average revenue per user at share. While the expansion of our physical footprint, such as the new Sydney data center, enable us to do more to effectively serve the global market opportunity. Other investments such as evolving the customer onboarding process are enabling us to better identify higher growth potential customers early and get them the support they need to accelerate their use of our cloud services as well as better match them from a product perspective earlier in their life cycle which yields higher average revenue per user. A good example of this is identifying candidates for a managed hosting solution through cloud rates instead of them self-serving directly onto the DigitalOcean platform with the mismatch of their needs, leading to under optimization of their experience. The newer capabilities that we've introduced over the past 10 months are growing significantly faster than our overall company. We expect these offerings and the other capabilities on our second half roadmap such as enhancements to our storage capabilities to be more material drivers of our future growth. We also continue to invest to build out direct sales and partner channels to augment our proven self-serve go-to-market model. While it is early innings in the establishment of these new channels and they are not yet material contributors to growth, we continue to see them as important growth levers next year and beyond. On the inorganic investment front, we are very happy with the results we are realizing from the strategic acquisitions that we have made to date. We are incredibly excited about the acquisition we reached when we announced. The Cloudways managed hosting business continues to be a very strong addition to our platform with performance that exceeds our initial expectations. We've seen net new Cloudways customers grow rapidly since the time of acquisition, benefiting from both our cross-selling activities and the strength of our highly efficient self-serve model. Cloudways revenue which grew 45% year-over-year in Q2 continues to be a strong contributor to overall company growth, aided by our focus on top of funnel and customer acquisition enhancements and is becoming a larger percentage of our revenue mix and therefore, an increasingly more meaningful contributor to driving a higher overall company growth rate in 2024 and beyond. Which brings me to the exciting announcement that we made about a month ago that we acquired Paperspace for $111 million. We couldn't be more excited about this highly strategic and synergistic acquisition in the dynamic and explosively growing AI/ML market, whose impacted opportunities projected to be transformative to how the technology sector is driving the global economy. We are very focused on building an AI platform that enables developers and SMBs to leverage the power of these technologies to build and run applications while maintaining our differentiation of simplicity in how we deliver these capabilities. Paperspace has tremendous potential. We have been very familiar with the team, having tracked them carefully over the years as they have built their business. The addition of Paperspace to the DigitalOcean platform makes tremendous sense on three key dimensions. First, DigitalOcean and Paperspace are philosophically aligned both in the segment of the market that we target and in how we differentiate ourselves versus the larger enterprise-focused providers. We are both focused on enabling smaller companies from individual developers to startups to emerging growth SMB customers to leverage technology to grow their businesses. We both win customers in this segment of the market by providing simpler, more cost-effective solutions that can be leveraged on a consumption basis without the constraints of long-term contracts with a higher level of support than these customers get from the larger providers. We expect AI will be a force multiplier for small and medium-sized businesses, just as the advent of cloud computing eliminated many of the barriers to entry for developers and startups to create a digital business, allowing anyone in any geography to start a business. We believe that AI/ML will provide a similar accelerant to new SMB creation and their subsequent growth as it will enable them to scale more efficiently to create new and innovative solutions and to compete in novel and dynamic ways. Paperspace's software layer allows SMBs to execute AI/ML use cases simply rather than just providing access to physical GPUs on demand. This simplicity strategy fits very well with DigitalOcean's key differentiators. With Paperspace, we will be able to provide multiple products for AI and ML use cases, including compute storage and databases, allowing these customers to scale on DigitalOcean's integrated platform. The second dimension of importance is there are substantial synergies between DigitalOcean and Paperspace that will accelerate both of our growth rates. Paperspace serves the fast-growing segment of the market that brings together the combination of AI platforms and accelerated compute which allows customers to build and maintain AI applications while providing the computational capacity required to do this at scale. Together, IDC estimates that the compound growth of the SMB portion of this market will be 36% over the next three years. Today, Paperspace has established itself as a leading player serving this market with a proven differentiated GPU-based AI/ML product that serves over 12,000 paying customers today despite having invested very little in marketing of go-to-market. We will accelerate Paperspace growth by leveraging DigitalOcean's scale, marketing and global go-to-market motions to increase the top of funnel and drive new customers for Paperspace's business. There is also a significant cross-selling opportunity to sell Paperspace capabilities to DigitalOcean's 616,000 plus learners, builders and scalers many of whom are already evaluating how AI/ML can be leveraged to accelerate their businesses. In addition, AI use cases clearly drive increased compute requirements but Paperspace had no capability to capture those additional production workloads requiring customers to leverage other cloud platforms. The combined platform of AI/ML software and high-performance and GPU-based compute will enable us to capture more of Paperspace's current and future customers' broader infrastructure needs for database-as-a-service, high-throughput networking, spaces and Kubernetes, driving higher average revenue per user and creating more stickiness and loyalty on the DigitalOcean platform. The third dimension that has us so excited is how clearly it will integrate with our platform and helps dramatically accelerate our time to bring this capability to market. With Paperspace, we immediately have a proven AI/ML offering and have demonstrated a clear product market fit and it comes with a team with valuable experience operating in this dynamic market. The talented and entrepreneurial Paperspace team adds more than three dozen employees to the DigitalOcean team and brings significant experience providing AI solutions to thousands of SMB customers. Also, as an active and important player in the AI ecosystem that is not tied up with the hyperscalers that have plans to build their own chips, Paperspace on its own has strong industry relationships, such as having elite status with NVIDIA. These critical industry relationships will only be strengthened when combined with the larger scale relationships that DigitalOcean has with other players in the market. We are already leveraging these combined relationships to ramp up Paperspace's investment in GPU capacity. Clearly, we are very excited about the possibilities that Paperspace brings to us and you should expect to hear more from us on this potential over the coming quarters. While Matt will walk you through the financial implications of the Paperspace deal on our overall business later in our discussion, I can say unequivocally that after owning Paperspace for just a few short weeks, the potential is far greater than we had expected. We acquired a triple-digit growing business that we feel confident we can accelerate from here. And as such, we expect Paperspace to contribute at least three percentage points towards our total growth rate next year. We are excited to be on a path to deliver a truly differentiated set of capabilities with an aspiration to be the AI cloud for SMBs. With our acquisition of Paperspace and aggressive entry into the AI/ML market, many of you are likely interested in the implications on our projected cash flow margins and our current capital allocation strategy. While Matt will cover the specific projections in his commentary, I'd like to share my thoughts on how we view the economic impact on our business at a strategic level and how this translates to our go-forward capital allocation framework. We have demonstrated a clear focus on driving attractive returns on invested capital since going public. With that as our guiding principle over the past two years, we have repurchased more than 27 million shares for $1.3 billion and lowered our fully diluted shares outstanding well in excess of the shares granted to employees over the same timeframe. When combined with the six-fold increase in free cash flow since 2021, our first fiscal year as a public company, through these actions, we have increased free cash flow per share by more than 590%. As another part of this capital allocation strategy, we have invested nearly $500 million on content, technology and capability acquisitions which have bolstered customer acquisitions, driven average revenue per user growth and meaningfully increased our addressable market. Although we continue to evaluate M&A opportunities that are consistent with our goals of enhancing our market position to drive profitable growth. In the near term, we are prioritizing the integration investments in Cloudways and Paperspace, both of which are growing substantially faster than the core DigitalOcean business. Our commitment to driving attractive shareholder returns under any market conditions and to delivering the long-term free cash flow margins required to do so, does not change as a result of our entry into the AI/ML market with Paperspace. Our growing free cash flow margin and the $551 million on the balance sheet afford us the flexibility to both invest appropriately in this exciting new market and, at the same time, maintain focus on delivering profitable growth across our entire business and delivering capital return to our investors. We have consistently said that investing in organic and inorganic growth is our first priority use for capital and that remains true. Given the significant opportunity we are looking at with key growth levers, we may moderate the magnitude of buybacks from 2023 levels. However, we will remain committed to managing the portfolio of balanced growth and capital return through share repurchases going forward. I'll close by saying we've made good progress through the first half of 2023. We've dramatically improved our financial profile by driving greater efficiency in our core business while maintaining the flexibility to aggressively invest in several attractive growth opportunities. We will invest in two of our fastest-growing segments in Cloudways and Paperspace, while we continue to target investment in the highest revenue potential opportunities and optimize profitability as we work to return to higher growth in our core business. We continue to see a material opportunity in an expanding addressable market in the growing $100 billion-plus market for SMB cloud infrastructure and are increasingly well positioned to capture our fair share. Now, over to Matt to provide details on our financial results and our outlook for Q3 and for the balance of this year.

Matt Steinfort, CFO

Thank you for joining us today to discuss our solid quarter, which highlights the significant progress we've made toward our long-term profitability goals, showing strong revenue growth while improving our margins. We continue to achieve consistent free cash flow growth despite the macroeconomic environment. Today, I will go over our second-quarter financial results, discuss Paperspace's expected impact on our financials, and share our updated financial outlook for Q3 and the full year. Before that, I want to address the material weakness and tax expense error mentioned in our recent 8-K filing. Recently, we have strengthened our tax capabilities and expertise. With new leadership and support from external tax advisors, we found an error in our tax expense calculation related to R&D expenses under Section 174. This error did not materially affect our 2022 financials but had a significant impact on our Q1 2023 results, representing a material weakness in both periods. Correcting the approximately $18 million overstatement of Q1 tax expense will result in a lower net loss and higher non-GAAP earnings per share for that quarter, as well as a reduced net operating loss as of December 31, 2022. We believe that our new tax leadership and the additional resources we've integrated will help us address this issue and improve our accuracy in tax estimates going forward. In Q2, our revenue was $169.8 million, reflecting a 27% year-over-year growth and a 3% sequential increase from Q1 2023. Our net dollar retention was 104%, down 300 basis points from Q1, which is an improvement from the 500 basis points decline we saw from Q4 2022 to Q1 2023. We have seen stability in churn, with customers remaining on our platform at historical levels, and a decrease in contraction over the past three months, indicating that customers may be finishing their optimization cycles. We are watching for similar trends in expansion to confirm we've navigated through the macro growth challenges. On the customer front, we saw continued growth among our higher spending customers, with our builders and scalers accounting for 86% of total revenue in Q2. We added over 3,600 builders and scalers in Q2 compared to about 2,300 in Q1, bringing our total to over 150,000. These customers are driving a 28% year-over-year revenue growth and have increased our average revenue per user by 14% year-over-year to $90.84. The addition of Paperspace further enhances our ability to increase average revenue per user by cross-selling our new AI/ML capabilities. Profitability was strong in Q2 due to effective execution and progress in our cost-saving initiatives. Our GAAP gross margin improved from 56% in Q1 to 60% in Q2 as we optimized our costs alongside growing into our increased colocation and bandwidth capacities. Adjusted EBITDA reached 43%, significantly up from 34% in Q1, driven by cost management and the impact of employee transitions to our capability centers in India, Pakistan, and Mexico. Two-thirds of the margin increase came from people-related cost savings, with the rest from efficiencies in cost of goods sold and other expense reductions. Our free cash flow was robust at $45 million, which represents 27% of revenue, showing an improvement compared to Q1 due to higher gross margins, higher adjusted EBITDA margins, and disciplined capital investment, keeping expenditures at 15% of revenue like Q1. Regarding the earlier mentioned tax expense overstatement, we are finalizing our non-GAAP diluted net income per share for Q1 and Q2 2023 but expect the correction to enhance our previously reported Q1 figures and anticipate that Q2's will exceed our earlier guidance of $0.40 to $0.41 per share. Additionally, the repurchase of 2.8 million shares in Q2 for $103 million at an average price of $37.08 per share contributed to the anticipated increase in earnings per share. We ended Q2 with 105 million fully diluted shares outstanding, down from 120 million in Q2 2022. Operationally, we have made significant strides toward securing the $60 million run-rate cost savings we had disclosed in Q1, and we expect to surpass our initial full-year savings targets. Our strong financial position allows us flexibility to invest in high-growth segments without compromising our long-term profitability goals. Now let's move to our financial outlook for Q3. We expect revenue to be between $172.5 million and $174 million, suggesting a year-over-year growth of approximately 13% to 14%. Net dollar retention is projected to dip into the mid-90s as we adjust for the 10% price increase effective in July 2022. However, we expect this metric to improve steadily in the latter half of 2023 as we celebrate the anniversary of our Cloudways acquisition, which is expected to contribute positively to our retention metrics. For Q3, we anticipate adjusted EBITDA margins between 38% and 39%, with an estimated 105 million to 106 million weighted average fully diluted shares outstanding by the end of Q3. With ongoing challenges in net expansion, we're updating our full-year 2023 revenue guidance to a range of $680 million to $685 million, a 3% to 5% reduction driven by a softer outlook for cohort growth. Our self-serve revenue performance remains steady, and Cloudways is outperforming its pre-acquisition growth rates. However, we do not expect these contributions to completely offset the anticipated shortfall from slower growth in our existing customer base. Despite these adjustments, we still expect to maintain adjusted EBITDA margins of 38% to 39% for the year, thanks to our focused execution. Our investment in Paperspace will impact free cash flow by $15 million to $20 million in 2023, with additional one-time integration costs excluded from our non-GAAP metrics. Despite the investment and the anticipated effects on our long-term free cash flow margins and the commencement of federal cash taxation in the U.S. in 2023, we continue to aim for long-term free cash flow margins in the mid to high 20s as we pursue operational leverage opportunities. We anticipate having between 105 million and 107 million weighted average fully diluted shares outstanding by the end of the year. We will provide updated estimates for non-GAAP diluted net income per share in the coming weeks. That wraps up our prepared remarks, and we're now ready to take questions.

Operator, Operator

Our first question will come from the line of Raimo Lenschow with Barclays.

Raimo Lenschow, Analyst

Can I start with Paperspace? Obviously, it's a really exciting one. AI is a topic for everyone. If you think about your installed base and what kinds are doing with them, like what do you see as kind of uptick use cases or where people are kind of doing more work with that? Is this going to be like a very broad-based adoption product? Or is this going to be some specialized side that I'm going to spend a lot with you? And then I had one follow-up for me, please.

Yancey Spruill, CEO

Well, I think as we've said before, we've been participating in the portion of AI that's in the inference aspect. What Paperspace brings to us is large language models and other complex machine learning algorithms and applications that require or utilize GPU capacity versus the standard high-performance compute. What we've seen with our customers is a rising tide of inquiries over the last year, related to AI and our potential for investment in AI capabilities. And so again, we serve a long tail of use cases, industry verticals, etcetera. And so I think everybody across the SMB landscape and our customer base, like everywhere else in the world is trying to figure out how to get most leveraged, where to get most leveraged. And we're really excited that we now can bring this capability that's consistent with our historical process and capabilities around simplicity. And I could tell you the inquiries have accelerated since we've made the acquisition a month ago in terms of our sales folks, our customer success folks engaging with customers educating them on what Paperspace brings. So I would expect to see broad adoption, not necessarily tied to any particular industry really as people start to really want to invest to resources to build out use cases to help them drive productivity, whatever the case may be and they can do that on our platform. And likewise, with the Paperspace customer base, Paperspace has had a very narrow, just sort of the ML ops and AI capabilities for application development. When their customers have historically wanted to leverage that on the broader compute platform once the applications were developed, they have to go elsewhere and now we can serve those customers. So we see a lot of synergy on top line synergies in both directions here. And again, we're really excited about that.

Raimo Lenschow, Analyst

Yes. Okay, perfect. That makes sense. And then, one for you, Matthew, is, obviously changing full year guidance in the middle of the year is always a tough decision for a management team. If you think about it like that decision, what was for you like the driving thing to say like, okay, I need to change it? And how did you come up with a new level? What are kind of the puts and takes in there?

Matt Steinfort, CFO

Yes, it's always a difficult decision. As everyone saw in our guidance, we expected only moderate growth in the first two quarters, which we delivered as anticipated. However, the expected increase in the second half relied on two factors. Firstly, we needed to see a stabilization of the cohort, ensuring it would not worsen, and we discussed that. Secondly, we needed to observe the progress of our monetization initiatives and other investments. The positive news is that we are seeing growth in our monetization initiatives and new products like the city data center, aligning with our expectations. Unfortunately, we underestimated the pressure on the cohort, which has persisted longer than we thought. By July, we clearly wished we had exceeded the revenue guidance for the second quarter, but instead, it met expectations amid continued deceleration in growth. Although we see some signs of improvement in terms of deceleration of contraction, we felt it was not prudent to maintain an optimistic outlook. Therefore, we provided a fairly narrow range for guidance, reflecting a scenario where the current rate of decline continues, with net dollar retention in the mid-90s for the second half. This projection does not account for any improvement in the cohort or substantial growth in our monetization or go-to-market strategies and assumes minimal impact from Paperspace. We believe this approach presents a reasonably conservative view of potential performance for the second half, which is appropriate until we find a bottom, as we cannot continuously hope that we will hit a bottom each month. We must acknowledge that it may take a couple more months or quarters for that to happen.

Operator, Operator

Your next question will come from the line of Patrick Walravens with JMP Securities.

Patrick Walravens, Analyst

Maybe we can start with Paperspace. This morning, I noticed a company that secured a $2.3 billion debt financing, partially backed by NVIDIA. It appears that Paperspace is operating in a similar space. Can you explain the similarities and differences between these businesses?

Yancey Spruill, CEO

As I mentioned earlier, Paperspace offers a product with an API that makes it easy for users to build applications utilizing GPU capabilities for language models and machine learning applications. It functions as a traditional cloud service, while others in the market are primarily focused on renting GPUs without the additional applications or enhancements. Our customers typically lack extensive DevOps and IT development resources, so they prefer to concentrate those efforts on their end products. We believe our solution is well-suited for developers, startups, and small businesses, whereas others are targeting larger enterprises. We see a significant opportunity for ourselves, although it may not be a winner-takes-all scenario. Many players can thrive in this market, and we are confident we will be among them. We remain focused on our niche, where our core value differentiators—support, community investment, and simplicity—are essential.

Patrick Walravens, Analyst

All right. Great. And then, Matt, I think you addressed it but just to be really explicit about it. Are you seeing higher churn?

Matt Steinfort, CFO

No. The churn experienced an increase towards the end of last year but then returned to more typical levels at the start of this year and has remained relatively stable. This is not due to customers leaving us; rather, it involves a higher rate of contraction, which affects customers who continue to use the platform but are optimizing their usage. This has been the largest challenge for us during the first half of this year. As Yancey mentioned, this rate is several hundred basis points above our historical average. However, it's stabilizing and not worsening; it's elevated but not increasing. We have noticed that expansion is gradually declining, meaning customers are not growing as quickly as they did a year ago, and this trend has continued month-over-month. When we refer to deceleration, we're observing stability in churn, which is favorable. Contraction is stable yet remains elevated, while the rate of expansion continues to decrease. To determine that we've reached a low point and can begin to see growth again as contraction lessens, we need to see the decline in the rate of expansion flatten or reverse. Currently, contraction remains stable at an elevated level, and expansion is weakening, but churn has been acceptable this year.

Operator, Operator

Your next question comes from the line of Michael Turits with KeyBanc Capital Markets.

Unidentified Analyst, Analyst

This is Billy on for Michael. You talked about how potentially there is some indication that optimizations are moving behind us. So when you speak about optimization in your customer base, kind of what does that look like? Is it more or less what we've heard from the hyperscalers? Or are there differences in how customers optimize spend on DigitalOcean? Just some more color on that would be great.

Yancey Spruill, CEO

There are two points to consider. First, due to our consumption-based model, we experienced a more rapid growth slowdown last year when demand decreased in the macro environment. Our customers' spending would adjust immediately as their business slowed. While they are still spending less than a year ago, the rate of decline is less severe now. Second, unlike longer-term contracts that others have where volumes can fall below committed payments, we operate with 30-day contracts. This allows our customers to adjust their spending based on their actual usage. Recently, we've noticed more customers reaching out to ask if they’re using our services efficiently, whether they need to reduce usage without compromising their current needs, or if they’ve activated too many resources. They’re considering how to optimize their deployment with technologies like Kubernetes. We discussed in earlier earnings calls that customer conversations were quite active, but that has slowed now. Customer support engagements have decreased as well. However, I believe our customers are in a good position; the rate of contraction has stabilized over the past quarter at a higher level. In this lower-growth environment, they are more vigilant about resource management, seeking to maximize efficiency since for them, every dollar saved is crucial. This aligns well with our strengths, as we provide high support and engagement to help customers make the most of our cloud services, complemented by community resources and tutorials. The flat churn rate reflects the high value we provide even during challenging times, indicating that customers are remaining loyal, which is essential. Although there is a slowdown in growth, it is not at a point of recovery yet, but it is slowing at a much less severe rate than earlier this year or last year. The stable churn is a positive sign that when recovery does occur, we can expect a significant rebound. While we are uncertain about the timing of that recovery, we have adapted our outlook accordingly and are well-positioned to support our customers through this period. Our consumption model allows customers to manage their spending effectively while we assist them in enhancing operational efficiency.

Operator, Operator

Your next question comes from the line of Mike Cikos with Needham & Company.

Mike Cikos, Analyst

I just wanted to circle up on some of the earlier comments but I guess, take it from a different angle. I know you guys have been talking about churn, contraction and expansion. If I tie all those up and just think about the linearity that played out over the course of the June quarter and even into July now that the month is behind us, can you discuss how things trended as we went from April to May to June, just to give us a sense of what's going on in the quarter for some of those real-time data points that you're seeing?

Matt Steinfort, CFO

Yes, this is Mike. It's Yancey. When we examine our metrics, we evaluate them monthly as well as quarterly. Churn has remained relatively stable in the low double-digit range of 10% to 11%. We have not seen a deterioration in that area. However, we did notice an ongoing increase in contraction, meaning more customers are withdrawing funds from our platform, and a decline in expansion, which refers to the year-over-year amount being added each month. The contraction rate is slowing down, indicating that it is not worsening as rapidly as it was earlier this year. In fact, in the last month, we observed a positive shift where the overall contraction decreased, which is encouraging. We experienced several months of slower contraction and even a reversal recently, but the expansion side continues to shrink. This leads us to conclude that it's challenging to predict the future direction—whether contraction will stabilize or if it will continue on the positive trend we saw last month, and whether expansion will keep declining. Given this uncertainty, we felt it was important to update our guidance as we move into the third and fourth quarters, as these trends present enough headwind to counterbalance the positive growth from our self-serve initiatives and other strategies we are implementing.

Mike Cikos, Analyst

I appreciate the insight, Matt, and the honesty as well. I want to be very clear on the outlook; it seems like you are managing several factors simultaneously. Regarding the assumptions you're utilizing, can you clarify what you're considering with churn contraction and expansion that supports your confidence in meeting the guidance you've shared with investors?

Matt Steinfort, CFO

I'd say we're assuming that nothing gets better than what we're currently seeing. So the rates have declined and the level that we're landing on the things that stabilized. Stay the same. We don't see an improvement in any of those which would imply we're not forecasting a bottom in our guidance.

Operator, Operator

Your next question comes from the line of Pinjalim Bora with JPMorgan.

Pinjalim Bora, Analyst

Yancey, can you talk a little bit more about Paperspace? Can you talk about maybe the customers that Paperspace brings to the table with some of the use cases those customers are working on? And as I look at the numbers, I think you're saying $5 million for the second half. So call it, $10 million, $10 million, $12 million for the year, 12,000 customers. So is it something like $1,000 ACV about. Help me understand that. And then lastly, what portion of Paperspace's customers are on the ML Ops platform versus kind of the core infrastructure?

Yancey Spruill, CEO

I think we'll provide more detail around this as we analyze the business analytics regarding the mix at a future call. However, I can share that their customers are quite similar to ours, primarily small emerging startups, many of which may be unfamiliar names. Our customer base also covers a broad range of industries with diverse use cases. Language models are expected to be a significant growth driver in the short term. Generative media is also very intriguing, particularly in dynamic advertising, media, and video, tailored to various verticals or use cases. Many people are utilizing large amounts of data to achieve outcomes, which is very exciting. What I've observed is that you can examine the logos and names of the customers. Like our business, it has a long tail, allowing people globally to leverage their ideas in the cloud, and now we can facilitate that in AI/ML as well. I believe the average revenue per user is higher than what I expected from our average customer, and I’ll share more specifics on that later. This collaboration really aligns well in numerous ways. I'm excited to provide this opportunity to our DigitalOcean customers and to offer Paperspace customers a similar experience when developing their AI applications, once they get those applications operational on our platform, allowing them to enjoy ease of use, simplicity, robust support, and affordability.

Operator, Operator

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

Quinton Gabrielli, Analyst

This is Quinton on for Jim Fish. Yancey, maybe first for you. I'd like to touch a little bit on the timeline side of coming to this Paperspace deal. Thinking back to Q3, Q4, we talked a little bit about how CPUs would be able to support AI workloads. And then kind of Q1, we transitioned to GPUs are probably an attractive expansion to the platform. And then obviously, now we have the Paperspace offering. Can you talk through what trends or maybe inputs changed from Q3, Q4 to Q1, Q2, where now you know you need this kind of GPU as a service offering? And then any color you can provide around the acquisition process of Paperspace, whether it was competitive bidding or anything would be helpful.

Yancey Spruill, CEO

Yes. I want to clarify that we never said we didn't need GPUs. What we meant is that there are several AI-based algorithmic business models running on our platform that work well with high-performance compute. This mainly applies to inference rather than language models. We've always aimed to develop GPU capabilities and an AI/ML platform since going public. I've known the Paperspace founders for years and have maintained a close relationship with them since I became CEO in 2019. We are thrilled to finally welcome them to the DigitalOcean family. Recently, we've noticed a significant increase in capability and market interest in language model opportunities, which definitely calls for GPUs, particularly for getting models up and running. While the level of compute needs may change once those models are in customers' hands, we're rapidly learning and are eager to have this new compute capability on our platform. Whether the timeline was accelerated or not, this is a critical addition we aimed to complete this year. I won't discuss the specifics of the conversations that led to our announcement about acquiring Paperspace last month.

Quinton Gabrielli, Analyst

Yes. Understand. And then, Matt, maybe for you. As I look at the customer segment, it looked like really the scalers is the segment of the business that saw some deceleration in the ARR growth. And I think you've been pretty clear that it's really not churn. So is it fair to think that the optimizations hit this segment of your business the heaviest compared to maybe some of the builders or learners?

Matt Steinfort, CFO

Yes, that's very accurate. The larger the customer, the greater the opportunity for optimization. We have significant examples where a large customer, storing a considerable amount of data on our platform, may reconsider their data storage policy. For instance, they might decide to reduce their storage from 60 days to 15 days based on their consumption model. This kind of adjustment typically occurs within our larger customer base, which explains the slowdown in average revenue per user growth among the scalers compared to other segments. However, the scalers have the lowest churn rate across all segments. Once customers join our platform, as their consumption increases and they use more products, their churn decreases. The churn levels in the scalers are quite favorable, although we are currently observing more contraction in that area, which is expected.

Operator, Operator

And our final question will come from the line of Tim Horan with Oppenheimer.

Tim Horan, Analyst

Yancey, can you discuss how you manage the generation of free cash flow alongside growth? You mentioned a free cash flow rate in the high 20% range, possibly due to some timing factors. I bring this up because there is immense demand for GPUs. If you increased your capital expenditures, you could likely see a corresponding increase in revenue growth. It appears that now might be the right time to make such an investment. Can you elaborate on your strategy for balancing these factors?

Yancey Spruill, CEO

I believe what we have discussed today reflects our current outlook. Since acquiring Paperspace, we see a significantly greater potential for growth compared to last month. While I won't provide a specific figure, it's clear that the opportunity is substantial. We have already increased our capital purchases beyond our initial expectations to support this year's growth and enhance our growth rate, which is already in triple digits. We are also concentrating on the opportunities for 2024. One reason we are rethinking our capital allocation is to seize the potential for significant growth. Should we have the chance to grow at 500%, we will pursue it, depending on the opportunities that arise. We are fully committed to these plans. I want to clarify that our discussions about free cash flow this year were not meant to imply that we are hesitant to grow. We have always aimed to invest our capital primarily into both internal and external growth, and we are currently showcasing that commitment. I recall our conversations with the Board about intentionally lowering margins to invest more in Paperspace, which generated a lot of enthusiasm. We are thrilled about this direction and will provide more updates during our next earnings call based on our observations. If the pace of opportunity continues as it has in the first 30 days, we anticipate significant investments in Paperspace, as it represents a very exciting opportunity for us.

Operator, Operator

I'll now hand the conference back over to Yancey Spruill for closing remarks.

Yancey Spruill, CEO

Thank you and thanks, everybody, for joining us today. As usual, we really appreciate your support. And we're looking forward to talking with you over the coming weeks and months about where we are and where we're heading. And we hope that you all have a good rest of the day. Thank you so much.

Operator, Operator

That will conclude today's conference call. We thank you all for joining and you may now disconnect.