Box, Inc. (BOX) Q3 2016 Earnings Report, Transcript and Summary

Welcome to the Box Inc.'s Third Quarter Fiscal 2016 Earnings Conference Call. This call is being recorded today Wednesday, December 2nd, 2015. At this is time, all participants have been placed on a listen-only mode and the floor will be open for your questions following management's prepared remarks. [Operator Instructions] It is now my pleasure to turn the floor over to Alice Lopatto of Investor Relations. You may begin.

Good afternoon everyone and welcome to Box's third quarter fiscal 2016 earnings conference call. On the call today, we have Aaron Levie our CEO; Dan Levin, our COO; and Dylan Smith, our CFO. Following our prepared remarks, we will take questions. Our press release was issued after close of market and is posted on our website where this call is being simultaneously webcast. The webcast replay of this call will be available for the next 90 days on our company website under the investor relations link www.box.com/investors. During portions of today's call, we will be referring to presentation materials posted on our Investor Relations website. We'll also post the highlights of today's call on Twitter at the handle BoxIncIR. On this call, we will be making forward-looking statements, including our Q4 and FY 2016 financial guidance and our expectations regarding our financial results, our market adoption of our solutions, our market size, our operating leverage, our path to and our expectations regarding achieving positive cash flow and profitability, our planned investments, our growth strategies, and expected benefits from our new products and partnerships. These statements reflect our best judgment based on factors currently known to us and actual events or results may differ materially. Please refer to the press release and the risk factors in documents we file with the Securities and Exchange Commission, including our most recent quarterly report on Form 10-Q for information on risks and uncertainties that may cause actual results to differ materially from those set forth in such statements. These forward-looking statements are made as of today, December 2nd, 2015 and we may disclaim any obligation to update or revise these statements. If this call is reviewed after today, the information presented during this call may not contain current or accurate information. In addition, during today's call, we will discuss non-GAAP financial measures. These non-GAAP financial measures should be considered in addition to, not a substitute for or in isolation from, our GAAP results. You can find additional disclosures regarding these non-GAAP measures, including reconciliations with comparable GAAP results in our earnings press release and in the related PowerPoint presentation, which can be found on the Investor Relations page of our website. With that, let me hand it over to Aaron.

Thanks Alice. Q3 was another record quarter for Box. Revenue was 78.7 million, an increase of 38% year-over-year. We added 4,000 paying customers in the quarter and we're proud to now have to 55% of the Fortune 500 as Box customers, an increase from 52% in Q2. In Q3, we had major wins and expansions with leading companies such as Amgen, Westfield Corporation, Sally Beauty Holdings, Grey Global Group, Southwest Airlines, Nest Labs, Universal Music Group, and many more. Enterprises today are investing in the new cloud platforms that will power their businesses for decades to come. Just as they are with CRM and ERP, businesses are moving content management to the cloud where their information can be centrally secured, managed, and, made available to employees, customers, partners, and their extended networks. Box is uniquely positioned to meet this demand. To capture as much of this opportunity as possible, we're executing against three key strategic objectives. First, we're investing in new products and innovations like Box Governance that will differentiate Box as the next-generation enterprise content platform. Second, with the new Box Platform offering, we are expanding our adjustable market and pursuing a new growth driver. Companies in every industry are investing in building software that connects them with their employees, customers, and partners through new digital experiences and Box Platform will power content and collaboration for these new applications. Third, we're building a world-class partner ecosystem to expand our product capabilities, drive interoperability with other key business applications, and create new go-to-market channels. These partnerships include Microsoft, Apple, IBM, and several other leaders in enterprise IT. In September, we featured significant progress against all three key strategic objectives at BoxWorks, our annual customer conference held in San Francisco. We hosted nearly 5,000 attendees at this year's conference, representing thousands of customers and partners. As demonstrated at BoxWorks, our first strategic objective is to new invest in new products and innovation and not -- that not only solve basic file sharing and sync and collaboration, but that also extend into advanced enterprise content management or ECM use cases. By adding ECM capabilities, we make it easier for enterprises in every industry to move more content, more use cases, and more spend to Box while allowing them to retire costly legacy technology. For example, at BoxWorks, we announced updates to Box Governance, which in addition to data retention will also include legal hold capabilities early next year. Governance is a major differentiator against competitors and drove several key wins over one drive per business over the quarter. Overall, we sold Box Governance to nearly 100 customers since its June launch. In Q3 a large global pharmaceutical company adopted Box Governance as part of its renewal with Box expanding their total account value by $700,000 in part to help them retire legacy storage infrastructure. And a global consumer products company also invested in Box Governance adding $200,000 to their total account value as a part of expanding its Box deployment enterprise-wide. Box Governance was instrumental in meeting the legal requirements that enabled these customers to move more users, more content, and more use cases to Box. As we continue to deliver innovations like Box Governance, we are increasingly able to go after the nearly $6 billion spent annually on traditional ECM software as tracked by industry analysts IDC. And this does not even include the tens of billions of dollars and related infrastructure that these systems require and that Box already can replace. We've been investing in the enterprise market for 10 years now and only Box has the talent and technology to seize on this massive opportunity. Our second strategic objective is Box Platform, which we formally launched to customers at BoxWorks and which became generally available to both enterprise customers and independent software vendors in October. Box Platform, which we previously called Box Developer Edition while it was in beta over the summer, is a new growth opportunity for Box. As enterprises in every industry create applications to interact with their own employees, partners, and customers, Box Platform will power the core content management and collaboration within these experiences. Instead of enterprises spending countless hours or millions of dollars on creating their own storage, encryption, compliance, collaboration, and previewing technology, they can instead quickly and easily leverage the technology stack we've been building for the past decade. The licensing model for Box Platform is seat-based and derived from the number of people that use the apps our customers and partners develop. We have the potential now to power applications that will in aggregate reach hundreds of millions of people greatly expanding our total addressable market. Even though Box Platform was only generally available starting on October 15th, we're thrilled to announce we already closed our first major Box Platform deals in Q3. Our first deal valued in the high six figures annually was with a large global financial services leader that will leverage Box Platform to securely share investment information with hundreds of thousands of clients. The second deal was with a major investment bank that will use Box Platform to securely exchange trading data and document at scale with their community of hedge funds. We are just scratching the surface of the Box Platform opportunity that these deals represent a strong start. Our third key strategic objective is to build a dominant partner ecosystem to both add key product capabilities and drive go-to-market leverage as we grow. We've made major inroads on this front over the past year and we've deepened our relationships with industry leaders like Apple, IBM, and Microsoft, all three of which were prominently featured at BoxWorks. Mobile is a massive opportunity in the enterprise and as Tim Cook shared at BoxWorks, we're collaborating with Apple to drive new innovation on iOS devices. For example, we released Box Capture, an iOS exclusive app focused on helping companies more easily integrate fields and mobile workers in the key business processes. Capture will help accelerate innovation in a variety of industries and it's a great step in our collaboration with Apple to transform how people work. We also saw fantastic momentum with our landmark IBM partnership in this quarter. IBM is deeply connected to our strategy to expand in the traditional enterprise content management. At BoxWorks, we announced the availability of the first joint IBM and Box Solutions. Additionally, at IBM Insight in October, we debuted one of the first joint Box-IBM customers, Sally Beauty Holdings. As a result of this partnership, Sally Beauty will rollout Box in combination with IBM Solutions to more than 6,000 employees worldwide. While it's still early in our partnership with IBM, we already have well over 100 joint deal prospects in the pipeline with more being added every week. We've also continued to build on our growing Microsoft relationship. First, we showcased our integration with Office 365 at BoxWorks, then in November, we debut our new universal Box app for Windows 10 which was jointly developed with Microsoft support and finally, we were also selected by Microsoft as one of the first partners along with Adobe and SAP to integrate with Microsoft's InTune mobile security solution. You can expect even more mew capabilities and deeper integration between our products and platforms including Office 365 in the months ahead. To summarize, we're focused on three strategic objectives; investing in new product innovation, growing the Box Platform, and building a dominant partner ecosystem. By focusing on these key three objectives, we're extending our competitive lead in the market and reinforcing our position as the next generation enterprise content platform. Before I hand it over to Dylan to provide more details on our financial performance, I want to take a brief moment to reiterate our commitment to achieving positive free cash flow at the end of our next fiscal year and the quarter ending January 31st, 2017. We continue to experience great success across our business and we intend to continue investing to capitalize and what we see is one of the largest market opportunities in all of enterprise IT today. We're now benefiting from the increasing scale, customer expansion, diverse go-to-market channels, and in early calendar 2016, the completion of capital investment projects that will position us to more efficiently scale for years to come. As a result, while we anticipate continued strong growth, we also anticipate continued improvement in our cash from operations and a reduction in capital expenditures over the course of the next several quarters. As we head into Q4, we couldn't be more excited to deliver a strong finish to our first year as a public company. Dylan?

Thanks, Aaron. Good afternoon everyone, and thank you for joining us today. For the fourth quarter in a row, we exceeded guidance on both growth and profitability. We continue to consistently deliver solid financial results while innovating aggressively to develop products and services that are solving the productivity and security needs of the world's largest enterprises. We're seeing benefits from the investments we've been making over the past several years and our customer base continues to grow and mature. This dynamic in our business model allows us to continue demonstrating leverage as we scale and sets us up to achieve positive free cash flow in the quarter ending January 2017. Now on to our results for the third quarter which ended on October 31st. We delivered record revenue of 78.7 million, representing year-over-year growth of 38%. Billing set another record at 89.4 million, up 37% from Q3 of last year. Cash flow from operations was negative 17.3 million, or 22% of revenue, improving from negative 19.6 million or 34% of revenue in the prior year. Non-GAAP operating margin was negative 48%, a 12 percentage point improvement compared to negative 60% a year ago. Finally, our retention rate was 119%, which includes churn of less than 4% and net expansion of 23%. Let me now provide a deeper look into our financial results beginning with revenue. As I mentioned, we generated revenue of 78.7 million in Q3, up 38% year-over-year. This strong result was driven by our growing enterprise customer base as well as our best-in-class retention rate. Our churn rate remains best-in-class for software companies and improved less than 4% annualized. This result was a full percentage point better than the same quarter last year, demonstrating the value our customers are getting from their Box investments. Our net expansion rate was 23%, primarily driven by strong seat growth in existing customers. As we continue to see customer contract value increase and our recurring revenue base grow, this will inherently put pressure on our net expansion rate. On the other hand, our new products including Box Platform, Box Governance, and Enterprise Key Management provide an opportunity for this rate to improve. In the third quarter, these products were crucial in closing some major customer expansion wins. Let me now turn to billings. Third quarter billings were 89.4 million, representing 37% year-over-year growth. This strong performance we delivered this quarter was due to a combination of major customer wins, as well as longer customer payment durations, which reflect our success in selling to large enterprises. As a reminder, customer payment durations can range from monthly to multiyear which affects our billings resulting and can also create fluctuations in our quarter-to-quarter billings growth rates. Normalizing this quarter's payment durations, our adjusted Q3 billings growth was 35%. As we reminded everyone on our last earnings call, Q3 of last year was exceptionally strong overall and therefore would be a tough compare. In the third quarter of this year, we closed three deals over $500,000 in annual account value versus six a year ago and 27 deals over $100,000 versus 48 a year ago. I'd note that we were able to close a couple of deals worth more than $1 million versus none a year ago which contributed to our strong billings results this quarter. We ended the third quarter with 141.1 million in deferred revenue, up 40% year-over-year and consistent with the 41% growth we saw in the second quarter. These healthy deferred revenue balances provide us with strong visibility and predictability in our business model. Now, let's take a look at non-GAAP gross margin. As you remember from our last earnings call, we highlighted that we expected gross margin to decrease slightly over the back half of this year due to investments in our data infrastructure and our Box Consulting team in order to prepare for increasing demands. Non-GAAP gross margin came in as expected at 73.4%. We have also been temporarily incurring real estate expenses on two headquarter locations. Earlier this week, we moved into our new headquarters in Redwood City and by the end of December, we will no longer be incurring real estate expenses on our old headquarters. Next let's move to non-GAAP operating expenses. Sales and marketing expenses during the quarter were 59 million, representing 75% of revenue compared to 91% in the prior year, demonstrating leverage in our sales and marketing efforts. We also saw a year-over-year decrease in the relative cost to support our free user base at 11% of revenue in third quarter compared to 15% in the same quarter a year ago quarter despite significant user growth. As Aaron mentioned, we hosted thousands of customers and partners this past quarter at BoxWorks, our largest marketing event of the year. The cost impact of BoxWorks in the third quarter came in as expected at roughly 6% of Q3 revenue. We remain focused on improving sales and marketing efficiency which is an important driver of leveraging our business model. As our customer base grows, we will naturally benefit from more efficient expansion and renewal sales. We also expect to improve efficiencies through a more tenured and productive sales force, sales of our newer products, and growth in our partner and online distribution channels. Next, research and development expenses were 19.9 million or 25% of revenue relatively flat from the prior year. While over time we anticipate some improved leverage in research and development, we're focused and committed to furthering our leadership position with the most innovative offerings and best-in-class product development organization. Finally, our general and administrative costs were 16.7 million or 21% of revenue compared to 25% in the prior year. We continue to drive efficiency and scale in this area while also benefiting from lower legal expenses than the prior year. Let me now move on to our cash balances and cash flow. We ended the third quarter with 244 million in cash, equivalents, short-term marketable securities, and restricted cash outflow roughly 29 million. Cash flow from operations in the quarter was negative 17.3 million or 22% of revenue compared to negative 19.6 million or 34% of revenue a year ago. As a reminder, our Q2 and Q3 cash flow results are typically lower than Q4 and Q1 due to the seasonality of our cash collections as Q3 and Q4 are typically our strongest billings quarters. In Q3, total CapEx was 20 million. Of this approximately 16 million was related to our Redwood City facility and the remaining 4 million was related primarily to data center investments. With respect to our Redwood City facility, we remain on track to execute the plan we laid out at the beginning of the year and we expect to incur the remaining 23 million of net cash spend for tenant improvements over the next two quarters with the bulk of the net cash spend of 18 million in Q4 and the remaining approximately 5 million in Q1. As we enter FY 2017 we anticipate realizing sharply reduced facilities related capital expenditures in addition to lower facility expenses. We remain committed to achieving positive free cash flow in the fourth quarter of next year ending January 2017. We expect to exit FY 2017 with cash balances including restricted cash of at least 150 million. Given key headcount investments we've made fiscal 2016, we believe we are well positioned to support our growing business into FY 2017 with a lower rate of headcount and spending growth going forward. Now let's turn to our guidance for the third quarter and updated guidance for the full year of fiscal 2016. For the fourth quarter of fiscal 2016, we expect revenue to be in the range of 81 million to 82 million, representing year-over-year growth of 29% to 31%. Next, we expect our non-GAAP operating margin to be in the range of negative 43% to negative 44%. The weighted average share count used to calculate GAAP and non-GAAP net loss per share is expected to be approximately 123 million shares. We expect CapEx related to data center investments to be in the 5% to 6% range of revenue in Q4. This is in addition to the 18 million in net cash spend related to our new office that I mentioned earlier. For the full year of 2016, we are raising our full year revenue guidance by 3.5 million at the midpoint to 299 million to 300 million, representing year-over-year growth of 38% to 39%. We're also updating non-GAAP operating margin guidance and now expect it to improve at the midpoint by 200 basis points to approximately negative 46%. And finally, our weighted average share count used to calculate GAAP and non-GAAP net loss per share is expected to be approximately 121 million shares. To recap, we had tremendous success this quarter across the Board, adding or expanding deployments with leading enterprises including Amgen, Sally Beauty Holdings, Southwest Airlines, and over 54,000 other customers leveraging Box for secure content management and collaboration. We made significant progress around our partnership with IBM, including the launch of our first set of joint solutions. We're seeing strong momentum from this partnership across both of our global sales teams and we already have more than 100 joint prospects in our pipeline. We're seeing proven demand for our new Box Governance, EKM, and Platform products which we expect to drive additional revenue opportunities and further strengthen our competitive differentiation. And finally, we continue to be laser-focused on disciplined spending, operational excellence, and delivering operating leverage on our path to achieving positive free cash flow in the quarter ending January 2017. With that I would like to open it up for questions. Operator?

The floor is open for questions. [Operator Instructions] Thank you. Our first question is coming from Mark Murphy with JPMorgan. Please go ahead.

Thank you very much. Congratulations on the solid quarter. Aaron, I wanted to ask you, in terms of the replacement of legacy content management systems that Box is disrupting, is there any discernible change in the mix of those systems between, say, SharePoint, Documentum, FileNet, Intralinks, OpenText, whatever else you might be coming across? I'm just curious which of those are feeling the most vulnerable to replacement by Box.

Yeah, great question. So, I guess maybe just two parts to the answer. Certainly any content management platform that is primarily used as really a document management system in an enterprise, we now more and more have the capabilities to fully replace. So, many of the ways that SharePoint is used in an enterprises is just as a document management site, and so we can -- so we are often replacing those environments. But for situations where SharePoint is powering complex workflows or complex business applications, we're not quite there yet from a functionality standpoint. We are seeing some customers begin to retire legacy content systems from Documentum, OpenText and others, but I don't know that I would point to a single vendor where we see a predominant trend. And I think from a more macro standpoint, the overall trajectory that we are seeing at least in terms of early customers that are seeing this vision in the power of our platform is content management is one of the few categories that over the past two decades or so large enterprises have just developed more and more of these content management systems in their enterprise. And so when we go into the average large 10,000, 20,000, 50,000 person company, they might be dealing with five, 10, 20 different systems where content is being sprawled and where they have a lot of redundancy in terms of their spend where they don't really have a single source of truth with their information. And so as we're seeing enterprise IT move toward new modern platforms, whether it's Workday for human capital management, or NetSuite for accounting and finance, or Salesforce for CRM, we're seeing more enterprises recognize that they want to take a similar approach to content management. Instead of having 10 or 20 different systems -- how do they begin to centralize on one common platform across their business. So, that's certainly what we talked more about at BoxWorks. That's what we're starting to see customers do because of Box Governance where they have the ability to manage the full life cycle of their content. And we think for the next couple of years that's really going to be the momentum in our customer base and driving our business forward, is doing both a lot of takeouts of legacy systems and really consolidating more and more content into Box as a single platform for our customers.

Thank you. And, Dylan, I had a quick one for you. Are you able to content on all on the subscription versus services revenue mix? Perhaps anything at a high level directionally. Which we has it been trending the last quarter or two? Which way do you think that might trend going forward into the next few quarters there?

Sure. Our Box consultant revenue which makes up the vast majority of that revenue were talking about from services revenue has been fairly stable over the past few quarters at 3% to 4% of revenue and that was the outcome we saw in Q3. And we expect that to likely remain in the mid-single-digit percentage of revenue for some time, but to trend up slowly over time as we increasingly move and serve larger and larger enterprises.

Okay. And the last question I wanted to ask you is I think we've been expecting the IBM relationship to drive perhaps a material impact next year. I was wondering if there is a possibility of some minor benefits in the January quarter just given that you have described over 100 joint prospects in the pipeline. Is there any chance that we could begin to feel some of that impact in your fiscal Q4 or would there be any change one way or the other in your timing expectations?

This is Dan. We're very excited about the level of engagement we're seeing with the IBM field organization around the world and with the response on the part of customers and prospects to the idea the two companies working together to change the future of enterprise content management. We do have over 100 deals in the pipeline and while we expect the bulk of that benefit to occur in the next fiscal year, there is a reasonable possibility that we'll see some impact in our fourth quarter.

Fantastic. Thanks very much for taking my questions.

And we'll go next to Melissa Gorham with Morgan Stanley. Please go ahead.

Great. Thanks for taking my question. So, just to drill down on that question earlier on the IBM relationship. I know the IBM sales force can now sell Box, but they'll likely require some education of the IBM sales force. Can you talk about where you are in terms of getting IBM fully ramped and selling Box and those 100 potential deals in the pipeline, is that coming from IBM sourcing those deals or is that coming from the Box sales force?

We were incredibly fortunate in the timing of this relationship and that it occurred just prior to IBM's global sales kickoff process for their enterprise content management field organization. So, right at the beginning of the relationship, we had the opportunity to get in front of thousands of IBM sellers around the world in three different venues Madrid, Las Vegas, and Macau I believe was the third one to begin that education process. And we have continue to engage very aggressively with the IBM field organization from a training and skilling point of view as well as working with them closely on each of these 100 deals not only obviously with the goal of closing them, but obviously with -- in addition with the goal of educating the IBM field organization across the Board about the benefits of selling Box products alongside IBM's analytics security and enterprise content management products. So, we're very pleased with the way that process is going. And those 100 deals were all sourced by IBM's field organization and then placed in our deal registration process and accepted by us, meaning we did not already have a significant level of engagement with that account.

Okay, great. That's helpful. And then just one quick one for Dylan. On gross margins, you noted a few factors that were driving margins lower during the quarter including investment in infrastructure and consulting. But can you maybe elaborate on other factors that could be impacting gross margins, in particular I'm interested in hearing if you are getting leverage from lower storage cost and then if you are seeing any changes in pricing?

Sure. So, as mentioned on the call we have been making investments and building out our data center infrastructure and building out our Box consulting team to support our expected customer growth and what we're seeing as well as the duplicative rent from the Redwood City facility buildout before we made that move just recently. I would say that the non-GAAP gross margin impact that we expect to be more one-time in recovering steady state of Box consulting and facility spend was a combined 1.5% of revenue in Q3 with the remainder of the impact being from the data center of a structure we have been building out. There hasn't been significant changes in the recent past over the cost in storage. That is definitely a driver in the market that has benefit the company over time as we're not selling storage and that's not how our customers value us. So, as those price -- as that pricing has come down, that has benefited us and our bottom-line. And what I'd also note is that we've not seen any sort of changes in price per seat in the market. So, over the past many quarters, we have continued to see price per seat in that $9 to $10 range per user per month and with the launch of some of our newer products, we also see the opportunity to improve price per seat over time.

Great. Thank you.

And we'll go next to Joyce Yang with Bank of America. Please go ahead.

Hi. Thanks for taking my question. Congratulations on the quarter guys. I have one question regarding the large deal that you guys saw this quarter. Can you talk about the large deals over $1 million what's driving that? Because that's something we haven't seen before. And also are they being held by the IBM relationship from BoxWorks and do they include Governance and Platform as part of the deal?

Yeah great question. We certainly have done many seven-figure deals over the course of the history of the company, but we are seeing more and more of a trend where seven-figure deals are coming in every quarter at this point and so that's being caused by both the Governance capabilities because more and more customers -- customers can put more and more of their data on the Box. I should note that the $700,000 deal we did in the quarter pushed up that specific customer to greater than seven-figure total account value, so, just as an example, what Governance can drive from a total spend for existing customers in this case. Platform was also a meaningful driver to that seven-figure for the growth of again total account value increased to seven figures for one customer. And we expect to continue to see that and Q4 and going into next year. So, it's really just the Platform becoming more robust, our customers beginning to put more sort of mission-critical workloads onto Box and thus valuing us as a more important part of their architecture and their strategy going forward. So, we will expect this trend to continue quite a bit into the future.

Yeah. This is Dylan. And the only thing I'll add is that within those deal side categories that we break out, the average contract value of the deals above the 100,000-plus and 500,000-plus deal categories were much larger this quarter than what we saw a year ago. And that's what driving some of the outcome. Not just those million dollar deals. And we also had a very healthy quarter for growth in our commercial business adding more than 4,000 new customers in the quarter. So, we expect to see the size of deals within those categories that we breakout continue to increase over time and we'll continue to give more color on this dynamic as we increasingly move up-market and sell these newer products into our customer base.

Yeah, that's helpful. Just to follow-up, Aaron, that question you were mentioning were a lot of these deals also coming from existing customers versus new customers?

I don't know if we break out the percentage, but it was definitely a mix across some of the big names, so we're continuing to drive up sales because of Governance and Platform. One of the seven-figure deals was a net new customer in the quarter, but we do see a mix across the Board.

Got it. And just one quick follow-up on the EKM Solution you guys are saying 100 customers adopting EKM. Can you talk about the type of adaption there? How are you distant customers integrating EKM into the company? Is it deployed enterprise-wide most of the customers that are adopting it?

Yeah. So, it’s a good question. So, the difference between EKM and Governance as it relates to now customer attraction is because Governance is a pure software-based solution, you can very easily add it into your account. It doesn't require change management, you literally turn on the feature and then you have retention management capabilities. We've seen the rate friction to selling that be incredibly low and so that is really emerged across our sales team again nearly 100 deals that have signed on in the quarter that we have been able to sell. And so that's again driven big up-sales as well in the quarter. On EKM because it does require a very sophisticated security approach from the customer side as well as managing the hardware security module within Amazon, we're seeing that for a far more constrained group of customers either highly regulated organizations or deeply security conscious companies, but the really interesting thing is we're seeing EKM being an enabler to many deals that we would not have been able to get otherwise. So, the existence of that product and the fact that the customer in the future can elect to turn it on is driving significant -- again a significant kind of reduction in the barriers of the friction to being able to sell to large enterprises even when they don't turn on the feature right away.

Yes, got it. Thank you very much.

And we'll go next to Rob Owens with Pacific Crest. Please go ahead.

Hey guys, this is Ben on for Rob. Thanks for taking my question. Dylan I wanted to start with [Indiscernible] 35% you still aren't really getting a big shift in long-term deferred. I was wondering if maybe you could provide a little more color kind of what you are seeing from a mix as far as contract duration is it just a shift from monthly to annual. Any additional color that you could provide there would be great.

Sure. So, the most of the shift that we have been seeing over time. It's actually a little bit of both on both the contract duration and then the payment durations. So we have seen increasingly a shift although it's having a somewhat modest impact on the overall billings rate from customers paying monthly and quarterly into paying annually. And so that's what's driving that small difference the two percentage point difference between our calculated the links rate and our adjusted or normalize billing rate of 37% versus 35%. At the same time, as we've been moving up market over the past couple years, we are increasingly signing up our largest customers to multiyear contracts, so while by volume, the substantial majority of our customers are signing one-year agreements that has been shifting over time and the majority of our largest customers are signing on for multiple years and as we're increasingly being involved in more strategic and broader use cases with customers, we're seeing that trend we're expecting to be signing on more multiyear deals over time. And so I think you'll see those two dynamics play out in both the deferred revenue balance as well as the backlog which will be breaking out on an annual basis.

Okay, great. And then Aaron I know it's still really early days for the Platform, but just any color you can provide as far as the structure of how these are shaping up as far as the sales cycle of the developer platform looking like it would be consistent with what you see with your core product ASPs kind of how those are initially shaping up as well as the length of sales.

Yeah. So, it is extremely early as you mentioned work it was again made generally available 15 days near the end of -- I mean with only 15 days left in the quarter. So, we are only starting to see some of the early examples of what the sales cycle looks like and that was a customer that was in beta throughout the summer, so that wasn't a 15 day deal. But we generally are expecting it to look similar to our other large deals from a deal-length standpoint. We are executing on the strategy and in the go-to-market through our existing sales force and starting first with many of our most successful customers and getting them to expand but they are doing with Box. In the case of the big deal that we mentioned in the call the financial services firm, this is with an existing customer, but they ultimately paid for the Platform at a level that was multiples higher than what their previous total account value was. So, from an ASP standpoint, we see an opportunity where depending on the use case the customer has they could be paying us two, three, four times more than they would have paid on an internal use basis, but again it's so early in terms of the use cases that we're seeing now, so I think we're going to see across the Board, particularly driven by the number of customers that our customers are building applications for. So, if you have a situation where one of our clients has maybe 10,000 employees, but 100,000 clients or customers that would maybe increase the TAV, but if you have a situation of a professional services firm that maybe had the same number or fewer number of clients than employees than that would necessarily drive and multiple on top of the total account value. So, it will be across the Board, but no matter what we do see this has dramatically increasing both our strategic relevance for our customer as well as dramatically increasing the total account value.

Great. Thanks, guys.

And we'll go next to Ittai Kidron with Oppenheimer. Please go ahead.

Thanks. Hi guys, congrats on a good quarter. Dylan, I wanted to dig a little bit into the retention rate the 19% it's been declining steadily for a few quarters. Can you just first of all remind us if this is an in-quarter retention rate or an annualized fourth quarter moving average kind of retention rate math?

Yeah, so it's based on what the total account value was 12 months ago and then the relative value of those same customers today. So, it is over a 12-month trailing period.

So, it's an in-quarter calculation, meaning the third quarter 2016 -- third quarter 2015, what it's doing in third quarter 2016?

Yeah, so it's related to that base is how we calculate it for each quarter, but we disclose that blended average of how rate is been trending over the past four quarters.

Right. Can you then explain why is it on a continuous steady decline; is there a bottom to it? And how should we think about the progression of that figure going forward?

Sure. So, the sequential drop this quarter was due entirely to the net expansion growth rate which was declined to about two percentage points or a little over that to 23% while our retention rate continues to improve over time. And what we have said in the past is we remain that -- we expect that expansion rate of 23% to remain above 20% for some time. So, we do expect that to stabilize and level off in fairly short order largely because of the new products that we have been introducing in the market that are just now starting to show up in customer deals as Aaron highlighted in a handful of different examples.

Well, would it be fair to say that over the next four or five quarters, you'd actually potentially see that numbers are moving up again?

It is possible depending on the success rate that we see and the attach rates of some of these newer products. Particularly some of those with larger opportunities like Box Platform and Box Governance. Wouldn't necessarily set that expectation, but would expect to see the trajectory change and for that to at least stabilize although there is the potential for that to improve.

Very good. Can you update us please on percent of paying users out of our register number?

Sure. So, we ended the third quarter with a 4.8 million paid users out of our registered user base of about 42 million. So, roughly 11% of our total user base is currently paying.

Okay. It's quite a significant sequential increase. That's good to see. But that also implies a very good solid seat expansion within your customer base, am I calculating that correctly?

So, it's a combination of the expansion of seats within our base, but that paid number also includes the net new customers that we signed on in Q3 with respect to that paid growth, so it's a little of both. I think it more demonstrates the strength and the traction we're seeing across both expansion and net new customers and really the relative focus and increasingly strong focus over time on paying businesses versus free users if you think about our acquisition efforts.

Very good. And then lastly for you Aaron, on Platform, you highlighted the two deals first two deals that you mentioned both of the financial industry if I got this correctly, but if I'm not mistaken those were things that were kind of in the oven for a little bit of time I would assume those were kind of bit customers for this as well. Can you talk about how the pipeline for this looks like? I mean you mentioned how your pipeline looks like for Governance, I think you talk about 100 customers there and the pipeline for IBM the 100 prospects, but about Platform specifically, how the pipeline is building for that and is this going to be something that we should think about as much longer sell cycle?

Yeah so -- and just to clarify, the Governance was nearly 100 deals closed and the IBM number was 100 in the pipeline. So, we're not sharing the Platform pipeline, but in case it's in general just literally rolling out right now, but it's strengthening pretty rapidly. We're going on roadshows; we're starting to develop the marketing for Platform into our existing customer base. So, two really, really strong reception from -- receptivity of the customers is very strong right now, so we're pretty excited about how that's developing. Again, the sale cycle because it's so early, it's going to be hard to say with that sale cycle looks like, again, especially because of the diversity of use cases that our customers are going to have, some of are going to build transformational applications that completely digitize the business and some customers will plug us into an existing app that they have already created and those two sales cycles will be very, very different. But that said we don't expect it to an aggregate to look that different from our overall customer sale cycle.

Very good. Congratulations. Good luck guys.

Thank you. Appreciate it.

And we'll go next to Brian Peterson with Raymond James. Please go ahead.

Hi, guys. Thanks for taking the question. Just wanted to hit on the Box Platform and congrats on the wins this quarter. But I'm just curious on the $700,000 type of opportunity as you look at the pipeline and I appreciate that it's early days, is that something that you think is a consistent type of win that you guys can get as you look at the gamut of opportunities, could there potentially be seven-figure deals specifically from that product or is it just too early to tell?

It's really interesting. If you look at our top three deals one of them was a net new customer -- not a net new customer, but an aggregation of a set of subsidiaries that were already customers rolling into an ELA for a very large global enterprise. One of them was large transaction driven by Governance were about a third of the deal was Governance revenue and the rest was seat expansion enabled by the features of Governance which allowed that organization which is in regulated business to feel comfortable rolling Box out more broadly. And the third was this financial services institution that will be leveraging our Platform to digitize their relationship with their customers. That example of how the Platform is being used is very common. You see large enterprises around the world trying to figure out how to engage with their customers on mobile, how to engage with their customers in a more digital way. And in many instances, they will have many more customers than they have employees. So, as Aaron said, it might be a 5,000 or 10,000 seat opportunity for us to sell our service to their employees, it might be a 50, or 100 or even million seat opportunity for us to sell them the Box Platform to help revolutionize and digitize the experience they have with their end user customers. So, we expect to see Platform deals of all sizes. We certainly expect to see small Platform deals and pretty high volume, but we absolutely believe there is a large opportunity for six and seven-figure deals for the Box Platform and we have a number of such transactions in the pipeline today.

Okay, great. That's really good perspective. Last one for me, Dylan, just want to hit on the gross margin. I appreciate some of the color there, but just curious what gross margin assumption is embedded in your operating margin forecast and I'm just trying to see when that decline should stabilize, would that be in the fourth quarter or first quarter of next year? Thanks.

Yeah, so we would expect that to stabilize the next couple of quarters and to begin trending upwards and FY 2017 toward our 75% to 80% long-term range which is still our current view in terms of a steady state and long-term gross margins of the business. Of those few factors that I mentioned, some of them we're going to see some pretty immediate relief from, for example, in terms of the real estate expenses that we have been paying on two headquarters, the fourth quarter is going to be the end of that dynamic so that will get better in Q1. Box consulting, we expect the drag on margins to improve pretty steadily over the next few quarters as we get to that steady-state margin and then the data center that investments as we're depreciating that year and still in the midst of building out that project, we expect that a longer term impact, but still as we scale on an over time, the scale into those investments and for that to improve within the next year or so as well. So, there's a lots of puts and takes and we'll provide a bit more color into how -- what our expectations are for next year on our Q4 call. But we do expect that to turn around and fairly short order.

Thank you.

And we'll take our next question from Aaron Rakers with Stifel. Please go ahead.

Yeah. Thanks for taking the question, also congratulations on the quarter. I wanted to go back to the opportunities that you seem to have in front of you going into next year. One of the comments earlier made was that you're currently seeing kind of a $9 to $10 per seat per month type of model. If you're successful and kind of expanding into the Platform, into the EKM products, what do you think as a reasonable explanation of an uplift of that $9 to $10 range? Is it 20%, 30%, I'm curious what kind of goalpost you're looking for as you look out over the next 12 months?

Sure. So, for both products that would be sold that they are kind of on top of the core licenses and kind of across the entire enterprise for Enterprise Key Management as well as Box Governance, we've seen -- while there are range of outcomes in the customers who choose to deploy those products to their customer to their employee basis we're seeing for each of those products an uplift of about 20% to 30% relative to what the core content and collaboration price is. So, independently it would be a 20% to 30% uplift in those cases combined I think 40% to 60%. However, at the same time, as we are selling these products largely to larger enterprises, there is the headwinds of the volume discounts that we give. So, the overall price per seats may not change materially, but in terms of the like-for-like comparisons within certain sized deals reduce opportunity and have been able to actually increase those prices over time. So, that's the dynamic with those two products. Box Platform is a little bit different as the overall pricing model while it is seat-based, starts at $5 per app user per month which is a fraction of the seat price for internal users, but the opportunity as Aaron and Dan have mentioned is much, much greater in terms of the user population. So, wouldn't think about the price per seat of being a very good apples-to-apples comparison between Box Platform and some of our -- and the way that we sell other seats, but over time and especially ones we have sold more of those deals and have more of those deals in the pipeline, we'll get more visibility into what that pricing is looking like over time as well.

That was very helpful. And then real two quick follow-ups. First of all I apologize if I missed it, but did you give the percentage of revenue related to expenses for supporting free customers this quarter? And also I'm just curious on the IBM relationship as you expand that relationship; I think one of the points of leverage looks to be international expansion and the ability to leverage the software investments that IBM has made from a data center. So, I'm just curious where you stand on that 100 deals in the pipeline are you starting to see those actually utilize the software data center from IBM or those still bringing in-house to Box's data centers and if so when do you think software might be a point of leverage?

Sure this is Dylan all take that first question on turn it over to Aaron and Dan. We did disclose that so in that third quarter, we spent 11% of revenue on our free user base which is down from an improvement on 15% of revenue in the year ago period. And we continue to see a lot of benefit lot of that free user base both directly and indirectly influencing some of our larger deals and at the same time we're very focused on making sure that we continue to drive efficiency in terms of how we service those free users as well as the factor terms of how we monetize the free user base. So, over time you can expect that trend to continue and in the coming quarters that to move into the single-digit range as a percentage of revenue.

Sorry, this is Dan. Of the deals in the pipeline sourced by IBM, I would describe a significant of them is being outside of North America which is obviously delightful for us, especially when they are sourcing deals and regions where we do not have our own physical presence. While we have announced the intention to work with SoftLayer for international data centers, we haven't announced any concrete products or plans there, so I wouldn't expect to see any financial benefit deriving from our leveraged -- the leverage of our relationship with SoftLayer in the near future.

Thank you, guys.

And there's no further questions at this time. I'd like to have to back over to the presenters for any closing remarks.

Thank you everyone for joining us on our call today. And we look forward to speaking with you next quarter.

Thank you. This does conclude today's teleconference. Please disconnect your lines at this time and have a wonderful day.