Box, Inc. (BOX) Earnings Call Transcript & Summary

Great. Thanks for joining. My name is Josh Baer, software analyst at Morgan Stanley. And we have the Box co-founders, CEO, Aaron Levie; and CFO, Dylan Smith. Thank you for joining us.

Thanks for having us.

And some research disclosures. For important disclosures, please see the Morgan Stanley Research Disclosure website at www.morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley sales representative. Thanks again for joining us today for the conversation.

A lot of interesting topics to cover. I wanted to start with macro and really hoping, Aaron, you could sort of summarize what you're seeing as far as current demand trends? And also what assumptions are embedded in outlook for FY '24?

Sure. So maybe I'll cover the general kind of qualitatively on the macro front and then Dylan can talk about how that gets embedded in the fiscal plan. So I think we called this out on the Q3 earnings call that we were starting to see some of the macro and especially FX headwinds start to flow into the business. We were starting to see some situations where IT buying behavior was coming in with a bit more just financial pressure. We obviously saw more of that in Q4, but it was more of a kind of a consistent trend but just the numbers in Q4 ended up being bigger, as you can imagine, for -- from a seasonality standpoint. So in general, I think the tone is the critical priorities of digital transformation remain front and center for every single IT buyer, talked to dozens of CIOs throughout the quarter in Q4. And if you kind of look at it from a qualitative standpoint, they're investing in how do they enable their teams to be more productive, how do they move more to the cloud, how do they retire legacy infrastructure. So those conversations are driving our -- and data security kind of fundamental as well. And so I think we saw a lot of healthy signal of just general appetite for our Content Cloud platform with the added kind of counter pressure of IT buyers just have fewer dollars on a kind of -- from a growth standpoint than it maybe would have a year ago. And so the way that shows up is maybe they have to sequence out their priorities a little bit differently than what we thought from a pipeline standpoint, a few -- maybe a quarter or 2 prior or their company is sort of growing its head count less quickly, which obviously then equates to fewer seats as those companies begin to buy SaaS products. So we kind of look at that, that's ultimately what impacted the Q4 outcome, and we certainly embedded that same set of trends into this fiscal year. So that's kind of how we're seeing things so far. And as we talk to our peers and as we look at the kind of broader SaaS landscape, I think it seems like a pretty consistent trend that we're seeing from most folks.

Great. And I wanted to ask about 1 metric that we watch closely is net retention rate. It ticked down to 108% as expected, and now you're expecting it to move to 106%. So on the one hand, I think you covered some of the dynamics that are pressuring that slightly. On the other hand, what gives you confidence that it holds at 106%.

Yes. So as a reminder, there are 3 components in our net retention rate. The first is seat expansion. The second is the impact of pricing and then the third is that full churn rate, which is netted against those expansion rates to deliver the 108% net retention that we just reported. And as we think about how the macro is impacting the various components of that, we're really seeing all of the impact on the seat growth, right? Again, as headcount growth expectations, budgets are seeing more pressure. That's what's the most impacted, whereas we're seeing a lot of stability and strength continue on the pricing side, which is up 5% year-on-year as well as on the full churn rate, which actually came down by a point year-on-year to be 3% annualized. And so as we think about the expectations for the coming year, we're really baking that in, to Aaron's point, expecting these macro challenges to persist if not get incrementally worse through the course of the year. And one of the things that also gives us confidence in the net retention rate is we've been moving more and more of our customers in the Suites who have stronger net retention rate, so that should help offset some of the economic pressure from this environment.

Great. Wanted to dig in on Suites. So from the customer perspective, could you lay out the value proposition of moving over to Suites, particularly Enterprise Plus.

Sure. So the value proposition is quite strong. So previously, and I think everybody in this room knows we had a core product and then multiple add-on products. And the sales motion was just becoming quite inefficient and overly complicated for our customers. So at the moment, they wanted a security product. We had to sell them the Shield add-on the moment they wanted workflow. We had to sell the Relay add-on and so our suites really just brought that together as a bundle. And from an economic standpoint, there's meaningful savings when you buy into the suite. But frankly, at this point in our go-to-market motion, it's almost negligible the new deals we bring in that are just like sort of 1 or 2 kind of pure add-ons. It really is the suite sale is our sales motion. So economics are fantastic for the customer if you kind of did a comparison of how much they would spend on those add-on products. And then for us, obviously, it's a much more efficient sales motion.

You talked about efficiency, you talk about pricing and net retention as it relates to suites. What else does it do to you -- for you from an economic perspective, thinking about margins, deal size and other impacts?

Yes. So really, we see positive impacts on our Suites customers across the board, top to bottom. So in addition to what you mentioned, Josh, we also see even above and beyond the pricing uplift much larger average contract values as Suite customers tend to really understand, buy into the full value of the platform, serving a multiple of the number of seats as well. So average contract values are much higher than even the rough doubling that we tend to see on price per seat versus customers' issues in the basic service. And then that higher pricing also flows through into higher gross margins as well. So really, it's everything from pricing and average contract values to all the components of net retention, both the seat expansion as well as stronger retention rates and stronger and higher gross margins as well.

That's great. And we've seen this benefit. I guess like the question is how much more room is there to go? Any context for -- well, the answer to that question, think about the mix of suites right now and where that can go.

Sure. So right now, Suites customers represent about 46% of our total revenue. That's up from 35% a year ago. And when we think about the total addressable market for suites, that's really applicable for virtually all of our customers other than the smallest kind of self-serve online customers, which make up about 10%, a little less than 10% of our business. So still kind of roughly halfway into where we see the potential of suites and a lot of room to run there. And then on top of that, you can think about similar to the way that we introduced Enterprise Plus a higher tier, higher price suite, a little less than 2 years ago, over time as we continue to build more functionality into the product, you can think about us and expect us to introduce higher-priced, higher-tier suites as well to take even those Enterprise Plus customers and add another upsell vector over time.

That's great. Let's talk about AI a little bit. Why not? We've been hearing a lot about it, obviously. Can you talk a little bit about your thoughts? What opportunities does it open up for Box?

Yes. So we've been -- we were pretty early in the kind of -- maybe the past decade, AI wave. We have a skills product, which basically lets customers through our API, connect to any third-party AI model. And so the use case there is customer uploads an image, and they want to be able to tag that image. They want to send that to a computer vision, AI model from Google or Amazon or whatnot. So that was our skills technology. The big challenge with skills, with less skills but more the prior wave of AI was that you needed a model specific to almost every use case you had in the enterprise. And so if somebody came in and they wanted to do architecture diagrams, they really needed a model that was finally tuned for architecture diagrams. If somebody wanted to come in and do contract analysis, they needed a model that was finally tuned for contract analysis. The big breakthrough recently, it goes back a few years, but really the past 3 months is OpenAI's kind of latest sort of GPT-3 x. So that could be 3.5 all the way to 4. These large language models basically can cover a much more generalized set of use cases. And so the power of that is that a customer could come with a set of documents or files that really kind of have required no pretraining, it could be contracts with research reports, it could be memos and the AI models now at this point, understand and can synthesize really a very broad set of content. So that's really compelling for us, and it's actually an acronym itself, large language model, where do you see a lot of language, you see a lot of language in documents. And so the breakthrough is the ability to start to structure unstructured data in a way that was never possible before. So for us, these use cases could range from data classification. So a customer says, I want to classify my most important movie scripts if they're in Hollywood. Well, previously, again, that would have been a sort of pretrained exercise that would have been relatively prohibitive for most companies to go do. And now you can do it with a couple of lines of text. So you kind of look at the range of use cases from data security and data protection, all the way to kind of end user productivity where you could begin to sort of ask a system to summarize information or pull out key insights or be able to have a better way of discovering or searching data. That those are all the potential use cases. One thing that we're somewhat cautious of is sort of thinking through what the economics of this type of technology are. The first thing to keep in mind is, obviously, the underlying GPUs are pretty expensive to run a lot of these use cases. And so -- and we're trying to figure out where the cost curves go of this industry in terms of how much can you kind of add pricing on top of that? And then ultimately, what becomes kind of table stakes inside of software versus where can you get additional pricing power. So some of these things are kind of the big unknowns of AI right now, we are unbelievably excited because it unlocks a tremendous amount of value of all of this unstructured data inside of Box. We have tens of billions of documents and unstructured files. And so the breakthrough is 100% obvious to us. And then the big question is sort of how do you commercialize it? How do you productize this in a very scalable way that we can impact the most number of customers? And to Dylan's point, as you imagine, kind of plan types over time, one could theorize that, that would be another area where you'd have additional functionality and there might be additional upsell vectors as some of these products get introduced. So still on the one hand, very early, but on the other hand, something that we're very prepared for architecturally because of our early work in Box Skills.

Great. That's great opportunity, exciting opportunity. I guess one follow-up is in regards to Microsoft. And you've partnered with Microsoft. You have close integration also competitive at times. Does Microsoft's relationship with OpenAI kind of increase the intensity of competition from Microsoft when thinking about...

Yes, I actually almost flip it. It actually is a boom for us. So you can't get into obviously all the dynamics of the OpenAI Microsoft relationship, but one should just generally assume that OpenAI as an organization is looking for the most amount of developer activity as possible and Azure just happens to be their compute partner, obviously, with an investment relationship there. So the 2 of -- those 2 organizations are highly motivated to get as many developers to use their APIs as possible. That's the foundational business model of OpenAI. And so for us, you have the choice of going directly to OpenAI. You have the choice of going to Azure. We've got great relationships on both fronts with those organizations. But the really exciting thing about our position is that we're going to be Switzerland. And so we have the advantage of, you can imagine there's a company in Mountain View that is incredibly motivated to make sure that there's not just 1 leading AI provider. And so over time, as there's more competition at the AI model space, we think that actually over time means that the models themselves are relatively commoditized, probably eventually converges with the cost of compute. And then what you want as an enterprise is you don't want to be locked into one particular model provider because there's going to be leapfrogging that happens in different spaces in different subdomains. And so by being able to work with Box, you're going to be able to have the choice of working with models from wherever it comes from. So our ability to play a [ Switzerland ] role, which is what we already do in terms of our integration strategy with things like Salesforce or ServiceNow or Slack or Zoom that will also apply to the AI space as well. So I think one of the big architectural questions that enterprises are going to face is how do you make sure you don't get locked into just a path-dependent approach to how you leverage AI, but you have some flexibility and you can have a future-proof architecture. That's what we're going to be providing customers from a content standpoint. One other point -- just again, this is more conceptual in terms of why you would want a Content Cloud as an enterprise. If you look at the data fragmentation that enterprises deal with today, they have got content in OpenText and Documentum and network file shares and DocuSign and workflow providers and collaboration tools. Now all of a sudden, we have this AI wave and the company wants to be able to go query their data. Well, how do you query your data when it's across end number of systems. Very, very complicated, both is extremely expensive, but also the permissions and the access controls that will then feed into AI and make that very difficult because you can't have any situation where somebody can query your data and then get a result that they shouldn't have access to. And so being able to get your data in a format that can be managed and secured and be privacy-oriented is going to be one of the big kind of new frontiers for unstructured data, and that's what the Box Platform and the Content Cloud essentially solves for our customers. So we think Switzerland being highly permissioned, enterprise grade is going to be a strong advantage we have.

Very helpful. You kind of covered some of your competitors and the competitive landscape from the AI lens just wanted to ask on more broadly what you're seeing in the competitive environment. You've made comments about in easing competitive landscape. Does that still hold true? What are you seeing out there?

Yes. And what that's referencing when we talk about easing competitive landscape is when we are in deals today, our differentiation is meaningfully higher than it was 5 years ago, let's say. 5 years ago, we would go to an organization. The conversation would be you need secure internal, external collaboration. We have got better security. We have a better end-user experience, and we've got open APIs. That got us to let's say, $0.5 billion of revenue. But now at this point, our ability to go into an organization and talk about we're going to retire multiple legacy systems. We're going to consolidate spend from various kind of content adjacent use cases, whether that's workflow e-signature, collaboration tools. We're going to be a much more sort of meaningful partner because we can tie to a broader set of digital transformation initiatives. So our differentiation has gone up meaningfully. And then probably the single biggest threat that is always looming out there for any SaaS provider is sort of the big incumbents. And I think versus the big incumbents we are much more complementary and much more kind of partner oriented than we were just even a few years ago. So customers have the choice of being able to swap out Box for Microsoft products within Microsoft Teams. So you can be using teams with Box at the back end for content. We do the same within Microsoft Office things like co-authoring of office files and documents. We plug deeply into Azure for a variety of use cases. AI becomes yet another area of opportunity for us to partner with Microsoft on. So partnership has only gone up over time. And then our differentiation has deepened pretty meaningfully. And then the only other kind of category would be more of the real kind of pure legacy players. And we see just a tremendous advantage that we have on a cloud-first multi-tenant SaaS platform, every feature we build instantly becomes available to all of our customers if they so choose to turn them on. It's a very different architecture than any of the legacy players have. And so that just remains a strong tailwind for us.

Great. Thank you. I wanted to flip over to Box Sign. I guess, how would you characterize the customer demand right now? What types of conversations are you having? Are you seeing customers switch over from competitors? Is it more testing out like new workloads? What are you seeing on Box Sign?

Yes. I'd say kind of all of the above. We have customers at every stage of the journey. We're in an increasing number of RFPs just to kind of e-signature use cases, which is exciting to see it. So that means that customers are having sales cycles with us just on e-signature. We want to make sure that they're buying into the full platform, but it's another kind of on-ramp into the Content Cloud. Some customers have kind of fully standardized on Box Sign and replaced or retired legacy or not legacy, but alternative e-signature solutions. So we're seeing the kind of cost savings play out and the ability to go and actually bring more value to our customers on that. And then at the same time, we have a tremendous of surface area left that we can go and attack. So -- we kind of got into the product space at exactly the right time. It's a deeply integrated product. The user experience is incredibly simple in terms of how baked in it is to the product, and then it's just going to continue to advance rapidly. So -- it's one of the sort of most funded product road map areas that we have in the business.

Great. Before getting into financials and then asking seeing if there's questions in the audience, I wanted to ask one on new logos. So we've talked a lot about suites and pricing benefit, seat expansion within your base. What about new logos? Is there still an opportunity to add customers? And where is that coming from?

Yes, there absolutely is. And what we've seen, even in an environment is fairly stable contribution between new customers buying Box for the first time, customer expansion. So roughly 20% to 25% of our new bookings come from new logos with the remaining 75%, 80%, coming from customer expansion. And interestingly, what we're actually selling to those customers, the deal cycles, the suite attach rates are pretty comparable, even for new customers as that, as Aaron mentioned, really is the de facto sales motion that we're leading with. And then in terms of where we see those new logos coming from, we have untapped opportunity in every market that we serve, but we tend to see the greatest contribution from new logos in some of our less developed markets. So for example, Japan, which has been growing extremely nicely for us has a little bit higher of a new logo contribution. We just see the same thing in EMEA, but relatively consistent across the board in terms of that balance between new logos and customer expansion.

Great. Thanks, Dylan. So on the last earnings call, you updated your rule of guidance for revenue growth and free cash flow margins. And you've expressed that you're leaning a little bit more into the margin and profitability side there. I guess the first question about growth. Has anything changed outside of macro? We used to have these forward-looking targets expecting teens type of growth if macro improved, is that still on the table? Or has something else changed?

Yes. So I think in this environment, we always sort of struggle with this element of like what is the steady state model and then what is the one that we need to talk to investors about. So we can make sure that we have a conservative target out there that works given the economic climate. And we sort of always debate this because the moment you have anything in the latter that assumes a growth accelerant, you're kind of making macro predictions to some extent. And so we wanted to be thoughtful about not leaning in too much on, okay, we expect a certain recovery at a certain date, in particular because it's not even clear that we've gotten through what this current macro looks like. So -- so I think our view is, on a steady-state basis, we believe in that sort of kind of teens growth rate. The issue is sort of just when are we in that steady-state macro environment. I think the market is only larger today than it has been a couple of years ago for Box. Our position and strength in the market is only better. And so the big question is sort of when are you at that steady state, and we want to be conservative and thoughtful about the environment that we're in. But I will say that it is -- we are being increasingly focused on the bottom line side of the story. And I think you will see that be an important area of rebalance for us. And it's a continuation of the past few years of driving increased profitability. And so that's the -- that's sort of our focus right now. And I think we'll be as long as this environment persists.

Clear. On that increased profitability over the last few years, I think it's been 20% margin or more. So what's it going to take to get that next leg of improvement? Where are there still sources of leverage?

Yes. So we think about the next, call it, 2, 3 years ahead, really a couple of main areas that we call out. The first of which is gross margin expansion. So even though we have improved gross margins over the past few years, the lows 70s to an expected 77% this year. This year, we're also going to wrap up a multiyear journey of transitioning to run fully in the public cloud. And so once we get through that, especially the first half, of this current year, we expect to see a good amount of gross margin upside from there. So we'll show up in particular in the full year results next year. So that's a big area of opportunity for us. And then the second kind of big bucket that we call out is continued focus on our workforce and location strategy. So in particular, continuing to scale up do the significant majority of our hiring in our engineering center of excellence in Poland, which is not just an engineering site, but that's been the focus. So going from a standing start a few years ago, have about 10% of total employees there. You can expect that to meaningfully increase over time as well. And then beyond that, just part of the way that we're just operating in the company day-to-day, very focused on cost discipline across the board. And so you can expect to see improvements in everything from outside services spending, our real estate footprint, things like that to get us the next several points of margin expansion.

Great. One more for me and then see if there's any questions in the audience. You mentioned gross margin improvement from here. Can you remind us what's the mix of professional services and thinking about your overall gross margins, is there anything structural that would prevent you from getting to 80% plus when you think about intensity of workloads or anything else?

Yes. So today, about 97% of our revenue is subscription, the remaining 3%, professional services. And if you think about even this year, I had said we expect in the back half of the year to have roughly 78% gross margins. Subscription margins that's already at about 80%. And so structurally, as mentioned, as we build from there, no, there's nothing that would prevent us from being an 80% gross margin company over time. And I would say a couple of the biggest levers are just the efficiencies that we continue to drive as we kind of execute through the public cloud migration as well as another tailwind to gross margins that we've seen contribute pretty steadily over time is the impact of higher pricing. So the faster we get more and more customers into suites with their corresponding higher gross margins, the faster we can get to that kind of 80% gross margin clip.

Great. Any questions?

Great. Aaron, you talked earlier about the Content Cloud. Can you just describe how you see the competitive environment for what you see to be the Content Cloud?

Yes. So it's interesting. The way that we've certainly defined our strategy and the evolution of our product, we think, is quite unique. There's probably not a single product you could buy in the market that has the selection of features that we have in a single architecture. So customers would otherwise have to buy a mix or integrate a mix of solutions together. So you would need an e-signature vendor and a workflow vendor and a content management or document management vendor. So that brings with it just a very -- a variety of different categories that you have to spend on. And so that again, that could be anything from network file share providers or enterprise content management providers, e-signature providers. But there's literally no other platform that has a single architecture, powering the full life cycle of content in the way that we've designed Box. So that puts us in a good position when we're in deals where there's 2 or 3 of those capabilities as a requirement. We're the only one that can basically provide that.

Any other questions? Dylan, one more for me on capital allocation. So now mid-20s free cash flow margin and expanding healthy balance sheet. How should we think about buybacks versus M&A and other capital allocation priorities?

Yes. So we'd say that kind of what we have is pretty kind of representative of how we think about capital allocation, at least for the foreseeable future, just with larger numbers as our free cash flow is growing at a rate much more quickly than our revenue growth which is to say you can expect us to continue using the majority of our free cash flow generation to return capital to shareholders through share repurchases. As one note, the last year, we've reduced total shares outstanding by more than 3% because of that approach. And so you can expect that type of trend to kind of gradually reduce total shares outstanding over time to continue. And then we also allocate a portion of our free cash flow generation for very kind of targeted M&A to accelerate our product road map. And so for example, the team that we brought in that within a year became a generally available Box Sign is a great example of that.

Perfect. We're out of time. Thank you so much, Aaron. Dylan, really appreciate it.

Thank you. Appreciate it.

Thanks, Josh.