Good afternoon, ladies and gentlemen. Thank you for joining Dropbox's second quarter 2018 earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. 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 hand the call over to Darren Yip from Dropbox's investor relations team. Please go ahead.
Thank you. Good afternoon and welcome to Dropbox's second quarter 2018 earnings call. Today, Dropbox will discuss the quarterly financial results that were distributed earlier. Statements on this call include forward-looking statements, including statements relating to the expected performance of our business, future financial results, strategy, long-term growth, and overall future prospects. These statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those projected or implied during this call. In particular, those described in our risk factors included on our Form 10-Q for the quarter ended March 31st, 2018, and the risk factors that will be included in our Form 10-Q for the quarter ended June 30th, 2018. You should not rely on our forward-looking statements as predictions of future events.
All forward-looking statements that we make on this call are based on assumptions and beliefs as of today, and we undertake no obligation to update them except as required by applicable law. Our discussion today will include non-GAAP financial measures. These non-GAAP measures should be considered in addition to, and not as a substitute for, or in isolation from, our GAAP results. A reconciliation of GAAP to non-GAAP results may be found in our earnings release, which was furnished with our Form 8-K filed today with the SEC and may also be found in the supplemental investor materials posted on our investor relations website at investors.dropbox.com. I would now like to turn the call over to Dropbox's co-founder and Chief Executive Officer, Drew Houston. Drew?
Thanks, Darren. Good afternoon, everyone, and welcome to our earnings call. On the call with me are Dennis Woodside, our Chief Operating Officer, and Ajay Vashee, our Chief Financial Officer. Before we discuss our results, I want to take a moment to thank Dennis for all of his contributions to Dropbox. As you know, earlier today, we shared that Dennis is stepping down in his role as COO, and his last day will be September 4th, and he'll stay on as advisor through the end of the year. It's hard to overstate Dennis' impact on Dropbox. When he started, we had a couple hundred million in revenue, and our company was a fraction of the size. During his time here, we've grown into a publicly traded company with over $1 billion in annual revenue and a dozen offices around the world.
Dennis has been a critical part of our company's evolution, and he's helped us reach operational maturity, and he's helped us through the important milestone of an IPO. While we're sorry to see him go, he's leaving the business in great shape and in the hands of an incredible team he's helped to build. I'm excited to share that we're promoting two of his senior leaders to take on his responsibilities. Yamini Rangan, who will become Chief Customer Officer and oversee our customer and partner-focused functions, including sales, marketing, and business development, and Lin-Hua Wu, our current VP of Communications. Yamini brings over 18 years of experience from companies like SAP and Workday, while Ling joined us a few years ago from Square and brings more than 15 years of experience in communications. I know we'll benefit from their perspective and leadership.
Dennis, we'll miss you and wish you all the best in your next adventure.
Thanks, Drew. It's been an incredible four years and truly an honor to be part of the Dropbox journey with you, Arash, and the entire team. I'm grateful for my time here and know the business is well-positioned for the future. I'm a huge believer in this team and in Drew's vision for the company.
Thanks, Dennis. Let's continue with the call. I'll touch on our business and product highlights. Dennis will give you an update on our go-to-market strategy and ecosystem, and Ajay will review our Q2 financial results and provide guidance for Q3 and fiscal 2018. Q2 was another great quarter, with revenue growth of 27% year-over-year, driven by continued paying user growth and meaningful ARPU expansion. We also generated a strong non-GAAP operating margin, which helped us deliver solid free cash flow. Overall, our results continue to demonstrate the strength of our global collaboration platform, our efficient go-to-market strategy, and our operational discipline. Let's move on to our product update. We achieved some important milestones in Q2 that made the Dropbox experience for our users, teams, and admins even better.
Last quarter, we announced more than a dozen new features to enhance the Dropbox mobile app, Paper, Showcase, and admin functionality. We'll start with the mobile app. On our mobile app, we introduced new features to help users collaborate more easily with their teams while on the go. Users can now add comments, access teammate feedback, and view file activity updates while previewing a file in Dropbox. These updates are great for getting a quick pulse on how a user's work is moving along without disrupting a team's flow. Features like these help make Dropbox an intelligent workspace for people to collaborate on all of their content across all of their devices. Turning to Paper, one of the new product features I've been most excited about was launched in direct response to feedback from our users, the ability to turn any Paper doc into a shareable template.
Paper templates help our users start docs without having to format them from scratch so that teams can get projects moving quickly. Features like templates have helped drive higher adoption of Paper, as well as continued business impact. As we've mentioned previously, teams using Paper both convert and retain at higher rates than those without Paper usage. Next is Showcase. We've also been gathering feedback from Dropbox Business teams that we've been able to build into our Showcase product in Q2. These new features give teams the ability to share and collaborate more quickly and efficiently with things like drag and drop uploads, Showcase copying to easily duplicate existing presentations, and recipient previews. Finally, the admin experience. While we're always improving the Dropbox experience for our users, we've also been investing in simplifying security and admin controls for Dropbox Business teams.
One, admins can now export member data reports to simplify security auditing, and two, they can convert individuals' business accounts to personal accounts when removing them from a team. We also gave team admins the ability to disable downloads of shared links and implement directory restrictions to help protect identities of team members. We rolled out a number of advanced deployment tools, including Team selective sync. Team selective sync helps speed team deployments by allowing admins to specify which shared folders will be synced to users' computers, saving time and expensive hard drive space. Let's move on to the infrastructure that powers our platform. Many of you are familiar with Magic Pocket, our unique, custom-built cloud infrastructure. In Q2, we announced another industry-first advancement.
I'm excited to share that Dropbox is the first major technology company to test and implement shingled magnetic recording, or SMR, drive technology at scale. Today, data is stored in hard drives on tracks, which are circular paths on a disk surface on which information is magnetically recorded. SMR drive technology layers new tracks on top of old ones instead of in parallel, like conventional hard disk drives, which reduces the physical space needed to store an equivalent amount of data. Using SMR technology will increase overall storage density from eight terabytes to 14 terabytes per disk and provide continued cost savings without sacrificing performance or reliability. As more and more people collaborate on Dropbox, SMR technology will help us continue to flexibly and efficiently grow our cloud infrastructure. We're also proud of some of the external recognition we've received, as investments like these have strengthened our platform.
In Q2, Dropbox was named a leader in Gartner's Magic Quadrant for Content Collaboration Platforms report, published on July 9, 2018. We improved our position on the completeness of vision axis relative to the 2017 report. We believe that this kind of recognition is a testament to the transformative work we're doing to help individuals and teams create, share, and collaborate around the world. To sum up, we're constantly working to add new tools and functionality to Dropbox so our users can get their best work done. We're also strengthening our product leadership team. Yesterday, we announced that Adam Nash will join Dropbox as our VP of Product, reporting to Quentin Clark, who's our SVP of Engineering, Product, and Design.
Adam is the former CEO of Wealthfront, which is one of the world's most innovative asset management companies. He held key roles at companies like LinkedIn, eBay, and Apple, building and scaling several major products and managing global teams. We're also excited that Naman Khan has joined us as VP of Product Marketing. Most recently, Naman was VP of Product Marketing at Salesforce, where he led enterprise and commercial product marketing for the Sales Cloud. Before that, he held strategic marketing roles at Autodesk and Microsoft. With this team in place, we'll continue innovating to improve our platform and deliver more value to our users as we execute on our mission of designing a more enlightened way of working. I'd now like to turn the call over to Dennis to talk about our go-to-market traction and ecosystem.
Thanks, Drew. The kind of innovation that Drew highlighted increases the attractiveness of our platform and helps drive our go-to-market momentum. In Q2, we saw this materialize with strong adoption of our premium team subscription plan, Dropbox Advanced. As you may recall, we launched Dropbox Advanced a little over a year ago. It offers sophisticated administrative, security, and device management functionality, along with new products like Showcase. At the time of the launch, we grandfathered all existing standard teams into the Advanced plan at their legacy price point. As of the end of Q2 2018, we completed the renewal process for nearly 50% of grandfathered teams. A meaningful portion of these teams elected to remain on our Advanced plan at an approximately 30% price premium, helping to lift ARPU in the quarter to $116.66.
While still early, these results demonstrate that our users are deriving real value from our premium team features. Going forward, renewals from grandfather teams will be more evenly spread across the next few quarters. We're also focused on driving higher adoption of our premium individual subscription plan. Towards the end of 2017, we launched Dropbox Professional at a 100% price premium to our Plus plan. Based on user feedback and experimentation across the first half of this year, we determined that further segmenting storage capacity between our individual plans would help to differentiate our product range and drive further adoption of Dropbox Professional. As a result, we recently increased the storage cap for our Professional plan from 1 terabyte to 2 terabytes. We believe that this change will serve as a tailwind to ARPU and be net positive to margins in future periods.
We've also been working to improve our data science models and self-serve growth engine. Our large user base gives us access to hundreds of millions of messaging services and data points to fine-tune our conversion and retention efforts. Our data science team recently built an upsell propensity model to predict the likelihood of outbound accounts to expand their deployment. Using a sample of over 10,000 teams, we analyzed more than 100 indicators to distinguish which customers had the highest potential to grow their paying user base. We found that teams with scores in the top decile of our model are six times more likely to upsell compared to the average team. Utilizing this data science tool, we're helping our outbound sales reps improve deal velocity by more efficiently targeting accounts for expansion. Turning to our ecosystem, we continue to make progress against our announced partnerships with Salesforce, Google, and Adobe.
In Q2, we participated at Salesforce World Tour events in New York and London, launched our Gmail add-on at Google Next, and worked with Adobe to strengthen our product integrations within Document Cloud and Creative Cloud. You'll recall that last quarter, we also noted new partner integrations in the architecture, engineering, and construction vertical as part of an effort to advance partnerships across a number of key industries. In Q2, we announced that we were expanding our integration efforts in the media and entertainment vertical. Media and entertainment teams use Dropbox to collaborate on a wide range of file formats. Last year, teams across these industries created and saved more than 1 billion files in Dropbox. At this scale, we have a tremendous opportunity to help streamline end-to-end workflows and serve as a unified home for team content and collaboration.
To better support these teams, we announced a number of integrations this past quarter with companies like Canva, Final Draft, Frame.io, Getty Images, SHIFT, Marvel, and Widen. As a reminder, our ecosystem strategy is to position Dropbox at the center of our users' workflows. This has tangible business value for Dropbox, as teams that link a third-party app to our platform expand faster and retain at higher rates. Turning to customer wins, our industry-focused partnerships are paying off. We have paid team deployments in eight of the top 10 media and entertainment companies within the Fortune 500, and we continued to see great traction in Q2 with organizations like Macmillan Publishers, Meredith, Aller Media, and Hearst. I want to share two examples from the past quarter of why media and entertainment companies are choosing Dropbox.
The first is a global media company that committed to an initial deployment of 700 Dropbox Enterprise licenses for its team of over 3,000 employees. As part of the sales cycle, we showed this customer that a large cross-section of users in important creative functions were relying on Dropbox rather than the company's existing solution. These users prefer Dropbox for its strength in real-time collaboration, large media files, and external sharing. Another major entertainment and news conglomerate also expanded its deployment with Dropbox by 750 licenses to 4,500 seats. The customer, an owner and operator of cable television networks, noted the ability to more easily collaborate on a variety of content types with external partners as a primary driver for its adoption of Dropbox. While we've seen solid momentum with our vertical strategy, we also continue to see great wins across all the industries we serve.
In Q2, this included enterprise deployments at Deutsche Bundesbank, the central bank of Germany, chemical manufacturer FMC, and women's clothier, MM.LaFleur, among others. I'll now turn it over to Ajay, our CFO, to walk through our financial results.
Thank you, Dennis. Our Q2 results continue to demonstrate our strong execution and focus on delivering top-line growth and free cash flow generation. Total revenue for the quarter was up 27% year-over-year to $339 million, driven by an increase in total paying users and strong ARPU expansion. We ended Q2 with 11.9 million paying users, with the majority of growth primarily driven through our self-serve channels. We also saw healthy uptake of our premium, Professional, and Advanced plans, with a strong tailwind from the expiration of a grandfathering period for certain team subscribers, as Dennis mentioned earlier. ARPU was $116.66 in Q2, up 5% from $111.19 a year ago. Before I move on, I want to note that unless otherwise indicated, all income statement measures that follow are non-GAAP and exclude stock-based compensation as well as an equity-based charitable donation to the Dropbox Foundation in Q2 of 2017.
A reconciliation of GAAP to non-GAAP results may be found in our earnings release, which was furnished with our Form 8-K filed today with the SEC and in the supplemental investor materials posted on our investor relations website. Gross margin for the quarter was 74%, an increase of seven percentage points compared to the second quarter of 2017. The increase in gross margin was primarily driven by unit cost efficiency gains with our infrastructure hardware, including lower depreciation as a share of revenue. We expect depreciation to continue to decline as a percentage of revenue in the second half of 2018, offset by higher spend on network expansion as we grow our global footprint. We continue to expect gross margins to be approximately 74% across the remainder of fiscal 2018.
Moving to operating expenses, second quarter R&D expense was $92 million, or 27% of revenue, compared to 26% in Q2 a year ago. The increase as a percentage of revenue was primarily driven by higher headcount as we continue to invest in new product experiences to broaden the value of our platform. S&M expense was $80 million in the second quarter or 23% of revenue and consistent with S&M expense as a percentage of revenue in Q2 a year ago as incremental spend on our brand campaign was offset by more leverage on headcount. G&A expense was $33 million or 10% of revenue and consistent with G&A expense as a percentage of revenue in the prior year as headcount and other costs grew in line with revenue. Taken together, we earned $48 million in operating profit in the second quarter.
This translates to a 14% operating margin, which is a six percentage point improvement from Q2 of 2017. Net income for the quarter was $48 million, up from $20 million a year ago. Diluted EPS was $0.11 per share, up from $0.06 per share in Q2 2017, based on 423 million diluted weighted average shares outstanding as of Q2. Moving on to cash balance and cash flow, we ended Q2 with cash and short-term investments of $982 million. This includes the $108 million of net proceeds from the underwriters' exercise of their greenshoe option in April. Cash flow from operations was $112 million in the quarter. Capital expenditures were $10 million, yielding free cash flow of $102 million or 30% of revenue. CapEx in Q2 included $2 million of spend on our new headquarters, net of tenant improvement allowances received.
As a reminder, at the end of 2017, we entered into a lease to move to our new San Francisco headquarters, which will be completed over approximately the next two years. In Q2, we modified the build-out schedule of our new headquarters, which deferred some CapEx spend for the building. This will result in approximately $20 million in CapEx and related offsetting tenant improvement allowances to shift from 2018 to 2019. These changes to CapEx and OCF roughly offset, and therefore, do not impact free cash flow. We now expect total CapEx related to the build-out of our new headquarters, net of tenant improvement allowances received, to be approximately $30 million-$35 million in 2018. In Q2, we had $19 million of additions to our capital lease lines for data center equipment.
We continue to expect additions to capital lease lines to be high single digits as a percentage of revenue this year. Turning to our guidance, for the third quarter of 2018, we expect revenue to be in the range of $350 million-$353 million, non-GAAP operating margin to be in the range of 7.5%-8.5%, and diluted weighted average shares outstanding to be in the range of 424 million-429 million, based on our trailing 30-day average share price. For the full year of 2018, we are raising our revenue guidance, which was previously $1.343 billion-$1.355 billion to $1.366 billion-$1.372 billion. We are raising our non-GAAP operating margin guidance, which was previously at 9%-10% to 9.5%-10.5%, and we continue to expect free cash flow to be in the range of $340 million-$350 million.
This figure includes one-time spend related to the build-out of our new corporate headquarters. Finally, we expect 2018 fully diluted weighted average shares outstanding to be in the range of 411 million-416 million, based on our trailing 30-day average share price. I'll now turn it back to Drew for closing remarks.
Thank you, Ajay. In closing, we had another great quarter. In Q2, we added new features to improve our user and admin experiences, strengthened our infrastructure, and were recognized by Gartner as an industry leader. We achieved all of this while driving solid growth and a strong operating margin. On behalf of our management team, I'd like to take a moment to thank our customers, partners, and the entire Dropbox team. With that, I'd like to open it up for questions. Operator?
Thank you. Ladies and gentlemen, at this time, we'll begin conducting a question and answer session. To ask a question, you may press star then one on your touch-tone phone. To withdraw your question, please press pound. Please limit yourself to one question and one follow-up question. Thank you. Our first question comes from the line of John DiFucci with Jefferies. Your line is open.
Hey, guys. Thanks for taking my question. Zach Lountzis for John. Just wanted to dig in on the ARPU, with the pricing of the Advanced plan there. I think you guys said 30% uplift, implying that the 60% kind of list price that was discounted for the first year. Can you just kind of elaborate on that? Does it go back to the $240 aside from traditional discounting after that? Any color on churn in the quarter, particularly given the end of grandfathering here? Thank you.
Sure. This is Ajay. I'm happy to take that question. To the first part of your question on the price premium for grandfathered team subscribers. At this time, for folks that are coming up for renewal, our monthly subscribers, as well as for annual subscribers that reached an expiration period last quarter, a meaningful portion of them elected to remain on our Advanced plan at roughly a 30% price premium. That's a step up from their legacy price point, but it's not full list price for the Dropbox Advanced SKU. I think looking forward, it's a little bit early for us to comment on any future pricing-related initiatives. I do want to clarify that for us, that ARPU expansion that we've driven is really a reflection of the value that we're delivering to our users.
It's a function of higher attach rates to our premium SKUs and not a general pricing increase. To your second question on color on churn in the quarter, we don't disclose churn on a regular basis. We did provide some color on gross retention rates as part of the IPO process. Churn for us has been stable and improving for many quarters and for a long period of time. I can say on the margin, with initiatives like grandfathering expiration for Dropbox Advanced
It's a meaningful driver of revenue growth, but can impact in-period churn. Nothing notable there, but on the margin, it can have an impact on in-period churn.
Great. Okay. Thanks a lot, guys.
Thank you. Our next question comes from the line of Heather Bellini with Goldman Sachs. Your line is open.
Hi. This is actually Ted Lin on for Heather. Thank you very much for taking my question. On the strong ARPU growth, I guess how much of it is being driven by a one-time grandfathering effect versus kind of new customers selecting more premium SKUs? What are the biggest features that are leading users to select the Advanced and Professional SKUs?
Well, at a high level, it's certainly driven by the work we've been doing to create higher tier SKUs and higher adoption among our customers of those higher tier plans, also a general drive towards getting our customers to adopt the business version of Dropbox. I would say across the board, all those things, Ajay can comment on some of the numbers.
Yeah. For some more specific kind of Q2 commentary, I would say the higher ARPU was driven by a few different factors. One was increased adoption of our Professional and Advanced SKUs, both from gross new subscribers, also increased adoption from grandfathering expiration, as well as a higher mix of teams licenses. We are seeing a mix shift towards more and more teams licenses as a percentage of net new licenses added to the platform. Just to comment on grandfathering for a moment, we did complete that process, just to reiterate what Dennis said earlier, for about 50% of grandfather teams last quarter, a meaningful portion did elect to renew at a higher price point to our Advanced plan. I would say adoption of premium SKUs more generally, inclusive of grandfathering, was the primary driver of ARPU expansion for us.
There are other drivers, things like this customer journey that we're facilitating from individual plans to team plans and that subscriber mix shift over time.
Great. Thanks. That's very helpful. As my follow-up, noticed that your R&D ticked higher as a percentage of revenue versus the year ago period. How do we think about the cadence of the introduction of potential new SKUs? I think the Advanced SKU came early last year, and the Professional SKU was kind of a later timeframe last year. Any kind of color on how you're thinking about the introduction of new premium SKUs would be helpful. Thanks.
Well, I think we don't have any plans to change our SKUs meaningfully. We did want to create multiple tiers, and you'll notice that new functionality like Showcase and Smart Sync is only available in either the Business version or product, or in some cases, the highest tier individual plan. We want to continue to evolve and differentiate those SKUs, and strike the right balance between being able to capture more of the value that we deliver and have some level of price discrimination or matching our customers who really get a lot of value out of Dropbox to higher tier plans. We also want to keep things simple.
I would say our focus will be on improving the experience and driving more adoption of the higher tier plans, and moving people along that journey from free use to maybe a paid individual subscription to a paid corporate subscription, and then the higher tier plans within that.
Excellent. Thank you for the color.
Thank you. Our next question comes from the line of Mark Murphy with JPMorgan. Your line is open.
Yes. Thank you. I'm curious, what is your early telemetry on the effectiveness of the Dropbox television advertising campaign that you launched, I believe, late last year? Are the views and impressions you're getting there helping to drive ARPU or retention or user additions in any measurable way?
Hi, Mark. It's Dennis. Thanks for the question. The majority of our investment in our brand campaign was actually made through digital channels, because we feel that by and large, that's a highly effective way of reaching prospective customers. You'll recall that one of the objectives of the campaign, the primary objective, was to shift perception slightly among people who might be considering Dropbox as a collaborative platform. The focus was on explaining how Dropbox helps teams unleash their creative energy. We had fairly rigorous metrics that we had in place, both pre and post-campaign, measuring among our target audience, which in that case, were people who were likely to be considering forming a Dropbox team. We saw considerable lift among all the metrics that we wanted to track there.
We don't directly link that to or expect our brand campaign to be driving immediate changes in monetization. We think that's a longer-term investment over time. We think it's important as we have more collaboration features in Dropbox, that people think of Dropbox as a broader collaboration platform, which is a reason to continue investing in brand.
Okay. Thank you, Dennis. As well for Ajay, is it fair to think that the Dropbox engine overall is being built for fairly consistent gross new user adds, clearly there's more attrition naturally as you scale, that therefore ARPU is going to be a more important driver. I guess I'm curious what you would think if we were modeling the net new user adds at perhaps 350 to 550 per quarter going forward. Do you think that's a reasonable range moving forward to try to find the right balance between the user adds and the ARPU growth, which has been a very healthy total equation for you?
Yeah. Thanks, Mark. Happy to answer the question. I would say at a high level, our strategy continues to be to drive revenue growth through a combination of paying user conversion to our individual and team plans As well as ARPU expansion, that's what drove revenue performance last quarter, that'll be what'll drive revenue growth in the future. To comment specifically on your question on net new paying user adds, we added approximately 400,000 paying users in Q2, we continue to add paying users at a healthy rate. I would say in any given quarter, the paying user conversion lever and the ARPU lever, one may outpace the other depending on the initiatives that we're deploying in that period.
To comment on a point that you made specifically, our engine for gross new paying user adds has been very consistent over the past few quarters and the past few years. There can be some quarterly variability there based on things like the timing of larger outbound and EDU deals, as well as major initiatives like our grandfathering expiration for Dropbox Advanced, which can impact on the margin, things like churn.
Okay, thank you very much.
Thank you. Our next question comes from the line of Alex Zukin with Piper Jaffray. Your line is open.
Yeah. Hey, guys. Thanks for taking my question, and congrats, another strong quarter. I guess, maybe piggybacking on Mark's question a little bit in terms of modeling, as we look at the first half performance, particularly on the ARPU side, has been accelerating growth on ARPU. As you think about the back half of the year, given the slightly tougher comps, how should we think about the second half ARPU growth versus the first half ARPU growth? I've got a quick follow-up.
Yeah, this is Ajay. I'm happy to take that. Again, I would just reiterate both paying user growth and ARPU growth, important levers for us. Looking forward, paying user conversion will continue to be the primary growth driver. ARPU expansion will also contribute to growth. Some commentary on ARPU as you think about building your model. In Q2, we did see an outsized move in ARPU, given that we completed the renewal process for about half of grandfathered teams. Going forward, renewals from grandfathered teams will be more evenly spread across the next few quarters. I'd expect more moderated expansion in ARPU going forward.
Okay, great. Then maybe just one for Drew or Dennis. A bigger picture question on your enterprise pipeline and enterprise traction. Then in general, when you boil up to be a strategic deal for one of these larger companies, who are you usually displacing and what budget are you usurping? I'm trying to figure out, are they considering you more as a next generation enterprise content management player or kind of in the collaboration and productivity area? Thanks again.
Sure. This is Dennis here. Typically, when we're selling into larger enterprises, we're dealing with the CIO or a senior level IT director. Sometimes, depends on the organization, that's someone who is responsible, if not the CIO, is responsible for collaboration. Other times, it's the person who's responsible for infrastructure and in some cases, dedicated storage. We displace a lot of different solutions. In many organizations, they are still reliant on fairly distributed file servers. Some organizations, we are displacing small and fragmented SharePoint deployments. In other cases, it literally is hard drives. An example there from earlier this year was Clear Channel, which has offices all throughout the U.S., and each of them has a file server under a desk somewhere, which is, when you think about it, not particularly secure. The central organization has no real visibility into what's going on there.
Moving to cloud makes a lot of sense in that organization and putting all those files in one place where you can secure it and have visibility to it. That's typically the kind of budget that we're going after and the kind of return we can drive is both driving enhanced security, but also all those older solutions are costly to maintain, and Dropbox is a very cost-effective solution for those organizations.
Hey, Alex, Drew here, just adding a little bit more. We find that a lot of what drives adoption and eventually drives adoption by IT is just how end users organically use Dropbox. We're finding that more and more as end users choose more of the tools that they're using day-to-day, they're mixing and matching from different Office suites, and there's a level of fragmentation that's increasing that where the employees turn to Dropbox to help them tie all of that together. Increasingly, we find that, especially in the future, IT is turning to Dropbox to help with the governance and securing all that data, especially in a world of GDPR and so on. Just another point is that competition isn't necessarily zero-sum for us. We live side by side with the Office suites.
We find that our users are invariably either using Office for a variety of use cases, or they're using the Google ecosystem for a variety of use cases, or they're using a bunch of other SaaS tools for different use cases. We find that in a collaborative setting, in that bottom-up adoption plays to our strengths because people need to work across different ecosystems.
Great. Thank you, guys.
Thank you. Our next question comes from the line of Richard Davis with Canaccord. Your line is open.
Hey, thanks. You guys are getting nice early traction with Dropbox Teams. When I kind of think about that, to what extent in your product roadmap, and you have a little bit of it already, but does it make sense for you guys to kind of build out a workflow or BPM engine to kind of surround that product? Right? You have a little bit of it, but does it make sense to build that out? Thanks.
We certainly want to address that use case, although we'll likely do it in a way that differs from how it's been done historically. Specifically, we want to take a more integrated approach rather than some separate workflow tool. The way that shows up in the product includes evolving our preview surfaces to include commenting and annotations and a bunch of collaborative features that are in line with the content. We bring a lot of the coordination features together with the content. Dropbox Paper is another example of that, where you can embed the content that's in your Dropbox or really any kind of cloud content. When you have a team working around that content within a Paper doc, you can also have, not just comments and conversations, but you can also assign tasks.
Instead of using several different tools and toggling back and forth between them, we think there's increasing need and increasing demand to have a more integrated approach, and one that's a lot more streamlined and involves less overhead than traditional workflow tools or project management tools.
Got it. That's very helpful. Thank you.
Yep.
Thank you. Our next question comes from the line of Justin Post with Bank of America. Your line is open.
Hey, thanks for taking the question. This is Ryan Goodman for Justin. Two for me. First one, I think you've talked a lot about the upsell strategy. I think that's pretty apparent at this point, and you've also discussed efforts around new enterprise customer acquisition. I'm curious, can you talk more specifically to initiatives underway for converting the current non-paying users more at the top of the funnel? Is this still an opportunity you're looking at, and are there initiatives that you can talk about to accelerate individual plan adoption at the top? Second question from me, and then I'll let you answer. On the competitive landscape, there has been some noise during the quarter. One of your larger competitors announced a standalone enterprise storage solution. Others have been enhancing their offerings in the cloud as well.
Are you seeing any change in the dynamic of customer conversations around this? Have you had to adjust your go-to-market approach at all? Just any color on that would be helpful. Thank you.
Sure. This is Drew Houston. I'll take the second part first, and thanks for your questions. For sure, of course, the other folks in our space will continue evolving our products. That said, we don't see these changes meaningfully changing the competitive landscape for us. Importantly, when you talk about a standalone storage offering and Google pricing for storage, our higher tier or advanced and enterprise SKUs of Dropbox Business already include unlimited space. In fact, we see ourselves as favorable on that dimension. For sure, we keep an eye on competition, but we're more focused on our customers and more focused on just improving our core product experience. As far as driving adoption of paid plans more generally and just driving conversion with the business, one area where we make huge investments is in what we call product-driven conversion.
Because over 90% of our revenue comes from self-serve, we've managed to automate a lot of the activities that would otherwise be done by a sales team or a marketing team. More and more, we're using technologies like machine learning, AI, data science, not only to improve the end-user product experience, but also to match our customers with the paid plans that make sense for them, and to get them to engage with functionality that they might not be aware of. For example, if you're using a lot of space in your Dropbox and don't have a lot on your computer, we might show you something about Smart Sync. If you're sharing a bunch of rich media, we might show you something about Showcase.
Showing people these offerings in context is an area where we make a big investment in product-driven conversion, and that's at the root of a lot of the improvement you've been seeing over the years in ARPU and the attach rates to our paid plans. We will continue to invest there for the years to come.
Okay, thank you.
Thank you. Our next question comes from the line of Karl Keirstead with Deutsche Bank. Your line is open.
Thanks. I've got two for Ajay. Ajay, if we could go back to the sub-adds. Your 400,000 was solid, but it was a little bit light compared to 500,000-600,000 that you've put up the last bunch of quarters. In response to a prior question you mentioned, just generally variables that can impact that, but I'm wondering if you could zero in on 2Q and just help us understand what might have weighed on it in the quarter, and then I've got a follow-up for you.
Sure. In the quarter, I would just reiterate what I said before. Those were some of the drivers of our net new paying user adds in the quarter. A few points. One, that engine for gross new paying user adds has been very consistent over the past few years, and that continued to be consistent in Q2. There can be some quarterly variability, so things like the timing of larger add-on and EDU deals, as well as major initiatives like grandfathering expiration for Dropbox Advanced, the latter can impact in-period churn on the margin. Those are some of the factors that we saw last quarter.
Okay. Good. That's helpful. Then maybe a follow-up for you. I think a decent portion of Dropbox revenues may be denominated in non-U.S. dollars, yet I haven't heard you mention any kind of an FX impact. Maybe it's small, but I thought I'd ask.
Sure. It's a good question. Quarter-to-quarter movements in FX rates have a smaller impact on top line for us, given how our revenue recognition model works. The vast majority of our revenue is already on our books as deferred revenue heading into a given quarter at historical FX rates. For us
Movements in FX rates or currencies have less of an impact in the near term versus the long term. Where they can have a more pronounced impact is on things like billings and free cash flow. What we noted in our S1 was that about 30% of our sales are denominated in foreign currencies, so non-USD.
Got it. Was there any FX impact, or would there be on, let's say, cash flow in 2018, Ajay?
Well, I can say that the guidance that we gave for revenue and for free cash flow is net of any movements that we're seeing in currency and FX today.
Yep. Okay. Very good. Thank you.
Thank you. Our next question comes from the line of Sarah Hindlian with Macquarie. Your line is open.
All right. Thank you very much, and congratulations on the quarter, guys. My first question, the balance sheet is looking really healthy, so I thought it would be helpful if you could give us a reminder in terms of how you're thinking about cash usage and proceeds, and then I have a follow-up.
Great. Hi, Sarah. Our business has been cash flow positive for the last couple of years, our IPO, in many ways, was opportunistic. Having a healthy balance sheet gives us optionality on a number of dimensions to both invest in our core business, M&A, and pretty much whatever comes along. We think it's just a good idea to have a healthy balance sheet, and Ajay can also add some color.
Yep. I would just reiterate what Drew said. We think it's important, A, to make sure that we have the right operational cash to fund the business as a free cash flow positive company. We feel good about our position there. Also having dry powder to pursue strategic initiatives is important to us, and we feel like we have the appropriate amount of capital on our balance sheet today to give us the flexibility that we need over the next few quarters and year.
All right. Thank you, Dennis and Ajay. That was helpful. My follow-up, really, when I'm thinking about investment areas, you made a lot of updates to Paper, some of them pretty small, but some of them a little bit more significant in the quarter. How are you prioritizing sort of the add-on attached services, investment areas to drive more adoption of advanced plans?
We think of these improvements as part of a portfolio, some of these improvements, like Showcase, will drive monetization pretty directly because Showcase is an example of a feature that's only available in Dropbox Business and in the professional highest tier individual SKU. Others will drive more engagement in the Dropbox ecosystem. You think about Dropbox Paper, that's more broadly available, and we find that, as we said before, teams that have Dropbox Paper usage or Dropbox Business teams that have Paper usage convert and retain at higher rates than ones who don't. That drives retention, drives lifetime value, even though it's not a separate SKU. We have a number of levers to drive engagement and monetization, and sometimes it'll be driving adoption of higher tier SKUs, sometimes it'll be driving engagement more generally.
All right. Thank you very much.
Thank you. Our next question comes from the line of Greg McDowell with JMP Securities. Your line is open.
Great. Thank you very much. I first want to ask about infrastructure and Magic Pocket. You mentioned you're the first major tech company to adopt SMR, the things that really stood out to me from the June blog posts were lower costs, greater density, and better cost structure. My question is, in the longer term, how should we think about this SMR technology impacting your infrastructure costs and maybe your CapEx needs as a percentage of revenue? Then maybe one follow-up.
Yeah. We think SMR is a great example of one of just a technical achievement. I think one of the barriers to adopting SMR or cutting-edge technologies like that are that you have to customize your applications, and change a bunch of things from an engineering standpoint, which our team was able to do because we control our entire stack. It's a good example of not only providing a cost advantage, but also flexibility, because adopting SMR would not be an option at this moment through the public cloud. We think that it's a good example of how being more integrated or vertically integrated in the long run is a big advantage, especially as workloads evolve and things like machine learning and compute become a bigger part of the picture. Ajay can add more color on the cost effectiveness.
Yep. This is Ajay. While we aren't providing specifics on our future savings projections from SMR today, I can say that it will be a phased multi-year undertaking for us and one of the drivers of gross margin expansion toward our long-term target of 76%-78% of revenue.
Yeah. Again, it's an example of, as the technology evolves in all parts of the supply chain, we can ride that cost curve down a lot faster than if we had to wait for other folks to pass it along to us.
Thanks. One quick follow-up, not to beat a dead horse with this grandfathering, we've talked a lot about the grandfathering expiration of Dropbox Advanced, which was introduced in January of 2017. We're feeling the tailwinds sitting here 18 months later. I wanted to ask about actually the professional SKU for individuals, which was introduced in November 2017, a full 11 months after Advanced. I guess my question Really is how should we think about the grandfathering expiration phenomenon of that professional SKU for individuals, compared and contrasted against the advanced SKU? Thanks.
Well, I'd say, in short, it'll be a little bit more moderated because with the grandfathering on the business side, folks that were on the original Dropbox Business plan were defaulted into a higher tier SKU. That's not the case with Plus and Professional. It will affect, certainly the presence of the higher tier SKU is an opportunity that presents itself immediately for new users or for new subscriptions. We will, of course, offer it, Professional is also available to folks who have the Plus subscription and who are interested in driving up sales there too. It's not the case that we'll be opting everyone in, or all existing Plus users into Professional. It's a little bit of a different dynamic.
This is Ajay. Just to clarify, we have not to date and don't plan to in the near future, grandfather existing Plus subscribers into the Professional SKU. We're taking a different approach and strategy there relative to what we did with our team subscribers and Advanced plan. That being said, to reiterate what Drew just said, we are focused on driving higher and higher attach rates through different levers to that Pro SKU.
Continuing to improve features like Showcase. We found a lot of our customers were emailing us saying that they had more than one terabyte, or they needed more than one terabyte of space and didn't want to buy multiple licenses of a Business subscription if they were a freelancer. We just didn't have that alternative available to them. There are a lot of levers that we have to drive higher adoption of Professional and our higher tier SKUs in general.
Got it. Thanks.
Thank you. Our next question comes from the line of Mark Mahaney with RBC Capital Markets. Your line is open.
Okay, thanks. Most of our questions have been already asked and answered, maybe just two. Any color on international markets, those that may be performing better, those that may be challenging. For Dennis, I get all the details. We get all the details on your stepping down, could you give a little more color on the why you're stepping down, and now are you going to go join a cryptocurrency startup or something? Thanks a lot.
That's a great idea.
Thanks for the question. Let me start with the second one first. When I joined Dropbox, one of the challenges that Drew set out for me was help build a world-class team that can scale the business, first to scale it into a public company, but then scale it over time, and we've really done that. I think you see with the leadership changes, we have two very strong leaders who are stepping up to Drew's team. Ling, who has led communications here for a number of years and is a professional in the valley with deep experience. Yamini Rangan, who has been in sales roles for over 20 years at companies like SAP and Workday. One of the roles of a good leader is to know when to step aside and let the next generation take over, and the business is in great shape.
Drew and I have been talking about it for a while, and this seemed to make a lot of sense. There's no immediate plans. I'm going to remain an advisor to the company through the end of the year. I'm involved in a couple of boards already, the Red Cross and ServiceNow, so I'll obviously stay involved with them and then figure out what's next. I think on the international question, international is a huge opportunity for us, and close to half the revenue's coming from outside the U.S. Those markets tend to be a couple of years behind in cloud adoption. We're seeing markets like Japan in particular, I think I talked about Japan last time, really accelerate. Our primary markets are Western Europe, the U.K., France, Germany, Australia, Japan. That's where we see most of our growth.
We're seeing some growth in areas that we wouldn't have otherwise expected. I talked about Bundesbank on my remarks, and that's an example of a customer who came to us through self-serve, and we were able to grow. We think we see a lot of opportunity outside the U.S.
Okay. Thanks, Dennis, and congratulations.
Thank you.
Yeah, I just want to echo that Dennis can never truly be replaced, we're very excited that the transition provides an opportunity for Ling and Yamini to step into bigger roles. I think that's a testament to the team that Dennis has built.
Thank you. We have time for one more call. Our last question comes from the line of Rishi Jaluria with D.A. Davidson. Your line is open.
Hey, guys. Thanks for squeezing me in. Ajay, I just wanted to dive a little deeper on the margin guidance. Based on your guidance for the year, operating margins are going to drop from 12.5% so far year to date to 8% in the back half of the year. Can you just give us a little color on what this reflecting? Is it a ramp of investments? Maybe help us understand some of the moving parts here. Then a quick follow-up for Drew.
Sure. Two primary reasons there for some of that variability in operating margin between what we delivered in Q2 and what we guided to for Q3. I would say, one, we drove more efficiency in the business in Q2, but we're preserving the flexibility to spend across Q3 and Q4. Two, it's due to the timing of spend, so things like marketing spend and hiring between quarters in the year. I would note that we are bumping up our operating margin outlook for the year, and we certainly continue to be committed to driving year-over-year operating margin expansion on an annual basis.
Okay, thanks. That's helpful. Drew, just since there's been commentary on the international front, just wondering if you had kind of any early insights from the adoption of GDPR and any impact on inbound interest or business in the European theater. Thanks.
Actually, Dennis and I and the leadership team were out in Europe a couple of months ago, I did a couple of customer visits. I think GDPR does create urgency for IT administrators to get a good handle on where their data is and wrap their arms around it. They see Dropbox as a really powerful way to do that. It certainly puts the need for something like Dropbox higher in their minds, we want to be there for our customers as they navigate GDPR.
Great. Thanks, guys.
Thank you.
Thank you. That concludes our question and answer session. I'd now like to turn the call back over to Drew Houston.
All right, everyone. Just one more thank you for joining us today, and we really appreciate your support and look forward to speaking with you again next quarter.
This concludes our call. Thank you for joining us. You may now disconnect.