Q4 2023 DigitalOcean Holdings Inc Earnings Call

Participants

Jason Noah Ader; Analyst; William Blair & Company LLC,

Gabriela Borges; Analyst; Goldman Sachs

Brad Reback; Analyst; Stifel

Raimo Lenschow; Analyst; Barclays Bank PLC

Joshua Baer; Analyst; Morgan Stanley

Pinjalim Bora; Analyst; J.P. Morgan

Timothy Horan; Analyst; Oppenheimer & Co. Inc.

Jim Fish; Analyst; Piper Sandler

Mike Cikos; Analyst; Needham & Company, LLC

Wamsi Mohan; Analyst; Bank of America

Presentation

Operator

Ladies and gentlemen, good afternoon. My name is Abby, and I will be your conference operator today. At this time, I would like to welcome everyone to the Digital ocean Fourth Quarter 2023 earnings conference call. (Operator instructions) Thank you and I will now turn the conference over to Mr. Rob Bradley, Vice President of Investor Relations.
You may begin.

Thank you have a good afternoon and thank you for joining us today to review Digital Solutions Fourth Quarter and Full Year 2023 financial results. With me on the call today, are paddy Srinivasan, our newly joined Chief Executive Officer, and Matt Stein for our Chief Financial Officer. After prepared remarks, we will open the call to a question and answer session before we begin, let me remind you that certain statements made on this call today may be considered forward-looking statements, which reflect management's best judgment based on currently available information. I refer specifically to discussion of our expectations and beliefs regarding our financial outlook for the first quarter and full year 2020 for our actual results may differ materially from those projected in these forward-looking statements. I direct your attention to the risk factors contained in the Company's annual report on Form 10-K filed with the SEC, and those referenced in today's press release that is posted to our website. Digital ocean 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. Reconciliations to the most directly comparable GAAP financial measures are also available in today's press release as well as an updated investor presentation that outlines the financial discussion in today's call. A webcast of today's call is also available on our website in the IR section, so that I'd like to turn the call over to Patti.

Thank you, Rob.
Good afternoon, and thank you for joining us today. I'm very excited to be here with you on my first call as the CEO of the solution, as today is my first opportunity to talk to you. I would like to start by sharing a bit about my background, why I was drawn to the digital solution opportunity before providing an overview of our priorities for 2024 and highlighting the focus I will bring to the company to start. I'm thrilled to be here at this solution, having worked my entire career in technology companies and having a professional arc that spans engineering, product management and C-level positions. They have a deep appreciation for the opportunity that this solution has in front of us and strongly believe, but I'm well positioned along with the video solution leadership team to help the company reach its full potential.
I started my career as a developer and spent my formative years of my career at Microsoft, where he worked on various products, including Windows Server, a variety of developer centric distributed technology, and finally, the Microsoft Office ServerAttach as they progress in the leadership ranks at Microsoft. I had hands-on experience building platforms aimed at developers working with independent software vendors and managing businesses with tens of millions of users from Microsoft. I move to Oracle to help launch its Asia R&D center focused on innovating products for the unique needs of that market. As an entrepreneur at Oracle, I picked up experience identifying market opportunities and developing platforms like mobile embedded databases with extremely small footprint and near real-time performance in a very low bandwidth network environment to meet those unique emerging market requirements.
After Oracle, I co-founded UPS data and application monitoring and managed cloud services platform. This experience again reinforced the importance of having a deep understanding of developer needs and using that to drive innovation as we work to keep up with the evolving needs of nearly 500 early adopter cloud companies, including most of Microsoft's top Azure customers at that time, following the successful sale of Sara, I spent the majority of the last decade at go to formerly known as LogMeIn SaaS Pioneer, delivering cloud-based software applications with a global footprint for the state of Amazon in between at LogMeIn I experienced Ten-X growth has picked up the Company from a little over $100 million at the time, I joined to over $1.3 billion in revenue through both organic and inorganic expansion. As part of this journey, my team build an Internet of Things platform, which was later acquired by Google to form the foundation of its IoT strategy after leaving for Amazon to be the General Manager of the data and machine learning platform that powers Solexa.
I will turn to go to assets, Chief Product and Technology Officer before ultimately taking over as CEO at LogMeIn and go-to, I picked up what it takes to build a product-led growth motion and augment it with a high velocity sales and customer success machine to attract, convert and expand hundreds of thousands of growing digital businesses at scale. All these roles and experiences have shaped my perspective and have nurtured my passion to understand customer needs, especially those of developers innovating on their behalf by anticipating their needs, running modern infrastructure platforms to support global scale products, building efficient customer acquisition and expansion engines and delivering value for all stakeholders, customers, employees and shareholders. I'm really looking forward to bringing these experiences focus and operating discipline.
So digital switching gears now there are few compelling reasons that drove me to join this solution, but three standout that I would like to share with all of you today. First is a market that digitalization is focused on the cloud computing market and especially the one that serves developers is one of the largest and fastest-growing markets in the history of technology. This market, consisting of infrastructure-as-a-service and platform-as-a-service is a $114 billion opportunity, which IDC is forecasting and forecasting to grow in excess of 23% through 2027. This growth should continue well beyond that timeframe.
As the market benefits from ongoing migrations to the cloud, acceleration of new business formation that cloud computing enables and the still very early impact of AI and machine learning and the new generation of applications that these capabilities are all ready unlocking in a variety of different industries.
Second reason is the strong position that this solution has in this market. Video is the cloud leader, focused on developers, startups and growing digital businesses. This solution has more than 640,000 customers, a global footprint with revenue in over 190 countries and serves customers across a wide range of industries and use cases. Our brand is beloved with a large and loyal developer community that leverages our extensive library of content, including tutorials, Q&A, product photos, video games and articles. This solution has carved out a compelling segment in this market, providing a simple and easy to use developer cloud for transparent and cost-effective billing and the level of support that small growing businesses will not get from the larger hyperscalers. This solution has also steadily expanded its array of offerings starting with core infrastructure as a service with its compute technology called droplets object and block storage and networking capacity with a global footprint to power our customers' apps and services. These are complemented and extended by platform-as-a-service products, including managed databases, managed Kubernetes, it platform and managed Casco for those customers that need to leverage high volumes of data streaming.
In addition to our core infrastructure and platform offerings with cloud base. We offer managed cloud hosting that is used to power digital agencies, e-commerce storefronts and a variety of other online businesses.
Finally, to take advantage of a generational technology shift. We acquired a leading AI machine learning application development platform paper space last year, increasing our addressable market and adding a very valuable growth lever. This further extends our platform by enabling developers to test, develop and deploy AI and machine learning centric cloud applications that harness the power of GPUs in ways that have been predominantly available only to large enterprises I just talked about the vast and growing market that digitalization is in the strong position we have with our platform and customers, our customer trust that we have learned over the years.
But now let me talk about the third compelling reason that drew me to this solution, the growth and value creation opportunity that is still ahead of us. This solution has the opportunity to reach even more developers and expand the services we provide to these customers, driving higher revenue growth while maintaining our strong profitability, enabling us to generate compelling investor returns the plan for achieving this growth centered on understanding and addressing the needs of developers as they build growing digital businesses, we will achieve our near term growth objective and position ourselves for higher sustainable long-term growth by focusing on these very specific growth levers. First, we are enhancing our platform with global load-balancing data resiliency, granular identity and access management, storage enhancements and many other new features that will enable our customers to operate and scale globally.
Number two, we are investing in both networks and infrastructure, providing increased diversity, lower latency and enhanced speed on our core IP backbone and edge to enhance the performance of our platform to benefit our customers and allow us to migrate more customer workloads from other providers onto our platform. On top of these product offerings and platform foundation, we will continue to expand our managed services offering to serve customers that want an assisted experience with robust scaling capabilities on our platform. As an example of this, just a few days ago, we announced autonomous, a new cloud-based offering that enables growing businesses to scale their hosting, meet dynamically without having to overinvest in infrastructure building or are building on our recent paper space acquisition. We are investing in our AI ML strategy to take advantage of this market opportunity by bringing simple, easy to use AI ML capabilities on both hardware and software to developers. Machine learning engineer an application builder across a broad range of business types as we have done successfully with our core digital ocean cloud services.
And finally, point number five is we will augment our durable self service customer acquisition model with direct sales and customer success motions to acquire, retain and expand customers and amplifying our reach through our vibrant partner ecosystem. For these reasons, I'm very excited to have joined digital ocean at this critical time of inflection company begins 2024 having weathered a challenging macro demand environment where like many large platform providers, top line growth slowed from historical highs, recognizing early in 2023, that near term growth could be pressure, we successfully accelerated the attainment of long-term target margins to build a durable cost structure that will generate attractive free cash flow with plans to improve net dollar retention or NDR through increased customer engagement and continued product innovation and driving higher growth opportunities across cloud base and our new AI ML platform, we are positioned to establish a foundation to deliver low double digit growth in 2024, while setting ourselves up for the future of finished by articulating the key focus areas that will be driving.
While I'm excited about the Company's long-term growth plans as CEO. I will leverage by product and engineering background and deep cloud experience to bring an elevated focus to two critical priorities in the short term product innovation and efficient go-to-market that we explain quickly. First and foremost, we will obsess over the developer experience on our platform. We will develop an intimate understanding of their needs, whether the use case is an SAP application deployment and scaling running the backend of web and mobile applications, game development for data streaming, e-commerce storefronts or education technology or any other workload. And we will be unrelenting in our quest to understand how to make their jobs easier and to be a critical part of their growth through our platform offerings. We will use this understanding to rapidly develop on our product road map, which includes several important enhancements in security, resiliency, performance, networking and storage, which are really critical to our customers scaling on our platform. We will also increase the pace of identification and development of new capabilities that will drive value to our customers and fuel our growth. Further, our ongoing investments in AI and machine learning capabilities is a perfect example of this. In addition to driving innovation, we will augment our best-in-class self service, our product-led growth customer acquisition engine with an effective high velocity sales and customer service engine to improve NDR by establishing a trusted relationship with our top customers, drive adoption and visibility into our other offerings in our platform and continue providing world-class support and community engagement that these customers have come to expect from digital solutions by obsessing over the developer experience and innovating on their behalf and enhancing our go-to-market. We will take advantage of the tremendous growth opportunity that is in front of us. Our aim is to cement our position in this $114 billion addressable market for infrastructure and platform as a service and be the foundation for developers at start-ups and growing digital businesses to rapidly build, deploy host and scale applications that change the world.
In conclusion, over the first several weeks as CEO. I'll spend the majority of my time meeting with customers, employees and investors to gather their feedback and sharpen our understanding of the market we serve. While we will continue incorporating this feedback into our ongoing plans and very confident confident in the immediate priorities that I just outlined. We will continue to invest in our key revenue growth drivers to achieve our 2024 plan and position the Company for further growth in 25 and beyond. We will obsess over the developer experience and focus on innovating to meet their evolving needs with platform innovation and Chris go to market initiatives. We will reignite growth in our core infrastructure and platform as a service offerings. We will leverage the strong margins in the core digital solution business to help fund investment in our strategic long-term bets like AI and machine learning centric cloud application development, we will maintain our long-term focus on increasing operating leverage and delivering attractive free cash flow margins, creating a compelling return for investors.
As you can tell, I'm very excited to be here at Digital ocean. I've got a very busy quarter ahead, but I'm really looking forward to meeting many of you in the upcoming months.
With that, I will now turn it over to Matt.

Thanks, Betty. It's great to have you on board. And I can tell you the entire digital ocean team and I are excited that you joined as CEO, and we're very much looking forward to working with you to achieve digitalizations enormous potential.
In my comments, I will review our Q4 results and cover the full year 2023 financial highlights before sharing our first quarter and full year 2024 financial outlook and our go-forward capital allocation strategy. Q4 2023 was a good finish to the year with revenue, adjusted EBITDA and net income per share. All exceeding the outlook that we have provided. Revenue was $181 million, which was up 11% year over year and was $3 million above the high end of our revenue outlook. This performance was driven by the stabilization of net dollar retention within our corporate business and strong execution on the cloud-based front. And we got some contribution from our recently acquired AI and machine learning solutions. We also delivered strong profitability as we continue to appropriately manage our investments, balancing investment for growth with efforts to improve operating efficiency in our core business, which resulted in adjusted EBITDA of $73 million, a 41% margin. Adjusted free cash flow was $29 million, representing 16% of revenue due to working capital timing and increased investments in our AI and ML capabilities.
In the fourth quarter, non-GAAP fully diluted net income per share was $0.44, which was up 57% year over year as we continue to successfully implement our strategy of increasing operating leverage while executing our ongoing share repurchase program. As Patti mentioned, and as it was for many players in the industry. 2023 was a challenging year with slowing revenue growth in the face of persistent macroeconomic headwinds. While top-line pressure lasted longer into 2023 than we had originally expected. We saw a bottoming of the headwinds in Q3 and with stable net dollar retention and steady growth in cloud ways. In the second half, we exceeded the revised full year revenue outlook for 2023, total revenue increased 20% year over year to $693 million. This growth came from over 18,000 new customers that joined our platform through our durable self-serve funnel. And that came from increased spending from existing customers as well as overall revenue per customer increased 6% year over year. Growth also came from the steady performance of our managed hosting platform cloud wins, which increased revenue to $80 million, growing 43% year over year and from our recently acquired paper space, AIML. products.
On the operating leverage front, acknowledging the growth headwinds early in 2023, we proactively accelerated our long-term margin profile, positioning the business to generate attractive free cash flow. Regardless of the economic growth environment, we successfully achieved that objective, increasing adjusted EBITDA margins from 35% in 2022 to 40% in 2023 and free cash flow margins from 13% in 2022 to 22% in 2023. We accomplished this through difficult, but necessary cost management of headcount as well as non-headcount related spend and by expanding our global workforce, setting ourselves up structurally to improve margins in our core business as we grow these strong margins in our core digital ocean platform enabled us to absorb paper space and invest in the generational growth opportunity that we see in AML, while still exceeding our full year profitability guidance.
Now I want to come back to the solid growth foundation that we have established as we launch into 2024. We have a high degree of confidence in achieving double digit growth on the back of several growth levers. First, we expect new customer revenue, which includes revenue growth from any customer that still in the first 12 months on our platform. That's incremental to the 2023 revenue to contribute 8% growth in 2024. But the majority of that growth coming from self-serve as we are still in the early innings of our direct and partnership motions.
Second, we continue to invest in our managed hosting capabilities, having, for example, recently launched our cloud-based autonomous service that you mentioned which enables customers to automatically scale their businesses on cloud waste. And we anticipate Con-Way's contributing two to three points of growth in 2022.
Third, our AI and machine learning solutions will be another key growth driver. We see tremendous long-term growth potential in the AI market, and we are increasing our investment in both operating expenses, adding engineering resources to advance our AI software platform and capital, adding incremental GPU capacity to take advantage of this opportunity. We recently announced initial availability of H. one hundreds and expect additional offerings and further capacity to come online over the course of 2024. We anticipate our AI ML solutions contributing 3% revenue growth in 2024.
Yes, our fourth and final major lever growth levers. Net dollar retention, as we have discussed, NDR declined over the course of 2023 with a bottoming and beginning in Q3 at 96% MBR as we lap the 2022 pricing. Ndr increased several basis points in Q4, but remained at 96% due to round. And we anticipate NDR continuing to improve as we move through 2024 as we're working aggressively to return NDR above 100% in the latter half of the year as an early indicator of our progress on this front in January, we saw increasing month-over-month growth in customer usage on the core digital ocean platform, and we're seeing similar higher usage growth trends in February as well.
With that context, I will now share our financial outlook for the quarter and for the year. For the first quarter of this year, we project revenue of $182 million to $183 million, with adjusted EBITDA margins of 37% to 38% and diluted net income per share of $0.37 to $0.39. As you may recall, we did not provide free cash flow guidance on a quarter by quarter basis, given it's heavily influenced by working capital. With that said, our 2024 plan is front loaded on capital as we navigate a constrained supply chain and build critical mass in our AI market capacity. So we expect free cash flow margin to dip in Q1 and then increase over the balance of the year. For the full year 2024, we project revenue between $755 million and $775 million which represents year-over-year double digit growth at the midpoint. This range takes into account the early stage of our AIML. offerings and the timing related risks of a constrained GPU supply chain, but it doesn't require any further improvements in the broader macro demand.
With our 2024 investments, we will see modest declines in both adjusted EBITDA and free cash flow margins as we invest to generate a higher growth trajectory as we exit 2020, adjusted EBITDA margin will be in the range of 37% to 38% for the year as improved margins from our core digital ocean platform are offset somewhat by increased investment in our AI ML capability. Non-gaap fully diluted net income per share for the full year will be in the range of $1.60 to $1.67. With our increased investments, we expect to invest north of about $50 million alone on the AI and ML machine learning capabilities. Free cash flow margin will be in the range of 19% to 21%. We strongly believe the potential growth opportunity of this new market warrants the near-term investment of one to three points of free cash flow.
Before concluding my remarks, I'd like to reiterate our long term capital allocation strategy, growing free cash flow per share remains our ultimate goal and what we believe is a primary shareholder value creation lever in that pursuit, we remain committed to driving top line growth with increasing operating leverage while continuing to execute a regular stock repurchase program to return capital to our shareholders. Together, we believe these priorities create a compelling return profile for investors.
On the buybacks front, the Board has approved a $140 million share repurchase authorization that we will execute over the next two years, utilizing the full repurchase authorization by the end of 2025. We made strong progress on our buyback program in 2023, repurchasing $488.5 million in stock and reducing our weighted average non-GAAP fully diluted shares by 11% year over year from $118 million to $105 million shares. Stock-based compensation expense also declined materially from 18% to 13% of revenue year over year.
With respect to leverage, we continue to believe that 2.5 to 3 times net leverage is an appropriate long-term target. And with our strong free cash flow generation anticipate being in the low threes by the end of 2024. Based on the guidance that we have provided today, we continue to benefit from the 1.5 zero-coupon convertible debt instrument that does not mature until December of 2026. With that said, we will manage and steadily reduce our net leverage over the remaining three years to ensure that we have an appropriate capital structure flexibility and could take advantage of the company's growth potential while increasing our levered free cash flow per share at attractive rates to close my remarks. The Company achieved a great deal in 2023 and is well positioned for profitable growth in 2024. We have a tremendous and expanding market opportunity and an actionable strategy to capitalize on with Patti. Now in the seat, we're eager to execute the plan and deliver strong results for our investors. Thank you again for your time today, and I'll now turn it over to the operator for your questions.

Question and Answer Session

Operator

(Operator instructions)
And we'll take our first question from Jason Ader with William Blair. Your line is open.

Jason Noah Ader

Yes, thank you. Good afternoon and welcome aboard. Paddy, I wanted to ask you just as you've I guess, I know we've been in the seat for a few weeks, but from your perspective and observing the business so far and talking to folks on, where do you see the low the lowest hanging fruit for the Company?

Yes.
Hello, Jason. Nice to talk to you and thank you for the welcome.
Yes, this is my day seven on the job. Last week, I spent the whole week in Boulder, Colorado with my management team. And I'm just taking stock of where we are and the plan ahead for 2024?
Yes, I don't want to comment on low hanging fruit. For me. Everything looks like a great targets two to accelerate our product road map. And as I was saying in my prepared remarks, it all starts with really understanding who our customers are and solving their challenges. So I'm super excited given the breadth of offerings we have the on how much our product is loved by our customer, the community engagement. All of these things are great foundation for us to build on.
And in terms of my priorities, as I outlined, it's really straightforward. There are two buckets of priorities. One is accelerating innovation and delivering on the product roadmap and there are several aspects of that, whether it is fortifying our core network capabilities and innovating on our infrastructure and platform as a service to the exciting world of AI, ML and everything in between. I think we have so much innovation to do. It's going to be super, super exciting.
And the second thing is the experience that I bring in from go to another places, which is how can we grow not only augment our product-led growth on engine that has gotten digital ocean to Wairakei, but drive positive NDR by really establishing a real, a great relationship with our top one thousands of customers, exposing them to the breadth of offerings that we have in our platform already and building a great drumbeat in terms of engaging with them and exposing them of all the great product capabilities that our teams are going to be rolling out. So all in all, I feel very energized by all of these opportunities. And of course, I'm going to be building a series of operational mechanisms to to ensure that we are looking at all these initiatives one by one and driving execution across the board. So I'm super excited to be here. And thanks for the question, Jason.

Jason Noah Ader

Yes, one quick follow up on just how long do you think it will take to see the return on some of these initiatives directed by 2025. But do you think we could see some actual some kind of material impact later this year? Just give us a sense of the time line that you're thinking about.

Yes, I think of many of these initiatives are going to be long running, but we will never be done with innovation or of fortifying and enhancing our performance, stability, security kind of thing. So I think a lot of these things are evergreen initiatives in terms of when you're going to start seeing results. I hope it is sooner rather than later.
In terms of the outlook that Matt laid out, I think it is a very appropriate outlook for the year given the year that we are coming off of and we will absolutely be laser focused on execution. So there's a great opportunity ahead of us and you can count on us to be very disciplined and come and be laser-focused on execution.

Jason Noah Ader

Thank you and good luck.

Operator

And we will take our next question from Gabriela Borges with Goldman Sachs.
Your line is open.

Gabriela, we can't hear you kidding.

Gabriela Borges

M&m.

Yes, yes.

Gabriela Borges

Okay. Great.
And clear, Patty, I want to pick up on the comments that Matt made about generating a higher growth trajectory exiting 2024. So Patty, either for you or from that, how do you think about what the sustainable growth rate is for this business and the sustainable margin profile that supports right?

Yes, Gabriela, thank you for your question and nice to meet you. So you're absolutely right.
My overall philosophy is to find the right balance between long-term growth and profitability I'm a firm believer in the concept of growth at a reasonable price with growth being the ultimate value driver for all of us. And you heard Matt talk about this right I don't want to put an exact exit trajectory growth rate. I think it is too early for me to do that. But given where our core market is and where our developer customers are going. I think there is a tremendous opportunity in front of us in terms of participating in the AI ML market and make the right responsible investments to help us accelerate our growth going into next year and beyond. I think you will find us be very active and busy in our product road map, not just on the AML front, but also you saw just in the last few days we announced on the auto scaling capability of cloud-based call autonomous. You will start seeing a string of announcements and string of releases on our core infrastructure and platform as a service offerings. So I think our job is to focus on delivering for our developer customers. And then once we do that and we become very disciplined at doing that. I think the rest is going to take care of itself. There's no shortage of growth opportunities here, right? There's just so many different problems that developers face today that I'm super excited to start solving in. And I think it's a it's really setting ourselves up for the future. And I think we have the luxury of having such a strong foundational, our financial profile to be able to make some quick and thoughtful calibrated investments to help us are lay the right foundation for next year and beyond.

Gabriela Borges

Okay.
That makes sense. And then the follow-up I have is a strategy question on how you think about a I know if I were to oversimplify and think about digital solutions value proposition. So much of it is tied to the bread and butter offerings, the ease of use, the getting SMBs and developers off the ground with straightforward configuration and invisibility help me understand where animals fits into that. How do I reconcile the classic value proposition? Have simplicity with something that could arguably much more sophisticated, much more sophisticated and target, perhaps a different customer set from WAVE traditionally participated.

Yes. It's a great question, Gabriela. And that's one of the main reasons why I was so excited to come here and work a bit solution because I feel like the rest of the market is just up making a lot more complicated than it needs to be. And I'm a fundamental believer that the future of any kind of application development arm on the cloud is going to be AI and ML centric for the years to come by. I've had a lot of background in the last few years, both at go to as well as at Amazon.
And I'm a firm believer that we are in the very early innings in this space.
And to your point about, hey, this is a market for very sophisticated developers. That's because everyone is talking about large language models and the the GPU forms that you need to power them. But I believe that there's a lot more to this than just dumb building and training elements. So there's obviously a hardware part to it, but I think the power of this is again, going to default back to software.
That's where the magic is going to happen. And we at this location firmly believe that the durable competitive differentiator for us long term is going to be in the software layer.
And you rightly mentioned that developers are finding it extraordinarily hard to say, okay, where do I believe where do I start my AI ML application development from should I build a model for a train a model? What is fine tuning? What is our ag? Just so many buzzwords in the market today, we have a phenomenal opportunity to do what digital Motion's founding principle was, which is deliver the best cloud computing experience for developers so that they can forget about the infrastructure and worry about the software that is going to change what we have that exact opportunity to do it in AML. And we are going to unleash the same playbook in a different domain of AML and so having said that, I feel the paper space acquisition is very strategic to us. The gradient experience, and I personally played around with gradient over the last few weeks. It is phenomenal. This is exactly what the market is missing today. And we have a lot of work to do to integrate and we are very busy doing that integration between the gradient of experience and the core solution offerings. But as I said, this is super early innings in the world of AI ML despite all the hype cycle. So I think this is an opportunity that we are in the very early innings of. And I feel super energized that this is exactly in the wheelhouse of digitalization and every app developer in the world that is going to build a cloud application will have to consume it and make sense of the complex AI machine learning landscape today. And that's a great opportunity for us to add value to them.

Operator

Brad Reback with Stifel. Your line is open and Great.

Brad Reback

Thanks very much, Patty, given everything you just laid out there around the opportunity, why not invest more and faster, especially given some of the people you're competing against or investing on?
First, some that we've never seen before?

Yes. Thank you, Brad, for the question. That is a really important question. So I'll start and then I would love for Matt to give us a little bit of color as well, as I said, Matt Blatt, it is very early innings, right? So and I've only been here for a week so on I think the our strategy that we have is a very responsible strategy that balances the right mix of investing for our future while not being carried or getting carried away by the hype cycle of today. And as I said, our long-term competitive differentiator is going to be in the software experience we provide to the developers and we absolutely have to invest responsibly in the hardware that powers this experience but we have to be careful not to go to trial and become a hardware provider, which is not our long-term strategy, but we have to find the right balance. And I am a firm believer that we are going to be very focused on looking at our value proposition, how developers are consuming our services, and we have the ability to calibrate the investment as we go along the year. So that's those are my early thoughts.
But Matt, why don't you chime in, but

I completely agree that it's a very similar model to the model that we have versus the hyperscalers today. I mean, we have a very small footprint of locations and a very small capital budget relative to any of the three hyperscalers I mean, it's because we target a different market that doesn't require that level of sophistication or that level of scale. And then what you're seeing when you see a lot of these companies raising a massive dollars there. They're basically just providing bare metal solutions is renting the GPUs. And in some case running into the hyperscalers, that's not a model that will ever compete and at scale, it's just we won't have the cost structure for that. What we do have is what Pat described is we have differentiation in the target market and we have differentiation in the software layer, and that's where we're going to devote our there are investments. So we're investing more in R&D and in the software layer, and we clearly need GPU capacity. And as I said, we'll spend $50 million this year in GP. alone for 2024, which is a big third of our capital budget. And that's an appropriate amount. I think given that done, we think that we're taking a slightly different angle that we think is perhaps some I don't say more durable, but it's certainly got a long, a lot of legs from our perspective, and we see a lot of long-term growth potential in that strategy.

Brad Reback

That's great. And then just one quick follow up, Matt, it may be sort of splitting hairs, but the cloud weighs contribution, I think you said 2% to 3% for next year. I believe last quarter you put it at 3% so any specific changes there or is it just rounding things?

It's right. It's just rounding. We I'm we were, as you would expect, coming out of the year. We wanted to establish a baseline growth rate that we and everyone can count on, and we're going to build from there. And we've tried to be real clear on that, and we're not expecting any kind of major recoveries in the market. So when you look at the exit growth rates of the various businesses and products we have, that's kind of what you get and done. And again, the NDR that's assumed in the and the guide is we're not assuming any macro improvement that all the MBR improvement that we have, which is still not much it's we won't we won't get in the baseline plan to above 100 in our latter part of the year. It's all tied to discrete products and initiatives that we're driving So I'd just say it's it's there's no no message in that number. It's a little bit of rounding, and it's based on the December's exit run rates that we're seeing.

Brad Reback

Perfect thank you very much, Kevin.

Operator

We'll take our next question from Raimo Lenschow with Barclays. Your line is open.

Raimo Lenschow

Thank you and all the best for me as well.
Terry, I just wanted to ask more about expansion into new areas and how you think about that. I mean, if you look at the last few quarters, it was more and over M&A to get you into a deeper speeds and cloud-based, et cetera, like how do you think about that balance of kind of having internal product development? And you talked and you've been at AWS and Microsoft versus kind of buying expertise from the outside.
Can you just talk speak to that, please?
Thank you.

Yes, hello, Raimo.
So nice to be here. And I think my fellow AFFAIRS. We have to do both in a market that is evolving quickly and I don't want to make make this sound like it is all about AI ML. I think we have a lot of core innovation left, both in our infrastructure platform as a service as well as in our cloud-based hosting offering. I think we have a lot of innovation left within the core digital solution. And also, as I mentioned, we are still building the bridge between creating an experience at paper space and the close and the core deal offering. So we have enough to keep us very busy organically. But as you would expect, we are on very diligent in scanning the landscape, whether it is to buy talent as you're talking about or buy new capabilities, which our customers will appreciate on expand from a geographical footprint perspective, there's so many dimensions that we could add inorganic capabilities into our into our offering. So I'm super excited and having the financial structure that we have gives us the opportunity to make the right responsible bets to accelerate our growth.

Raimo Lenschow

Okay, perfect. Thank you.
And And Matt, one for you.
And if you think about the environment out there, you mentioned in your plans, there's no assumption of things getting better. But if you think about the linearity in the quarter and the different geographies as well as what has been your observation this quarter? Thank you.

Yes, so yes, it's again, one of the things I love about this business is how Joe the lack of concentration we have in any vertical or in any industry or use case or country. And so we're pretty diversified on that front. And we haven't seen any kind of one sector region performing materially different than the rest. But what I would say is while that the NDR was still 96% in the fourth quarter, we are seeing increased usage in the core DO platform, and we saw that continue into January. It's continued into February, and we're seeing we are seeing signs of that, like we said, we expect NDR to improve over the course of the year, and we're seeing good leading indicators at this point as customers are starting picked up their activity on the core video platform itself, which is has been kind of the real headwind of growth over the last several quarters.

Raimo Lenschow

Thank you.

Operator

We'll take our next question from Patrick Walravens with Citizens' JMP. Your line is open.

Well, great. Thank you. And let me add my congratulations, Patti. So my question is really basic. What is your philosophy and leadership and

Patrick, thank you for your question.
So my philosophy leadership, all starts with the customers we serve. I think our purpose of existence as a company is to serve our customers and if we do that well, and if we understand their needs and we deliver at a group face and solve their cup of problems, I think the rest is going to take care of itself. And I think as I mentioned, those are the couple of things that really excite me here. It's a large market and we already have a very, very strong foundation. And it is a market in which our core customers, which are the developers have an emerging set of very complex problems that are worth solving for. So my leadership philosophy starts with that. Number two is we need to have pure tech business. So our technology has to be world-class. So that's something that I'm going to be super focused on a number three years. Technology has to come from world-class people. World-class technology should come from world-class people. I've been very impressed with the caliber of talent we have here at DISH lotion tool, and we are really excited to get to work. And in my job as the CEO is to A., help us understand our customers very deeply and be put the right people in the right jobs to deliver innovation to help take care of our customers. So hopefully, that gives you an answer, which is not super flat, fluffy or high level but you will hopefully I will come back up these things over the next several quarters with data and with product innovation and some in delivery that backs up my leadership principles.

Thank you.

Operator

And we'll take our next question from Josh fair with Morgan Stanley. Your line is open.

Joshua Baer

Great.
Thanks for the question, and welcome, Paddy.
I was hoping you could give an update on the revenue composition between products, like how much mix is droplets or infrastructure as a service versus platform as a service, what products are contributing most in the platform and I guess I'm wondering if with the net retention rate below 100, like looking at the average revenue per customer, if some of the adoption of multiple products is sort of masked by lower consumption overall bringing that average revenue per per customer, keeping that more modest growth?

Hey, Josh, it's Matt. The yes, we don't disclose the mix of Xi has hasn't has solutions like that. I'd tell you is that the path solutions are growing faster than the core kind of infrastructure as a service offerings. So database and some of the other products and Kubernetes laser are all growing at a more rapid clip than is the core kind of droplet and compute business. And that's so the take rate of those services is that is very healthy. I think when you see that, again, the big driver in the MDR challenges that we've had has been, as I've said, multiple times on our last several calls, its expansion has slowed, right that the churn has not James. It's right around where it was even a year ago. That contraction is a little bit elevated, but it's been fairly stable over the last now seven, eight months where we saw the most pressure year over year last year was in expansion and that expansion was the customers' own businesses just weren't growing as fast.
And so they didn't need more compute.
And so we didn't see as much growth in the core kind of droplet part of the business. And so I think that done, I'm very excited by the product roadmap that we have. And with Patti coming on the ability to even more focus on driving adoption and increase them kind of take rate of our existing products into the into the installed base. Most of the headwind that we've seen though has been in kind of the just the core droplet core compute.

Joshua Baer

Great.
And just wondering on Patty, if you're thinking about all the opportunity in front of you all the growth levers, levers available to you, how are you thinking about potential for future pricing increases over the medium term.
And Matt, just wondering in your breakdown of growth drivers for the year, is there any contribution from pricing embedded in those different categories

Yes. Hey, Josh. I mean, there is no factored in price increase as part of our outlook. And just my philosophy is we will continue to have packaging changes and lineup changes and we will introduce new products and premium capabilities and things like that, but nothing which is on which is already baked into our outlook for this year. And my philosophy is we'll continue. We have to innovate and and trial new packages and different thresholds and things like that. So it's a it's an ongoing thing. And as with any other technology vendor on, we will pay close attention to what our customers are asking for. So at sum, that's my overarching philosophy.

Joshua Baer

Perfect.
Yes.

Operator

And we will take our next question from Pinjalim Bora with JPMorgan. Your line is open.

Pinjalim Bora

Great. Thanks for taking the questions, and welcome, Barry.
Just a two-part one question on paper space. Anyway to understand kind of the adoption of the ML Ops platform versus the iOS side of paper space. Is the ML Ops platform landing with customers? Are they using that more versus DI side of things? And Matt, maybe help us understand your I think assuming about $6 million from paper space this year, was that did that land at that point about $6 million or was it more?
It started off?

Thanks, Ben, for the most part, it's Matt with the latter question. Yes, we came in, right exactly what we had expected. We had signaled, I think, around $5 million and we came in around $6 million for the year. And clearly on a IRR basis, it's higher than that. That was just the last six months of the year. And we think that again, that that business should give us three points of growth on the entire business. So it's still it's more than doubling on an ARR basis over the course of as of this year.
And to answer your first part of your question on doing, I think it is a mix of both, right? So the Michilla, the ML Ops platform, nice and steady dose of infrastructure. And as we go into this year, as we start bringing the two platforms closer together, we expect a lot of our ARM paper space, our AI ML customers to start consuming more of the dislocation compute capabilities as well. So it's still early days. It's a little arm. So there are customers that are very heavy users of data. The AML stack and they might use a little bit of compute on an as needed basis. But then there are other customers who are who are in a steady-state inferencing on type of workload. So it is still a little training heavy, as you would expect, given the nature of what customers are on our trying to do with the ML. and many of our customers are in core use cases like tax to image generation or text to video generation and those kinds of things. So it's a very heavy on training oriented mode where it has a lot more of the the AI machine learning ops on marshaling data, getting the data set organized and just start training. The data set is what we are seeing a lot more of now, but once you get to the steady state is where the spillover to the compute side is about to happen in the infant stage. So that's why we are getting I'm ready with our integration of the core deal infrastructure.

Pinjalim Bora

Thank you.

Operator

And we'll take our next question from Tim Horan with Oppenheimer. Your line is open.

Timothy Horan

I think slowed.
Just a few clarifications about, as you said, $50 million on GPUs this year, it's one-third or so. Are you guiding to CapEx closer to $150 million for the year?
If so, how does that square with 20% free cash flow margins?
Or maybe I'm just missing some adjustments and a can you just give us some color on the outlook, the demand for GPUs, you know, how confident are you that you can now utilize that $50 million in GPUs?

Yes.
So the guide for the year for free cash flow is 19% to 21%. So going to 20% in the middle, the is consistent with that. We're not guiding to the CapEx. I gave you general parameters on it so you can kind of sorted out but done. And we're pretty confident in our ability to hit that 19% to 21% free cash flow margin as we demonstrated this year, we had the opportunity to drive material kind of leverage in the core DO platform, and we can use that to offset that incremental investments that we're making in both OpEx and CapEx in in the paper space business from a demand standpoint. And this gets back to the pendulum question before, which is why did we exceed what we thought we would do in them and revenue for for AML in 23. Part of this is a supply constraint. So you have to order the gear six, nine months in advance to be able to get GPU capacity. And even when you do that, the vendors and these are major kind of Tier one distributors, not them not the kind of small shops even then they can't guarantee that you get it all and you get it all at the right time and you get it out with all the right parts. And so there's there's more of us. It's more of a supply challenge right now. To be honest with you, the demand challenges I can get at, can we get it installed and get it up and running. And we're also, again, very focused on the software side of things, which is an integration that we're doing with the between our platforms. And so it's we're not worried at all about the demand. We're worried about how quickly we can get it turned up and available. And when you're starting again, a business from the small size that when we acquired paper space. And if you turn something up two months later in the month than you had anticipated, that's a big hit on the in-year revenue, which we're not fussed about. But that's why we're, I think, being conservative in terms of the amount of revenue that we're going to drive off that capital in 2024.

Timothy Horan

And then, Patrick, can you and all the due diligence you did.
Can you talk about who you think your primary competitors are, you know, Akamai acquired loan note and they seem to be more focused in R&D and enterprise and SMB, do you think competitive intensity is decreasing? Or do you expect that to or expected to increase?

Yes, that's a good observation. So yes, I think the competitors are who all of you can get slight. And I feel when we are looking at our arm, our competitive posture, I am always I have a very healthy dose of Founder's paranoia on. So I feel like every dollar has to be earned, every customer has to be earned. So we will go with the assumption that all of our competitors are fiercely coming after our customers. So I think that's really the way I like to operate and push our teams to make sure that our innovation, Arm A., outpaces our competition and also our delivers in terms of ease of use and the ability of our platform to our stand on its own and impress our customers. So yes, Akamai's note, I have also heard what you just said, but that's not to say that they might not change their strategy in the next few quarters. So we like to operate or I like to operate with that philosophy. So And same thing for AML at some point, everyone is throwing the kitchen sink at this problem. But as Matt and I have been repeating ourselves over the last hour, I will focus on. Yes, hardware is an essential means to an end, but our long-term durable differentiator is going to be on the software side.

Operator

And we will take our question from Jim Fish with Piper Sandler. Your line is open.

Jim Fish

Hey, this is Quinton on for Jim Fish. Thanks for taking my question. And Patty look forward to working with you and Patty, maybe for you, you talked about a focus on augmenting this self-service motion, investing more in a direct customer relationship. Is that something that's going to require a further increase in the sales rep headcount as we look to 2024? Or is it more of a rebalance of the existing resources within the sales team?

Yes. So it is so it's all factored into the outlook that Matt gave on. So yes, it is a rebalance and we are not talking about building an army of salespeople, right? So our customers are developers. And we have to this is again going back to my core philosophy of we really need to be our world-class in understanding our customers and their preferences and how they want to be reached. And so we're not going to start dialing for dollars and call our customers day in and day out. That's not what I'm talking about it out, but there are customers that are reaching a certain point in time of sophistication and requirement from our platform, which is required on the platform to be to be rich. Number two is a careful customer success and ongoing relationship to make sure that they are getting the best value from our platform. And many of our customers don't even know the breadth of our how much we have evolved since they started their journey with us. So I think it's a great opportunity for us to wave the flag and make sure that we are engaging with them in a very scaled manner. So on and also using our technology to make sure that we are establishing that relationship at the right time with the right set of tools to raise the visibility and offer them help on an updated basis.
Matt, I don't know if you wanted to add any color on the actual expense outlay.

So you know, that that is the plan we have already factored in the refactoring and kind of investment in the sales marketing into which part of the guide.

Jim Fish

Very helpful.
Then maybe a quick follow up on that. I think for you, we've talked about in the past crypto being a headwind to top line. We've seen a little bit of improvement in the underlying pricing has that correlated to any sort of return in usage on the platform? Or maybe what are you seeing from that specific vertical?

Yes.
We've we looked exactly at that for the reasons that you described. And we haven't seen nearly the kind of surge that we had seen in the past that we are seeing, as I said, more usage on the platform and and we we saw increasing kind of usage patterns in January. We're seeing that an increase in February, but it's not coming disproportionately from crypto as we had said previously, last year, crypto was down like 2% of revenue. So it's not a it's not it by itself a needle mover at this point.

Jim Fish

Appreciate it.
Thank you.

Operator

And we will take our next question from Mike Cikos with Needham & Co., your line is open.

Mike Cikos

Hey, thanks for getting me on and taking the questions here, guys. I wanted to start first, I know that you guys are talking to some of these investments in direct sales and customer success. Wanted to get a sense here. Could you remind us what is the time to maturity for these reps? And also what's the profile of the customer that you're looking to invest in as partners taking them through the solution to increase attach rates or better serve those customers.

So yes, so first of all, it's not that we are starting from a clean slate. So we do have people in roles that are already engaging with the customers both on the customer success side and sales perspective. So I'm I'm too new to answer your question in terms of what the ramp-up time is going to be for new reps but I just wanted to make sure that I'm not inadvertently signaling that all we have to start from scratch and nobody nobody has thought about this so far in the company so in terms of from just on and the types of customers will go after, it's both a looking at the top arm consumers of our platform with an implicit a nod to the fact that the more you consume the more and you would want to have a trusted relationship with your biggest platform provider. So that's one.
Number two is we are also investing in it. We already have technologies that we have invested in that gives us great visibility into customers, and that are about to hit a certain threshold of usage and consumption that we can get ahead of and be proactive in in building a relationship with. So that's a more of a technology enabled engagement, if you will, to augment on building this relationship to drive expansion and reduce churn with some of our top consuming customers.

And I would add that the third kind of leg of that is as customers and we get millions of visitors to our site every every month and in tens of thousands of those sign up as customers and three, three, four months later, you get kind of shakeout which ones are viable customers and which ones are grow. And part of that sales motion is taking those customers as they come on and trying to figure out which ones have growth potential and is it made they may only be spending a little bit as they're dabbling with our platform, but they might be a part of a bigger company and there's a bigger workload that they could they could bring. And so part of that go-to-market motion is triaging those customers and figuring out which ones are the higher value prospects. And then making sure that you're you're disproportionately helping them through the onboarding and trying to understand what their potential is.

Mike Cikos

Understood.
Thank you for that, guys. And for the follow up, I know last quarter, Matt, you had given us some great parameters around that retention. I remember and churn had been relatively stable at 12%. Contraction had improved entering the quarter as the September quarter at 16% and you exited at 15% based on your comments today. Is it fair to assume that churn and contraction were stable and then the big overhang on that 96% are we're seeing today really ties to the expansion rates.
Yes, that's what I consider.

No, no, yes, I think you've got it. I mean, it's just frustrating because it's a rounding. But then we actually saw improvements in all three over the course of if you look at like June, July to January, it's actually a it's a much better than it appears improvement. Part of the problem is the way we define NDR. It's averaged over the month. So it's the July. The third quarter number was the average of July, August, September and the fourth quarter numbers, the average of the three months. But if you look at the actual months, which you can't because we don't disclose that, but there's actually more kind of steady progress. It's still modest. So it's clearly it's rounding as an issue. It's not massive improvements, but we have modest progress on each of the three dimensions over that period. And as I said, January is that was strong and a month in terms of usage and DR for the month of February is looking good as well so I'm I'm confident that it will continue to steadily go up and I would expect it to go up at a faster clip than clearly what it did in the third to fourth quarter.

Mike Cikos

Makes sense.
Thank you for the color there, Matt, and look forward to working with you as well.
Patti?

Thank you, Mike.

Operator

And we will take our final question from Wamsi Mohan with Bank of America. Your line is open.

Wamsi Mohan

I thank you so much, Patty. Congrats on the role. I look forward to working with you as well. You can imagine focus on product innovation and enhancing developer experience. But as Matt mentioned, you have your very diversified customer base. So how are you thinking about prioritizing across these use cases you know, you mentioned several including in SaaS or back end of that game development e-commerce. How much of those? And is there a specific and maybe intersection of that with the product road map that you mentioned between security, resiliency, storage, networking, et cetera, that really stands out or jumps out as the area that you would tackle first? Or how are you thinking about prioritizing these.

Hi, Wamsi. Very nice to meet you and look forward to working with you again. I think in terms of the on the workloads themselves and the workloads might be very diverse. Yes, you are right, but are the core capabilities that most of these workloads need are fairly finite. So you have the core network, core compute, different types of storage and even in AI and machine learning, then it's a very finite number of work of capabilities that they need to power, whether it is a classification type of on a workload or a large language model or any any other type of AI, machine learning workload?
It is about making sure you have the data curation right and figure out the data pipeline and you have the right training and right inference on infrastructure. So I feel fairly confident having dug into some of the platform capabilities that we have and also spend a bulk of my time last week are going into the customer feedback and looking at some of what our customers have been asking us for. I think the priorities are on our very overlapping between these workloads. So I think if and I think we have enough to keep us super busy over the next several quarters in terms of product innovation and the prioritization of the roadmap. And I think most of what we are going to be doing and most of what we have actually released, like, for example, I mentioned the cloud-based autonomous functionality, regardless of whether you're an e-commerce store or any other kind of posting customer NAM auto scaling and sophisticated rules-based configuration are universal more or less. So I feel fairly confident that our innovation is going to impact multiple customers across different workloads. So as we go along, I'm pretty sure that we will find ways by which we can accelerate our specific workloads as we get into the later part of this year. But I feel fairly confident that we have a robust road map that addresses a broad set of functionality.

Wamsi Mohan

Okay, thanks that is helpful. As a follow-up, Matt, the incremental quarter on quarter growth of learners and builder seems to have decelerated a bit in Q4. How are you thinking about the trajectory of growth and customers over the over the next few quarters, just directionally come in over the course of the year, maybe?

Yes, that's a good question, Wamsi. I'd say one of the things that I've been paying attention to is the incremental ARR. Clearly, I'm looking at the customer count. I'm less worried about the customer count because it's such a broad set of customers that we have. And again, churn is not a factor. So I feel like there's a lot of opportunity for us to accelerate the growth of the customer base and as we drive them these new capabilities into the market and turning to our platform. That's where we're assuming the growth comes from that, not that we suddenly drive tons and tons of new customers on the platform. It's more growing the existing customers. But when you look at the ARR growth and you take out paper space from the third quarter, clearly the first and the second quarter, we're really light in terms of incremental ARR growth. But then in third and fourth quarter, we got back to closer to kind of historical levels at that time at around $18 million in incremental ARR, excluding what we picked up from paper space in the third quarter, $17 million in the fourth quarter and with the increase in usage that we're seeing. It's not again, it's not being driven by we have tons of more new customers is because the customers we have are starting to spend more. That's what is giving us optimism as we we go into the beginning of this year.

Wamsi Mohan

Yes.
Thank you so much.

Operator

And there are no further questions at this time. I will now turn the call back to Mr. Patti Srinivas for closing remarks.

Thank you all for your time and really excellent questions and great engagement.
As you can tell, I'm super excited to roll up my sleeves and get to work lot of great opportunities to innovate, enhance our product offerings and really augment our great product-led growth motion.
I'm looking forward to working with all of you and meeting many of you over the next few months. Thanks and have a good rest of the day.

Operator

And ladies and gentlemen, this concludes today's call and we thank you for your participation. You may now.