Preface

Please enjoy our one-on-one conversation with the CEO of DigitalOcean (DOCN).

 

One on One with the CEO of DigitalOcean

Ophir Gottlieb:
Thanks for taking the time. I want to try to wrap my arms around the slowdown for DigitalOcean, and just generally the SMB world.

I’ve done this now with other companies that are usage based in the enterprise software world, but DigitalOcean is our only IaaS company.

So where is the revenue slowdown most pronounced?

Is it a slowdown in learners moving to builders, a slowdown in builders moving to scalers, or is it simply that builders and scalers aren’t expanding as quickly due to a slowing usage in a tech recession?

Matt Steinfort (CFO, DOCN):
What we’ve seen is a lot of consistency in the growth of the larger customers, and that’s part of the reason we got that new disclosure.

So that you can see that while the builders and the scalers, the growth may have come down a bit, they’re still growing very, very healthy.

Where we’ve seen more of the variability is in the smaller customers, so the learners or the sub 50 [dollar per month].

And the testers are, it’s interesting, we called them customers historically, I think going forward we’re going to peel them out.

We think of them more as prospects, so it’s really customers that come onto our platform, they try us out, they may only stay for a month or two. And that’s where we’ve had a lot more variability in our number of customers.

So yeah, we think that it’s right to focus on the larger customer base. And again, we want to continue to nurture that learner pool.

We have seen and we saw in the latter part of the fourth quarter, some of the larger customers, like you’re hearing with I’m sure a lot of the other technology companies that you’re speaking with, where there’s a lot of optimization work going on.

We just did that as part of our announced reduction in force and cost saving.

And you’re seeing a lot of the other players that are our customers, see their businesses slow down and then immediately go look to say, “Okay, well where can I cut back on costs? Can I reduce the number of workloads that I have from nine to seven? Is there optimization that I can do? Can I just go talk to my vendors and see what kind of relief they can give me?”

So we’re definitely seeing a decent amount of that and that’s why we’re guiding to continued pressure perspective in terms of the expansion in the first quarter.

But we feel good about our ability to kind of weather that, the cost savings and the change to our capital or our cash flow model that we put forth with the new strategy.

OG:
Okay. So that’s a really good segue.

I thought the call was very good. And I did appreciate the extra color now on the dual graduation rates, to builder and scaler cohorts.

I’m very curious to know what DigitalOcean is seeing with respect to scalers, these sort of the largest versions of your customers, coming directly to DigitalOcean from hyperscalers to reduce costs.

So I feel like there could be a tailwind here for new scalers.

And it’s not a graduation on a platform, but they just moved to DigitalOcean at scale from one of the hyperscalers.

Is that a meaningful trend yet, or is that not materializing yet?

Yancey Spruill (CEO, DOCN):
Well, I would say it’s an opportunity for sure. We’ve had anecdotal success with it.

What we’re focusing now, our team, is to productize migration, both in terms of we’ve done enough of them very successfully from Azure, GCP and AWS.

The profile is somebody spending in the hundreds of thousands of dollars a year, scalers, and they aren’t getting the service levels, their complexity in their cloud is evolving.

And because they’re not big enough to matter, they don’t get support. And so that’s a great opportunity for us.

So we’re focusing on productizing that through dedicating a team, creating a real playbook.

Another ingredient for us, and why we have accentuated the need to enhance our storage capabilities is, what we see frequently is we’ll meet with a company who checks, all the boxes for somebody being underserved at a hyperscaler, and they’ll look at us and we’ll even give them some credit, they’ll start testing.

And they’ll say, “Well, the compute’s a no brainer. You’re store storage is fine, but for our use case it’s not quite there. So we wouldn’t migrate that.”

And in that case, the NTV isn’t quite there relative to the level of effort.

Because it does take 60 days or so now to meaningfully migrate.

And so I think when we enhance storage, and I’m really excited as we get to the back half of the year and we will have made meaningful progress, it’ll change the nature of our story and the value proposition.

And I think then we’re going to see that opportunity really become a systematic reality for us.

OG:
So Yancy, is there a sales team that goes after SMBs on the hyperscalers, or are the sales people still as of now focused on that internal pool of 677,000 paying customers?

YS:
Yeah, we’re largely focused on the internal.

I think if we move through this year, you’d see us start to have a small sort of outbound, seeking those sorts of opportunities, the SMB migration.

OG:
Okay. So anecdotally, as a CEO who also runs a company, not just the analyst, and speaking to other SMBs, I think there’s several billion dollars of opportunity for DigitalOcean just in this group.

There are a lot of people, I’m not talking about Pinterest, I’m not talking about the companies that spend $500 million a year on infrastructure, that’s fine.

There are a lot of people companies in the $100,000 to $500,000 spend a year that they want off big time. They want off AWS, they want off Azure and they want it simpler.

The blockchain part of DigitalOcean’s business was hurt when Bitcoin basically melted down.

But now Bitcoin is rising. Is there a cyclical nature to this in that the blockchain revenue comes back as Bitcoin prices come back, or swing?

Or is it the case that many of these blockchain companies just, they didn’t make it, so there is no kind of return?

YS:
Yeah, so I think it’s the latter. So we certainly saw the decline from 5% [of total revenue] to 1.5%, 2% exiting Q3, 5% peak in Q2 last year down to one point half 2% in the end of Q3.

We’ve been pretty flatlined there. I’d say we had a lot of churn of customers just going from 100,000 of spend a month to zero, and leaving the platform.

That has stabilized, and it’s been very stable since the end of Q3.

Maybe, I think what happened is a lot of the props came out of the market as exposed by the churn dynamic, and I don’t think there’s been enough traction yet in crypto where reconstitution of new ideas happens on our platform and we’re starting to see the next wave.

Maybe that happens, maybe it doesn’t. Who knows. But we’ve been very stable at that one and a half, 2% since the end of Q3.

OG:
Okay. Yeah, I had a sense that some of those blockchain businesses just won’t come back. It’s not about DigitalOcean, it’s about that they’re just not solvent.

We talked about storage for a second, and I want to come back to it.

Last quarter Q3, you brought up the storage product upgrades to come to the forefront and I got excited on the call.

And yesterday obviously you noted again, and even gave some long-term guidance to doubling the share of company revenue that comes from storage, I think from 10% to 20%.

So I think you may have answered this a little bit, but how is that progressing? How quickly can broader offerings get into GA?

YS:
So first, we made some real progress in Q4 by dramatically increasing response rates on our storage transactions for a second kind of thing, which was one of the key gaps.

So we narrowed that pretty dramatically last quarter.

We just announced the backup acquisition with SnapShooter.

In terms of the internal product development, we have a handful of things that have been in flight for a while that will be targeting GA the second, or as we get into mid-year Q3.

So we should exit this year with a dramatically enhanced portfolio on the storage side.

So we should start creating incremental growth as we get into the back half of this year, and certainly see that in 2024.

OG:
I want to try a different tac here. Okay, Yancy, if I were essentially to magically tell you that I could see the future, and I tell you, “Hey, with the current business, so not another acquisition, just DigitalOcean actually grew revenue by 30% in 2023.”

I just said, “I just want you to know I just saw the future.”

What would you then tell me happened? In other words, what got better that doesn’t look good right now that could get better?

Other than, I don’t know, the war in Ukraine ending. Just something on the business side. Can you answer that?

YS:
Well, clearly the initiative we talked about to get us to the high end of guidance, those all hit, and they all got traction that took us beyond that. That would be one.

The second is, we saw that 400 basis point decel[eration] in expansion last year re-expand, so that our cohort’s growing faster.

And then I think the third leg of that would be the stabilization, or the reduced volatility of small customers, of learners and testers on the platform.

I would say those would be the three things I would expect to see.

Obviously we have even more upside on the synergies of Cloudways, probably the fourth.

OG:
And right now based on guidance, and it’s really not specific to DigitalOcean, but DigitalOcean is usage based and SMB, my sense from other companies…

I just spoke to Datadog’s CFO yesterday for example, just as one example. Obviously a different business, but they’re still enterprise software. And they don’t even deal with SMB that much.

I’m getting two different pictures. One is companies that are pretty bleak about the macroeconomic environment… Moving forward I mean.

Everyone knows where they are today. And then I get other ones who are like, “Yeah, it’s not that bleak. It’ll be better.”

And I don’t know if the optimists are foolish, or I don’t know if the pessimists are getting too pessimistic.

If you had to tell it to a three year old, like how do you see the rest of the year playing out?

It’s okay, DigitalOcean gave specific guidance. That’s fine.

I just mean, based on what you’re seeing as of February 17th, and the trends leading to it, how good or bad is this tech recession looking?

And I know you can’t forecast for sure. I’m just very curious. You have an unbelievably valuable perspective.

So how bad is it, or how bad does it look?

YS:
Well, as I told our company the other day, I mean, we’re still… even 20 to 25% growth is five times global GDP.

So there’s still massive tailwinds in this lower growth period.

I’ve also said that I think this will be an extended period of time for price discovery, and what’s the naturalized growth rate.

And the reason I say that is partly from experience when I was a banker, growth tech banker 20 years ago, what happens in my view with… And this is a much bigger hangover caused by 15 years of zero interest rates, is the entire ecosystem of tech has been funding… losses have been getting funded by outside investors.

OG:
Yes.

YS:
And so there’s just been a lot of spend in that category.

And also, cloud and social and mobile are all tailwind. I think cloud, social, mobile are going to be tailwinds for the next decade plus.

But we don’t know how much of those were boosted by zero interest rates. And I have a feeling we will start to know that as we exit this year in terms of the magnitude of it.

And then the question is, when does it normalize and what does it normalize to? And I don’t know how long that will take.

And frankly, that progression of thought is how we kind of concluded that, “Let’s just get to longer term margin targets now, because we’re not going to grow into them given the growth outlook and the uncertainty in the outlook.”

And you’re better positioned to run a business where your returns are where they need to be.

You can manage the upside, the growth rate’s higher, but you can also manage that business in a lower growth environment versus your ramping margins assuming a higher growth environment.

So, we changed our posture to accelerate for longer term because of this dynamic where there’s some uncertainty.

I don’t know that we’re far from the bottom, although I’m not calling a bottom, but I don’t know that the bottom matters, because I think it’s going to be around for a while.

And I think 20 years ago is a really good guide.

It took a while for companies… You know, have a whole generation of entrepreneurs who, I was talking to one of our customers the other day, who’s gone from zero to 150 plus million dollars on our platform of their own revenue.

He’s never had a sequential quarter be flat until last year.

He’s a 35 year old person, so he’s never… There’s whole people who’ve never had a context for what’s happening right now.

And they have to realize, they have to figure out how to run a profitable business.

And running a business profitably, it’s about choices, it’s about process…

That whole ecosystem that we’re a part of has to figure that out. We figured that out sooner than other folks, but it’s still going to impact us.

So I personally think we could be at the trough for a while before we start to see recovery.

And the good news is, we still have the massive tailwind of cloud in terms of productivity.

And in our case, all new customers may start with a digital business.

And so SMB, business formation of small businesses is very robust, record year in the US last year. So we have a lot to feel good about.

I think the data that we shared around builders and scalers validates that. And I don’t know that we’re in a… People are still used to the last 10, 15 years, everything was a blip, and then growth resumed.

Think about it now, we’re now at a 15 month window, where at least tech valuations have collapsed. It’s 15 months.

I mean, that’s not… And nobody’s ringing a bell yet that we’re at the bottom in terms of when growth is going to stabilize.

So that’s why we pivoted the model to get to the long term now. And I think it positions us to capture upside when it does return.

OG:
Yeah, I completely agree. The private world has been frozen.

Like you said, a lot of companies that would, yeah, they’d be customers of all of these software companies, all of these infrastructure companies, they’re just not going to make it.

And also, the youth of… the age, or the lack of experience in a down environment is making people… When we trough, like you said, we have history to see this, people remain pessimistic far, far longer than in retrospect they should have been.

And we don’t have to go that far.

You can just look at the Great Recession, the financial crisis.

We bottomed in 2009, business wise. By 2012, people were still thinking we were in a recession.

Okay, one last question.

The stock buybacks are getting pretty large, and now there is one and a half billion in debt.

I saw that the goal was to buy back, I think, 125% of free cash flow in the near term.

So this is actually the most common question I get from investors that understand the DigitalOcean business, that don’t ask about like, “Why would someone go to DigitalOcean?”

That DigitalOcean will hyper focus on stock buybacks and not the customer experience and growth while weakening its balance sheet.

What can you say about that to them? What’s your response?

MS:
This is Matt. I think we’ve got an incredibly healthy capital structure.

We’ve got 864 million in cash. With the new guidance, we’ll be approaching 30% free cash flow by the end of this year.

We’re going to be spitting off a material amount of cash over the next few years. Even if you, which we have, set aside some kind of, in your mind, M&A, a very large amount of kind of an M&A budget, we’re going to have a lot of excess cash over that period.

And so, the belief we have is that the best way to return the value to the shareholders is, first drive operational efficiency and free cashflow margins, but then put some of that money to work to reduce [inaudible] that drives free cash flow there.

This is a business that if you look forward a couple of years, if we’re still, even if we’re only growing 20 to 25%, we’re free cash flowing 30%, we’re going to have a tremendous amount of ability to lever this business to the two and a half, three times range.

Which is a very conservative, I think, leverage level, particularly for a business with that kind of economics. And we’ll be able to refinance the convert.

But all of that assumes that we’re still investing in material and growth of the business, organically and in M&A.

I guess when I look at this, I come from telecom, I come from a business that levered it almost six times that leverage that was spending a billion dollars in capital, and had that really high leverage in burning cash every year.

This is the business that can afford to fund its growth, and invest in prudent investments that clear the hurdle of the high kind of bar that we’ve set for the business, but still is going to generate a lot of excess cash that we can use to improve the shareholder returns.

OG:
Okay. Thank you guys. I’ll talk to you next quarter.

Enjoy your weekends upcoming and the rest of your calls. I appreciate your time.

Conclusion

Thanks for reading, friends.

The author is long DOCN at the time of this writing. 

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