Earnings Call: Q2 2018

Aug 9, 2018

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. 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 Q2 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 31, 2018, and the risk factors that will be included in our Form 10 Q for the quarter ended June 30, 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 ks 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 4 and he will 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 of 100,000,000 revenue and our company was a fraction of the size. And during his time here, we've grown into a publicly traded company with over $1,000,000,000 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 2 of the 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 Ling 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. And Dennis, we'll miss you and wish you all the best in your next adventure. Thanks, Drew. It's been an incredible 4 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 of 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. So 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 team and feedback and free file activity updates while previewing a file in Dropbox. These updates are great for getting a quick pulse on how users 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. And 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. 1, admins can now export member data reports to simplify security auditing and 2, 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. In addition, we rolled out a number of advanced deployment tools including Team Selective Sync. Team Selective Sync helps speed team deployments by allowing admin to specify what shared folders will be synced to users' computers, saving time and expensive hard drive space. Now 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 show that Dropbox is the 1st major technology company to test and implement shingle magnetic recording or SMR drive technology at scale. Today, data is stored in hard drives on tracks, which are circular pass 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 8 terabytes to 14 terabytes per disk and provide continued cost savings without sacrificing performance and reliability. And 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 received as investments like these have strengthened our platform. In Q2, Dropbox was named a leader in Gartner's Magic Quadrant Content Collaboration Platforms report published on July 9, 2018 and we improved our position on the completeness of vision access 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. And 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 is 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, and 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 Naiman Khan has joined us as VP of Product Marketing. And most recently, Naiman 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 and 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 demonstrate that our users are driving 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 100 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 6 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 a 1,000,000,000 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. Io, Marvell and Wyden. 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 8 of the top 10 media and entertainment companies within the Fortune 500 and we continue to see great traction in Q2 with organizations like Macmillan Publishing, Meredith, Oller Media and Hearst. I want to share 2 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 and owner and operator of cable television networks noted the ability to more easily collaborate on a variety of content types external partners as a primary driver for its adoption of Dropbox. And 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 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 $339,000,000 driven by an increase in total paying users and strong ARPU expansion. We ended Q2 with 11,900,000 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 ks 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 7 percentage points compared to the Q2 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 twenty eighteen 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, 2nd quarter R and D expense was $92,000,000 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 and M expense was $80,000,000 in the 2nd quarter or 23% of revenue and consistent with S and 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 and A expense was $33,000,000 or 10% of revenue and consistent with G and 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 $48,000,000 in operating profit in the 2nd quarter. This translates to a 14% operating margin, which is a 6 percentage point improvement from Q2 of 2017. Net income for the quarter was $48,000,000 up from $20,000,000 a year ago. Diluted EPS was $0.11 per share, up from $0.06 per share in Q2 2017 based on 423,000,000 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 $982,000,000 This includes the $108,000,000 of net proceeds from the underwriters exercise of their Green Shoe option in April. Cash flow from operations was $112,000,000 in the quarter. Capital expenditures were $10,000,000 yielding free cash flow of $102,000,000 or 30 percent of revenue. CapEx in Q2 included $2,000,000 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 2 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 $20,000,000 of 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 $30,000,000 to $35,000,000 in 2018. In Q2, we had $19,000,000 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 Q3 of 2018, we expect revenue to be in the range of 350 dollars to $353,000,000 non GAAP operating margin to be in the range of 7.5% to 8.5% and diluted weighted average shares outstanding to be in the range of $424,000,000 to $429,000,000 based on our trailing 30 day average share price. For the full year 2018, we are raising our revenue guidance, which was previously $1,343,000,000 to 1.355,000,000 to 1.366 to 1.372000000000. We are raising our non GAAP operating margin guidance, which was previously 9% to 10% to 9.5% to 10.5 percent and we continue to expect free cash flow to be in the range of 340 dollars to $350,000,000 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 411,000,000 to 416,000,000 based on our trailing 30 day average share price. I'll now turn it back to Dhruv 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, strengthen our infrastructure and were recognized by Gartner as an industry leader. And 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. And our first question comes from the line of John DiFucci with Jefferies. Zach Lounsos 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 was discounted for the 1st year. Could you just kind of elaborate on that? I mean, does it go back to the $240,000,000 aside from traditional discounting after that? And then any color on churn in the quarter, particularly given the end of grandfathering here? Thank you. Sure. This is Ajay, and 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. And so 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. But 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. And 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. Turn for us has been stable and improving for many quarters and for a long period of time. I can't say on the margin with initiatives like grandfathering exploration for Dropbox Advanced, it's a meaningful driver of revenue growth, but can impact in period churn. And so 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? And 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 and then also a general drive towards getting our customers to drive to adopt the business version of Dropbox. So I would say across the board all those things and Anjay can comment on some of the numbers. Yes. And for some more specific kind of Q2 commentary, I would say the higher ARPU was driven by a few different factors. 1 was increased adoption of our professional and advanced SKUs, both from gross new subscribers, but also increased adoption from grandfathering and expiration, as well as a higher mix of Teams licenses. And so we are seeing a mix shift towards more and more Teams licenses as a percentage of net new licenses added to the platform. But just to comment on grandfathering for a moment, we did complete that process just to reiterate what Dennis said earlier for about 50% of grandfathered 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. But 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. And as my follow-up, noticed that your R and 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 mean, I think the advanced SKU came early last year and the professional SKU was kind of the later timeframe last year. So any kind of color on how you're thinking about the introduction of new premium SKUs would be helpful? Thanks. Well, I think we want to make sure or 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 products or in some cases the highest tier individual plans. So 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, but we also want to keep things simple. So I would say the 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 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? And are there 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. So the majority of our investment in our brand campaign was actually made in through digital channels, because we feel that by and large that's a highly effective way of reaching prospective customers. And you'll recall that one of the objectives of the campaign, the primary objective was to shift perception slightly about people who among people who might be considering Dropbox as a collaborative platform. So the focus was on explaining how Dropbox helps teams unleash their creative energy. We had some 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 and 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. And 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. And 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, but then clearly there's more attrition naturally as you scale and that therefore ARPU is going to be a more important driver. And I guess I'm curious what you would think if we were modeling the net new user adds at perhaps 3.50 to 5.50 per quarter going forward. Do you think that's a reasonable range moving forward to try to find the right balance between the user ads and the ARPU growth, which has been a very healthy total equation for you? Yes. 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, and that's what drove revenue performance last quarter and that will be what will 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 and 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 may one may outpace the other depending on the initiatives that we're deploying in that period. But 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 which can impact on the margin things like churn. Okay. And then just which can impact on the margin things like churn. Okay. Thank you very much. Thank you. And our next question comes from the line of Alex Zukin with Piper Jaffray. Your line is open. Hey, guys. Thanks for taking my question and congrats on 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, is given the slightly tougher comps, how should we think about the second half ARPU growth versus the first half ARPU growth? And I've got a quick follow-up. Yes. 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 teens. So going forward, renewals from grandfathered teens will be more evenly spread across the next few quarters. So I'd expect more moderated expansion in ARPU going forward. Okay, great. And then maybe just one for Drew or Dennis. A bigger picture picture question on your enterprise pipeline and enterprise traction. And then in general, when you do some of these bigger 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 productivity area? Thanks again. Sure. This is Dennis here. So typically when we're selling into larger enterprises, we're dealing with the CIO or a senior level IT director. Sometimes, it 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. So in many organizations, they are still reliant on fairly distributed file servers. Some organizations, we are displacing small and fragmented SharePoint deployments. And in other cases, it literally is hard drives. An example there from earlier this year was Clear Channel, which had has offices all throughout the United States and each of them has a file server under a desk somewhere that which is, when you think about it, not particularly secure. The central organization has no real visibility into what's going on there. So moving to cloud makes a lot of sense in that organization and putting all that all those files in one place where you can secure it and have visibility to it. So that's typically with 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, it's Drew here. Just adding a little bit more. So we find that a lot of what drives adoption and eventually drives adoption by IT is just how end users organically use Dropbox. And we're finding that more and more then 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 of that together. And 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 the world of GDPR and so on. And so and I just another point is that competition isn't necessarily zero sum for us. So we live side by side with the Office suites. So 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. So we find that in a collaborative setting that 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. So you guys are getting nice early traction with Dropbox Teams. So 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? So you could I mean, you have a little bit of it, but does it make sense to build that out? Thanks. So 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. And specifically, we want to take more integrated approach rather than some separate workflow tool. And so 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. And so 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. And then 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. And instead of using several different tools and toggling back and forth between them, we think there is 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. Yes. Thank you. And 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. 2 for me. First one, I think you've talked a lot about the upsell strategy. I think that that's pretty apparent this point. 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 I'll let you answer. On the competitive landscape, there has some been I'll let you answer. On the competitive landscape, there has some been some noise during the quarter. 1 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 if you had to adjust your go to market approach at all? Just any color on that would be helpful. Thank you. Sure. I'll take the this is Drew. I'll take the second part first, and thanks for your questions. So on the for sure, we like of course, our 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. And 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. So we don't really in fact, we see that ourselves as favorable on that dimension. So for sure, we keep an eye on competition and 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 product what we call product driven conversion. So because 90 or 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. So and more and more using technologies like machine learning, AI, data science, not only to improve the end user products product experience, but also to match our customers with the plans that make sense for the paid plans that make sense for them and to get them to engage with functionality that they might not be aware of. So for example, if you have a lot of if you're using a lot of space in your Dropbox and don't have a lot of your computer, we might show you something about Smart Sync. Or if you're sharing a bunch of rich media, we might show you something about Showcase. So showing people these offerings in context is an area where we make the big investment in product driven conversions and 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, and we will continue to invest there for the years to come. Okay. Thank you. Thank you. And our next question comes from the line of Karl Keirstead with Deutsche Bank. Your line is open. Thanks. I've got 2 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 to 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. So 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. 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 outbound and EDU deals, as well as major initiatives like grandfathering expiration for Dropbox Advanced, the latter can impact in period churn on the margin. And so those are some of the factors that we saw last quarter. Okay. Good. That's helpful. And 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. So quarter to quarter movements in FX rates have a smaller impact on top line for us given how our revenue recognition model works. And the vast majority of our revenue is already on our books as deferred revenue heading into a given quarter at historical FX rates. So 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. And what we noted in our S-one was that about 30% of our sales are denominated in foreign currencies, so non USD. Got it. So was there any FX impact on 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. Yes. Okay, very good. Thank you. Thank you. And 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. Sarah, so are the IPO we our business has been cash flow positive for the last couple of years. So our IPO, in many ways, is opportunistic. And so it gives our balance sheet having a healthy balance sheet gives us optionality on a number of dimensions to both invest in our core business, M and A and pretty much whatever comes along. So and we'll so there's no we think it's just a good idea to have a healthy balance sheet, and Ajay can also add some color. Yes. 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. It's a free cash flow positive company. We feel good about our position there. But then 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 Ajit, that was helpful. So when I'm thinking about 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. And how are you really how are you prioritizing sort of the add on attached services investment areas to drive more adoption of advanced plans? So we think of our these improvements as part of a portfolio. And so some of these improvements like Showcase will drive monetization pretty directly because showcase is an example of the future that's only available in Dropbox Business and in the professional highest tier individual SKU. Others will drive more engagement in the Dropbox ecosystem. So 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 Dropbox that have paper usage convert and retain at higher rates than ones who don't. So that drives retention, drives lifetime value even though it's not a separate SKU. So we have a number of levers to drive engagement and monetization and sometimes they'll be driving adoption of higher tier SKUs and then sometimes it'll be driving engagement more generally. All right. Thank you very much. Thank you. And our next question comes from the line of Greg MacDowell 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 1st major tech company to adopt SMR. And the things that really stood out to me from the June blog posts were lower costs, greater density and better cost structure. So 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? And then maybe one follow-up. Yes. So we think SMR is a great example of one of just a technical achievement. So 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 how you develop change a bunch of things from an engineering standpoint, which our team was able to do because we control our entire stack. And so, 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. And so we think that it's a good example of how being more integrated or vertically integrated in the long run is a big advantage and especially as workloads evolve and things like machine learning and compute become a bigger part of the picture. And Ajay can add more color on the cost effectiveness. Yes, this is Ajay. And while we aren't providing specifics on our future savings projections from SMR today, I can say that it will be phased multiyear undertaking for us and one of the drivers of gross margin expansion toward our long term target of 76% to 78% of revenue. And again, it's an example of we can as the technology evolves in all parts of the supply chain, we can ride that cost curve down a faster than if we had to wait for other folks to pass it along to us. Thanks. And one quick follow-up and not to beat a dead horse with this grandfathering, but we've talked a lot about the grandfathering expiration of Dropbox Advanced, which was introduced in January 2017. So we're feeling the tailwinds sitting here 18 months later. I want to ask about actually the professional SKU for individuals, which was introduced in November 2017, so a full 11 months after Advanced. And 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 will 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. So 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. And we will, of course, offer it offer professionals also available to folks who have the Plus subscription and or interested in driving upsell there too. But it's not the case that we'll be opting everyone in to all existing Plus users into Professional. So it's a little bit of a different dynamic. Yes. And 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. So we're taking a different approach and strategy there relative to what we did with our team subscribers and advanced plan. And 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. Yes. And so continuing to improve features like Showcase, we found a lot of our customers were e mailing us saying that they had more than a terabyte of or they needed more than a terabyte of space and didn't want to buy multiple licenses of a business subscription if they were freelancer. And so we just didn't have that we didn't have that alternative available to them. So 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 Mahaney with RBC Capital Markets. Your line is open. Okay, thanks. Most of our questions have been already asked and answered. So maybe just 2. Any color on international markets, those that may be performing better, those that may be challenging? And then for Dennis, I get all the details, we get all the details on your stepping down, but could you give a little more color on the why you're stepping down and now are you going to go join a cryptocurrency start up or something? Thanks a lot. That's a great idea. So thanks for the question. The 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, 1st to scale it into a public company, but then scale it over time. And we've really done that. And I think you see with the leadership changes, we have 2 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 and then, Yamini Rangan, who has been in sales roles for over 20 years at companies like SAP and Workday. So 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. So Drew and I have been talking about it for a while and this seem 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 is coming from outside the U. S. Those markets tend to be a couple of years behind in cloud adoption. So we're seeing markets like Japan in particular, I think I talked about Japan last time, really accelerate. But our primary markets are Western Europe, so the U. K, France, Germany, Australia, Japan, that's where we see most of our growth. And we're seeing some growth in areas that we wouldn't have otherwise expected. I talked about Boumbues de Banc on the on my remarks and that's an example of a customer who came to us through self serve and we were able to grow. So we think we see a lot of opportunity outside the U. S. Okay. Thanks, Dennis, and congratulations. Thank you. Yes, I just want to echo that Dennis can never truly be replaced, but we're very excited that the transition provides an opportunity for Link and Yamini to step into bigger roles. And I think that's a testament to the team that Dennis has built. Thank you. And 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. I mean based on your guidance for the year, I mean operating margins are going to drop from 12 point percent 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? And maybe help us understand some of the moving parts here. And then a quick follow-up for Drew. Sure. So 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, 1, we drove more efficiency in the business in Q2, but we're preserving the flexibility to spend across Q3 and Q4. And 2, it's due to the timing of spend, so things like marketing spend and hiring between quarters and the year. And 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. And 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. Yes. So actually, Dennis and I and the leadership team were out in Europe early a couple of months ago, and I did a couple of customer visits. So 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. And they see Dropbox as a really powerful way to do that. So it's certainly something that or it certainly puts the need for something like Dropbox higher in their minds. And so, we want to be there for our customers as they navigate GDPR. Great. Thanks, guys. Thank you. Thank you. And 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.