Earnings Call Transcript - DOCN Q3 2022

Operator, Operator

Good afternoon and welcome to the DigitalOcean Third Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you. I will now turn the call over to Rob Bradley, Vice President of Investor Relations. Please go ahead.

Rob Bradley, Vice President of Investor Relations

Thank you, and welcome, everyone, to DigitalOcean's third quarter 2022 earnings call. Joining me today is Yancey Spruill, our Chief Executive Officer, and Bill Sorenson, our Chief Financial Officer. Before we begin, I want to cover our Safe Harbor statement. During this conference call, we will be making forward-looking statements, including our financial outlook for the third quarter, 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'll be discussing non-GAAP financial measures on our call, and reconciliation between our GAAP and non-GAAP financial results can be found in our earnings press release, which was issued earlier this afternoon and is also in the investor presentation on our IR website. With that, let me turn the call over to our CEO, Yancey Spruill. Yancey?

Yancey Spruill, CEO

Thank you, Rob, and thank you all for joining us as we review our strong third quarter results, another quarter in our ongoing commitment to delivering robust revenue growth and improving profitability and free cash flow. I'm proud of the entire DigitalOcean team for delivering these results, given the challenges in the operating environment this year. I'd like to begin today by framing where our business stands in the context of where we've been and how we are set up for durable, profitable growth even in these times of uncertainty. I'll then share some insights on our growth and profitability priorities as we close out this year and work our way towards 2023. I'll specifically address the early indicators resulting from our recent pricing initiatives and discuss our exciting Cloudways acquisition, which we closed on September 1st. Bill will then provide more details on the financial results, our financial outlook for Q4, and then turn to your questions. We have a highly resilient business due to several key factors, and they've been clearly on display this year. First, we have a truly global geographic footprint with our revenue and customer base spread across 185 countries in similar proportion to global GDP. So, we are not dependent on any one region or country. Second, we have customer diversity, with our top 25 customers representing less than 10% of total revenue. So, our revenue is not concentrated in a small number of customers. Third, we serve a wide range of industry verticals and use cases from e-commerce, web and mobile applications, website hosting, media and gaming, publishing, ad tech, and many more. So, we aren't overly reliant on any industry or business model. Finally, we also have a consumption-based revenue model, which creates the flexibility for our customers to pay for what they need as they scale their business, but also to adjust their use to address any economic headwinds they are facing. This customer-centric model, with simplicity at its heart, builds customer loyalty that historically has been a great benefit to us, as demonstrated in our low churn levels, and will pay long-term dividends as we exit this turbulent environment. Collectively, these factors position us well when there is an economic downdraft, like we have seen this year, allowing us to achieve continued strong revenue growth, coupled with improving profitability. With our consumption-based model, we were early in seeing the impact of the economic downturn during the first half of 2022. These economic headwinds, which include a global economic slowdown, high inflation, US dollar strength, the Russia-Ukraine war, and the decline in blockchain, continued in the third quarter. Undoubtedly, these factors contributed to slower growth within our cohort than we had forecast at the beginning of the year. Along with the reduction of revenue in Russia and Ukraine and significantly lower blockchain customer spend, this has resulted in a 900 basis point headwind in Q3 to our stated goal of 30% growth. Importantly, churn within our cohort has remained flat during this period, and our customer engagement remains strong. So we are very optimistic that when things turn in the broader economy, we will be well positioned for expansion across our cohort, serving as a tailwind to our top line growth rate, as it was throughout 2021 and even Q1 this year. Despite these unforeseen challenges, we managed to deliver 37% total revenue growth, with 33% organic growth. We aren't ready to call a bottom in terms of the lower growth across our cohort. Given the number of uncertainties in the broader macro environment, we will remain cautious in our planning and in setting expectations. Q3 marked my three-year anniversary at DigitalOcean, and it is a good time for me to reflect on our progress. In the summer of 2019, we inherited a business growing revenue in the low to mid-20s, with negative 25% free cash flow. We set a goal of getting the growth rate above 30% by focusing on the most impactful opportunities we saw, from improving the customer experience to reducing churn, which was in the upper teens, driving expansion in our cohorts through adding relevant products and features such as managed databases and Kubernetes, and building a sales capability to better penetrate our $70 billion addressable market. This strategy was successful, as we generated 35% growth in 2021 and will be above 30% this year. We expect to grow at least 30% next year from the midpoint of the 2022 guidance we are issuing today. Our net dollar retention has improved from below 100% to the mid-teens as we cut churn in half, and ARPU growth has improved from the mid-teens up to the mid-to-high 20s. Our second goal is to dramatically improve the profitability and cash flow profile of the business. Those that know me well can confirm that free cash flow has always been an obsession for me, not a revelation made in 2022 when the world started seeing signs of economic turmoil. We saw an opportunity here as capital intensity was too high, operating costs were too disconnected from revenue, and the resulting operating and free cash flow margins were significantly negative, which simply was not acceptable. Today, our non-GAAP operating margins are about 20%, and free cash flow margins are in double digits, both with plenty of upside from here. This work over the past three years has created a powerfully efficient, high-growth business model built around simplicity, with incredibly attractive customer lifetime value relative to acquisition costs, a modest requirement for incremental product investment, and an increasingly CapEx-efficient footprint to deliver value to our customers. These characteristics, when combined, are driving a 30% growth rate this year before Cloudways, along with the strong and increasing free cash flow generation we are seeing today. We remain committed to our combined goals of annual revenue growth of 30%, ramping free cash flow, and starting in 2024, free cash flow margins of 20% or better. Our $70 billion market opportunity is projected to continue to grow in coming years. The SMB economy is roughly 50% of global GDP. It's not going anywhere. Although it is not immune to the broader trends impacting our economy, smaller businesses are demonstrating how nimble and resilient they are during this period. There's a perception that SMBs are subject to a more significant impact than enterprise from weak macroeconomic conditions. The facts suggest otherwise, as the hyperscale cloud providers and other software companies, which are principally focused on enterprise customers, have reported similar levels of declines in their growth rates as we have seen this year. We believe that having an SMB-focused business, along with geographic, industry, and business model diversity, and a consumption-based model, is a key strength of our company. We plan to exit this turbulent economic period with a stronger set of capabilities grounded in an even better customer experience, resulting in greater market share. The levers we utilize in the next few years will be somewhat different from those we pulled the last three years. Our revenue and profitability targets, including achieving our first $1 billion of revenue in 2024, do not change. First, targeted product enhancements that represent large revenue opportunities will be one area of focus. This may come from internal development work or through acquisitions, like our recent Cloudways transaction, which I will address in a bit more detail shortly. One specific area of focus for us will be enhancing our storage offerings for SMB customers. Our storage revenue currently is in the high single digits as a percentage of our total revenue. Based on benchmark and customer surveys, we believe that we can double the revenue mix percentage from storage-related capabilities over the next few years. Providing a more performant feature for a storage platform, specifically tailored to our SMB customers, will also drive growth across our droplet, database, Kubernetes, and serverless products. The ARPU from our customers that use our object and block storage products is more than 25 times the ARPU for customers that do not use them. Many of our SMB customers may use us for compute but go multi-cloud for storage. Being able to capture the full compute and storage suite from current and new customers is a big opportunity for us. Second, we see opportunities to better align our pricing and packaging models with the different needs and wants of our diverse customer base. We took the first step here earlier this year, which I will address in a few moments. However, there are other opportunities we see to optimize our monetization approach aligned with the specific needs of our customers. One example is packaging the various security protections we provide on the platform to address specific customer needs. Third, we will continue to expand our sales and marketing engine around the world. This effort is working well, but it's still early, and we see a significant opportunity to sell more to our existing customer base while also targeting new customers. We recently announced the launch of our partnership program called Partner Pod. As part of this program, our partners receive free training and enablement on sales, products, and other topics, co-marketing opportunities, and market development funds so they can get help running their campaigns and bring in new customers. We believe that a robust partner program is an essential part of the go-to-market approach for a global SMB business. Growth from our sales efforts was up 225% year-to-date, and the mix as a percentage of total sales was just over 5% in Q3, up from 4% in Q3 2021 and essentially 0% three years ago. We're making very good progress in building a sales capability that will continue to generate an increasing component of our overall revenue mix in the coming years. Lastly, we expect to expand our global infrastructure in the coming years to better capture a more localized customer set in key markets. Our new data center in Australia will be launching this quarter. This has been a consistent ask from our customers, and we are pleased to offer this expanded capability to our infrastructure footprint. We’re in the planning phase for additional locations and expect to broaden our footprint to address other important regional markets, as well as to enhance the performance of our entire network for our global customer base. At the same time, on the expense side, we will continue to focus on operational excellence, optimizing our processes and deploying our capital efficiently, which will help us continue to drive operating free cash flow margin leverage, regardless of the economic environment. We have made great progress over the past few years in improving our profitability profile, but there is more we will do in this area as well. I would like to provide a bit more color on the two levers we pulled in Q3 that I just referenced. First, an action on the pricing of our portfolio of products, followed by our largest acquisition to date. This provides critical insight into how we manage our business, consistently working on opportunities to grow faster while also increasing free cash flow. Effective July 1, we introduced our new pricing model that we had been developing since the fall of 2021. This new framework, which we announced in May, incorporated higher prices for some of our products, including our flagship droplet, as well as the introduction of a lower-priced droplet SKU. The rationale had two main components. First, to ensure that our pricing reflects the tremendous value we have added to our portfolio over the years, in terms of reliability, performance, security, and support; and second, to align our pricing structure with the different needs of individual developers and SMB customers. Broadly speaking, after one quarter of operating under this new pricing framework, the positive impact on our business has exceeded our expectations, despite the weaker macro trends that offset some of the benefits of the pricing changes. Specifically, both customer churn and the number of customers downgrading to the lower price SKU have been less than we forecast. Pricing initiatives generated a 1,200 basis point benefit to year-over-year growth in Q3. At the same time, the headwinds that we've discussed diluted the impact of those pricing changes in the quarter. However, as those dissipate, our new pricing framework will endure as we continue to lead in the SMB cloud with a differentiated platform. I'd also like to note that other players in the SMB segment of cloud infrastructure have followed us and introduced price increases subsequent to our announcement. These results have confirmed our thesis that our customer base sees tremendous value from the platform improvements we have made over time. We are still roughly half the cost of the hyperscaler pricing, and our prices still could constitute a small expense as a percentage of their revenue for our SMB customers, who view us as a critical requirement to run their entire business. These pricing actions have created a tailwind to other key performance indicators as well, including net new annual recurring revenue, which was up 41% to $641 million, net dollar retention, which was 118%, and revenue per customer ARPU, which was up 28%. Perhaps the most important measure of the durability of our growth, which also saw a dramatic uplift, was with our high-spend customers. Excluding Cloudways, our high-spend customers, those that spend at least $50 per month, grew 29% year-over-year to 122,000 and now represent 86% of total revenue, up 300 basis points from Q3 2021. Including the 20,000 greater than $50 customers within Cloudways, our total high-spend customer count increased to 142,000, a 50% increase year-over-year. Again, these customers are fueling our revenue growth, and our ability to grow this business to greater than $1 billion in revenue and beyond is critically dependent on growth from this customer cohort. Next, I'd like to speak to Cloudways. We are very excited about the Cloudways acquisition, and frankly, our conviction has grown stronger in the two months since we have been integrating our two companies. Our enthusiasm is predicated on our shared passion for serving the SMB opportunity, the significant expansion of our serviceable market, and the increased benefit we will realize from the deep customer insights that the Cloudways team possesses, which will accrue to our entire business as we build a unified go-to-market motion. As investors view our $70 billion market opportunity, which consists of infrastructure and platform-as-a-service for businesses that have fewer than 500 employees, they often think that the customers we serve are all the same. However, that is not the case. While these customers represent a diverse array of industry verticals, geographies, and use cases, perhaps the most critical distinction is between customers that seek a managed experience versus a more do-it-yourself model for their cloud. For IaaS, the historical business model for DigitalOcean has been to target the do-it-yourself customers who possess both the internal expertise and desire to handle their infrastructure. As we have scaled our business over the last several years, it has become abundantly clear that there is a large universe of technology SMBs and a corresponding large market opportunity for us, likely as large as our core market, that seek a managed experience. We often see customers churn within the first few months on our platform because they were looking for more guidance—more of a managed experience—something we have not offered until now. With a more complete suite of offerings, we become an attractive provider to an even larger number of the 100 million global SMBs looking for a cloud solution. We are very optimistic about the potential for significant revenue synergies, and the early proof points are very encouraging. Cloudways brings deeper SMB customer insights to DigitalOcean, as a managed service entails a deeper relationship with end customers that provides valuable insights about the opportunities and challenges businesses face as they grow. As a strong indicator of the value of this customer intimacy, Cloudways generates two times the pricing for a similar-sized customer footprint. Obviously, this creates a significant opportunity for us over time, given the scale of our customer base. We are already acting on this opportunity by improving customer monetization and making our product development and go-to-market efforts much more integrated. Cloudways' deep customer understanding and intimacy is a key ingredient to DigitalOcean's aspiration to become the SMB cloud provider. The final piece of the puzzle with Cloudways is their very attractive revenue growth and free cash flow profile. They are growing faster, with free cash flow margins in line with ours, and we will invest to maintain that and leverage Cloudways' capabilities to accelerate growth across the business by better aligning customers with the service profile that best meets their needs. We are already realizing some of the significant opportunities for revenue synergies with Cloudways, as we match customers on our combined platform with the best outcome for their objectives. The Cloudways acquisition and these synergies will certainly be a critical contributing factor to sustaining our 30% annual revenue growth target. In summary, Q3 demonstrated our ability to operate in a challenging environment; we delivered 37% growth while maintaining free cash flow margins of 15%. We achieved this in the face of significant macro headwinds. I'm very proud of these results and what they say about the durability and resilience of our business in tough times, and it loudly speaks to the power of our business model in better times. Most exciting of all, despite the uncertain economy, we took decisive action that meaningfully increased our business capabilities with the Cloudways acquisition, which will help us better address the $70 billion SMB cloud market, positioning us for both self-serve and managed services customers. We will end 2022 with a larger and more profitable business, setting us up for continued success in 2023 and beyond. With that, over to Bill to provide details on the quarter.

Bill Sorenson, CFO

Thanks, Yancey, and thanks to all of you for joining us today to review our very solid third-quarter results. Before I begin, I would like to review the fundamental elements of our operating strategy, which have not changed since becoming a public company, and will continue to guide our efforts for the years ahead. At our core, we focus on three key areas: revenue growth in excess of 30%, faster than the SMB cloud market growth rate, increasing profitability, and growing free cash flow for shareholders. Those fundamentals have not changed and will not change as we go forward. Also, we frequently articulated that a variety of levers would be used to achieve those three objectives, including pricing and packaging, evolving our go-to-market strategy from purely self-serve to more direct customer outreach and interaction, and finally, accretive M&A opportunities that either expand and enhance our go-to-market capabilities or accelerate our product innovation. Entering the year with over $1 billion of cash on our balance sheet provided us with real opportunities to execute this strategy. Pulling the right levers and executing well has been critical this year. Over the past few quarters, we've experienced the war in Europe, a global economic slowdown, a strengthening dollar, and the collapse of the bitcoin market, all of which have put pressure on our top line. Despite these developments, we have delivered another quarter of better than 30% growth, coupled with improving profitability and cash flow margin. And going forward, we will continue to do the same. Today, I'm going to use my remarks to provide more color on the drivers of our top line revenue performance in the quarter, the gross margin impact from the adoption of the lease accounting standard, ASC 842, which we are required to do by the end of this fiscal year, and the contributors to the profitability we demonstrated in Q3, as well as our expectations for the remainder of the year. Following that, I'll share our outlook before turning it over to the operator to take your questions. I want to begin with revenue, which came in at $152 million in the quarter, an increase of 37% year-over-year and the fifth out of seven reported quarters where our growth exceeded 30%. Q3 does include a net revenue contribution from our Cloudways acquisition, but even excluding that, our revenue grew 33% year-over-year and exceeded the guidance we provided prior to the acquisition by $1 million. Several initiatives helped us achieve these strong results. The first of those initiatives focused on pricing and packaging, which we've consistently discussed as an opportunity. Q3 benefited from the implementation of increased pricing to reflect the improvements we've made in the product over the past several years. We strongly believe our new pricing model provides incredible value to our customers with our learners, builders, or scalers. Based on the customer reaction, our customers are seeing this value. Our price increase was not unique to the industry, as we've seen other cloud providers, both big and small, follow our lead. As we've long hypothesized, our product offerings were priced at too wide a gap to the DigitalOcean value proposition, and the results we have seen through the first three months of the new pricing taking effect confirm our hypothesis. Since July 1, we've had lower customer churn than we had assumed, reduced downgrades to the $4 droplet, and lowered negotiated discounts with our larger customers. In total, the price increase provided approximately $13 million of additional revenues in the quarter. To understand the reasons for customer churn, whether due to pricing, macro factors, or other issues, we conducted a survey with customers whose spending has contracted since the price changes took effect. The results of our survey were enlightening. More than half of those surveyed cited needing fewer resources as the main driver of their reduced spending, suggesting that our customers' demand environment has decreased, which is not surprising, given the global backdrop. In addition, less than a quarter of survey respondents cited DigitalOcean's increased price as the reason for their reduced spending. This gives us confidence that the value proposition of our offering endures, and we will recognize an ongoing benefit in subsequent quarters. Another initiative was in the area of go-to-market. We've long shared that a central component of our strategy has been to enhance our distribution capabilities to extend our customer reach and expand our serviceable market. Cloudways accomplishes these objectives and helps us accelerate our revenue growth. In the two months since we've acquired Cloudways, we've been pleased to see that their leadership team and business processes are even stronger than we expected. Importantly, a key strategic benefit arising from the acquisition will be our ability to leverage the customer relationships that Cloudways has nurtured for years to enhance our service offering and prioritize our product roadmap. Finally, we have continued to increase our investment in the DigitalOcean go-to-market team, so we can focus on our largest customers. During the quarter, the contribution from this group continued to exceed expectations and will continue to be a focus area in the years ahead. All told, these initiatives contributed more than $17 million to our top line in Q3 and sets us up well for continued strong revenue performance in the year ahead. Despite the several material headwinds we've discussed, we delivered 37% revenue growth for Q3 and anticipate 30% plus revenue growth for this year and 2023 as well. I'll address our guidance in more detail in a few moments. Now that we've discussed our top line, I'd like to move to profit and loss, beginning with gross margin. As most of you know, we are adopting ASC 842, the accounting standard for leases in Q4, which applies to our colocation contracts that contain both data center cage and power components. ASC 842 results in the company's straight-lining lease obligations over the respective lease terms for both components. In anticipation of fully adopting this standard, we adjusted the straight-line treatment for the cage component during Q3. This negatively impacted gross margin by roughly 1% in the quarter. As our data center agreements are frequently multi-year arrangements where the payments increase over the term. In Q4, the impact of adopting the new standard will require straight-lining both our cage and power costs and will result in a one-time charge of roughly $7 million. This is a non-cash charge that will not impact our free cash flow but will put pressure on margins in Q4. However, we have taken numerous steps to limit our overall operating expense growth during the quarter. So even with this adjustment, we will still deliver a further improvement in our overall non-GAAP operating income for the year, more on that in our guidance discussion. As I noted, this accounting standard does not change our free cash flow expectations, and we remain on track and committed to delivering free cash flow margins of 20% in 2024. In addition to the new accounting standard, we expect data center power pricing to increase as of January 1, particularly in Europe. We have been in discussions with our vendors and have factored this impact into our planning process for 2023. We're confident that we can manage price increases from power against our portfolio of other cost of goods sold spending where we are driving efficiency, including, but not limited to better pricing on non-power aspects of our data center vendor relationships. For next year, we expect to generate gross margins of 65% or better, even with the non-cash impact of the lease accounting standard treatment. Next, I'll turn to operating margin, which was very strong in Q3, as we delivered $40 million of non-GAAP operating income, representing a 26% margin on a consolidated basis. We significantly exceeded the high end of our outlook by 800 basis points, driven principally by compensation. During Q3, there was a one-time bonus accrual reversal that contributed 600 basis points to this beat. However, even adjusting for that, our margin was 20%, 200 basis points above the outlook we provided in August. This bonus reversal reflects our current expectation for 2022 revenue relative to the original internal plan. The additional outperformance for profitability resulted from our continuing discipline to prioritize hiring against the key initiatives that either generate revenue or improve efficiency in the near term, while at the same time limiting spending growth overall to only those elements needed to meet our operating goals. Additionally, we are maintaining lower spending levels on longer-term product projects, which allows us to dedicate incremental resources to them as they become available. Next, I wanted to share some of the drivers of our very strong free cash flow that we delivered in the quarter, which was $22 million and represented 15% of revenue. The improvement in cash flow was driven by the substantial increase in non-GAAP operating income and adjusted EBITDA, which reached 42% in the quarter and was enhanced by better working capital performance from our prior plan, as payments came in lower than expected, either due to negotiated reductions or different payment timing. Several payments are scheduled for Q4 and are fully reflected in our Q4 forecast. I want to reiterate that the new accounting standard will not impact our free cash flow targets. Similarly to operating income, we will be increasing our target for 2022, which brings me to our financial outlook. For the fourth quarter, we expect revenue to be in the range of $160 million to $162 million, reflecting 35% growth at the midpoint. We expect fourth quarter non-GAAP operating margins to be 16%, which is below Q3 levels, principally due to the one-time charge of approximately $7 million for the adoption of the new leasing standard and higher compensation levels. For the full year, we expect revenue to be in the range of $573 million to $575 million, which at the midpoint represents 34% growth. This range includes approximately $16 million of net revenue contribution from Cloudways for 2022. From a profitability standpoint, once again, we are increasing our expectations and are targeting full-year non-GAAP operating margins to be 17%. Finally, we are increasing our 2022 free cash flow outlook as a percentage of revenue to between 10% and 11%, which is the second consecutive 50 basis point increase from our previous call at the midpoint. Regarding 2023, we expect to grow at least 30% over reported 2022 revenue, targeting $746 million in total revenue based upon the midpoint of our guidance range. As we will benefit from product enhancements, pricing strategies, Cloudways, and our expanding go-to-market efforts, we expect all of these to yield positive results even in the face of broader macro uncertainties. That concludes our remarks, and now let's turn to Q&A.

Operator, Operator

Thank you. Your first question comes from Raimo Lenschow from Barclays. Please go ahead.

Raimo Lenschow, Analyst

Thank you. Congrats, that's really a good quarter in this environment. Yancey, just two quick questions. One is, if you think about the behavior that you're seeing from clients in the macro downturn, you saw at Azure, they were kind of putting less workloads on. They were looking to optimize their cloud spending because they had committed overcommitted. That seems like less of a problem for you. What are you seeing there in terms of behavior that’s coming out there? And then I had one follow-up.

Yancey Spruill, CEO

Yes. So what we're seeing—and in conversations I've had, as well as the feedback from our support and broader teams that engage with customers—is that they're very happy with our service. Bill referenced the survey we conducted just to check in with our customers a few months ago to learn more about contractions. Our customers are simply experiencing a weaker operating environment, and several have expressed appreciation to us for the fact that we have this consumption-based model, as it allows them to adjust without calling us up and trying to renegotiate, et cetera. So what we are witnessing is just a reflection of what they're seeing, and not them trying to shift things around. None of us are happy with the world we're living in today for various reasons, but I think our engagement with our customers and the positive sentiment they've had with us has continued throughout this year. Despite the pricing increase, the number of comments we've received from customers indicate they appreciate the value they see in our services, and we continue to work with them to help them through this, but we feel good about the relationship we have and are building with our customers in this environment.

Raimo Lenschow, Analyst

Perfect. Hey, yes, it makes a lot of sense. And then the second question was more on Cloudways. And now that you own the asset, how do you think about it more in the long run? Because it does offer a much deeper relationship. They're obviously much broader in terms of their offering. In that perspective, there's almost a question of how do you see DigitalOcean in the long run as a vendor in terms of IaaS versus being a much broader provider for the SMB? Have you started to think about that already?

Yancey Spruill, CEO

Well, we think a lot about that. The comment in the script was that we are more bullish today than when we signed the contract when we first approached them earlier this year about this combination. I think we're still learning as we dissect the opportunities between the combined companies. But one thing is clear—there are a ton of synergies in this transaction, both in terms of better matching customers from day one into a managed service. We have little quantitative data here, but we've experienced a decent amount of churn in our first 60 to 90 days for customers who come to DigitalOcean. Millions of people come every month. They read tutorials, sign up for an account, and then leave us within the first 60 to 90 days. Many say they were hoping for more help and a more managed experience. We like DigitalOcean, but it's just not for us. And now we have closed that gap. Similarly, from their side, we've already seen synergy—though it's early, and we won't provide a lot of stats yet. However, there is an incredible opportunity to offer the market a more integrated view, which is why we're planning a more integrated go-to-market. The potential for revenue uplift is substantial when you consider the traditional model versus the new offerings available for customers needing more support.

Raimo Lenschow, Analyst

Yes, sounds exciting. Thank you.

Operator, Operator

Your next question comes from Gabriela Borges from Goldman Sachs. Please go ahead.

Gabriela Borges, Analyst

Hi, good afternoon. Thanks for taking my question. I'd like to ask Yancey about the storage functionality that you talked about in the prepared remarks. When you think about your customers and what they're looking for, in order to double that storage revenue essentially as a percentage of sales, what do you think needs to be better from a DigitalOcean standpoint in terms of functionality?

Yancey Spruill, CEO

I think when we look at the breadth of our customer base, there’s a distinct cutover when customers hit different spending levels, which allows us to support the growth and scale of larger customers whose needs vary based on industry type and use case. We need to focus on enhancing the speed of performance and adding other features. We have a clear roadmap in this area, and having Cloudways in the mix has clarified our efforts, given they serve the SMB market and will assist us with product development. We have been improving and adding to our capabilities but really plan to ramp our focus in this area, as the potential unlock is significant when you look at multi-product adoption and doubling revenue as a proportional mix.

Gabriela Borges, Analyst

That's helpful. And as a follow-up, if I may. On the e-commerce vertical, in particular, we've seen trends that are slightly different during COVID, where end-market participants have talked about e-commerce normalizing back to trend line. I'm curious, when you look at the Cloudways business and then your broader set of e-commerce customers, how would you describe the trend there? Is it still deteriorating? Do you feel like it's stable? Is there a path, maybe it accelerates medium-term? Could you elaborate a bit on the e-commerce vertical specifically? Thank you.

Yancey Spruill, CEO

Given the high leverage to WordPress at Cloudways, it's a good proxy. What I would say is that we've seen with Cloudways throughout this year is they have been impacted, but not to the same degree that we have in terms of their growth rate; it is lower than what they would have expected coming into this year. That said, they appear to be much closer to their initial growth plan than we are. Thus, I think it indicates some of the trends you're observing in other areas of e-commerce are very resilient. Their new customer additions have also been strong. I believe that this reflects the value we provide; as SMBs can devote their resources to core activities rather than managing infrastructure.

Operator, Operator

Your next question comes from Pinjalim Bora from JPMorgan. Please go ahead.

Pinjalim Bora, Analyst

Great. Hey, thanks for taking my question. I want to continue with Cloudways, I guess. I want to ask you if—what are you hearing from customers using competitive solutions in terms of the likelihood of moving over? Are you having those discussions? And what are you thinking about in terms of pricing on Cloudways versus the increase that you made for DigitalOcean?

Yancey Spruill, CEO

Well, Cloudways, as a managed hoster, uses other providers. We haven't noted any shifts in conversations or from customers wanting to switch from one provider to another. We have yet to adjust prices since our announcement about Cloudways, and we'll continue to evaluate opportunities there. Our primary focus right now is ensuring we effectively route customers in our funnel, giving them the option from the outset—whether they want a more do-it-yourself experience or a managed service at Cloudways. There have been no significant changes in traction or overall conversations with our customers, and encouragingly, our churn levels remain consistent this year, compared to early last year. That's very reassuring, as when things turn, I believe the consumption pricing model, though a temporary headwind, will ultimately serve as a tailwind for growth.

Bill Sorenson, CFO

The sequential ARR growth of $97 million this quarter reflects Cloudways contributing approximately $4 million. Though we can annualize that to derive a rough ARR number. I've mentioned some of the headwinds previously, but projecting them comes with a degree of uncertainty amidst the current situation. Nevertheless, we're optimistic based on the resilience seen among larger customers, particularly those spending over $50 and even over $250, which are holding strong. So while forecasting headwinds is challenging now, the multiple levers we can use gives us confidence in hitting our 30% growth target.

Operator, Operator

Your next question comes from James Breen from William Blair. Please go ahead.

James Breen, Analyst

Thanks for taking the question. Can you talk a little bit about the impacts that the price increases have had? Did it primarily occur this quarter, or is there a tail related to that as we move over the next couple of quarters? And then secondly, just on the cost side; I understand the margins will tick down in the fourth quarter. How do you foresee that moving from there? Will it stay at this lower level for a while, or do you anticipate a rapid improvement?

Bill Sorenson, CFO

No, our focus remains on driving expense improvements. As Yancey indicated at our year-end results, we may not control revenue in this environment, but we certainly can control spending. The trajectory we see going forward will emphasize increased profit and cash flow next year, and we are still on track to achieve our 20% free cash flow target by 2024. The expense side is key to our approach. Regarding the price increases, we saw effects materialize mainly in this quarter, but we expect continued impact over the next few quarters as several larger customers reached maturity during this period. Thus, we anticipate price increases will support our growth while helping offset some of the economic headwinds.

Operator, Operator

Your next question comes from Tim Horan from Op. Co. Please go ahead.

Tim Horan, Analyst

Thanks, guys. Just two questions. Do you believe the free cash flow improvement from 10% to 20% is relatively linear? Should we be expecting around 15% next year, or is it more back-end loaded? Also, regarding your peers' price increases, was it primarily by hyperscalers or smaller providers like yourself, or was the magnitude weighted more toward one end?

Yancey Spruill, CEO

Yes. As for the last question, all the hyperscalers raised their prices this year, and I was referring to those competing in the SMB segment of the cloud. Their pricing magnitudes were similar to ours, and they announced those increases after we did. I believe this competitive positioning in the market is neutral for us, which can also serve as a tailwind if the market shifts in our favor. Regarding free cash flow, you will see a significant leverage in the coming year from this year's full results. We are committed to achieving 20% or better in free cash flow by 2024. It's noteworthy that we flipped funding from a negative 25% free cash flow margin to positive 30% in less than 36 months.

Operator, Operator

Your next question comes from Pat Walravens from JMP Securities. Please go ahead.

Pat Walravens, Analyst

Great. Thank you. Congratulations to you guys on the way you're managing this business. Hey, Bill, can we talk a little bit about the convert? So it comes due at the end of 2026, it's $1.5 billion, and the conversion price is $1.79. Are you just going to generate enough cash to close the gap? Would you refinance it? How do you think about it?

Bill Sorenson, CFO

I think we have a variety of opportunities available, Pat. What we've discussed is our goal for $1 billion by 2024. We aim to continue that trend from there as we maintain a growth rate of about 30%, along with a continued improvement in overall margin. The mantra for us is focused on improving free cash flow. Yancey has challenged us with a target of over 20% as we move forward. That's not a number we're putting out officially yet, as we have work to do. However, if you look two to three years into the future regarding our trajectory and financial model, we anticipate refinancing options will be readily available. If not, we may partially pay down or potentially repurchase portions of those notes over time as the macro landscape becomes clearer. Our initial position was limited capital availability, but we adapted well, reduced our debt, and the outlook is positive moving forward.

Yancey Spruill, CEO

Well, frankly, employee attrition has come down since the pandemic began. We have leaned into remote work and engaging with our team; consequently, our employee retention is strong. In the first few months following the announcement of the Cloudways acquisition, their retention has been notably high. We maintain a high level of engagement with them. They have critical roles in driving our business, and there’s overlapping synergy here. Many cross-collaborations are happening—our teams are frequently on the ground visiting with them. This isn’t a typical acquisition; we are fully committed to deeply integrating both companies. A shared vision is crucial for us, especially around serving SMBs and simplicity. We are very optimistic and keeping a close eye on our progress in terms of integration during this adjustment period.

Operator, Operator

Your next question comes from James Fish from Piper Sandler. Please go ahead.

James Fish, Analyst

Hi, guys. I wanted to revisit Gabriela's question, focusing more on the go-to-market side rather than the product. At what point does it start to make sense to bundle more of the compute and storage products together rather than try to sell them individually? Moreover, could you provide us an update on the net dollar retention for just the greater than $50 a month cohort? I think it was at 113% last quarter.

Yancey Spruill, CEO

I'll address the first question, and then Bill can tackle the second one. I mentioned earlier that one of the levers we will pull moving forward versus what we've done in the past relates to pricing and packaging. We are learning a lot about customer behavior and their responses to the pricing changes we've made a few months ago, which indicates there's an opportunity for us in terms of packaging. Customers have shown a preference for simplified options. Thus, we see a lot of potential in that area, and I assure you that we will continue to explore pricing and packaging strategies moving forward.

Bill Sorenson, CFO

Regarding the net dollar retention for our customers spending over $50 per month, we have seen a significant increase as we anticipated following the pricing enhancements. We are encouraged to see that the larger customers show resilience, with our greater than $50 and $250 customer cohorts seeing growth. This emphasizes the foundational opportunity in larger customer segments, underscoring the value these products bring to their operations, regardless of the economic environment. We are committed to leveraging our learnings for maximizing our engagement with larger customer cohorts to drive revenue growth.

Operator, Operator

And your last question for today comes from the line of Wamsi Mohan from Bank of America. Please go ahead.

Wamsi Mohan, Analyst

Yes, thank you. I apologize; I was jumping between calls, so I might have missed this. Can you discuss what you observed in terms of demand linearity during the quarter? Were there any differences you can highlight across various spending cohorts, and maybe touch on how this trajectory has changed, if at all, in October versus months prior?

Yancey Spruill, CEO

As you know, we initiated our price increase on July 1st. We experienced some noise during July and August connected to that; however, September started to normalize, and October exhibited the same trends. We feel optimistic about the path we are on entering Q4.

Wamsi Mohan, Analyst

Thank you for that. Just to clarify on the Cloudways aspect—what is your expectation for their impact next year on our at least 30% guidance?

Bill Sorenson, CFO

For this year, we expect Cloudways will contribute around $15 million to $16 million in revenue. Historically, Cloudways has consistently demonstrated a compound annual growth rate of approximately 40% to 50%. Although they have been affected by the same headwinds everyone else is experiencing, we maintain a positive outlook on their continued strong growth trajectory due to their excellent understanding of their target markets and customers. We remain optimistic about how they can assist us in fostering further growth across our entire customer base.

Operator, Operator

This is all the time that we have for today. I will turn the call back over to the presenters for closing remarks.

Yancey Spruill, CEO

I just want to thank everybody for joining us today. We're grateful for your support, especially in these tough times. Our goal is to be as transparent and communicative with you as we can. We look forward to speaking with you in the coming days, weeks, months, and years ahead. Have a great evening.

Operator, Operator

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