Dropbox, Inc. (NASDAQ:DBX) Q3 2023 Earnings Call Transcript
Dropbox, Inc. (NASDAQ:DBX) Q3 2023 Earnings Call Transcript November 2, 2023
Dropbox, Inc. beats earnings expectations. Reported EPS is $0.56, expectations were $0.48.
Operator: Good afternoon, ladies and gentlemen, thank you for joining Dropbox's Third Quarter 2023 Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask a question. [Operator Instructions] As a reminder, this conference call is being recorded and will be available for replay from the Investor Relations section of Dropbox's website following this call. I will now turn the call over to Karan Kapoor, Head of Investor Relations for Dropbox. Mr. Kapoor, please go ahead.
Karan Kapoor: Thank you. Good afternoon, and welcome to Dropbox's third quarter 2023 earnings call. Before we get started, I'd like to remind you that our remarks today will include forward-looking statements, such as our financial guidance and expectations, including our long-term objectives and forecast for our fourth quarter and fiscal year 2023, and our expectations regarding our revenue growth, profitability, operating margin, and free-cash flow, as well as our expectations regarding our business, assets, products, strategies, technology, employees, users, demand, industry trends and the macroeconomic environment. These statements are subject to risks and uncertainties that could cause actual results to differ materially.
They are also based on assumptions as of today and we undertake no obligation to update them as a result of new information or future events. Factors and risks that could cause our actual results to differ materially from these forward-looking statements are set forth in today's earnings release and in our quarterly report on Form 10-Q filed with the SEC. We'll also discuss non-GAAP financial measures, which are not prepared in accordance with Generally Accepted Accounting Principles. A reconciliation of GAAP and non-GAAP results is provided in our earnings release and on our website at investors.dropbox.com. I would now like to turn the call over to Dropbox's Chief Financial Officer, Tim Regan. Tim?
Tim Regan: Thanks, Karan, and good afternoon. Before I begin, I wanted to let everyone know that I'll be filling in for Drew today, because he and his wife Erin just welcomed their first child, Charlie, this week. So big congratulations and well wishes to Drew and his family. I'll first provide an update on our company strategy and share some recent product highlights before moving on to our Q3 results and guidance for the rest of the year. I will also offer some commentary to help you think about our 2024 outlook. While we continue to navigate an uncertain economic climate, we beat our revenue guidance, driven by strengths within our individual SKUs for the second straight quarter. And we again drove better than expected profitability.
However, we continue to see pressure across our Teams' customers and document workflow businesses, including seasonal softness within FormSwift. As we approach the end of 2023, I want to quickly provide an update on our company strategy. As you recall, earlier in the year, we simplified our focus around two main business objectives. The first is building AI-powered product experiences centered around organizing all cloud content. Starting with the introduction of Dropbox Dash, a standalone universal search product leveraging AI and machine learning. And the second objective is continuing to evolve our core File Sync and Share offering, integrating AI and other improvements in order to provide a more seamless product experience for customers workflows.
We first discussed this refocus strategy after we took actions in Q2 to realign our workforce in order to run a more efficient core business, while investing more towards longer-term AI product initiatives. We're pleased with how our teams have taken these changes in stride and how, as a company, we're able to look ahead with a unified product vision, while staying focused on responsible resource allocation. Now moving on to some of the recent progress we've made building our AI product portfolio. As a reminder, in June we introduced our first generation of products, including Dropbox Dash and Dropbox AI. I'll focus on Dropbox Dash as this represents our first major product launch within our next generation of AI powered products. And we see this opening a new market opportunity of universal search.
Drew has talked for a while about the growing challenge of fragmented content in this new world of distributed work. Last month, we met with hundreds of customers in New York, and many echoed the same pain points around organizing their work. And we believe we're in a good position to solve these new problems with our scale and platform neutrality. We also see the shift from files and folders, along with recent advancements in AI, giving way to new market opportunities. In particular, the search and knowledge discovery software market. IDC sizes this as a $7 billion market today that's expected to triple over the next four years. And we believe we're well positioned to take part in this secular wave with Dropbox Dash. As a reminder, Dropbox Dash leverages AI, while connecting your cloud tools, apps, and content into a single search bar.
It allows users to quickly find everything in one place, whether that content is pulled from Microsoft Outlook or Google Workspace or Asana. And because Dash is powered by machine learning, it learns about you and your priorities the more you use it. Since introducing Dash into closed beta over the summer, we've carefully rolled out the product to a select group of users in order to observe customer engagement and test our scaling capabilities. In the first few months, we've learned valuable insights from users and iterated on the product in a number of ways to address their top pain points. For example, we noticed users experiencing friction during the onboarding process and many were not initially establishing connected apps to work within Dash.
We rolled out a new web-based onboarding experience, reducing the number of steps in the sign-up process and made it easier to add connected apps. Since revamping this onboarding flow, we've seen a significant increase in the number of users who adopt at least one connected app versus before. We've also seen improvement in overall user retention. We've also significantly improved our search quality. We're currently rolling out semantic search functionality, which processes intent and context behind the search query to deliver more relevant results. Early feedback from this role has been positive as users previously had to rely more on using exact wording to find the right piece of content. And lastly, we're continuing to make stacks more intuitive for users to create and share.
As a reminder, stacks are smart collections for links that offer a quick way to save, organize, and retrieve URLs. Just like playlists organize songs, stacks organize URLs in a way that's easy to group by topic and share with colleagues. Adding more adoption of stacks is an important part of our strategy with Dash. As we found that users who add more links to a stack have higher retention profiles than those that don't. As we continue to evolve Dropbox Dash, we'll be investing more in sales and marketing to drive user education and distribution. And we also see an opportunity to sell Dash to Teams customers who are grappling with even more information overload and complexity. This is where we're also making sure we build Dash with security and transparency in mind.
We recognize in the rapidly evolving world of AI, customers are looking for tools they can trust to keep their content safe. This is why we're building in the right controls, admin and compliance features so customers can feel safe deploying Dash, whether they're a small team or a large organization. We're encouraged by the early progress with Dash, which is now in open beta. We've seen growth in the number of weekly engaged users since we removed the wait list last month, and we continue to observe healthy activation and retention rates with roughly half of the users returning to use the product within one to two weeks of first activating. Our near-term focus is continuing to improve the product and growing the user base before we plan to launch Dash into GA in the earlier part of 2024.
We believe our value proposition is resonating with customers and we're excited for the long-term potential for Dash. Moving on to our second objective, evolving the existing Dropbox File Sync and Share user experience to seamlessly address customer workflows around documents and videos. For years, we've been adding functionality within Dropbox through organic and acquired assets so that our users can do more with their content beyond storage, whether it's signing documents or creating and editing videos. These capabilities are even more important in today's era of distributed work. We've often heard from our customers that they were unaware of everything we offered, or they had a difficult time discovering new functionality within Dropbox.
It was clear we needed to modernize and simplify the web experience. That's why at our customer event last month, we announced an entirely new and intuitive web experience that helps users stay productive. Whether it's editing a PDF, recording a video message for a team, or tracking a proposal sent to a client, the web redesign makes it easier for users to access the right tools at the right time. With an adaptive interface, the view changes based on what users are working on, such as a dedicated tab focused on e-signatures. With a number of these capabilities integrated more seamlessly, users can avoid having to switch between apps. With our web redesign, we also saw an opportunity to refresh our business plans, making it easier for customers to discover all the value Dropbox can provide to them directly from our plans page.
Previously, we sold some of our additional capabilities with select plans, like our e-signature and professional plan package, but as two separate products, the end user experience was disjointed and difficult to navigate. It was also confusing for self-serve customers looking for more than just storage to discover how they could purchase the right plan for them. I'm excited to announce that we've rolled out the first generation of our fully integrated bundled offerings for new customers, and we've updated pricing and packaging to reflect the added value, including capabilities such as e-signature, tracking analytics, and PDF editing. These new offerings are Dropbox Essential for solo professionals, Dropbox Business for small teams, and Dropbox Business Plus for larger teams.
More details of each plan can be found on our website. as well as in our investor presentation. New customers can purchase these plans today, and we're currently migrating existing customers to the new plans at their existing plan price. We see an opportunity for these bundles to provide an ARPU lift over time from new user adoption, as well as retention improvements as we've seen the customers who use multiple products retain at significantly higher rates. I'll now move on to our financial highlights from Q3 and update guidance for the rest of this year, along with offering some commentary on how to think about our 2024 targets and growth outlook. Starting with our third quarter results. Total revenue in Q3 increased 7.1% year-over-year to $633 million, beating our guidance range of $626 million to $629 million.
Foreign exchange rates provided an approximately $7 million headwind to growth. On a constant currency basis, revenue grew 8.3% year-over-year. The revenue app performance was driven by strengths across our individuals' plans, which were once again partially offset by headwinds we continue to see across our teams and document workflow businesses. Total ARR for the quarter grew 3.8% year-over-year for a total of $2.525 billion. On a constant currency basis, ARR grew $25 billion sequentially and 7.5% year-over-year, primarily driven by individuals. I note that in Q3, we largely lapped the pricing and packaging changes we made to our Teams plans last June and hence added less quarterly net new ARR relative to the first half of 2023. We exited the quarter with 18.2 million paying users and added approximately 130,000 net new paying users sequentially.
Average revenue per paying user for Q3 was $138.71, down slightly on a sequential basis, but up over $4 year-over-year, driven by the Teams pricing increase, FormSwift as well as a shift to premium plans. Before we continue with further discussion of our P&L, I would like to note that unless otherwise indicated, all income statement figures mentioned are non-GAAP and exclude stock-based compensation, amortization of purchases and tangibles, certain acquisition-related expenses, impairments of our real estate assets, and expenses related to our reduction in force. Our non-GAAP net income also includes the income tax effect of the aforementioned adjustments. Moving to our real estate strategy where we have been actively seeking subleases and buyouts of our vacant real estate space, a majority of which is in San Francisco.
In October, we executed a buyout with our landlord of approximately 40% of our remaining sublease space in San Francisco for $79 million to be paid over three years, beginning with an approximate $28 million payment in the fourth quarter of this year. This payment was not previously factored into our 2023 free cash flow guidance, and I will provide an update on this when we share our latest view for the year. Overall, we expect this buyout to drive significant savings in the long term, as we will be avoiding over $220 million in aggregate rent payments and common area maintenance fees over the remaining 10-year lease duration. We will continue to actively seek subleases and pursue additional bouts where we see favorable returns. With that, let's continue with the third quarter P&L.
Gross margin was approximately 83% for the quarter, roughly flat compared to the third quarter of 2022. Operating margin was 36%, up roughly 400 basis points year-over-year. We beat our operating margin guidance by 300 basis points, primarily driven by delayed marketing and professional services spend, which we expect to incur in Q4. We are also being prudent with the pace of hiring as we remain focused on cost discipline. Net income for the third quarter was $194 million, up 27% versus the third quarter of 2022, driven by operating income growth. Diluted EPS was $0.56 per share, based on 346 billion diluted weighted average shares outstanding, up from $0.43 per share, based on 360 million diluted weighted average shares outstanding for the third quarter of 2022.
Moving on to our cash balance and cash flow. We ended the quarter with cash and short-term investments of $1.3 billion. Cash flow from operations was $256 million in the third quarter. Capital expenditures were $9 million during the quarter. This resulted in quarterly free cash flow of $247 million compared to $245 million in Q3 of 2022. In the quarter, we also added $26 million to our finance leases for data center equipment. Moving on to our share repurchase activity. In Q3, we repurchased 4 million shares, spending approximately $104 million. As of the end of the third quarter, we have approximately $1.5 billion remaining under our current repurchase authorizations. As a reminder, we remain committed to allocating a significant portion of our annual free cash flow to share repurchases.
I'd now like to share our guidance for Q4 and in turn the full year 2023 where I will also provide some context on the thinking behind this guidance. For the fourth quarter of 2023, we expect revenue to be in the range of $629 million to $632 million. We are assuming a currency headwind of approximately $2 million in the fourth quarter, and thus on a constant currency revenue basis we expect revenue to be in the range of $631 million to $634 million. We expect non-GAAP operating margins to be approximately 31.5%. This includes a roughly 90 basis point headwind from FX and FormSwift. Finally, we expect diluted weighted average shares outstanding to be in the range of 345 million to 350 million shares based on our trailing 30-day average share price.
For the full year 2023, we are raising the midpoint of our as reported revenue guidance range by roughly $5 million, to $2.496 billion to $2.499 billion versus our previous range of $2.487 billion to $2.497 billion. On a constant currency basis we are raising the midpoint by roughly $7 million to a range of $2.536 billion to $2.539 billion. We now estimate a full-year 2023 currency headwind of approximately $40 million or an approximately 170 basis point headwind to growth. We continue to expect FormSwift to contribute nearly 300 basis points of growth. We expect gross margin to be 82% to 82.5% up from our prior guidance of 82%. We expect non-GAAP operating margin to be approximately 32.5% up from our prior guidance of approximately 32%. This is inclusive of an approximately 75 basis point headwind from FX and FormSwift.
We are reducing our free cash flow guidance by $50 million at the midpoint and narrowing the range to $775 million to $785 million relative to our previous guidance range of $820 million to $840 million, which I will elaborate on shortly. As it relates to capital expenditures, we now expect CapEx to be approximately $30 million, the low end of our prior guidance range. In addition, the finance lease lines to be approximately 6% of revenue, up from our prior expectations of 5.5%. Finally, we are maintaining our 2023 diluted weighted average shares outstanding guidance range of $345 million to $350 million shares. To share some additional context on this guidance, as related to revenue, we are raising our revenue guidance for 2023 driven by better than expected performance across our individual's plans.
This has outweighed macroeconomic headwinds on our Teams plans, as well as both DocSend and Sign. I will also note that I expect lower net new paying user additions in Q4. Alongside the uncertain macro and economic environment, Q4 is a seasonally slower quarter for net new paying users. Additionally, as part of our recent bundles launch and plans page changes, we have minimized the family plan skews prominence on our plans page. While this skew is still available to existing customers, we found that business users were using it as a loophole to obtain licenses at a lower cost. As a result of these factors, we expect net new paying users to trend lower relative to our historical run rates. As related to operating margins for 2023, we are raising our operating margin guidance to approximately 32.5% or 50 basis points as compared to our prior guidance.
This increase is driven both by our revenue app performance, as well as our disciplined approach to hiring subsequent to our risk, which is translating to savings. As related to finance leases, as a reminder, in recent years we have seen users uploading increasing levels of high-density files such as videos and images to our platform, particularly within our advanced Teams plan, which allow for customers to use as much storage as needed. We also discovered that some customers were using this storage benefit for purposes that did not meet the spirit of the plan's design. To address this, in Q3 we sunsetted our as much space as you need policy and transitioned to a metered model. However, we accompanied this with an extended grandfathering window for the vast majority of impacted customers to support them with the transition.
While this will ultimately translate to a more profitable advanced plan skew in the long term, it will lead to incremental storage costs in the short term, as indicated by the uptake in finance leases to support the grandfathering window. We also expect a modest headwind to ARR from this change, as we expect some degree of refunds and incremental churn for those customers seeking storage solutions that we no longer offer. As related to full year free cash flow, we are reducing our free cash flow guidance range. There are a few factors driving this decrease. First is the aforementioned buyout of a portion of our San Francisco lease which was not factored into our previous guidance. The first tranche of the buyout is $28 million and is due in the fourth quarter.
Second, we now expect to receive our December installment payment from an App Store partner of roughly $14 million in January of 2024. Thus, we now only expect to receive 11 monthly payments in 2023. Looking ahead, we still expect to receive 12 payments in 2024. Lastly, we are also expecting a reduced level of billings in the fourth quarter due to two factors. First is FX, given the recent strengthening of the U.S. dollar, which has a more immediate impact on billings. And second, we're seeing incremental softness pressuring our Teams and Document workflow businesses, which we attribute to the macro environment, as well as the reduced headcount and marketing investments in these businesses subsequent to our risk. This free cash flow guidance range also continues to include several unique cash outflows that I have mentioned on prior calls, including approximately $23 million for the 2023 installments of acquisition-related deal consideration holdbacks for DocSend and Command E, one-time severance payments of approximately $40 million related to our reduction in force, and an approximately $50 million headwind as a result of R&D tax legislation.
This brings me to 2024, where I wanted to share some early thinking on our revenue growth expectations and our 2024 operating margin and free cash flow targets. I will not offer specific 2024 revenue guidance at this time. However, I would point to our Q4 2023 constant currency revenue growth expectations, excluding FormSwift as a fair proxy for our underlying organic growth rate next year, as we also lapped the benefit of the Teams price increase. As a reminder, the strategy behind our [REF] (ph) earlier this year was to rotate investments away from our legacy files, link, and share, and document workflow businesses to become more efficient in those areas and to use those savings to fund investments in areas of higher growth potential over the long term.
This, along with continued macroeconomic headwinds, is translating to a slowdown in billings in these legacy business lines. Separately, while we are making early progress on our new longer-term investments in Dash, bundles, and video products, these products are either only recently being introduced to the market or will not be going to GA until 2024. Thus, we expect that these initiatives will not be meaningful contributors to our growth until later in 2024 and beyond. This brings me to our 2024 operating margin and free-cash flow targets. We have made significant progress on these targets since introducing them over three years ago, when we made a commitment to driving higher levels of profitability and free cash flow. I'm proud of our progress against these targets, and we will continue to operate the business in a disciplined manner.
And while we remain at or above our margin targets, we continue to face challenges to free cash flow, including factors such as FX, which has grown as a headwind since last quarter, as well as the partial buyout of our San Francisco lease that will also serve as a headwind to our free cash flow next year. In addition, we are now planning as though the R&D tax legislation, which came to light after we initially developed our targets, will not be repealed. To overcome these mounting headwinds, we could withhold investments in our long-term initiatives such as Dash. However, we believe that this would be a short-sighted approach. As such, we are lowering our $1 billion free cash flow target to adjust for the R&D tax legislation now expected to be approximately $36 million in 2024.
In other words, we are resetting the 2024 free cash flow target to be $1 billion minus the ultimate R&D tax legislation amount. We will also continue to monitor exogenous factors such as FX and its potential impact to our 2024 free-cash flow expectations, where we will provide official guidance on 2024 in February. In conclusion, we've been focused on investing towards our longer-term product roadmap, while finding opportunities to run our legacy businesses more efficiently. While we continue to navigate macro headwinds, we believe we've been making the necessary changes this year to better position Dropbox for the long term. We continue to see opportunities to leverage our scale and brand as we enter new market opportunities centered around the future of work.
With Dropbox Dash representing an important first step in our next generation of AI-powered products. We will remain focused on our customers, while allocating capital efficiently and driving long-term value for our shareholders. And with that, I'll turn it to the operator for Q&A.
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