Dropbox, Inc. (DBX) Q4 2022 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen. Thank you for joining Dropbox' Fourth Quarter 2022 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded and will be available for replay from the Investor Relations section of Dropbox' website following this call. I will now turn it over to Karan Kapoor, head of Investor Relations for Dropbox. Mr. Kapoor, please go ahead.

Thank you. Good afternoon and welcome to Dropbox' Fourth Quarter 2022 Earnings Call. Before we get started, I'd like to remind you that our remarks today will include forward-looking statements such as our financial guidance and expectations, including our long-term objectives and forecast for our first quarter and fiscal year 2023 and our expectations regarding our revenue growth, profitability, operating margin and free cash flow as well as our expectations regarding our business, assets, products, strategies, technology, employees, users, demand and the macroeconomic environment. These statements are subject to risks and uncertainties that could cause actual results to differ materially. They are also based on assumptions as of today, and we undertake no obligation to update them as a result of new information or future events. Factors and risks that could cause our actual results to differ materially from these forward-looking statements are set forth in today's earnings release and in our quarterly report on Form 10-Q filed with the SEC. We'll also discuss non-GAAP financial measures, which are not prepared in accordance with generally accepted accounting principles. A reconciliation of GAAP and non-GAAP results is provided in our earnings release and on our website at investors.dropbox.com. I would now like to turn the call over to Dropbox' Co-Founder and Chief Executive Officer, Drew Houston. Drew?

Thanks, Karan, and good afternoon, everyone. Welcome to our Q4 2022 earnings call. Joining me today is Tim Regan, our Chief Financial Officer. And I'll start with a recap of 2022 and provide an overview of our strategy for 2023, then Tim will go over our financials for Q4 and fiscal year 2022, give guidance for Q1 and full year 2023 and provide an update on our long-term targets. So let's get started. While 2022 saw a more challenging macroeconomic backdrop, and we saw some elevated headwinds in Q4, of which Tim will discuss in more detail, I'm pleased with how our business performed for the year. We ended the year with over $2.5 billion in ARR. We once again increased profitability and free cash flow, and repurchased nearly $800 million of our stock. We also rolled out new plans for our Teams customers with expanded security and data protection capabilities, made progress improving revenue retention and closed acquisitions such as FormSwift and Boxcryptor, which I'll touch on shortly. Before we dive in, as you know, last month, we shared that Timothy Young is stepping down from his role as President. And I really appreciate everything that Tim has done for Dropbox over the past few years and wish him all the best. And I'd also enjoy digging in with our senior leaders to continue leveling up our execution and to pursue all the opportunities we have ahead of us. And over the last year, we've been focused on three strategic objectives to help us realize our long-term vision. Our first objective has been to evolve our core FSS product, driving retention gains and monetization efforts through better conversion of our free users and through pricing and packaging. Our second objective has been to expand workflows beyond core FSS around documents and videos. And our third objective has been to drive operational excellence and improve efficiency. And this year, we've added a fourth strategic objective, which is to move beyond files and organize all cloud content for our customers. This has been a critical step in our product vision for some time, and recent advancements in AI and machine learning have a huge role to play in accelerating our plans, particularly in building out our universal search and other capabilities. I'll discuss this opportunity in more detail shortly. We are already executing against these strategic objectives with a strong sense of urgency. Q4 showed us that we're not immune to a slowing economy, and that's why I'm focused on our speed of execution in 2023 and on areas where we can improve efficiency. I'll offer more details on how we plan to do that, but first, let me discuss some observations from 2022. Starting with our first strategic objective around evolving our core FSS business. Our focus over the last few years has been on improving user experience, particularly on mobile. And this is where a growing number of basic users sign up for Dropbox. We've also been focused on adding more capabilities to better serve small businesses and freelancers who represent a passionate user base for Dropbox. Regarding mobile, we observed that the uptick in churn from Plus individuals that we witnessed in Q3 continued in Q4 largely due to recent mobile operating system changes, which increased transparency around subscriptions. To mitigate some of the macro pressures impacting consumer behavior, we've identified areas where we can make the mobile workflow more seamless and reliable. And to drive higher basic user activity, we're focused on improving the onboarding experience. This quarter, we're rolling out Google One Tap, which will help streamline the sign-up flow for mobile and web users. Many of our customers, such as small business teams and freelancers, rely on Dropbox to store and share videos and other rich media. To better serve them, we've made improvements to the sharing experience of large files, particularly reducing the time in uploading of large files, which we do expect to drive improvements in customer satisfaction and reduced churn. And as we continue to see the growth in video-related content stored and shared on Dropbox, particularly among creative professionals, we've made progress with our video preview capabilities by increasing size and limits and adding editing functionality. By improving this lightweight of valuable functionality, we're seeing increases in active video users and time spent per user. Last quarter, we discussed our first full quarter's progress in rolling out new plans for our standard and advanced Teams customers with a focus on security and data protection. While we can see a net benefit to ARR from these changes, we saw incremental headwinds in Q4 from some of our larger Teams customers reducing licenses. We recognize that as our customers experienced challenges in their businesses and evaluate their budgets, there's added pressure to reduce software spend. But we see an opportunity to mitigate some of this pressure through more high-touch account management for these customers traditionally came through the self-serve channel. We're actively working to strengthen the alignment between our business units and our go-to-market teams and see opportunities to improve renewal activity as we increase customer awareness of the added functionality we're adding for Teams. We're also continuing to invest in our security roadmap to strengthen our offering for business users. In Q4, we acquired assets from Boxcryptor, a provider of end-to-end zero knowledge encryption for cloud storage services. And over time, we plan to embed these encryption capabilities natively within Dropbox for our business users, providing them an additional layer of security by encrypting files locally on their devices prior to taking their content to Dropbox. We know that security is a top priority for our customers. And in the time of consolidating spend, we'll continue to identify opportunities to bundle more value for our paying users. As we think about funding additional value into our different paid plans, we'll continue to evaluate the best pricing and packaging strategy that best serves our customers. Moving on to our second objective, which is to expand our workflows beyond FSS, particularly around documents and videos. I'll first share an update on DocSend and Sign in 2022 and where we see opportunity to scale these businesses in 2023. As we've noted throughout the last year, we've seen both DocSend and Sign growth moderate as headwinds in their respective markets continue. DocSend's core market, which is venture back fundraising, has seen activity pull back materially from 2021 levels, which has resulted in customers being more price sensitive. This year, we're focused on diversifying DocSend customer base, introducing its new geographies and extending beyond venture capital and other professional services such as consulting. Sign has also seen challenges amidst an overall slowdown in the eSignature market and increasing competition. While we saw strength in our Sign API offering, there's opportunity to stabilize Sign's overall growth as we leverage it under the Dropbox brand and drive more sales-led growth targeting small businesses. For both Sign and DocSend, our focus in 2023 is around deeper integration with core Dropbox. While we've made progress integrating certain capabilities into the core Dropbox experience, for example, DocSend's analytics within an individual user sharing flow and Sign's native send for signature entry point and PDF in Dropbox, there are still challenges for the end user experience due to multiple systems that need to be unified. For example, customers have been required to re-log in to the different applications, access multiple terms of service and checkout flows and different user interfaces overall. We're quickly working to remove the friction in the user experience to make it easier for customers to try, buy and use these products, which is a critical step in unlocking our platform strategy. And up until now, we've mostly talked about DocSend and Dropbox Sign as key pillars to our document workflow strategy. And today, I'm excited to discuss an important new piece to this business with our acquisition of FormSwift. FormSwift is a cloud-based service that helps customers create, complete, edit and save critical business forms and agreements. With FormSwift's vast library of templates, individuals and small businesses are able to access hundreds of forms rather than spending resources drafting them from scratch. Whether it's a lease agreement or an employment contract, FormSwift's cloud-based offering makes it simple for customers to complete their agreement workflows. Also, it's complementary to Dropbox with a similar target customer, a robust self-serve go-to-market engine and capabilities that allow customers to do more with their digital content. We plan to integrate FormSwift under the Dropbox brand this year, and over time, combine its content library with our Sign and DocSend capabilities, providing a comprehensive end-to-end agreement workflow. So with millions visiting FormSwift's website, we see a natural opportunity to drive more top-of-funnel activity to Dropbox and its suite of products. Outside of documents, the other adjacent workflow beyond FSS is around video where we see significant usage on our platform. This year, we plan to continue our focus on video workflows, building on the recent public launch of Dropbox Capture, a video communication tool for distributed Teams as well as our continued progress with replay, which allows teams to collaborate and edit videos all within Dropbox. This launch in Capture to all Dropbox users in October, we've seen this usage grow significantly. We see an opportunity for replay to follow a similar path for general availability as its adoption and retention continue to improve with the creative community. By continuously iterating on these experiences, we're excited to build a best-in-class platform for creatives to administer their video content. And as I mentioned earlier, our newest strategic pillar in 2023 is to organize all cloud content centered around AI and machine learning. We're entering a new era of augmented knowledge work where human and machine intelligence combined to unlock unprecedented levels of productivity. We've been working towards a mission of designing a more light way of working for years as a proliferation of cloud tools and the shift to remote work have left people with a more chaotic working environment than ever before. Instead of one search box, we all have a dozen search boxes across all of our productivity tools and apps, and there's never been a better time to help our customers organize and simplify their working lives. And with the recent developments in natural language processing and large language models, Teams can now take on more complex tasks than ever before, and they're providing us the building blocks needed to augment knowledge work as we first envision. AI and machine learning is an area where we've been investing for a long time. We view machine learning to improve content suggestions and retrieval and help users better search and organize their video content, but there's a lot more we can do. Where the biggest opportunities we see is in tackling content fragmentation and universal search, and I'm looking forward to sharing more about what we'll be launching in the coming quarters. I believe we're operating from a position of strength given our scale and our platform neutrality and the millions of people and businesses that already use Dropbox for work and entrust us to store their most valuable content. I'm working very closely with our product teams on our roadmap and I couldn't be more excited about what Dropbox can do to leverage all these new technologies to unlock significant levels of productivity for millions of our customers and ultimately design a more enlightened way of working. In closing, 2022 was a solid year despite increasing challenges from the macro environment. We're making important changes within our business to better position us for the long term and continue to focus on improving our execution as we navigate what is likely to be another difficult year for our customers. But challenging times can be transformative for any business. We launched Dropbox during the great financial crisis, and I've learned that operating under more difficult environments can result in producing our best work. While we're not immune to a worsening economy, we're well positioned given our scale, our trusted brand, our healthy financial profile and our strong balance sheet. We remain focused on operational excellence, identifying areas of efficiency and capitalizing on emerging growth opportunities to invest in our future. And with that, I'll hand it over to Tim to walk through our financial results.

Thank you, Drew. Before turning to our quarterly results, I'd like to start with a reminder of our financial strategy. We are continuing to pursue sustained growth and profitability in a disciplined and thoughtful manner while remaining committed to our longer-term financial targets. We also remain focused on allocating capital to growth initiatives that we believe will drive future revenue, both organically and through acquisitions, while also returning a significant portion of our free cash flow to shareholders in the form of share repurchases. As Drew highlighted, we are seeing more signs of macro-related weakness impacting our business. And today, I'll walk through our guidance for 2023, which takes the current environment into consideration. I'll also provide an update on our financial targets for 2024. But first, let me discuss our fourth quarter and full year 2022 results. Total revenue for the fourth quarter increased 5.9% year-over-year to $599 million, beating our guidance range of $592 million to $595 million. Foreign exchange rates provide an approximate $19 million headwind to growth, in line with our previous guidance. On a constant currency basis, revenue grew 9.2% year-over-year. I'll note that our Q4 revenue was inclusive of a partial month of revenue from our acquisition of FormSwift, which we closed on December 15. Total ARR for the quarter grew 11.2% year-over-year for a total of $2.514 billion. On a constant currency basis, ARR grew by $83 million sequentially and 11.8% year-over-year. More than $50 million of this ARR was driven by the acquisition of FormSwift with an additional contribution from our pricing and packaging changes to our Team plans that we announced in June. As a reminder, we include the ARR related to acquired companies in our total ARR in the period of the acquisition. We exited the quarter with 17.77 million paying users and added approximately 230,000 net new paying users in the fourth quarter, with over 200,000 of these paying users stemming from our acquisition of FormSwift. As with ARR, we include all paying users of an acquired company within our total paying users and period of the acquisition. Excluding FormSwift, additions to paying users fell below our expectations driven by two main factors. First was the churn of a large education customer where I'd note that these customers have a very low ARPU and, hence, an immaterial impact to our total ARR base. The second factor was softness around our Plus and Teams plans as we continue to see increasing macroeconomic headwinds, as Drew mentioned. Specifically, we continue to see softness in our Plus SKU, particularly on mobile. And we began to see increased price sensitivity to our Teams plans. Average revenue per paying user for Q4 was $134.53, up slightly compared to Q3, with the benefit from our Teams pricing initiative, partially offset by FX headwinds and the continued mix shift towards Family plan, which is comprised of six seats, and therefore, carries a lower ARPU profile. We also saw an ARPU headwind from the acquisition of FormSwift as we recognize the entire paying user count, but only half a month of revenue. Before we continue with further discussion of our P&L, I would like to note that unless otherwise indicated, all income statement figures mentioned are non-GAAP and exclude stock-based compensation, amortization of purchased intangibles, certain acquisition-related expenses, impairments of our real estate assets and net gains on equity investments. Our non-GAAP net income also excludes the income tax benefit from the release of a valuation allowance on deferred tax assets and includes the income tax effect of the aforementioned adjustments. I'll now provide a brief update on our real estate strategy where we have been taking steps to de-cost our real estate portfolio as a result of our transition to a virtual-first model. We made progress against our subleasing goals in 2022, and a vast majority of our space outside of San Francisco headquarters has now been subleased. However, while we continue to actively seek subleases and consider buyouts of our San Francisco headquarters, recent downsizing and reductions in corporate needs throughout the San Francisco real estate market have resulted in a more challenging subleasing environment than we had originally anticipated. Given the current corporate real estate market, we are no longer assuming that we enter into additional subleases in San Francisco in the next few years. As a result, we have revised our subleasing assumptions, resulting in an additional write-down of our facilities and other related assets of $162 million in the fourth quarter. This brings our cumulative impairment charge to $604 million. This revised subleasing assumption also reduces our expected cash flow benefit over the next few years. Additionally, in Q4, our GAAP net income was favorably impacted by a $420 million onetime income tax benefit from the release of a valuation allowance on our U.S. deferred tax assets. This is a result of our improved profitability in the U.S., leading us to conclude that our valuation allowance on these deferred tax assets is no longer necessary. I would also note that there is no cash impact associated with this onetime benefit, and it is excluded from our non-GAAP net income. With that, let's continue with the fourth quarter P&L. Gross margin was 82% for the quarter, representing an increase of 1 percentage point on a year-over-year basis. The improvement in gross margin was primarily driven by ongoing efficiencies in our data center infrastructure. Fourth quarter R&D expense was $174 million or 29% of revenue, which increased compared to 26% of revenue in the fourth quarter of 2021. We have seen our R&D expense as a percent of revenue rise over this past year as we have been investing in key initiatives across our core file sync and share, Dropbox in and DocSend businesses while also investing in our universal search and AI roadmap that Drew discussed. This has coincided with attrition rates falling to record lows, which has resulted in the increased levels of R&D spend relative to 2021. Fourth quarter sales and marketing expense was $96 million or 16% of revenue, which decreased compared to 17% of revenue in the fourth quarter of 2021. Fourth quarter G&A expense was $43 million or 7% of revenue, which decreased compared to 8% of revenue in the fourth quarter of 2021. In total, we earned an operating profit of $179 million in the fourth quarter, representing an operating margin of 30%, in line with the fourth quarter of 2021. Net income for the fourth quarter was $141 million, which is a 12% decrease versus the fourth quarter of 2021. This decrease in net income is driven by the substantial increase in our tax expense in 2022 due to the impact of the R&D capitalization tax legislation effective in 2022 and given that we have now fully utilized our NOLs for non-GAAP tax purposes. Diluted EPS was $0.40 per share based on 354 million diluted weighted average shares outstanding, in line with $0.41 per share based on 386 million diluted weighted average shares outstanding for the fourth quarter of 2021. Moving on to our cash balance and cash flow. We ended the quarter with cash and short-term investments of $1.3 billion. Cash flow from operations was $195 million in the fourth quarter. I'll note that as part of our acquisitions of FormSwift and Boxcryptor in Q4, we paid a total of $33 million of key employee retention holdback to escrow, which decreased our cash flow from operations. Capital expenditures were $13 million during the quarter. This resulted in quarterly free cash flow of $182 million compared to $161 million in Q4 of 2021. In the quarter, we also added $53 million to our finance leases for data center equipment. As we had guided on our last call, we had planned for this significant step-up in Q4 leases as part of the build-out of a new data center going into service in Q1 of 2023. Let's turn to our share repurchase activity. In Q4, we continued executing against the $1.2 billion authorization that was approved earlier in 2022 by repurchasing 8 million shares, spending approximately $174 million. As of the end of the fourth quarter, we have approximately $748 million remaining under the current authorization. Now let's turn to our full year 2022 results. Total revenue for 2022 was $2.325 billion, representing 7.7% year-over-year growth, beating our guidance range of $2.318 billion to $2.321 billion. On a constant currency basis, relative to the average rates across 2021, year-over-year growth was 9.4%. Gross margin was 82% for the year, up 1.5 percentage points from 2021. Operating margin was 31% for 2022, which was up 1 percentage point from 2021. Net income was $574 million for the year, which is a 6% decrease from 2021, driven by the substantial increase in our tax expense in 2022, as I've mentioned previously. Diluted EPS was $1.58 per share based on 363 million diluted weighted average shares outstanding, up from $1.54 per share for the full year 2021 based on 396 million diluted weighted average shares outstanding. Cash flow from operations for 2022 was $797 million. Capital expenditures for the full year totaled $34 million, which resulted in free cash flow of $764 million or 33% of revenue. Our free cash flow for 2022 came in slightly below our guidance of $770 million to $790 million due to the $33 million in FormSwift and Boxcryptor acquisition-related holdbacks that we paid to escrow in Q4. We do not anticipate additional payments related to these holdbacks for FormSwift and Boxcryptor. These amounts will be expensed over time as they're earned by the respective key employees. In 2022, we also added $106 million to our finance lease lines for data center equipment or nearly 5% of revenue. Net of repayments, our finance lease balance decreased by $22 million. Finally, we repurchased approximately 36 million shares, spending $795 million in 2022. I'd now like to share our 2023 first quarter and full year guidance where I will also provide some context on the thinking behind this guidance. For the first quarter of 2023, we expect revenue to be in the range of $600 million to $603 million. On a constant currency revenue basis, we expect revenue to be in the range of $616 million to $619 million. We are assuming a currency headwind of approximately $16 million in the first quarter, which translates to nearly a 300 basis point headwind to growth. And as a reminder, there are two fewer subscription days in the first quarter of 2023 as compared to the fourth quarter of 2022. We expect non-GAAP operating margin to be approximately 26.5%. As a reminder, there is some seasonality with first quarter operating margins as payroll taxes reset at the start of each year. This also includes roughly 100 basis points of headwind from FX and 60 basis points of headwind from FormSwift. Finally, we expect diluted weighted average shares outstanding to be in the range of 351 million to 356 million shares based on our trailing 30-day average share price. For the full year 2023, we expect revenue to be in the range of $2.475 billion to $2.490 billion. On a constant currency revenue basis, we expect revenue to be in the range of $2.510 billion to $2.525 billion. We now estimate a full year 2023 currency headwind of approximately $35 million or approximately 150 basis points headwind to growth, with the FX headwinds moderating each quarter as we lap the headwinds of last year. We also expect FormSwift to contribute approximately 2.5 points of growth. We expect gross margin to be approximately 81% to 82%. As a reminder, we made infrastructure investments related to a new data center, which just went live this quarter, resulting in slightly lower full year gross margin than 2022. We expect non-GAAP operating margin to be approximately 30%. This is inclusive of an approximately 50 basis point headwind from FX as well as a 50 basis point headwind from our FormSwift acquisition. We expect free cash flow to be in the range of $825 million to $855 million. This includes approximately $23 million in cash outflows for the 2023 installments of acquisition-related deal consideration holdbacks for DocSend and Command E. Additionally, our free cash flow guidance is inclusive of an approximate $50 million headwind as a result of the R&D tax legislation, which I will elaborate on shortly. As related to our capital expenditures, we expect our addition to finance leases to be approximately 5% of revenue, and we expect cash CapEx to be in the range of $25 million to $35 million in 2023. We expect 2023 diluted weighted average shares outstanding to be in the range of 346 million to 351 million shares. I'd share some additional context on this guidance. As related to revenue, we saw incremental headwinds from the deteriorating macro environment across all lines of our business in the fourth quarter. We continue to see our mobile Plus users turn at higher levels, and we saw our Teams users carefully evaluate their license counts. In addition, while we are still seeing a net positive impact from our pricing and packaging changes to our standard and advanced Teams plan, we did see elevated churn relative to Q3. While we have seen the majority of Teams customers come up for renewal under the higher price point, we are now expecting a lower incremental contribution from the pricing change over the next two quarters for those that have not yet seen the pricing change in light of these recent trends. In addition to the softness that we're seeing within our file sync and share core business, we also continue to see incremental macro headwinds and across our Sign and DocSend businesses. We are factoring all of these recent trends into our revenue guidance for the year. As related to operating margin, we are expecting operating margins of approximately 30%, slightly below our 2022 margins. We expect Q1 to represent the trough of the year as a combination of factors, including the resetting of payroll taxes, FX and the acquisition of FormSwift are pressuring operating margins below our recent trend. For the full year, we expect FX and the acquisition of FormSwift to represent roughly a 100 basis point headwind to margins. Additionally, our guidance contemplates the annualization of the hiring we did in the second half of 2022, particularly within R&D. We are closely monitoring the efficiency of the spend to ensure that we are being prudent and expect our R&D as a percentage of revenue to trend lower through the year following Q1. As related to full year free cash flow, our guidance includes a $50 million cash tax headwind as a result of the law that now requires R&D costs to be capitalized for tax purposes. While there is a possibility that the current legislation may be amended or repealed, we are including this impact in our guidance until such time that it is repealed, which brings me to our long-term financial targets of delivering gross margins of 80% to 82%, operating margins of 30% to 32% and $1 billion of annual free cash flow by 2024. We continue to operate within our long-term margin range, and we have made significant progress growing free cash flow since we introduced our target three years ago. However, changes to R&D tax legislation and deteriorating FX rates relative to the rates we used when initially issuing our free cash flow target currently represent a combined headwind of over $75 million in 2024. While these and other factors have introduced pressure on our ability to achieve our $1 billion free cash flow target by 2024, we continue to have multiple ways to achieve this target. Thus, while the path has become more challenging, it is too early to make any changes to our long-term financial targets at this time. In conclusion, despite the macro headwinds we observed in the fourth quarter, we remain optimistic about our strategy and the opportunities in front of us, including our multiproduct efforts, our recent acquisitions and our plans to organize our users' cloud content. We will remain focused on our customers, operating the business efficiently and driving long-term value for our shareholders. With that, I'll now turn it over to the operator for Q&A.

[Operator Instructions] Our first question comes from the line of Rishi Jaluria of RBC Capital Markets.

First, I want to maybe think about FormSwift. And what is the customer overlap within that customer base look like? So in other words, not only what is the cross-sell potential for you to sell FormSwift to the existing Dropbox customer base and integrate the asset, but maybe are there net new customers that you have the ability to sell Dropbox -- the core Dropbox into and expand your reach? And then I've got a quick follow-up.

Sure. So thanks for the question. And I'd say short answer is yes to all the above. I mean I think, first, a lot of overlap or complementary fit between FormSwift and Dropbox in terms of a similar target customer, similar self-serve go-to-market and addressing the content life cycle and then there's fit in the other direction. So every -- or often contracts that you send out for signature originate in the form of a template where if you think about getting an NDA done or some office lease or something, that might start with a Google search and you land on a site like FormSwift to find a template. So it's complementary in both directions. And FormSwift has its own audience of millions of visitors every year that are potential Dropbox customers. So we see a lot of synergies in all directions.

Wonderful. That's really helpful. And then, Tim, when you're talking about kind of the elevated churn that you've seen, maybe can you give us a little bit of color in terms of what you're seeing on the churn? Are these customers just going out of business or shutting down at the low end? Are they going to maybe larger platforms where they're consolidating their spend, be it with the Microsoft or Google? And maybe alongside that, what's happening on the consumer side of the business, which -- last, I think you disclosed about 20% of total paying customers?

Sure. So we did see our churn rate increase this past quarter largely due to the deterioration in the macro economy, and we continue to see churn from our Plus customers, particularly on mobile devices. And we also saw heightened price sensitivity amongst our Team customers where, in particular, we saw a greater degree of churn from customers subject to our Teams pricing and packaging changes than we saw in the third quarter. Now that all said, our overall churn rate is currently in the low teens, and that's an improvement from where it was just a couple of years ago. So improving retention continues to be a focus for us. And of course, our revenue guidance factors in all of these latest trends. And as far as what's happening on the consumer side of the business, I wouldn't say there's been any material deviation in those trends as far as the 80-20 split that you referred to.

Our next question comes from the line of Michael Funk of Bank of America.

So just a couple, if I could. So on the ARPU change, you mentioned a few different factors there, family for one, obviously. The change in pricing has also been a factor and then FormSwift. Can you deconstruct the change in ARPU for us based on those different factors?

Sure. So we ended Q4 with ARPU at $134.53, which was down about $0.25 year-over-year. So a few key factors there. So FX was a $4.20 headwind. And continuing headwinds from a mix shift to Family plan are also a factor there. Now this was offset by benefits from our Teams pricing initiative, which we launched in June. And then FormSwift represented a small headwind, roughly $0.25, because we recognize all of FormSwift users, but only a half a month of revenue. Now looking forward, we don't formally guide to ARPU. But again, there are some factors that will impact our trends next year. Again, the Teams pricing change, that will be a tailwind to ARPU. FormSwift, we expect FormSwift to be a tailwind to ARPU as well next year as its monthly plan is roughly $40 per seat. FX, we expect that to be a headwind, but that to moderate throughout 2023, assuming current leasehold. And then again, Family plan, as a reminder, that SKU is a headwind to ARPU as this plan includes six licenses for friends and family.

Got it. And then also on the call, you mentioned some incremental revenue headwinds baked into the '23 guidance. You gave us a few different things, churn and mobile user count, elevated churn relative to 3Q, what you're experiencing there. Can you just break this down for us as well -- you already talked about ARPU, but in terms of gross set expectations versus churn expectations that are part of the incremental headwind, are you also expecting to have fewer gross additions? Or is the majority of the change on the churn side?

Sure. I'll give you some context on our net new paying user additions. So again, we added 230,000 net new paying users in the fourth quarter, a majority of that did come from FormSwift. And then excluding FormSwift, the addition to paying users did fall below our expectations, as I touched on. Now there were a few factors to that. First was the churn of a large university, which did carry a low ARPU. This had an immaterial impact on ARR. And then second was the softness across our Plus and Teams plans as we continue to see increasing macro headwinds. Now as far as what we expect going forward from a net new paying user perspective, I would expect that our net new paying users going forward to be a bit lower than the run rate that it was in the first half of 2022. And while we don't firmly guide to net new paying users, just as we navigate the pricing and packaging changes in the current macro environment, I'd expect something in the neighborhood of roughly 100,000 net new paying users per quarter, with ARPU expansion being more pronounced next year.

Okay. That's really helpful in thinking about the piece parts of trying to model out the growth for the year. So 100,000 net new per quarter. And just one more quick one, if I could. Just on the impairment related to real estate, specifically San Francisco. Did you explore other options such as early exit from the lease, simply negotiating maybe a -- from a stronger position with the landlords? Or I'm assuming you probably explore all options here rather than simply taking that off of the expectation for subleasing.

Sure. We've been actively exploring all options here. We have actually executed a few subleases in years past in San Francisco. We were relatively quick to market with our subleasing plans, but the market has deteriorated with many companies reducing their real estate footprint. And there's certainly been an increase in supply of real estate for sublease, which has pushed out our anticipated time to lease. And so we originally anticipated we would sublease San Francisco in mid-2023. Now we expect we won't begin subleasing until mid-'25. We've also lowered the rates we expect to receive. So we've certainly been active, and we continue to be active in partnering with our landlord and in searching for subleases. But at this point in time, this is our revised assumption just given what we're facing at this moment.

Our next question comes from the line of Steve Enders of Citi.

I guess maybe just to start, I think would love to get a little bit more detail on how you're thinking about kind of future packaging and pricing levers to potentially pull and how you see FormSwift coming into the rest of the portfolio and how you're thinking about kind of future monetization and pricing with picking and buying suite there going forward?

Sure. Well, FormSwift is a good example. It's complementary to a lot of our other use cases, and we've been building towards supporting document workflows end-to-end throughout the whole life cycle. So for example, a contract that originates as a template. Now we can -- we have the top of the funnel covered. And then as you send out a draft for review or iteration, you might use DocSend and then send it out to signature and sign and then have the signed version archived on Dropbox. So we've been building towards this on our roadmap for a long time, and there's a lot of -- as far as pricing and packaging, as you'd imagine, building that more integrated experience, bundling these experiences together, having a broader portfolio of products, all these things contribute to monetization. And with them zooming out from document workflows, our philosophy in general has been to add more value to add new features to our core products. So last year examples include a lot of new security features. And then as we add beyond a sufficient threshold of value, increased prices. And so you saw us do this last year with our 20% price increase for Teams customers. So that philosophy will -- that will still hold. That said, as we're all monitoring the macro environment, every company is looking to -- looking at budgets and consolidating spend. You have to -- we have to be mindful of what customers are going through and what they want. And so price -- it might be less around just straight price increases and more around bundling or looking at our customer -- our share customers and talking to them about if they're using some separate eSignature tool to buy a bundle that includes Sign and FSS instead. So I'd say what customers are interested is shifting, and we have to be mindful of the balance of continuing to increase monetization and ARPU while also being -- monitoring churn and what our customers want.

Okay. Got you. That's helpful context. And I guess maybe for the outlook here, I guess, particularly as we think about the '24 outlook on free cash flow. Understand there's the $75 million headwind there. But I know you mentioned that there's some further levers that you could potentially pull. I guess how are you thinking about what the potential -- biggest areas are to potentially pull there? And how are you thinking about, I guess, the general kind of hiring environment and outlook as you think about trying to drive towards that free cash flow target?

Sure. So we continue to have multiple ways to achieve our target. We have several organic initiatives, including improving our file sync and share business, expanding our multiproduct capabilities and organizing cloud content that can drive revenue growth. We also have inorganic opportunities we can pursue, which can contribute. We're also actively looking at ways we can drive more efficiency in the business. And of course, it's possible that exogenous factors such as R&D capitalization and FX can turn in our favor. So while the path has certainly become more challenging, it's too early to make any changes to our long-term targets at this time. And then as related to hiring, we are aware that many other companies are facing hiring challenges and taking restructuring measures in the industry right now. We did see an elevated impact of the macro economy on our business in the fourth quarter. So we're not immune to those pressures. We're closely reviewing the efficiency of our spend to ensure that we are seeing a sufficient level of return. And we will remain thoughtful and disciplined in making appropriate decisions for the long-term health of our business.

Our next question comes from the line of Joey Marincek of JMP Securities.

Drew, you mentioned increasing competition in the eSignature market. So I'm curious, how do you think Sign stacks up relative to competition? And what assumptions are baked into the guide on overall demand for Sign in 2023?

Sure. So I mean I think in the competitive environment, we're seeing certainly lots of different activities where different products are adding eSignature or different new kind of pricing and packaging approaches from different folks. So in general, we see Sign as having a very complementary motion to Dropbox. So we're self-serve, somewhat more SMB focused. We think that segment is relatively less addressed than -- in the enterprise with higher-end customers. Certainly, one of our big advantages is our existing audience of tens of millions of Dropbox FSS subscribers. So we're doing a lot to better integrate Sign and DocSend and our products -- I'd add FormSwift to that list, attaching it to our base. And I'd say we're pretty early in terms of our pricing and packaging and bundling optimizations there. And then when you sort of zoom out from just the eSignature to just the whole end-to-end workflow, as I said, we have a lot of different parts that we're stitching together and I think that our ability to provide a seamless and integrated end-to-end experience starting from, again, that Google Search to find a template with FormSwift all the way down to signature and archival. We are -- that's an advantage being able to have all those pieces of the puzzle, whereas with a lot of the competing point solutions, you have to like log in, log out. There's a lot of friction that is in that overall experience. So as you can see, we've been building -- our big source of differentiation is building the end-to-end experience, and we're relatively early innings in terms of driving adoption among our base and beyond.

That's very helpful. And can you give us some more details around Timothy's departure? How are you thinking about replacing him? Do you feel like you have the bench already? Or would you potentially look outside the company? Any thoughts there would be helpful.

Sure. Yes. So just for color, Timothy -- or last month, we announced that Timothy was stepping down. He's still at the company. He'll be here through March, and he contributed a lot. So I really appreciate everything he's done for us. As far as the go-forward leadership structure, nothing like preannounced here. We'll keep everybody posted. But it's been great for me to get closer to our operating leaders given all the opportunities we have in front of us and to focus on continuing to improve our execution.

Our next question comes from the line of Brent Thill of Jefferies.

This is Luv Sodha on for Brent Thill. Maybe one for you, Drew. I guess as you view as the long-term growth potential of this business, how should we think of the long-term growth potential? And what are the main levers that you have to drive growth, both organically and inorganically?

Sure. So many growth levers, I mean, starting with just organic levers, so continuing to optimal core business, which is at scale. And optimization is there. There's still a lot of returns to those. Second, we've been building out our broader portfolio of growth stage businesses like Sign and DocSend. And we also have a pipeline of newer products like Capture and Replay and Backup. And then there's M&A we've done in the past around things like Command E and universal search. And then looking ahead, as I shared on the call and in previous calls, I'm really excited about the opportunity to move beyond files and organize all of our customers' cloud content because if you look over the last decade or so, a lot of workloads have shifted from files to cloud tools, but there's a missing organizational layer there, and there's a lot of customer pain points. Search is one that is kind of obvious. Like what used to be one search box and kind of the file in PC era is now dozens of search boxes in the cloud era. And we see Dropbox is very well positioned to help address customer pain points and acquisitions like Command E bringing in a company that was already working on some of these problems and investing more behind it has been a big initiative for us. So there's a lot on the organic front, and I think this is -- this will ultimately be a bigger market than FSS. I think everybody, they're -- no one is solving these challenges around organizing cloud content. There's a whole lot of room for improvement in that experience, and we're investing very heavily there. And it also dovetails with a lot of the recent advances in AI and machine learning. So we're very excited about the prospect of having a self-organizing Dropbox or to be able to bring natural language in the experience for search or workflow or other areas. And these are areas we've been investing for a long time, and we're doubling down here even further. So there's a lot on the organic front, and we're continuing -- also, there are a number of growth levers on the M&A front. And even just the last quarter, we were really happy with some of the acquisitions we made with FormSwift and Boxcryptor. And so we'll continue to be on the lookout there, too.

Got it. And a quick follow-up for Tim, if I may. Just, Tim, just wanted to dig deeper into the revenue guide for next year. Could you just walk through your assumptions? Are you think -- are you embedding a worsening macro? Or are you expecting macro -- just any color in terms of churn and -- both the macro environment. And then you mentioned R&D efficiency. How should we think of that as a lever, especially as you look at your medium-term margin outlook of 30% to 32%?

Sure. Good question, Luv. So we are baking in, I'd say, an appropriate level of conservatism given the evolving macro landscape. We have assumed that key trends such as the increased levels of price sensitivity that we saw in the fourth quarter will continue throughout 2023. And so we are factoring in the latest signals and not assuming a turnaround in the economy in our guidance for 2023. Now consistent with our historical approach, we do factor in growth initiatives when we have sufficient signal on their performance. And as we see additional data over the course of the year, we will revise our guidance as needed. And then as far as R&D efficiency as a lever, just given our medium-term margin guide of 22% -- or sorry, 30% to 32%, we certainly will be looking at our R&D efficiency and closely reviewing the output that we're getting relative to that investment, and we'll continue to manage this business with discipline as we make our decisions going forward.

Our last question comes from the line of Mark Murphy of JPMorgan.

This is [Puneet Kaur] on for Mark Murphy. First, I just wanted to ask if you could walk us through any changes that you're seeing in the competitive landscape for Dropbox. Given Dropbox' scale and reputation, curious if there's an opportunity to kind of gain share given some of the macro pressures may be weighing on smaller vendors with less runway.

Sure. I'd say our competitive dynamics have been pretty stable. And I think you can see this in a -- while there were macro headwinds in Q4, I think broadly retention has been pretty stable. Margins have been pretty stable and so on. We haven't seen major changes in the environment. I'd say the dynamics are maybe a little bit by business by business or Sign and DocSend have some different factors than the core business -- or when fundraising comes down, that affects DocSend disproportionately things like that. But I'd say overall, it's been pretty stable. And then as we look ahead, especially as you think about organizing all cloud content, especially as you think about things like AI and machine learning and having a new generation of smart tools and products, we feel we're well positioned given our scale and our brand around trust and privacy and our platform neutrality. And we've already been investing a lot in machine learning and AI for a long time. So compared to start-ups, a lot of our accumulated advantages leave us well positioned. So pretty stable, but we're obviously continuing to monitor the environment.

Great. That's very helpful. And then as a quick follow-up, I just wanted to ask around some of the changes and enhancements you've made with your document workflow-oriented products, are there any early indications on the attach rates or initial proof points for some of these specific features that you've added that seem to be resonating more deeply with customers?

I don't have any additional stats to share right now, but we have been making increased progress in cross-selling Sign and DocSend in to our base and things like the rebrand from HelloSign to Dropbox Sign have been helpful. And then we're -- we've made -- we continue to make progress in building tighter integration points between file sync and share, our core Dropbox product and the broader portfolio. So we see a lot more upside there, both in terms of better integration and then continued duration on pricing and packaging and bundling.

Thank you. This concludes today's conference call. Please disconnect your lines at this time, and have a wonderful day.