Dropbox, Inc. (DBX) Earnings Call Transcript & Summary

Thank you all for joining on the line. My name is Josh Baer. I'm a software research analyst at Morgan Stanley. Joined today by Tim Regan, CFO of Dropbox. Thank you so much, Tim, for joining.

Thanks, Josh. Thanks NASDAQ for having us. I was laughing a little bit because my power just went out. And so I'm operating on battery power here. And so my video may be a bit dark. And hopefully, the lights come back on mid session, but the challenges of 2020 continue, I think.

That's very exciting. I'd say let's talk fast, but hopefully, we'll make it through the end of the half hour. A quick disclosure. For our important disclosures, please see Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. So thanks again. And wanted to start with sort of a COVID operating [Audio Gap] you were and are a beneficiary from COVID, seeing that initial surge in demand, but just elevated trials and engagement levels. I'm wondering with today's COVID environment, a rise in cases and certain geographies globally locked down, are you seeing any similar demand changes in this climate?

Sure, good question, Josh. We haven't seen a recent noteworthy shift in trends, but I think most businesses went through the initial shift to remote work back in March where this is where we saw our initial spike in activity. We do continue to see pockets of strength relative to pre-COVID levels in some of our premium SKUs and our new products. So for example, our Professional SKU, we're still seeing trial starts show a 25% increase relative to pre-COVID levels. And our HelloSign products, we're seeing trial starts show a 45% increase relative to pre-COVID levels. And we're seeing steady conversion and retention relative to historic trends. And so in the long run, we think the shift to remote work benefits us and aligns with our focus on keeping teams in sync anywhere at any time. And again, that's the latest on what we're seeing.

Perfect. And what about when -- like thinking about the larger outbound deals, how would you characterize sort of current levels of pipeline generation?

Yes, good question. We're seeing a bit less volume in terms of large deals in this new environment. Travel restrictions do continue to introduce some friction into our new deal pipeline generation, where in this climate, our sales team is focusing on our highest efficiency motions, which include retention and expansion of existing customers. And cross-selling add-ons and HelloSign into our customer base. So we're seeing success with this targeted, efficient sales motion, and that's where we're leaning in right now.

Okay. Perfect. Before jumping into the investment thesis and growth and margins, I did want to ask about your Virtual First strategy. Obviously, there are the cash flow impacts from real estate, potential, I think, to get different or better talent or more geographically diverse talent. So I'm wondering, from your perspective, what are the most meaningful impacts from this strategy? Is there a change to how sales and marketing or R&D teams work? Any commentary there would be interesting.

Sure. Maybe to give some context as to what Virtual First is. So we have made a decision that focused individual work will happen at home, and we're turning a portion of our offices into the collaborative spaces, we call Dropbox Studios, for in person group collaboration. So we've said because of COVID, we're all working from home through June of next year. And so this is really going to start kicking in when a vaccine is available. And let's say, that's July of next year. And so we haven't quite lived this just yet. This, of course, is the intention. This is the strategy. And this is what we talked about as far as the real estate footprint, and to your point, opening doors to diverse talent markets. As far as the potential strategic implications, I think the biggest thing that we are thinking through and the biggest reason we made this decision was from a product and a customer perspective, where we are focused on designing products to transform how remote work happens. And by living this, by living remotely and working remotely every day, we think we'll be best able to understand what our customers are going through, and to evolve our products to address those needs. So this is somewhat of a strategic decision from a product perspective to make sure that we are living the reality of this distributed work environment and adapting our road map to continue to design products that best enable people to get their work -- best work done in this environment. And so -- go ahead, Josh.

I think that's really interesting. So just shifting from sort of near-term impacts to longer term, thinking about growth and margin, maybe just to start, it would be helpful for you to frame the Dropbox investment thesis for investors.

Sure. And I tried to start off our script in our November call with a recap of this, but to recap it again here, our investment thesis is to consistently execute against the guidance that we give. So we want to do what we say. We want to generate and earn credibility with the market by doing exactly what we say, and part of that is executing against our guidance. We're going to invest for continued revenue growth. We're going to drive annual improvements in operating margin, and we've certainly seen that this year as we're on target to deliver operating margins of, call it, 20% this year, which is about an 8-point improvement year-over-year. We're going to deliver free cash flow of $1 billion in 2024, which represents a CAGR of roughly 20% over this time horizon. And we plan to allocate our capital thoughtfully according to our organic initiatives, M&A and share repurchases, where we do plan to allocate a significant portion of our annual free cash flow to share repurchases on an ongoing basis with the intention of at least offsetting share count dilution. And so it's -- we will continue to drive revenue growth. We will continue to drive profitability, both on the margin front and the free cash flow front, hitting this $1 billion in free cash flow in 2024 and allocating our capital thoughtfully and with intention.

Okay. Great. I think I want to dig into all those different components, maybe starting with growth. We did see ARR growth slow a bit from Q2 to Q3. To start, if you could talk about some of the puts and takes on -- in ARR growth and then looking forward, what will the main drivers of growth in your business be?

Sure. So one of the main factors of that deceleration was our -- we lapped the plus pricing increase that we had over -- it was stretched from Q3 2019 all the way through Q2 2020, so the 4 quarters there. And so we lapped that. And so that drove a bit of a deceleration in ARR, though from a glass half full perspective, we did beat our guidance, and we did raise for the full year. And part of that was the COVID spike that we talked about earlier, where we saw a shift towards our product in the second quarter, and we're happy to have converted and retained those users and been able to raise our guidance as a result. As far as our growth going forward, we're certainly investing for double-digit revenue growth. And I'll say that even with conservative revenue growth rates, we still have very high confidence in our long-term operating margin target and our free cash flow target. And we have a lot of levers that we're working on across our product portfolio that can contribute to revenue growth. And we're excited about several of them. Some of them, we've recently released and those include Passwords, Vault and computer backup to help with conversion and retention. Those went live here in this last quarter. We also introduced a family plan, which just went live this past quarter as well. We recently introduced Dropbox Transfer, which allows you to send up to 100 gigabytes of files in each transfer as part of our paid plans. And a lot of our most dedicated users or creatives use these large files that they tend to share with their partners. And so that's functionality that can best serve them. We have these new add-ons that serve key verticals. As I touched on a bit with these creative tools, data migration, legal hold, various add-ons that offer our sales teams cross-sell and upsell opportunities. HelloSign, which we can offer to new and existing customers. And we've done some work around that as far as natively integrating HelloSign and expanding its international capabilities. We have new products such as Spaces that we continue to iterate on, and make progress and see strong adoption of. And we also have pricing and packaging as another tool in our toolkit. And then, of course, we'll also continue to expand our partner ecosystem. And so at our scale, moving the needle on these innovations can have a large impact on our business. And from my perspective, it's hard to pinpoint any 1 particular initiative. It is all of these initiatives, we are seeing good early signals, and we will continue to invest in where we're seeing the right levels of momentum.

Great. I think you answered all my questions. I covered a lot of products. So I do have a few follow-ups there. So on the Passwords, Vaults and computer backup, I think a lot of value being added to the plus SKU. You mentioned conversion and retention. Any way to quantify or track the success that those new capabilities are having on conversion and retention?

Those are a bit early because they just did go GA in the fourth quarter. But the idea is we have 600 million users or folks that use our product. And we do have a $2 billion -- nearly $2 billion in ARR and a lot of our users are individuals with the potential to convert and to migrate to our premium and team SKUs. And so we're trying to offer functionality to attract users and to convert them and then to move them along our SKU chain, if you will, to our premium SKUs and introduce them to team functionality, et cetera. And so this is where we are optimistic. Part of us -- part of what we're doing with our product road map is seeing how people use our product and hearing from customers what would be useful for them. And so this is where we are introducing these new features and functionality that particularly help with the blending, the blurring of work and home that we're all experiencing right now. So I can go from working on a board deck from 1 minute to telling my kids to go do their homework the next minute. I constantly toggle between work and home. And again, a lot of people use Dropbox for work in home. So introducing this functionality that addresses both work and home cases will help with conversion, will help with retention. And so we are optimistic about these new features and these address this work-from-home situation that we're all facing. And so again, it's early days, but this is the intention of these products, is to address exactly what you're asking about, conversion and retention.

Perfect. And you mentioned family plan. How could that impact the same metrics, retention and churn, over time. Is there any risk of cannibalization, just looking at the pricing for the family plan SKU, or is it primarily marketed to the free user base?

Yes, yes. Good question, Josh. So again, the family plan, it's a new SKU that offers an organized place to share photos, videos, important documents, where now 6 family members can share 2 terabytes of storage under 1 plan and 1 bill. This also just went GA in the fourth quarter, and we're optimistic about how it can help improve conversion and retention. From a cannibalization perspective, this is a great example of where we're leveraging our data science team to avoid cannibalization, where we're marketing, exactly to your point, marketing this primarily to our free user base, where we can see, for example, people with the same last name within our free user base with sharing connections and sharing links, and we can market this product to those users to offer them this opportunity.

Got it. Very interesting. The last one, maybe on the product side, wanted to ask about is HelloSign. You launched a lot of new languages recently. How should we think about the global opportunity there?

Sure. We're really excited about HelloSign. It's one of our fastest growing businesses. As I mentioned, HelloSign trials were up 45% from pre-COVID levels, so seeing strong momentum there. And so this is where we're trying to put the foot on the gas, where we see momentum and this is where we've introduced, exactly to your point, HelloSign in 21 additional languages recently. And we've also made this a native integration where now HelloSign is the default signature option within Dropbox. And I think overall, e-signature is a big nascent market, where HelloSign can bring value to new and existing users. And pre-COVID, people are still using pen and paper to do their signatures, and that's no longer feasible in this moment, nor is it healthy. And so this is the time to capitalize on e-signature. And the shift to international is a big opportunity for HelloSign, where Dropbox, about half of our revenue is based outside of the U.S. and we're certainly leveraging our knowledge, our muscle, our distribution network, our self-serve engine to bring this to the HelloSign aspect of the equation to help accelerate that opportunity. And so we're also adding fuel to the effort, if you will, by establishing data center support in foreign countries and expanding local customer support. Also supporting this with marketing efforts and making sure that our sales teams are able to sell both Dropbox and HelloSign at the same time, where in the past, we had our sales teams -- we had separate sales teams, one selling HelloSign and one selling Dropbox. And now they're both all selling Dropbox and HelloSign together. And so we're seeing much more of these bundled deals get executed. And so we're certainly excited about this, excited about the momentum and if I just perhaps wrap up on HelloSign, I think one of our advantages relative to some of our competitors, if I think about the life cycle of collecting a signature on a document, I need to find the document, I need to get the document signed, and I need to store the document. I think Dropbox can help and HelloSign can help with all of those. As far as finding the document, getting it signed and where do I store it, you can do that all natively within Dropbox.

Perfect. That makes a lot of sense. Before shifting over to margins and capital allocation, wanted to ask one more sort of on the future of work, just get your long-term view, and maybe this is a question around Dropbox Spaces. But I'm wondering is Dropbox Spaces really making the bet that the content itself is that center of the future of work rather than the project management application or the chat-based channel application? I guess like why is it really important to have collaboration communication around content? And more broadly, looking 5, 10 years down the road, how does Dropbox's role in the future of work change from its role today?

Yes. That's a great question. I think we think about, we call it the 3 Cs as far as getting work done or productivity and collaboration space between content, communication and coordination. And so we do see content as critical in that equation, in that it is the output or it's the deliverable that results from collaboration and communication. It's the permanent relic of the work you do. And so we also think of ourselves as Dropbox as the long-term memory of an individual or a business, where you bring together your knowledge, your IP, and it tends to result in a piece of content. And so -- versus some of the communication-based folks, those interactions can disappear as the short-term memory. And so you pull together -- this is where we're partnering with Zoom and Slack, to pull together that short-term memory and the long-term memory that Dropbox represents so that work is all solidified and documented and captured, if you will. And so maybe just to elaborate and to give you an example. So we've got a Board meeting here in the next couple of weeks. All of our work right now is centered around the ultimate presentation that we will be delivering to our Board. And so I may be having a meeting with Drew and a conversation with my team and draft documents and draft e-mails and draft Slacks interactions, but they all eventually reside and end up in a document or in that PowerPoint or whatever it might be that represents what we share with the Board. And so we think that content has this gravity, content has this, again, long-term memory component that will always be there with work and will always be there for individuals and for companies. And fortunately, for us, that's our strength. That's what we do. We already have 550 billion pieces of content. We see how people use it. We are the best at storing, organizing, sharing, syncing and collaborating around that content. And this is what we're trying to do with Spaces, where we're trying to solve the problem of fragmentation in your Workday by bringing together your content, your tools and your teams in order to collaborate and execute against the content that will ultimately be the output of your work.

Okay. Great. We have a little less than 10 minutes. I'm also scanning for investor questions on a different monitor that I'll incorporate. But moving on to margins, 28% to 30% operating margin target in 2024, $1 billion free cash flow. I guess, starting with gross margins. You talked about unit cost efficiency gains and infrastructure hardware and depreciation as a percentage of revenue trending lower. Where are the sources of leverage on the COGS line and gross margin line? And how sustainable are those efficiencies?

Sure. So we've guided to -- we shared a long-term margin framework of targeting 78% to 80% on the gross margin side, and we're already actually at 80%. And so we made a lot of progress. Our team's done a great job of introducing innovation and improvements to help drive that path, if you will, where a few examples are SMR technology, shingled magnetic recording, which increases storage density per disk by 75% and we're roughly 70% of the way there as far as our storage leveraging SMR technology through the second quarter. And so that's one example of innovation that we're making and there's more runway on that front. We've also introduced this cold storage layer which stores less frequently accessed data at lower cost. And so the infrastructure team that we have, they continue to innovate and drive improvements in understanding how individuals and how teams are using their data and accessing their data and driving improvements in our cost structure given that knowledge. And so we're confident in the long-term targets that we've given along the gross margin front.

Okay. Perfect. And the same question on the operating line as far as leverage.

Yes. So here, we said we will achieve 28% to 30% operating margins by 2024. And we've gone from -- we ended 2019 with -- in the neighborhood of 12% operating margins. And we've guided to 20% operating margins this year. So we've made a lot of progress, a lot of headway along that path, which demonstrates that the first 3 quarters of this year shows that we can execute on this trajectory. And so where will that continue to come from? I touched on gross margins a little bit. Some of this is a level of discipline and rigor with our R&D and sales and marketing spend and looking at everything through an ROI analysis and making sure that everything we're doing on the product front, on the marketing front, as a sufficient ROI, that we're holding ourselves accountable to those thresholds. But then also some specific areas, really, one of them I'll point to is this Virtual First strategy, where now we can hire more in low-cost locations. And if I think about where our talent is now, a lot of it is based in the San Francisco Bay Area, New York, Seattle, London, Tokyo, some very high-cost locations. And so with this Virtual First strategy where we are all going to be working remote, this really opens the door for us to hire in some of these low-cost locations and to really shift our talent to those areas. And then again, I touched on this in our Q3 call, we're going to be subleasing a large portion of our facility footprint, which we expect may generate an excess of $800 million in cash flow over the course of those leases, which do range in duration between 13 and 15 years. So we're early on, and we need to go secure those subleases and subtenants, but this is another potential source of leverage in our model. And those are just a few examples. Those are not all the examples we can and we'll pursue. But that gives you a sense of some of the things that we've done and we'll be doing to drive towards those 28% to 30% targets.

Perfect. Taking one from an investor. Any color on how sales productivity has been developing? What are the main drivers there? And then also tying in sort of competition, as far as win rates versus the competitive landscape?

Maybe -- I'll start by saying, maybe just reminding the group that 90% of our revenue comes from our self-serve channels. And so obviously, the bulk of our revenue comes from folks signing up on those individuals and SMB base plans and then bringing them along that value chain through our targeted outbound motion. And I'll be honest and say that our outbound team has experienced some level of friction with this inability to travel. And so that's part of what we're seeing as far as -- in the second quarter, we closed a large EDU deal. We didn't have a similar deal in the third quarter. So there can be some lumpiness in deals, particularly on the outbound side of things. And so there has been a bit of friction on the sales outbound front, but we're fortunate to have this strong self-serve muscle to counterbalance that.

Okay. Great. In the last minute, I wanted to just touch on capital allocation, sort of how we started the conversation with -- around the investment thesis. M&A and buybacks, both big, big parts there. How should investors think about the priority of the two and what to expect?

Sure. The priority initially will be funding organic initiatives where we see the right return. And so for example, this year, even outside of stock compensation, we'll spend over $0.5 billion on R&D initiatives. And so we'll fund those, first and foremost, then we will continually assess M&A to make sure that we are thinking through potential targets that fit our product road map, that fit our culture, that fit our financial objectives. And so I think HelloSign and Vault are some good examples of the types of deals we will consider. But of course, we'll be thoughtful with respect to valuations. But again, M&A is certainly part of our strategy, and that is something we will contemplate. And then once we've considered organic and M&A, we will also pursue a share repurchase program. And so we've spent -- we have this initial $600 million authorization. Through the end of the third quarter, we spent $178 million against that $600 million. And I said on the last call that we do plan to accelerate the pace of that repurchase where we aim to exhaust that authorization by the end of the first quarter of next year. So we're really going to ramp up that $600 million authorization and exhaust that by the end of the first quarter of next year. Okay. So then I also said we intend on allocating a significant portion of our annual free cash flow to share repurchases on an ongoing basis with the intention of offsetting dilution at a minimum. So that gives a bit of a floor. So we'll ramp up this authorization through the end of Q1, then on an ongoing basis from there, we'll have this floor of offsetting dilution at a minimum as an ongoing commitment to share repurchases. And I think a lot of this stems from our -- the strength of our business model. We have over $1.2 billion in cash on hand. We're going to generate roughly $500 million in free cash flow this year. And we'll continue to do more, as I've demonstrated or shared with our investment thesis as we're aiming for $1 billion in 2024. And we're going to put it to work through this hierarchy of capital allocation methodology.

Excellent. That's all the time we have. Tim, thank you so much for taking the time and joining today, very interesting story. We really appreciate it. Thank you.

Thank you.