Dropbox, Inc. (NASDAQ:DBX) Q4 2023 Earnings Call Transcript
Dropbox, Inc. (NASDAQ:DBX) Q4 2023 Earnings Call Transcript February 15, 2024
Dropbox, Inc. beats earnings expectations. Reported EPS is $0.5, expectations were $0.48. Dropbox, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Good afternoon, ladies and gentlemen, thank you for joining Dropbox's Fourth Quarter 2023 Earnings Conference Call. [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 it over to Ishaan Gupta with Dropbox's Investor Relations Team.
Ishaan Gupta: Thank you. Good afternoon, and welcome to Dropbox's fourth quarter 2023 earnings call. Before we get started, I would 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 first quarter and fiscal year 2024, and our expectations regarding revenue growth, profitability, operating margin, and free-cash flow, as well as our expectations regarding our business, assets, products, strategies, technology employees, users, demand 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 those 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 will 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 will now turn the call over to Dropbox's Co-Founder and Chief Executive Officer, Drew Houston.
Drew Houston: Thank you, Ishaan, and good afternoon, everyone. Welcome to our Q4 2023 earnings call. Joining me today is Tim Regan, our Chief Financial Officer. I'll first provide a recap of 2023, share a perspective on our fourth quarter, and then close with an overview of our strategy for 2024. Tim will then go over our financial results for Q4 and fiscal year 2023, as well as provide guidance for Q1 and fiscal 2024. Let's get started. In 2023, we had two main business objectives. The first was to build AI-powered product experiences centered around organizing all your cloud content. The second was to continue evolving our core FSS offering to provide a seamless product experience for our customers workflows. I'm proud of the work our team accomplished on both of these fronts.
Starting with building AI-powered product experiences. In 2023, we introduced the first iteration of Dropbox Dash, a standalone universal search product, leveraging AI and machine-learning. With more of our work spread across hundreds of tabs in a browser, knowledge workers are spending far too much time, just finding what they need to do their work, particularly in this new world of distributed work. Dash connects all of your apps, tools, and content in a single search bar, so it's easy to find everything you need in one place, regardless of where it lives. And because Dash is powered by machine-learning, it learns about you and your priorities, the more you use it. In 2023, Dash moved from closed-beta to open-beta and represents our first major AI-powered product experience.
While still very early, we are gaining valuable insights into the types of customers that are engaging with this product and the features that are generating the most interest. For example, we're seeing that are more engaged in existing users on our Dropbox FSS paid plans tend to adopt Dash and retain at a higher rate. We also made significant progress against our second objective of evolving our core FSS offering to create a better product experience for our customers workflows. There were several highlights on this front in 2023, including the continued optimizations we made across the platform to reduce churn on a year-over-year basis, improve top of the funnel and ultimately ensure we're delivering the best product experience to our users.
Specifically, we made a number of operational enhancements, including improving the sharing experience across our mobile and web services, optimizing our payment processing to reduce churn and leveraging Google One Tap to streamline and improve the user onboarding experience. Given the size of our registered base, these changes impact millions of users and we believe the progress we made 2023 will strengthen our foundation, heading into 2024. Additionally, many of our customers lack awareness of our capabilities beyond storage, often asking us for features that we already have such as e-signature or document tracking and analytics. And we took several steps in the fourth quarter to address this awareness gap and to provide more value to our customers.
We introduced our new web redesign that makes it easier for our users to get the most out of the Dropbox platform, including the ability to sign and send documents and use our video products. We also introduced the first-generation of our fully integrated bundled offerings for our Teams customers. This included updated pricing and packaging with the goal of reflecting the added value of all of our product capabilities. I'll share more on the early results of this initiative in a moment. Along the way, we continue to grow our topline, exceeding the guidance we shared, while also achieving record non-GAAP operating margins of over 32%, generating more than $750 million of free-cash flow and returning $540 million back to shareholders in the form of share repurchases.
Tim will speak to the financial results in more detail, but I'm proud of our focus on improving the overall profitability profile of our business, while still investing in new initiatives and growth opportunities. Although I was proud of last year, Q4 was a challenging quarter, some of these challenges were expected. For instance, we continue to see the broader economic backdrop impacted both our Teams and document workflow businesses, as customers are being more cautious with their spend and exhibiting higher levels of price sensitivity. This resulted in reduced levels of gross new licenses and upsell activity, alongside higher churn and downsell. As an example, certain Teams customers, particularly those in the tech sector, continue to reduce licenses due to spending cuts, our headcount reductions of their own.
FormSwift and DocSend also saw elevated churn in the quarter. And as we've discussed on our call last quarter, we traditionally see seasonally low activity within our File Sync and Share business as well as our FormSwift business in the fourth quarter of each year. We also anticipated headwinds stemming from strategic business decisions we made last year, which we believe will benefit us in the long run at the cost of some negative impact in the near-term. For example, like others have done, we sunset unlimited storage and our advanced plan and transition to a metered model. We found that some customers weren't using the plan as intended and we're taking advantage of the policy to do things like mine crypto or use a business account for personal use cases or even resell storage.
While this change will ultimately translate into increased profitability in the long-term, I'd like to increase funds and incremental churn for those customers seeking storage solutions that we no longer offer. We also de-emphasize our family plan, as we found that some business users were also using it as a loophole to obtain licenses at a lower cost. As we noted last quarter, this negatively impacted the number of paying users in the quarter. We also faced a few additional challenges in Q4, which we're actively addressing. In Q4, we ran a number of tests and experiments across our individual plans with new trial flows and other initiatives, but they did not generate the uplift we were looking for. However, we still see opportunity here and we're iterating on these experiments and incorporating the related learnings into our plans for 2024.
In addition, the early results on our bundled offerings for Teams have been mixed. As a reminder, our approach was to offer multiproduct bundles to new Teams customers at a higher price point to reflect the additional value we were adding to the plans, while our intention was to migrate existing customers to the new SKUs at their current price point. For now, we've held off on migrating all our existing Teams customers, because while we're seeing an uptick in multiproduct adoption with new customers as well as an ARPU lift from these plans, we're also seeing a reduction in top of funnel activity and conversion rates. As a result, we're revisiting our approach. In Q1, we'll keep iterating on our pricing and packaging and will continue to improve the product experience for these customers.
At the same time, we will refine our marketing approach in our self-serve engine to ensure that we we're properly identifying and serving customers that are interested in FSS only SKUs versus our multiproduct. Ultimately, we're still aiming to serve those who want multi-product capabilities, as we continue to see that customers who engage with these capabilities converts and they retain at notably higher rates than storage only customers, but will be iterating on the past desktop forward with our bundle strategy and we'll have more to share in the following quarter. All of which brings me to our strategy for 2024. As I have been more hands-on in the business over the last year, I've been refocusing our team and our strategy on the fundamentals of our growth drivers and the quality of our user experience.
First, within our File Sync and Share business, we still see an opportunity to improve the collaborative experience to strengthen the funnel and drive growth. FSS is our largest business line, where small improvements can lead to a meaningful financial and customer impact. And in recent years, we focused heavily on churn improvements that resulted in better performance for our individual business and we see a similar opportunity with our Teams customers. For example, many of the actions conducted by our Teams users today are predominantly solo actions such as storing and viewing content as opposed to sharing and commenting on shared content. We've seen in the past that as we streamline and remove friction in our sharing and collaborative workflows like commenting, this contributes to more viral growth, faster team expansion, and higher retention and we see similar opportunities to improve this experience for teams as we have for individuals.
In addition, we see an opportunity to improve the team admin workflow as well, as the admin approval rate for new licenses on the team account remains low. Team admins often struggle with onboarding new users and by leveraging the admin console for permissions and controls, we're focused on making improvements to make it easier for admins to discover and leverage admin workflows so can more easily expand their team deployments. As I mentioned earlier, we will also invest in our Teams plans by iterating on our bundles experience to ensure that our customers are aware of and leveraging our multi-product capabilities. This includes weaving advanced sharing capabilities such as DocSend and Replay more seamlessly into our product experience, given our proven strengths and solving sharing for our customers as well as the viral network effects that stem from sharing content.
As we improve these team experiences, we can grow through license expansion or through introducing customers to our premium functionality. Our second big opportunity is with AI-powered product experiences, most notably Dash. Dash is aimed at solving many of the same challenges that we had originally solve with FSS, but instead of the problem of files scattered across different devices, Dash is addressing the challenge with cloud-based content and URLs scattered across hundreds of apps and browser tabs. We have a long history of solving our customer's problems as organizing and searching and sharing content and we believe our strengths of the scale of our platform, customer trusts and interoperability position us well to solve the same problems.
And this is a growing market. IDC estimates the search and knowledge discovery software market to be about $7 billion today with the potential to more than triple over the next four years. We'll continue to invest in Dash, as our lead AI products and we're taking a similar approach as when we launched Dropbox 1.0. And we're using this beta period with Dash to ensure that we're getting up to a high-quality and scalability bar before driving adoption. Our primary focus in 2024 is on finding product market fit with our customers. More specifically, we're going to focus on improving the onboarding, activation, and retention of users on Dash to ensure we are providing the best experience to customers. For example, we noticed users and a lot of friction in adding and connecting Dash to all the different apps, so we're making the experience of connecting apps during onboarding smoother, so that we can improve activation rates.
We're also investing in experiences like stacks, improving discoverability, improving sharing. This is critical to creating the type of virality that was essential to Dropbox's growth in the early years. And once we get the quality of the product experience in metrics like retentions to where we want them, we will run a lot of the same playbook that may Dropbox successful in the past, including growing the product virally, making big investments in sales and marketing and promoting Dash to our existing FSS users. As I shared earlier, we know our customers are often unaware of our capabilities beyond storage. To this end, last week we announced a partnership with McLaren Formula 1 team, where Dropbox is becoming an official technology partner.
As part of this partnership, McLaren will rely on Dropbox to securely share files and collaborate on video review and approvals and our branding will be featured on their cars and team assets. This is an important effort to drive awareness of our latest offerings and educate customers and partners about all the ways that Dropbox can help teams work more effectively together. We have ambitious goals in 2024 and I'm excited to work with our teams to achieve everything we have planned. We've also made several strong additions to both our leadership bench as well as our Board over the past few months. In December, Eric Cox joined us as our Chief Customer Officer, overseeing our go-to-market teams. Eric comes to us from Vimeo, where he was COO and prior to that, he spent nearly 20 years at Adobe in a variety of roles across sales, marketing and operations.
We also welcome Dr. Andrew Moore to our Board of Directors. Andrew is a leading expert in AI, machine-learning and robotics and he has had a decade-long career in academic and tactical leadership. He was previously VP for the AI division of Google Cloud and also served as the Dean of Carnegie Mellon University School of Computer Science. Andrew's technical expertise building AI-powered products will offer invaluable perspective, as we invest in AI internally across our product portfolio. Both Eric and Andrew will play an important role in the future of Dropbox, and I couldn't be more excited to partner with them to achieve our goals for the future. In closing, 2023 was a year marked by both successes and challenges and looking ahead, we're confident that we have the right team in-place to execute against our strategy for 2024.
This year represents a unique point in our Company's evolution. Many of our mature FSS products are seeing slowing growth and newer products like Dash are still early in their lifecycle. While we expect that our new products and initiatives will take time before they start to meaningfully contribute to our top-line results, we're excited about the large opportunity we see in front of us. As we embark on the next phase of our company's journey, I'm personally invested in-building the best products we can for our customers, delivering strong results for our shareholders and achieving our mission of designing a more enlightened way of working for all knowledge workers who use Dropbox. With that, I'll turn it over to Tim to share a recap of our 2023 financial performance as well as our expectations for 2024.
Tim Regan: Thank you, Drew. I'll cover our financial highlights from Q4 and share guidance for Q1 and fiscal 2024. I will then offer some context on the considerations underlying our guidance. Starting with the fourth quarter of 2023, total revenue for the fourth quarter increased 6% year-over-year to $635 million, beating our guidance range of $629 million to $632 million. Foreign-exchange rates provided an approximately $1 million headwind to growth. On a constant currency basis, revenue grew 6.2% year-over-year. Total ARR grew to a total of $2.523 billion, up 3.8% year-over-year on a constant currency basis. However, on a constant currency basis, ARR declined by $2 million sequentially. As Drew mentioned, the sequential decline in ARR was driven by a few factors, including business decisions we intentionally made such as eliminating unlimited storage for advanced plan users, which resulted in incremental churn and softness in our top of funnel, a continued challenging macro-economy and the typical seasonality we see in our business in Q4.
We exited the quarter with 18.12 million paying users, which reflects a sequential decline of roughly 50,000 paying users. A number of factors led to this decline, including our decision to reduce the prominence of the family plan on our plans page, macro headwinds facing our Teams SKUs, experiments that underperformed impacting our individual SKUs and finally, Q4 tends to be a seasonally low quarter for File Sync and Share and FormSwift in particular. Collectively, these factors served as headwinds to paying user growth in Q4, where I'll speak to our paying user expectations for 2024 shortly. Finally, average revenue per paying user for Q4 was $138.83, up slightly compared to Q3. Before we continue with further discussion on 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 purchased intangibles, certain acquisition-related expenses, net gains and losses on our real-estate assets, and our workforce reduction expenses.
Our non-GAAP net income also excludes the income tax benefit from the release of a valuation allowance on deferred tax assets and includes the income tax effects 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, majority of which is in San Francisco. As I mentioned during our last earnings call, in Q4 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 2023. The remaining payments resulting from the buyout will occur in Q2 of 2024 and Q1 of 2025. 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.
The result of this buyout was a $159 million gain in Q4 2023. The gain represents the reduction to our future lease payments in excess of the sublease income we previously anticipated collecting for this space. And as I previously mentioned, we will continue to actively seek subleases and pursue additional buyouts, where we see favorable returns. With that, let's continue with the fourth quarter P&L. Gross margin was 82.3% for the quarter, up 20 basis-points on a year-over-year basis. Operating margin was 32.2%, up 200 basis points year-over-year. We beat our Q4 operating margin guidance by nearly a point driven by our continued focus on being efficient with our spend across the business. I note that in Q4 we held both our in-person user conference, and we invested in product and brand awareness marketing campaigns, which resulted in a sequential decrease in operating margin.
Net income for the fourth quarter was $171 million, which is a 21% increase versus the fourth quarter of 2022, driven by operating income growth. Diluted EPS was $0.50 per share based on 344 million diluted weighted average shares outstanding, which increased compared to $0.40 per share based on 354 million diluted weighted average shares outstanding for the fourth quarter of 2022. Moving on to our cash balance and cash flow. We ended the quarter with cash and short-term investments of $1.4 billion. Cash flow from operations was $200 million in the fourth quarter. Capital expenditures were $10 billion during the quarter. This resulted in quarterly free cash flow of $190 million compared to $182 million in Q4 of 2022. I note that free cash flow for 2023 came in lower than our guidance range of $775 million to $785 million, due to a reduced level of billings as well as the timing of payments and collections.
In the quarter, we also added $51 million to our finance leases for data center equipment. As we mentioned on our last call, we expected this sequential increase in our finance lease lines, given the higher storage costs we are seeing with users on our advanced plan, as we wait for grandfathering periods to expire for customers maintaining elevated storage levels. As related to our share repurchase program, in Q4, we repurchased nearly 4 million shares, spending approximately $106 million. As of the end of the fourth quarter, we had approximately $1.4 billion remaining under our current repurchase authorizations. Our philosophy on share repurchases has not changed. We remain committed to returning a significant portion of our free-cash flow to shareholders in the form of share repurchases with the intention of reducing our share count.
I'd now like to share our 2024 first-quarter and full year guidance, where I will also provide some context on the thinking behind this guidance. In the first quarter of 2024, we expect revenue to be in the range of $627 million to $630 million. We expect a minimal impact from FX this quarter. I will note that Q1 2024 has one less day versus Q4 2023 and thus, we recognized one less day of subscription revenue in Q1 relative to the prior quarter. We expect non-GAAP operating margin to be approximately 33%. Finally, we expect diluted weighted average shares outstanding to be in the range of 342 million to 347 million shares, based on our trailing 30-day average share price. For the full year 2024, we expect revenue to be in the range of $2.535 billion to $2.550 billion.
On a constant currency revenue basis, we expect revenue to be in the range of $2.532 billion to $2.547 billion, equating to a full-year currency tailwind of approximately $3 million. We expect gross margin to be in the range of 83% to 83.5%. We expect non-GAAP operating margin to be in the range of 32% to 32.5%. We expect free cash flow to be in the range of $910 million to $950 million. I note that this free cash flow guidance range is inclusive of several one-time items totaling $47 million. The first is an approximate $30 million headwind as a result of R&D tax legislation, slightly lower than the $36 million estimate that we shared last quarter. The second is a $15 million payment for the second tranche of the buyout related to our San Francisco headquarters.
And the third is $2 million in cash outflows for the 2024 instalments of acquisition-related deal consideration holdbacks for Command E. Moving on to capital expenditures, we expect our addition to finance lease lines to be approximately 7% of revenue and we expect cash CapEx to be in the range of $20 million to $30 million in 2024. Finally, we expect 2024 diluted weighted-average shares outstanding to be in the range of 336 million to 341 million shares, based on our trailing 30-day average share price. I'll now share some additional context on the thinking behind our guidance. Starting with revenue, as a reminder, we are lapping the benefits of our Teams price increase and our acquisition of FormSwift and thus, we expected a slowing revenue growth rate.
Also, consistent with our historical approach, our guidance reflects what we have a high degree of visibility into today. This includes our current business trends and trajectory as well as the product and growth-related initiatives we have launched to date. Notably, our guidance does not include any benefit from Dash in 2024. As we mentioned, our primary focus in 2024 is centered on finding product market fit, driving usage of the product and closely following Dash's adoption, engagement, and retention trends. Once we have increased certainty that Dash is meeting our customers' needs, we will then pursue our monetization strategies. However, this may not be until the latter portion of this year or early next year. Similarly, our guidance does not include any benefit from our bundled SKUs, as our Teams continue to iterate on the optimal product experience and go to market motion for these plans.
As we gain more clarity on how we are approaching our bundles rollout to new and existing customers, along with signals on the customer response to our approach, we will update our guidance accordingly. As related to paying users, our guidance contemplates a reduced level of paying user growth relative to 2023 and there may be some quarters, where paying user additions trend negative. This is due to the continued headwinds we are facing as well as the de-emphasis of the family plan and the latest state of our growth initiatives. Ultimately, we do expect to add paying users in 2024, however, at lower levels than prior years. As related to gross margins, we are guiding to 83% to 83.5%, which is above our long-term target. I want to highlight that from the beginning of 2024, we are increasing the useful life of our servers from four to five years, which will apply to asset balances on our balance sheet as of December 31st, 2023, as well as future asset purchases.
As a result, we expect the benefit to our full-year gross margins of approximately $30 million. For Q1, we expect a benefit of approximately $10 million. As related to operating margins, we're guiding to 32% to 32.5%. This level of operating margins is above our long-term target and is roughly consistent with our operating margins in 2023. This range includes continued investment in our longer-term AI and growth-related investments such as Dash. Additionally, we are planning for increased levels of marketing investments, including our new partnership with McLaren Formula 1 racing, as we aim to drive market awareness of our platform's capabilities. Lastly, this guidance preserved some optionality to make strategic investments across the business over the duration of the year.
We also expect our additions to finance lease lines to increase in 2024 versus prior years. This was primarily due to two factors. The first is the one-time storage quota grants we are providing to a portion of our customers on the advanced plan, as we deprecate our previous as much space as you need policy. While this requires incremental storage capacity in the near-term, our revised plan around storage usage will enable us to have a more profitable SKU once the onetime extension for these customers has expired. The second factor is an anticipated refresh of some of our data center equipment consistent with past practices. As related to full year free cash flow, we are guiding to a range of $910 million to $950 million. This guidance falls short of our long-term free-cash flow target, which we adjusted during our previous earnings call to be roughly $970 million after taking into account headwinds from R&D tax legislation related payments.
And while our guidance range is below this figure, I'd note that we have more than doubled our annual free cash flow since we initially set the target, where I'm proud of the progress we've made. There are several factors driving the shortfall between our guidance and our target, the most prominent being a reduced level of billings associated with our revenue guidance, the incremental FX headwinds we are facing relative to when we first introduced our target as well as the investments we're making to fuel our future growth in products such as Dash. While we could scale back our investments in Dash to meet our free-cash flow target, we do not believe this would be the right long-term decision for the business. These investments in product initiatives along with decisions, such as our San Francisco lease buyout and the changes we made to our advanced plan are putting a short-term strain on our financial trajectory, however, are in line with our primary focus on strengthening the company's long-term position.
And while our current level of visibility does fall short of our long-term target, there is still time to draw closer to our free-cash flow target through improved product experiences or through identifying additional efficiencies within our operations during the year. In conclusion, we are mindful that we are in a unique period, where our core File Sync and Share business is maturing and our new products are in their early stages. However, our core File Sync and Share business is still generating growth in revenue and free-cash flow, while we also reduce our share count. Concurrently, we are in an exciting new phase in the evolution of our business, as we invest in our future in AI-powered areas such as Dash to drive long-term growth. We will make progress on both dimensions in 2024, and we will continue to maintain a disciplined mindset around how we are operating the company to ensure we're not only providing innovative solutions for our customers, but creating value for our shareholders.
And with that, I'll turn it over to the operator for questions.
Operator: Thank you. [Operator Instructions] And our first question will come from Rishi Jaluria from RBC Capital Markets. Your line is open.
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