DigitalOcean Holdings, Inc. Price & Performance (DOCN)

DigitalOcean expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward looking statements made today. Additionally, non GAAP financial measures will be discussed on this conference call and reconciliations to the most directly comparable GAAP financial measures can be found in today's earnings press release as well as in our investor presentation that outlines the financial discussion on today's call. A webcast of today's call is also available in the IR section of our website, And with that, I will turn the call over to Patty.

Thank you, Melanie. Good morning, everyone, and thank you for joining us us today as we review our fourth quarter and full year 2024 results. We concluded the year with strong momentum and continued to successfully execute on the initiatives we laid out at the beginning of the year. Our accomplishments included building out our executive and senior leadership teams, significantly improving the pace of product innovation, augmenting our product led sales motion with new strategic go to market enhancements, continuing to accelerate the early success of our AIML platform. All of which together positioned us with momentum heading into 2025. In my comments today, I will briefly recap our fourth quarter and full year results reiterate our strategy and priorities shared several product innovation and customer use cases across both core cloud and AIML that demonstrate the progress we're making against our priorities. First, I will briefly summarize our fourth quarter and full year 2024 financial results. Revenue growth accelerated in the fourth quarter to 13% year over year to $2.00 $5,000,000 with one of our biggest growth levers net dollar retention improving to 99% from 96% in of the prior year. Our efforts to improve growth and NDR in 2024 are evident in our Q4 results as NDR with our traditional cloud services reached 100% for the first time, since June of twenty twenty three, on the back of our rapid product roadmap execution, and our investments in several strategic go to market motions.

From these efforts, we saw increased expansion from our higher spend customers as we continue to focus both our product and go to market efforts on these top customers. Our higher spend customers which has traditionally included our builder and scalar cohorts, now represent 88% of total revenue and grew six We We have now further disaggregated our scalars and are disclosing our highest spend customer Cohort Scalars Plus, which are customers who were at 100 ks plus annual run rate during the quarter. These Scalar plus customers who are critical to our growth trajectory increased in count by 17% year over year and were 22% of the total company revenue in Q4. We reached over 500 of these customers for the first time in the company and more importantly, we saw a 37% year over year increase in revenue from Scalars plus customers. Which is clear evidence of both the wallet share opportunity we have with these customers and our demonstrated ability to scale with them. We also made material progress on our other major growth lever, our AIML platform and closed the year with continued momentum exceeding the three points of overall growth contribution from our AIML platform that we had guided for 2024, with Q4 just north of 160% ARR growth while staying true to our AI strategy and pursuing durable AI revenue.

We are very encouraged with the rapid growth and customer adoption of our newly launched AI products and I'll talk about them later in my comments. On top of the increasing growth signals, profitability remained strong as we delivered healthy 42% adjusted EBITDA margins both Q4 and for the full year, maintaining our cost discipline while we continue to invest to fuel future growth. Looking forward, our 2025 guidance reflects this ongoing momentum with full year revenue growth at low to mid teens and high teens free cash flow margins above our preliminary 15% to 17% indication. We continue to prioritize and rebalance our investments driving improved operational efficiencies, while shifting resources towards our top growth initiatives. Our upcoming Atlanta data center is a good example of both these priorities as the upfront investment in that facility, which will come online in Q1, not only provides us with incremental capacity for both AI and our core cloud offerings, but also gives us a lower cost facility And it's part of our longer term data center optimization strategy. Max will walk you through more detail on our financial results and guidance later in the call. In my first year at Distillotion, we had several very clear priorities as we sought to accelerate growth.

We needed to double down on product innovation to address key gaps in our core cloud platform, better address the needs of our larger customers return net dollar retention to a tailwind rather than a headwind, and build the foundation for our longer term AI growth strategy. We made material progress on each of these objectives and continue to deliver on our promise of making complex cloud and AI technology is simple. We also made substantial progress on making our platform even more scalable. Enhancing our ability to meet the needs of larger customers. And finally, we doubled down on our heritage of being the most approachable public cloud provider by continuing to invest in support of open source AI models, and even hosting our developer conference Deploy in January. Let me now give you some updates on the core cloud computing platform, In Q4, we continued to accelerate the pace of innovation as we released 49 new products and features throughout the quarter, which is more than four times what we released in Q4 of the previous year. Most of these products and feature enhancements directly address the need of our largest spend customers as we continue to remove blockers and implement the capabilities that they need to further scale on our platform.

I will highlight several of these product releases that we have made to help our customers grow their businesses using DigitalOcean DigitalOcean. Given that our larger customers run significant global workloads, they need the ability to securely connect different parts of their network so that their systems and applications in separate environments in various data centers in different countries can securely communicate without using the public Internet. To improve speed and efficiency while keeping their data secure. To address this need, in Q4, we announced Virtual Private Cloud Peering or VPC Peering for short, which is now generally available for all our customers. VPC peering enables customers to connect their separate private clouds and establish seamless communication between resources hosted in these clouds using private IP addresses keeping their information safe by traversing through the DigitalOcean backbone, rather than through the public Internet. Our larger customers also need the ability to distribute traffic across resources. While still keeping it within a secure private network. To support this, introduced a new feature called Internal Load Balance which enhances security by ensuring that internal workloads remain isolated from public Internet making it ideal for applications that require highly scalable private communications.

We also have several large customers with volatile traffic patterns that need mechanisms to handle these mass volume very smoothly while still optimizing cost and scaling them down where the demand is lower. To address this, we announced the general availability of droplet autoscale pools to ensure that the right resources are available to handle application workloads during these surges in traffic scaling up automatically to meet demand while also helping minimize costs by scaling them back down when the traffic surges over. We also introduced flexible management capabilities to our app platform which is our platform as a service offering for more granular lifecycle management, including archive and restore functionality and maintenance mode during the application's full lifecycle. Next, customers of spaces which is our fast growing S3 compatible object storage service, have long asked for the ability to grant granular permissions to different users or teams without exposing full account wide credentials. In response, we launched per bucket access keys for Spaces, This highly sought after feature provides customers with identity based, bucket level control over access permissions helping enhance the data security and ultimately simplifying management overhead. Complementing this accelerated pace of product delivery of capabilities one of our new go to market motions.

Where we bolstered our engagement with our top 1,500 customers By helping take these new innovations to our customers, and tightly orchestrating a closed loop between the various DigitalOcean teams, and our top customers this motion increased awareness and adoption of our new product capabilities facilitating migration of cloud workloads from other clouds to DO. And serving as a catalyst for both our improved NDR and faster growth rate of Scalar plus customers. Our higher spend customers have quickly started adopting many of these features that I just talked about that we released over the back half of twenty twenty four.

Over 50% of our top 100 customers have adopted at least one of the features that we released in Q3, and we anticipate similar adoption levels for our Q4 features over time. Together, the breadth of these new features and the pace at which we are executing our [indiscernible] is enabling our higher spend customers to grow on DigitalOcean and is enabling us to win more of their workloads that today reside on other hyperscaler clouds. As we discussed last quarter, we've been focused on helping our our One example of this is a customer called Digital Platform. A strategic software solutions development company that was experiencing high cost and latency issues with the cloud They were leveraging. Which was impacting their application performance. Through our customer facing teams, we were able to fully migrate their workload to DigitalOcean, leveraging our optimized database infrastructure to improve their performance while providing them with substantial cost savings. Another example is Hulu, a provider of enhanced IT documentation with features and tools made for assisting managed service providers and IT departments. Hoodoo has been a DO customer since 2019. And they continue to scale and grow on our platform. KUDU was an early adopter of our Kubernetes managed databases, Snap Shooter and premium support products.

As a result of the ease of use of our platform, they've been able to focus on their own scalability and have grown as a business over 70% since 2021. Another example of our customers' ability to scale with dish lotion is Moments, a fitness and wellness platform that manages bookings, communications and memberships, Moments needed a larger instance to house their database to meet the requirements of their rapidly growing customer base and continue leveraging our platform. The dissolution team was able to provide architecture DO products while delivering a new product they requested. A 48 vCPU storage optimized droplet with scalable storage. Let me now switch gears and give you a quick update on our AI initiatives. We remain committed to and are executing well against our AI strategy that we articulated last year. In that context, I'm very encouraged by the emerging innovations in this space like DeepSeq that drive down the cost of AI at all which will ultimately enable more customers to use AI. We see innovations such as Deepsea, even reports of some hyperscalers potentially moderating their data center commitments as reinforcing our conviction that while a lot of action to date has been at the infrastructure layer, that innovation and value creation will occur at the platform and application layers.

Where we are highly differentiated and well positioned to grow as we democratize AI for our customers. Our prudent approach to AI investment also allows us to ramp investment where we see customer demand. And as a case in point, we are increasing our allocation of our GPU capacity for our GPU droplets where we quickly ran out of capacity after launching at the beginning of Q4, Each of these three layers infrastructure, and AI applications have their purpose and very distinct customer targets. And although most of the action is still in the infrastructure layer, we are now starting to see more narratives in the market around the higher layers of the stack in platforms and agentic applications which is a good validation of our AI strategy that we laid out last year. We've been making excellent progress enhancing our AI infrastructure offerings as well as innovating at the GenAI platform [indiscernible] application layer as we build towards our goal of democratizing AI by enabling our customers to quickly experiment and build AI into their real world application On the infrastructure side, we are seeing strong adoption of GPU drop which we made generally available to all our customers in October.

As a reminder, GPU droplets allow dish solution customers to leverage on demand and fractional access to GPUs in a self-service way in just a few minutes, VAPS simplifying a very complex series of steps.

Let me now give you a couple of real world examples. [indiscernible] a company specializing in integrating generative AI into their own applications, leverages DigitalOcean's GPU infrastructure globally to efficiently manage their own products Protia accelerates generation speeds offering an easy to use API for AI powered image generation. Another example of an AI AI ML infrastructure company is Commodity Weather Group, a company that provides advanced weather model forecasts to their clients and runs AI based weather models to enhance decision making with additional insights. They also leverage DigitalOcean's AI infrastructure for its scalability and ease of use. These are just a few examples of how our customers are leveraging our infrastructure to develop and sustain data intensive software to be able to meet the needs of their own customers all while leveraging the simplicity of DigitalOcean's AIML infrastructure. Moving up to Stack, I'm very excited about our Gen AI platform, which is now in public beta. The DigitalOcean Gen AI platform is one of the simplest platforms to create, deploy and integrate AI agents into real world applications. Tipping back for a second, AI agents or software applications designed to autonomously perform multistep tasks that involve reasoning and decision making leveraging AI and ML.

Our new Gen AI platform gives customers everything they need to build AI into their own applications without the need for advanced expertise in AI or machine learning. Customers can easily and quickly build AI agents leveraging DDoS by adding their data to their pre trained third party Gen AI models and can seamlessly integrate those agents into their own application via secure endpoints or chatbot plugins. In the four weeks since we made the Gen AI platform beta public, we have seen well over 1,000 agents created on the platform with the most encouraging fact being that roughly 90% of these agents were created by existing DO customers, which is further validation of our belief that our typical DO and are willing to do it if you make it very, very simple and integrate it with the rest of our cloud platform.

In our latest version of the DigitalOcean Currents, a customer trends report that we published earlier this month, we found that almost 80% of our target customers are interested in leveraging AI but over 70% of them said that costs and lack of expertise are the two major impediments to AI adoption. Our Gen AI platform makes it very simple by abstracting out of this complexity associated with creating AI agents by having templatized agents, click through wizards and so on, and by providing easy access to a variety of open source models, including LAMA, DeepSeq and Vistra. The application layer, we introduced Cloudways Copilot in public beta. Which is a suite of AI solutions designed to bring intelligent managed hosting to small and medium businesses. Starting with AI powered diagnostics, to give customers recommendations and alerts to fix issues before they become problems. This helps our customers automate tasks, monitor performance and provide them with insights to keep their websites up and running smoothly. One such example is ClickIt, a web design and development agency which is already leveraging the newly announced cloud based Copilot in AI, ClickIT is finding a 4x reduction in the time spent manually handling issues and taking care of web servers.

We also started using Gen AI agent for our own internal DigitalOcean DigitalOcean operations. For a variety of operational incidents, Gen AI agents are invoked which analyze our service logs to determine the root causes This has resulted in a 39% improvement in our time to resolution and is one of the most sophisticated uses of Gen AI agents in the industry today. We are building these agents and using them not just to improve our own operations, but also to deeply understand the pain points and complexities of building AI agents so that we can incorporate these learnings into our Gen AI platform and making it even more simpler for our customers to use. Beyond our product and customer progress, another recent highlight was the Deploy Conference we hosted in January in Austin, Texas. This event brought together customers, [indiscernible] and some DigitalOcean employees amplifying our presence in the developer and AIML space and building out on our strong position as the most approachable public cloud. At Deploy, we introduced a slew of new product capabilities launched an AI variant of our popular startup incubator program called Hatch, and hosted many of our technology and channel partners. At Deploy, we also launched a new migrations program designed to seamlessly transition cloud workloads from the hyperscalers to DigitalOcean.

This program will eliminate migration related complexity, deliver lower operational costs and provide seamless technology assistance through our partner ecosystem and a newly formed digital ocean team of solution architects skilled at migrating cloud workloads. To recap, as I close my prepared remarks, we entered 2025 with increasing momentum In Q4 alone, we released more than four times as many products and features we did in the previous year, increased net dollar retention to 99% grew revenue 13% year over year and delivered 18% adjusted free cash flow margin. Our focused efforts on our higher spend customers and our continued traction in AI drove quarterly revenue for our top 500 plus customers representing 22% of our total revenue to grow at 37% year over year. This shows clear progress on our strategy and builds on our leading position as the simple, scalable and approachable cloud. Before I turn the call over to Matt, I'm very excited for our upcoming Investor Day. Which we will be hosting at the New York Stock Exchange on April 4, starting at 9AM Eastern Time. During this Investor Day, we will share more on our longer term strategy including more details on our progress and key metrics and we'll share a view of our long term financial outlook I will now hand it over to Matt will provide some additional details on our recent financial results and our outlook for Q1 and full year 2025.

Over to you, Matt.

Morning, everyone, and thanks for joining us today. As Patti discussed, we delivered a solid Q4 and full year 2024 on all financial metrics and made meaningful progress on the key initiatives and goals we set in place at the beginning of the year. In my comments, I will review our Q4 results in detail, and cover the full year 2024 financial highlights before sharing updated first quarter and full year 2025 financial outlook. [indiscernible] Revenue in the fourth quarter was $2.00 $5,000,000 up 13% year over year. Annual run rate revenue or ARR in the fourth quarter was $820,000,000 as we added $26,000,000 of incremental ARR in the quarter. Up from $24,000,000 in new ARR Q3. Of note, we made a methodology change to how we report ARR where we now calculate ARR by multiplying the quarterly revenue times four, rather than the final month of the quarter times 12. We decided to use aggregate quarterly revenue to calculate ARR to reduce potential volatility in this metric given the project based nature of some of the training workloads, customers are running on our AI ML platform. More details on this as well as a reconciliation between the old and new methodologies can be found in our Form 10 ks.

Revenue from our builders and scalars, which are our highest spending customer cohorts, and represent 88% of total revenue, grew 16% year over year. And customer count increased 6% year This quarter, we also began to disclose further disaggregation within our Scalars [indiscernible] And are now separately disclosing our largest spending customer cohort. Or Scalars Plus. Four customers that monthly spend is more than $8,333 per month during the quarter. Which is more than $100,000 on an annualized run rate or ARR basis. In Q4, revenue from Scalars Plus represent 22% of overall revenue, grew 37% year over year. Driven by a 17% year over year increase in Scalar plus customer count coupled with their expanded usage related solutions. The net expansion increase we saw from our top customers drove our Q4 net dollar retention rate up to 99%. Up from 97% for the first three quarters of twenty twenty four. The increases we are seeing in our net expansion levels coupled with churn that has remained stable for the last two years, is moving us closer to reaching and exceeding 100% NDR and shifting NDR from a growth headwind to a tailwind. Within this overall improvement NDR, We saw the NDR rate of our traditional cloud services reach 100% in the first quarter for the first time since June of twenty twenty three.

All of this progress is despite the fact that we are still lapping a few headwinds from our managed hosting products that we've spoken about previously. And this progress gives us confidence in our baseline growth rate heading into 2025. Turning to the P and L, gross margin for the quarter 62%, which was 300 basis points higher than the prior quarter and 500 basis points higher than the prior year. The increase in gross margin quarter over quarter and year over year is primarily driven by the increase in revenue as well as the change in useful life for our servers from five to six years as we've been able to extend the utilization of our equipment. In our Form 10 ks. Adjusted EBITDA was $86,000,000 an increase of 17% year over year. Adjusted EBITDA margin was 42% in the fourth quarter, approximately 200 basis points less than the prior quarter 100 basis points higher than the prior year. We feel confident in our ongoing ability to appropriately balance our growth investments with our efforts to improve operating efficiency. As is evidenced by our continued delivery of healthy adjusted EBITDA margins. Q4 adjusted free cash flow was $37,000,000 or 18% of revenue.

This is higher than Q3 by approximately 500 basis points due to timing of capital investment which will continue to create corded core variations in adjusted free cash flow margins. Finally, non GAAP diluted net income per share was $0.49 11% increase year over year. This increase is a direct result of our ability to increase our per share profitability levels continuing to drive operating leverage while mitigating dilution through share buybacks. For 2024, total revenue increased 13% year over year to $781,000,000 This growth came primarily from continued strength in our durable customer acquisition engine. Which in 2024 was augmented by new customer revenue on our AI platform. And from growth in our highest spend customer cohorts. Given our 98% NDR in 2024, the vast majority of our revenue growth in 2024 came from customer acquisition and new customers. Including those that consumed our newly launched AI services. Which delivered north of 160% ARR growth in Q4. Despite the NDR headwind in 2024, our Scalar and Scalar plus customer cohorts collect dollars dollars and fifty seven percent of total revenue in 2024, and grew revenue 18% year over year. Turning to the P and L, our gross margin for the year was 60%, which was 300 basis points higher than the prior year.

Which I noted earlier in my comments is primarily driven by revenue growth that is faster than our growth in COGS, as we delivered further operating On the profitability front, we delivered healthy adjusted EBITDA margins in 2024 at 42%. Up 200 basis points from 2023. We generated 17% adjusted free cash flow margin in 2024 [indiscernible] we had planned going into the year 500 basis points from 2023 margins as we ramped our investment in our compelling AI growth opportunity. On our customer metrics, as I mentioned previously, this quarter we are now disclosing further disaggregation of our Scalar customer cohort into Scalars, and Scalars Plus. As these higher spend customers are the focus of our investments, and the performance is key to our growth strategy.

In Q4, the number of Scalars Plus grew 17% year over year.

And the revenue growth from Scalars plus grew 37% year [indiscernible] We are also seeing an increase in average spend within Scalars Plus where average revenue per user or ARPU grew 18% year over year. The traction we are seeing with our highest spending customers is the result of our continued efforts across product development, targeted customer success and account management motions, and new go to market investments that are all focused on these customers this is an encouraging sign of our ability to drive future growth. Balance sheet remains very strong as we ended the quarter with $428,000,000 of cash and cash equivalents, We continue to execute against our share repurchase program in the quarter with $28,000,000 of repurchases in Q4 bringing total share repurchases to 57,000,000 in fiscal year twenty twenty four bringing our cumulative share repurchases since IPO to $1,500,000,000 and 32,600,000.0 shares. Through December 31, 2024. With our healthy cash position and ongoing free cash flow generation, we are well positioned to continue investment in both organic growth and share repurchases while maintaining appropriate flexibility to address our 2026 convertible note at the appropriate time is likely before it goes current at the end of this year.

Moving on to guidance, I will now share our financial outlook for the first quarter of twenty twenty five and for the full year. For the first quarter of twenty twenty five, we expect revenue to be in the range of $2.00 $7,000,000 to $2.00 $9,000,000 representing approximately 13% year over year growth at the midpoint of our guidance range. For the full year 2025, we expect revenue to be in the range of $870,000,000 to $890,000,000 also representing approximately 13% at the midpoint of our range. As was the case with our 2024 guidance, our 2025 guidance is underpinned by our baseline growth foundation. As we entered the new year. Our primary 2025 growth levers are bolstering customer acquisition, and continuing to drive customer expansion Customer acquisition includes revenue from any new customer including new AIML customers. Who are within their first twelve months on our platform. We anticipate customer acquisition revenue from new customers to again contribute the majority of our growth in 2025. But by continuing to improve NDR in 2025, and by expanding usage by our existing AI customers, that will soon have been on our platform for more than a year, we expect customer expansion to improve.

And to have a neutral to slightly positive impact in 2025. Where it was a headwind in 2024. For the first quarter of twenty twenty five, we expect our adjusted EBITDA margins to be in the range of 38% to 40%. For the full year, we expect adjusted EBITDA margins to be in the range of 37% to 40%. For the first quarter of twenty twenty five, we expect non GAAP diluted earnings per share to be $0.41 to 0.46 based on approximately $103,000,000 to $104,000,000 and weighted average fully diluted shares outstanding. For the full year 2025, we expect non GAAP diluted earnings per share to be $1.85 to 1.9 based on approximately $104,000,000 to $105,000,000 in weighted average fully diluted shares outstanding. On adjusted free cash flow, we expect adjusted free cash flow margins for the full year to be in the range of 16% to 18% slightly ahead of the preliminary indication for 2025 that we provided last quarter. Consistent with our historical guidance practice, we are not providing adjusted free cash flow guidance on a quarter by quarter basis given it's heavily influenced by working capital time. However, we would like to highlight that our 2025 expenditures will be front end loaded.

Is driven by additional AI related capital expense as we scale those services. One time startup costs to get our Atlanta data center online, and the usual Q1 cash expense events including bonus payments and higher payroll taxes. Given this front end loaded investment and expense, Q1 adjusted free cash flow margin will decline from Q4 levels. But we will quickly return to higher adjusted cash flow margins in Q2 and across the balance of the year. And we remain very confident in our ability to deliver the 16% to 18% full year adjusted free cash flow margin in our guide. That concludes our prepared remarks and we will now open the call to Q and A. Thank you. We will now begin the question and answer And your first question comes from Josh Baier with Morgan Stanley. Please go ahead.

Great. Thanks for the question. At your recent Deploy Conference, you talked about several customers that were disappointed with their experience at the hyperscalers and ended up migrating to DigitalOcean's platform. Just hoping you could expand on that and touch on what types of customers you're targeting, what types of workloads and then I have a follow-up.

Yes. Thank you, Josh, for the question. So, yes, what we highlighted during the conference was a handful of customers that are looking at alternatives primarily for two reasons. One is the simplicity of running a fairly sophisticated workload on a hyperscale it's not an easy undertaking. In eight specialists for many of the nuances like storage and networking and compute and so forth. And also the total cost of ownership has especially if you have spiky workloads, and you're unwilling or unable to commit to really long term contracts at a substantial amount of minimum commitment then it becomes a really onerous thing to keep running your workloads. On some of these hyperscaler clouds. [indiscernible] what we are offering as part of the migrations program that I was just talking about is a couple of things. One is the ability to to get our partner ecosystem involved to facilitate smooth transition of the workloads. But more importantly provide a super compelling scalable platform, which is far easier for most of the mainstream workloads to run and operate on the Slooshine platform. So we're seeing all kinds of customers, Josh, And we are staying true to our target customer segments, which is tech native, digital native cloud application software companies that are running globally distributed workloads that are typically network and bandwidth intensive Some of them require very bursty spikes in their traffic patterns, so that need to be supported in a very elastic And what attracts them to us is our our core value proposition of being simple yet scalable, but most importantly a very approachable cloud that really cares about them.

Thanks, Patty. And just wondering on the EBITDA guidance I mean, initial EBITDA guidance for this year was 36% to 38%. You ended up 42 I was hoping you could kind of provide just high level of the main drivers of that degree of outperformance and then how we should think about that level of conservatism in the initial $25 for EBITDA.

Great question, Josh. So I think we said this publicly last quarter that all the new executives that had come on and with the acknowledgment that we needed to accelerate that [indiscernible] We built in some cushion in Q4 for the R and D team in particular to surge resources that they wanted to bring in contractors, etcetera.

And what we were able to do was, we took a real hard look at the spend that we have and we were able to reallocate resources and Brethon and team did prioritizing on the top initiatives of getting the key products out. And so we didn't need that surge. You'll note that from a full year and even for first quarter, the guide is still pretty wide on EBITDA. And so we're signaling is a little bit of, well, don't get super fixated on what EBITDA is one quarter versus the next because we may be pulling expenses ahead or maybe we find efficiencies and we don't need to. But what I would focus on is our commitment. We raised the free cash flow guide from our preliminary indication to from 'fifteen to 'seventeen to 'sixteen to 'eighteen. And that's what we're managing more aggressively towards and I view EBITDA as a it will be a little bit more it will move a little bit more but we're very committed to driving improvements in gross margin, We're very committed to driving operating efficiencies. And improving the leverage we have in the business. But at the same time, we see an opportunity accelerate a product capability that drives revenue, we'll do that and that might have a near term impact on EBITDA margins, which is why we guide in the fourth quarter and why we provided a wide guide for [indiscernible] Your next question comes from the line of Gabriela Borgia with Goldman Sachs.

Please go ahead.

Hey, good morning. Great to see the NDR numbers Thanks for taking my question. Patty and Matt, I wanted to follow-up on the math you've given us in a prior quarter, on how much ARR you're able to capture per dollar of GPU related CapEx Maybe just refresh us as you move up the stack from IaaS to PaaS, are you able to generate more revenues per dollar of CapEx? And Matt, maybe you can comment on the gross margin profile of AI Services business as you move into more differentiated services? [indiscernible] what we found is in particular, if you think of the Gen AI product, and this has been a great learning for us and also very, very supportive of our strategy. Somebody comes in and they want to build a chatbot and they build they come in with their knowledge base and they come in and they want hook up with another model. They can certainly take advantage of our Gen AI capabilities and the GenAI capabilities have way higher margins on their own than do our the bare metal or more the infrastructure layer. But the thing that is probably most compelling to us is how much other revenue that will drive through of cloud services because for every chatbot you have, you need somewhere to store your knowledge base, so you need storage.

You need bandwidth to to get that to communicate with the models and you need a lot of our other database infrastructure So we think that the amount of pull through revenue we're going to get from the Gen AI services is orders of magnitude more than the actual Gen AI revenue itself. And so that's very, very compelling. The margins again on the infrastructure layer, as we've said and is very clear in the market, margins aren't spectacular gross margins on Just core GPU as a service and it's very price transparent in the industry. There's a lot of competition to get kind of an initial workloads and the costs even though there are new entrants, A and D is out with new capabilities and a lot of others are working on capabilities in addition to NVIDIA. It's still a fairly one vendor dominated industry and the costs are super high. So we expect that to come down over time and we expect to be able to leverage more of that infrastructure for inferencing over time, which will drive more consistent and higher margin revenue. But I think that the path that we're on is towards more of our revenue coming from the higher platform not only on their own have better margins, but they pull through higher margin cloud revenue as well.

Thank you. Your next question comes from the line of Mike Zekaus with Needham and Company. Please go ahead.

Great. Thanks for taking the questions guys. It's been great see the improvement in the NDR that you're talking to as well.

I guess first question I had for you was related to the AIML. Great to see the growth there remaining triple digits north of 160%. Is there any way to give us a little bit more as far as the size of that AIML ARR base today, what it represents as a percentage of the total ARR? And then the second piece on that point would be how do we think about [indiscernible] the AOR composition today, is the vast majority of that coming from that Scalar plus cohort? I know we have these new disclosures and you guys are seeing broad based adoption, but just interested where the revenue dollars specifically are coming from for that piece?

Yes. On the first question, Mike, and thanks for the questions. We're not disclosing the specific ARR for AI for very clear reason on our side. The revenue is kind of intermingled with like I was speaking to Gabriela we get a little bit of Gen AI revenue, we're getting a lot of pull through revenue in other parts of the business. And we also don't manage the business as like we have AI product group and there's other product groups It's kind of comingled in terms of whether it's compute or some of the other capabilities. So we believe that like we have infrastructure as a service and we have platform as a service, we have managed hosting, AI is just another one of our products and so we're not going to disaggregate that at the product level. In terms of the amount of AI that's with the scalers, recall that when we acquired Paperspace several years ago, it came with a lot of customers. It was like 15,000 customers or something like that. And And they had a run rate that was largely small customers that looked a whole lot like the DigitalOcean customer base. So we have a pretty deep set of customers that are smaller that are on the platform, a lot of them leveraging the legacy Paperspace kind of Notebooks capability And a lot of the new customers that are coming on in that that Patty talked about 90% of out of the gate are existing customers and their mix looks a lot like our existing customers.

So I'd say there's a healthy chunk of the the AI that's in the Scalars plus but it's not all of it and it's not the vast majority of it is is not in that yet. There is a healthy chunk. Thank you for that. Can I just tack on maybe one more on the on the gross margin? Just I know that we have the Atlanta data center coming online in Q1, which we're all looking forward to. But Can you help us think about how gross margins are likely to move through the course of the year?

With that Atlanta data center And then, we obviously have the news that the useful server lives are being How do we put those two pieces together when we think about how calendar twenty five looks?

It's actually not going to move a ton. It will be a little bit of probably see a little bit of a dip in gross margin in the beginning of the year and then it will pick back up, which is very consistent to what we what happened before with the when we did Sydney, you get some upfront expenses. We haven't fully ramped it clearly with revenue yet. So you'll see a little bit of a gross margin dip, but we don't see a fundamental shift in kind of the range of gross margin that we're in right now. And in fact, Breufin and the teams are working aggressively to to drive gross margin improvement over the multiyear period. As we continue our data center optimization strategy and we just look for ways to to better utilize the infrastructure that we have. So I think gross margin that you'll see a little bit of a drop in the beginning of the year. It'll come back.

And I'll keep pointing back to, but again, we're very confident in our 16% to 18% free cash flow margins for the year. So it'll all kind of wash out to better margins as we get gross margins sorry, better free cash flow margins as we get through the year.

Your next question comes from the line Patrick Walravens with JMP Securities. Please go ahead.

Great. Thank you. So Patty, you've been here a year, right? What has gone better than you thought it would? And what has proved a little more difficult?

Hello, Patrick. Good morning and thank you for the question. Yes, super early for you. Appreciate you dialing in. What has gone better than I expected? I think our product innovation and our ability to really understand what our customers need at a deep level has been growing better than I expected in the sense that when we look at the adoption, the reception from our customers and our hypothesis that our customers really, really want to stay with us And we were saying that now we have green shoots to prove that it is the case. If we take care of them, they're going to expand with us. So I think that has been really awesome. The thing I wouldn't so the whole AI land landscape, the way it is unfolding, has been really interesting. And I'm super encouraged by the fact that we are staying very disciplined to our AI strategy, not getting caught up with deploying too much capacity and running after the GPU forms business model and things like that.

It has been a really good learning experience for us. And slowly but surely, our some of our hypothesis in the AI space have also started bearing out in the sense that the cost of so the two biggest impediments as I talked about in my remarks were one, it is too complex and number two, it is too expensive for our customers [indiscernible] So, we can really help with the complexity by making it super simple, especially with open source models. It gives us a lot degrees of freedom to make it even more easier for our customers. And then number two is make it super affordable. And that's exactly what we have started doing with the on demand fractional access to GPUs and also our token based serverless endpoints with the Gen AI platform especially with the open source model, So that has also started growing really well for [indiscernible] I would say those were the two key learnings for me over the last year. Your next question comes from the line of Wamsi Mohan with Bank of America.

Please go ahead.

Hi. Thanks for taking my questions. It's Ruplu filling in for Wamsi today. I have two. First one for Patty. You launched a lot of products in 2024.

Patty, can you talk about the areas of investment in 2025? And thanks for disaggregating the Scalars plus at 22% of revenue. How do you see that percent, that cohort growing in 2025 And to do that, are you happy with the go to market investments you've made or do you need to hire more sales salespeople? And I have a follow-up for Matt.

Okay.

Thanks. Great question. So I'll try to go very fast. So what are our product priorities for this year? So I'll break it down into core Cloud and AI. On Core Cloud, we will continue our journey in terms of meeting our larger customers where they are in terms of their more sophisticated needs, in terms of whether it is more management capabilities or security capabilities or networking richer variety of droplets that are very specific single purpose droplets and things like that. So we still have some amount of work to do to meet our meet the needs of our large for for larger workloads to move to this solution from other clouds. From an AI perspective, we'll continue to fortify our infrastructure layer, which is honestly quite robust and very scalable and highly appreciated by our customers now. Gen AI platform is where we are going to have a lot of innovation to make it super, super simple for everyday software application company to consume and build agents into their applications. And finally, on the agentic layer, we have announced or we have launched in in the last couple of months the the site reliability engineering Copilot through cloud based first and then we'll make it available more generally And it is our intention to keep pumping out more AI agents that solve real business problems.

Rather than just doing things for R and D sake, we want to solve real world customer problems for our customers. And in terms of go to market, as I mentioned in my prepared remarks, we have already bolstered our the way we do customer engagement with our customers And as we go through the remainder of the year, I'll give you more updates in terms of additional go to market motions that we are standing up. The good news for us is we have tens of thousands, if not hundreds of thousands of customers that we can go and merchandise our expanding product platform capabilities and get a bigger chunk of the share of wallet. So as much as it is important to keep hunting for new logos for which we have a very efficient self-service product led growth funnel. A lot of our go to market efforts are intended or aimed at expanding the share of Follett with our existing customers, which is very different, more significantly more efficient go to market motion than trying to find a bunch of new logos. So we'll do a combination of both and I'll keep reporting our progress throughout the rest of the year.

Matt, just a quick follow-up On payables, looks like sequentially it was up meaningfully. Is that because of the Atlanta data center investments or did you get a new contract that is driving that up? And what would ARR be under the [indiscernible] In fiscal 4Q. Thanks for taking my questions. Sure.

So from a payer [indiscernible] for Q1 for the Atlanta data center. Bretton and team did a phenomenal job of being able to accelerate some of the the readiness of some of services. And so we bought a bit more equipment earlier than what we had expected. And so we were able to still able to do that within within the confines of our free cash flow that we delivered. So it was all about getting Atlanta ready to go and off to a good start. And from an 10 ks. It would have been higher in fourth quarter had we reported the December times 12, if we had not changed the approach. What we think is again, we're we got to remember, we're a consumption based business. In a lot of cases, our even our AI is consumption based. Based. It's not like committed contracts. And so if you measure the consumption at any given time and you multiply it by a number, you're going to get oscillations and variations based on whatever is going on at that period in time. So it's a more, I'd say steady metric if you just average it over the quarter. And so despite the fact that it made us look like we had lower ARR, that's I think the right thing to do for the market give you a metric that's I think more steady and less volatile than the Your next question comes from the line of Mark Zang with Citigroup.

Please go ahead.

Great. Good morning, team. Thanks for taking our questions. Maybe just thanks for the additional disclosure on the scalars, but how should we think of the behaviors of the scalars plus versus the non plus in terms of the pace of upsell, cross sell going forward?

And why aren't we really seeing a more accelerated pace of growth in the non plus cohort, just given the product and go to market I first you guys have already implemented. And what can drive the at least like past the or outpace the growth of builders? Thanks, Mark, for the question. The reason that we broke out this scalars plus and the 100,000 plus customers is the single biggest question we got from whether it was analysts or direct conversations with investors is, do we have a graduation problem? Do our largest customers leave us and those are your most valuable customers? And got a leaky bucket that's leaking from the most valuable part of the customer base. And there was I'd say there was an element of truth to that in that that what we certainly were struggling with those customers over the past several years not meeting their needs as well as we we could have or should have. And that was causing a lot of the the depression in NDR driving us below 100. With Paddy's arrival, with Bruffin's arrival, with the pace of product innovation that we have, it's very, very squarely focused on those large, large customers for us.

Again, a large customer for us is probably not a named account for the hyperscalers, but it's material for us.

And what we've done is we said, we're going to focus on that cohort. We're going to make sure we're listening to them. We're going to rapidly give them the capabilities they need to scale in our platform and we've done that. And the response has been very, very positive. We're now we're talking about migrations for those customers bringing workloads either back to us or to us for the first time from the hyperscaler. And so it's been a dramatic turnaround And we'll talk more about this in Investor Day in April, but if you look at the NDR improvement, if you look at the year over year revenue growth improvement, it's been dramatic within those top customers. And as Patty and I have said, we think we have a tremendous wallet share opportunity with our customers. And clearly, as you pointed out, well, scalars, the customers below that $100,000 plus aren't growing as fast. Okay, well, we haven't gotten there yet. And some of those we're trying to with our new go to market motions, how do we pick and find the ones in that the customers in that cohort that have the highest propensity to spend where we got the lowest wallet share and how do we go after those in a scalable way I'd say what you're seeing right now is, I'd say not low hanging fruit because it's very difficult and it's requiring a lot of effort and these are important customers.

But we're going after the biggest rock first. The biggest rock was the top spending customers and we're getting to the the other layers as we progress through the year.

And the only thing I'll add is the scalars and scalars plus they all look the same. These are the very similar looking customers. So that's the best news because now we can go and get and start working on this as Matt just talked about and get as many of them graduated into Scalars plus and keep expanding their share of wallet. And as we've been maintaining Mark, there's a tremendous, wallet share opportunity because they're all running [indiscernible] So that's a great opportunity for us to go earn the trust of these customers and get more of their workloads. Your next question comes from the line of Raimo Lenschow with Barclays.

Please go ahead.

Hey, thanks for squeezing me in. One simple one at the end.

How does the what do you see out in the market in terms of end to month, etcetera? And how is that helping you for this year? Ramon, I'm sorry. Could you repeat question? I didn't catch Oh, I was just asking for what did you see in terms of end demand Like if I look at the small business index, etcetera, that all starts looking better. Does that help you? Do you see the help coming there?

From that one? Or is that all neutral for you?

Yes. So, Raimo, thanks and nice to hear from you. From an end user demand perspective, we have not modeled any any major variation in our guidance or our plans. So we are expecting it to be stable and just like how it it has been over the last few quarters. And from our NDR improvement perspective, I mean, obviously, there's a lot that we have done to control our own destiny and own the right to keep our customers and keep them expanding on our platform But hopefully, the macro and the end user demand stays neutral to even positive, but we have not baked any of that into our projections.

Okay.

And ladies and gentlemen, that does conclude our question and answer session. And with that, that does conclude today's conference call. Thank you