Good afternoon, ladies and gentlemen, thank you for joining Dropbox's Third Quarter 2023 Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask a question. [Operator Instructions] As a reminder, this conference call is being recorded and will be available for replay from the Investor Relations section of Dropbox's website following this call. I will now turn the call over to Karan Kapoor, Head of Investor Relations for Dropbox. Mr. Kapoor, please go ahead.

Thank you. Good afternoon, and welcome to Dropbox's third quarter 2023 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 fourth 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, industry trends 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's Chief Financial Officer, Tim Regan. Tim?

Thanks, Karan, and good afternoon. Before I begin, I wanted to let everyone know that I'll be filling in for Drew today, because he and his wife Erin just welcomed their first child, Charlie, this week. So big congratulations and well wishes to Drew and his family. I'll first provide an update on our company strategy and share some recent product highlights before moving on to our Q3 results and guidance for the rest of the year. I will also offer some commentary to help you think about our 2024 outlook. While we continue to navigate an uncertain economic climate, we beat our revenue guidance, driven by strengths within our individual SKUs for the second straight quarter. And we again drove better than expected profitability. However, we continue to see pressure across our Teams' customers and document workflow businesses, including seasonal softness within FormSwift. As we approach the end of 2023, I want to quickly provide an update on our company strategy. As you recall, earlier in the year, we simplified our focus around two main business objectives. The first is building AI-powered product experiences centered around organizing all cloud content. Starting with the introduction of Dropbox Dash, a standalone universal search product leveraging AI and machine learning. And the second objective is continuing to evolve our core File Sync and Share offering, integrating AI and other improvements in order to provide a more seamless product experience for customers workflows. We first discussed this refocus strategy after we took actions in Q2 to realign our workforce in order to run a more efficient core business, while investing more towards longer-term AI product initiatives. We're pleased with how our teams have taken these changes in stride and how, as a company, we're able to look ahead with a unified product vision,…

Thank you. [Operator Instructions] Our first question comes from Matt Bullock with Bank of America. Your line is open.

Hi, thanks. Congrats to Drew. I'm on for Mike Funk. Really nice operating margin this quarter, nice beat. Can you provide any commentary on the pace of R&D, AI-focused headcount that you mentioned a few quarters ago following the [REF] (ph). Is that progressing on pace? And then more broadly, any commentary on customer behavior, whether it's churn or price sensitivity quarter-over-quarter? Thank you.

Sure, Matt. Good questions. With respect to hiring, we remain disciplined with our headcount investments, where our hiring will be focused on growth areas, such as Dash and our multi-product initiatives. And with respect to AI, we have been adding AI talent over the past few years. We will be adding more as we drive towards our Dash GA timing. And we've been able to attract strong talent from top tech companies as they see the opportunity to solve a big problem for our customers. And then as far as what we're seeing with customer behaviors recently, I'd say the macro trends remain roughly consistent with what we've observed over the past couple of quarters. On one hand, we continue to see elevated price sensitivity and down sell pressure from our team's customers, largely those that have had layoffs themselves. We've seen this particularly impact customers in the technology and construction verticals. And we are also seeing reduced top of funnel across our Teams plan subsequent to the price increase last year. DocSend and Sign also continue to face macro related headwinds. Now, on the other hand, we have been seeing some positive trends around our individual SKUs, particularly on retention and sign-ups, though our sense is that, this largely relates to actions that we have taken as opposed to a change in the environment. I'd say that our guidance does factor in these latest trends.

Excellent. Thank you.

One moment for our next question. Our next question comes from Mark Murphy with JPMorgan. Your line is open.

Great. This is Sonak Kolar on from Mark Murphy. Thanks for taking the question and then echo the congrats to Drew. Tim, given that you now lapped the price increase you had implemented back in June of 2022. I'm just curious how you're thinking about pricing going forward. Do you see the potential to continue to use price as a meaningful lever for growth, given some of these additional capabilities you're building out into the platform? And I have a quick follow-up.

Yes, I'd say that we are seeing increasing levels of price sensitivity in this macro environment where we're mindful of this as we assess our future pricing and packaging plans. Where for now we're focused on a bundling strategy as opposed to price increases, just given that price sensitivity. And this is where again in early October we did launch bundled offerings, where the idea with these bundles is to drive adoption of our non-storage products, where customers have been asking us to provide these capabilities, they just often don't know that we already do. And so, these new plans integrate additional functionality such as e-signature, DocSense tracking analytics, PDF editing and video recording in a seamless way. And we accompanied this with a refreshed web redesign that makes it easy to find and use this additional functionality. And we've seen that customers that leverage more than one product from us convert and retain at higher rates. And we will be migrating existing users at their current price points over the next couple of quarters. And so this bundling strategy is the priority right now as opposed to price increases.

Great. Thanks, Tim. And then I know the SFHQ is one of the larger remaining leases. Are there any other relatively larger leases that we should be mindful of remaining, or is it fair to assume that the major subleases have now been aptly right-sized?

San Francisco is the largest portion of our remaining space to be subleased. We've basically subleased the vast majority of our remaining space. And this is again where we just did a buyout this past quarter. That's of approximately 40% of that remaining sublease space or $79 million to be paid over three years. We do expect that that will drive significant savings over the long term, avoiding over $220 million in rent payments and common area fees over the remaining 10 year lease duration. So, we think that was a good decision for the long-term health of the company.

Great. Thank you so much.

One moment for our next question. Our next question comes from Steve Enders of Citi. Your line is open.

Okay, great. Thanks for taking the questions here. I guess maybe to start, I want to ask you about the customer event that you held last month in New York. And what was the feedback that you heard from customers there and how they're viewing the early beta access with the AI solutions?

Sure, so we gathered with a few hundred customers in New York earlier this month. As part of the event, we made several product announcements. We launched Dash into open beta. We released our web redesign as a core file sync and share experience. We introduced our new fully integrated bundled offerings, which I just touched on. And we also use the event to kick off paid digital campaign to drive awareness and signups of both Dash and our new plan lineup. And it was really great to talk with customers and to validate the thesis behind our new products is really resonating with them.

Okay, that's great to hear. And then, I guess, maybe on the outlook for next year, at least the preliminary review there. Just want to make sure that I’m thinking about this right, I think you said -- we'll get FX rate for this year. I think it was something like 5% growth that you're guiding to. And then on the free cash flow side, still going to have that $1 billion intact outside of the R&D tax. I guess with the building lease as well, is that being factored in or are you saying like outside of that and some of the other incremental CapEx that needs to come in here that you would still be able to hit that $1 billion number ex the R&D tax legislation?

For now we're only lowering our $1 billion free cash flow target to adjust for the R&D tax legislation. Now expected to be about $36 million. And if I take a step back, we've made significant progress against our free cashflow target over the past few years. Certainly proud of how far we've come, more than doubling our annual free cash flow since we set the target, but we do continue to face headwinds to reaching that target. For example, FX does remain a headwind, that's grown since last quarter. To your point, [indiscernible] San Francisco will also impact our free cash flow next year. And again, now planning as though the R&D tax legislation which came to light after we developed our targets will not be repealed. And we could withhold investments to our long-term initiatives such as Dash to meet that target, but again, we believe that would be short-sighted. So we will continue to monitor exogenous factors such as FX and its potential impact on our expectations, or again, we will provide official guidance on 2024 in February.

Okay, perfect. Thanks for taking questions.

One moment for our next question. Our next question comes from Rishi Jaluria with RBC Capital Markets. Your line is open. This is Richard Poland for Rishi Jaluria. Thanks for taking my question and would reiterate my congrats to Drew. First one, just in terms of the new bundles, how should we interpret difference between the new DocSend and e-signature pricing capabilities that are included in the bundles versus what was available in the standalone offerings prior? And how long until we expect more of the functionality like FormSwift or Dash and AI to be included in those bundles as well? Thanks.

Sure. So maybe I'll start with the back end of your question. Now that we've built these bundles, we will continue to iterate on further capabilities to add to them over time. And so, FormSwift is one of the areas that we are contemplating as far as future additions to the bundles, and we'll have more to share on that in future quarters. Dash, at this point, we are navigating towards selling that on a standalone basis. We're driving towards our GA in the early part of 2024 where we are still identifying our go-to-market approach and so much more to share on that front as we get closer to that point. As far as how we've integrated DocSend and Sign into these bundles. So maybe I'll just articulate that we are offering Dropbox Essentials for solo professionals for $22. That's relative to our professional plan, which was $20. Dropbox Business for small teams, that's $24 a month, relative to standard at $18. And Dropbox Business Plus for larger teams, $32 a month, relative to advance for $30. And so the way we've brought these in is we've brought in some degree of functionality, but not full functionality from our sign and send capabilities. And so, that's reflected in the degree of uplift in the pricing of those plans. Where again, the idea is to drive adoption of these multi-product capabilities that we have in these plans, where we've seen increased conversion and retention once users use more than one portion of our functionality. So that's the idea behind the bundles and we're excited to see how this progresses.

Okay, that's very helpful. And then just to follow up to that, I think in previous quarters you mentioned efforts to improve customer awareness of the document workflow capabilities. It seems like this kind of jives with that pretty well. But do you have plans, I guess, do any other like marketing campaigns or anything like that to boost awareness of the new pricing plans or maybe try and shift some of those family customers that should probably be on the team's business plans? Anything like that kind of as we look into 2024?

Absolutely. We're looking into many different angles to improve the awareness of our multi-product capabilities. Marketing campaigns, as you alluded to, and that's part of why our margins are going from 36% in the third quarter down to the guided level in the fourth quarter. That's where we're investing in marketing campaigns to fuel awareness of Dash as well as these bundled offerings that we just touched on. And then again, we've accompanied the launch of bundles with this refreshed web design that makes it very easy to find and use this additional functionality. So, a multi-prong approach to try to improve the awareness.

Got it. Thank you. That's very helpful.

One moment for our next question. Our next question comes from [indiscernible] of Jefferies, your line is open.

Hello. This is Eylon Liani on for [indiscernible]. Thank you for taking my question. First, you stated that the demand environment remained roughly the same versus 2Q. When do you expect that sentiment to shift, especially for DocSend and HelloSign that have remained under pressure in the past couple of quarters? And second, if you can shed some color on the international side, that would be helpful as well. Thanks.

It's really hard for me to predict when the macro will change and when sentiment will shift. It's not something I'm assuming in our guidance. So for now, certainly assuming consistency in the trends that we have. As far as international, FX headwinds continue to put pressure on our international growth rates. Our document workflow businesses are also predominantly in the US, and those tend to have faster growth rates. Though of course driving international growth through improved localization is an opportunity for us. And maybe just briefly on the Middle East, we do have double digit ARR from customers in Israel, and since the beginning of the conflict, we have seen some slowdown in activity in that region. However, I don't expect that to have a material impact on our overall numbers.

Thank you.

One moment for our next question. Our next question comes from Pat Walravens with JMP Securities. Your line is open.

Oh, great. Thank you. And forgive me if this has already been touched on. But is -- like I think with Adobe Firefly, there's something like 3 billion images that's been created. And with all the image generators, we're seeing more and more of it. Is it going to drive different storage requirements for you guys and other different sort of functionality and usage.

Sorry, Pat, are you referring to Adobe Firefly or…

Yes. Just with generative AI, there's so much more video and images that are going to be created than have ever been created before and you got to put them somewhere.

Sure, so Dropbox has actually been home to many PDF type files and users of Adobe. And so I would expect those sorts of trends to continue as users continue to find places to store their content, and Dropbox is one of their favorite homes for that. So that could be a catalyst for future storage growth for us and we're paying close attention to these sorts of trends.

Okay and so far not though right?

No material difference or No material deltas as related to Adobe Firefly at this point.

Okay. All right. Thank you.

Thank you. And I see that we have no further questions in queue at this time. Ladies and gentlemen, this concludes today's conference call. You may now disconnect at this time and have a wonderful day.