Dropbox Inc
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Dropbox Inc
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Good afternoon, ladies and gentlemen. Thank you for joining Dropbox’s First Quarter 2019 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. As a reminder, this conference call is being recorded, and will be available for replay from the Investor Relations section of Dropbox’s website following this call.
I will now hand the call over to Darren Yip, Dropbox’s Head of Investor Relations. Please go ahead.
Thank you. Good afternoon, and welcome to Dropbox’s first quarter 2019 earnings call. Today, Dropbox will discuss the quarterly financial results that were distributed earlier.
Statements on this call include forward-looking statements, including statements relating to the expected performance of our business, future financial results, strategy, long-term growth and overall future prospects. These statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those projected or implied during this call. In particular, those described in our Risk Factors included in our Form 10-K for the year ended December 31, 2018. You should not rely on our forward-looking statements as predictions of future event. All forward-looking statements that we make on this call are based on assumptions and beliefs as of today, and we undertake no obligation to update them except as required by law.
Our discussion today will include non-GAAP financial measures. These non-GAAP measures should be considered in addition to and not as a substitute for or in isolation from our GAAP results. A reconciliation of GAAP to non-GAAP results may be found on our earnings release, which was furnished with our Form 8-K filed today with the SEC and may also be found in the supplemental investor materials posted on our Investor Relations website at investors.dropbox.com.
I would now like to turn the call over to Dropbox’s Co-Founder and Chief Executive Officer, Drew Houston. Drew?
Thanks, Darren. Good afternoon, everyone, and welcome to our earnings call. On the call with me is Ajay Vashee, our Chief Financial Officer; and Yamini Rangan, our Chief Customer Officer, will also join us during Q&A.
Today, I’ll talk about our business and product highlights and the continued expansion of our ecosystem. Ajay will review our Q1 financial results such on our go-to-market strategy and offer guidance for Q2 and fiscal 2019.
In Q1, we saw strong results across our business. Revenue grew 22% year-over-year, driven by continued paying user growth and ARPU expansion. We also closed our first acquisition as a public company, adding that HelloSign team to the Dropbox family. And we accomplished all this while delivering a robust non-GAAP operating margin. These results continue to demonstrate the strength of our global collaboration platform, our efficient go-to-market strategy and our operational discipline.
So let’s begin with our product update. We’re building a collaborative workspace by bringing together content and all the communication and coordination around it. Over the last few months, we delivered a number of innovations that make the Dropbox experience even better for our users, teams and admins.
To start, we recently unveiled a number of new capabilities at Google Cloud Next that allowed users to work with Google Docs, Sheets and Slides right from within Dropbox. Managing work scattered across multiple platforms is difficult, distracting and time consuming. We’re changing that. Now users will be able to create, edit, share and store Google Docs, Sheets and Slides from within the Dropbox UI, viewing and organizing them right alongside their traditional files.
These capabilities make it easier for our users to organize and manage their content, control access and search the full text of their G Suite files natively within Dropbox. In addition, comments made within Docs, Sheets and Slides will appear directly as Dropbox notification. This enables our users to stay up-to-date on their most important work, quickly process feedback from the teams and maintain content and context in a single platform without having to toggle between multiple applications. Our deep partnership with Google allows us to bring this unique functionality to our users, breaking down silos and creating a digital workspace for content creation and collaboration.
Next, let’s take a look at search and retrieval, an area where we continue to make technical advancements. Last year, we announced the machine intelligence initiative called DBXi, which included our new suite for search engine and optical character recognition technology to help make content easier to find and organize. In April, we enabled an image specific metadata on file previews, allowing users to access tag data on file previews, across a variety of image formats. Users will now have access to critical information around images, such as focal length, shutter speed, camera model and artist, all of which ensures better searchability, version control and IP management. These are features commonly provided by digital asset management tools and help us expand the use cases for our creative audiences.
And, last week, we also announced the GIF content suggestions on the web, another feature powered by our DBXi machine intelligence initiatives. When users log on to dropbox.com, they’ll see list of files and folders that our algorithms predict that they might need based on their account and sharing activity. And because of machine intelligence, platform improves its predictions overtime, content suggestions get better, the more that users engage with Dropbox. With content suggestions, users will be able to get straight to work, without having to spend time digging through folders and files to find what they need.
Moving on to HelloSign. In Q1, we continue to deliver on HelloSign’s strategic roadmap, which is focused on e-signing features and functionality and on extending its market leading API to embed electronic signatures in any application website. We had in customers to validate text that signers enter to improve data accuracy and launched individual document tamper proofing capabilities that seal the each signed document to ensure its integrity.
In addition, we built new API features to make Hellosign a more seamless experience inside Dropbox. We also launched a new version of HelloWorks, which is HelloSign’s workflow automation product, complete with conditional logic functionality. Conditional logic brings static forms to life by allowing questions or information presented in a form to dynamically change in real-time, based on users inputs. This facilitates an intuitive form filling experience, even when managing some of those complex workflows. We’re really excited about the opportunity ahead for a HelloWorks and customers that have adopted the product see meaningfully higher phone completion rates and up to 3x faster turnaround times on key workflows.
Turning to Dropbox Paper. Paper continues to drive monetization through higher conversion and retention of team subscribers. Customers like Meredith Corporation, a media company that owns brands including Better Homes & Gardens, PEOPLE magazine and Sports Illustrated are already seeing a number of workflow and process benefits. Paper’s being used within the creative services team as a wiki for process and product knowledge, improving the way information is shared and decreasing ramp times for new employees. Paper is also being used to document and share meeting notes, which is helping to reduce silos and increase project visibility between team members.
In Q1, we expanded our market reach for Paper by adding HIPAA compliance, which we expect to drive more usage in verticals like education, healthcare, manufacturing and research. In addition, HIPAA compliance opens up usage to many customers not subject to the legislation, but use it as a proxy for security standards. Healthcare organizations, educational institutions and nonprofits already leverage our HIPAA compliant Dropbox business plans to collaborate on content like medical research and scientific datasets. Bringing Dropbox Paper up to HIPAA compliance allows these customers to leverage the tool to collaborate more seamlessly with their counterparts.
Next is the admin experience. In Q1, we launched Bulk Member Imports to streamline identity management and provisioning for teams. With our Bulk Member Imports tool, admins can now invite team members by importing a CSV file containing members e-mails, names and group memberships to efficiently grant and manage folder level access rights. This reduces the potential for errors and helps to onboard a large number of users more quickly as teams expand. To further improve the onboarding workflow, we also announced the admins can now G Suite single sign-on capability to automatically provision Dropbox business to users and groups that exist in the Google directory.
Now, let’s move on to the infrastructure that powers our platform. In Q1, we announced that Dropbox business customers will have the option to access and store their files locally in Australia and Japan. Working with our partners will deliver infrastructure capacity in both countries that connect to our points of presence for secure and high performance collaboration in country and around the world. Establishing a local hosting environment will help to support our strong growth in Asia and as an example of how we’re listening to our customers and responding to their collaboration needs.
Switching to our ecosystem. We continue to build partnerships that position Dropbox at the center of our users workflows. We’re firm believers in the power of integration and one of our most important differentiators that we’re uniquely open in interoperable platform. We help our user stitch together their content and work across all types of devices, operating systems and application.
A SaaS application proliferating in the workplace, switching between different tools to manage content results in waste of time and lost productivity. To help address this pain point, we’ve been strengthening our partner integrations with leading workflow automation tools, including Zapier, Nintex, Ocado, Trade.io, K2 and Cloudpipes. Our customers will be able to leverage these integrations to automate common manual actions across a range of enterprise applications. For instance, a sales person can manage opportunities across multiple apps like Salesforce, HubSpot and Copper and simply by changing the status of a lead automatically generate an RFP workflow in Dropbox.
In more complex workflows, users can even streamline hiring and onboarding by connecting a new employees resume in greenhouse to their signed contract in Dropbox and subsequently merge that content with the new higher record in Workday. Our strengthened integrations address clear collaboration challenges and are another step towards reducing work about work.
In summary, I’m really proud of the progress we’ve made over the last quarter. We added a wide variety of new product experiences and features and expanded our partner ecosystem to strengthen our platform. We continue to improve our search and retrieval capabilities, added new functionality to HelloSign and HelloWorks and launched HIPAA compliance for Paper.
And, finally, our strategic partnership with Google enables our users to create and collaborate across a range of file types, ultimately making Dropbox the true digital workspace for all types of content. By delivering more value to our users, we’re executing on our mission of designing a more enlightened way of working.
I’ll now turn it over to Ajay, our CFO, to walk through our financial results.
Thank you, Drew. Our Q1 results demonstrate our strong execution and focus on delivering a healthy balance of top-line growth and profitability. Total revenue for the quarter was up 22% year-over-year to $386 million, driven by an increase in total paying users and ARPU expansion. We ended Q1 with 13.2 million paying users. ARPU was $121.04 in Q1, up 6% from $114.30 a year ago.
The year-over-year ARPU expansion was primarily driven by strong adoption of our premium, professional and advanced plans by new paying users. We also continue to see some tailwinds from teams choosing to remain on our advanced plan following the expiration of their grandfathering period, though we completed the renewal process for substantially all grandfathered teams during the quarter. As a reminder, our strategy is to drive revenue growth through a combination of paying user conversion and ARPU expansion. Our continued growth in ARPU reflects our focus on converting our highest value users to drive sustainable monetization and retention.
Let me highlight a few ways we’re executing on the strategy. First, we are strengthening our growth engine by utilizing data science models to create new tools for our outbound sales team. Using advanced machine learning methods, we created an algorithm called Communities to better identify team expansion opportunities. Communities detects groups of users within a company, who are using Dropbox to share and collaborate with one another, but who are not yet part of one unified Dropbox team plan. Our machine learning enabled models then help to identify the Communities with the highest propensity to upsell to a team plan.
In addition, we’ve recently implemented a device limit for Dropbox Basic that prompts users to upgrade to a paid SKU if they’ve linked to more than three devices to their account. The breadth of operating systems and devices that we support is a major advantage of our platform and we found that users who link multiple devices to their account often used Dropbox for work. This revision to our device management policy is an opportunity for us to generate value, where we are delivering value to our users.
And, finally, we’re working to integrate HelloSign into our go-to-market efforts and to provide a frictionless experience for our collective users. We’ve already begun sales force enablement around HelloSign’s products and in Q2 we’ll rollout a more seamless authentication process, enabling subscribers to log into both their Dropbox and HelloSign accounts with the same credentials. It’s still early days, but we’re excited about the opportunity ahead. Go-to-market initiatives like these, as well as the product innovation that Drew talked to, help to drive customer wins and team expansion across a range of verticals in Q1, including construction, real estate, technology and manufacturing.
For example, last quarter, we grew our deployment at Avison Young, a commercial real estate services firm. Since our founding in 1978, Avison Young has experienced rapid growth and currently has 124 offices across 20 countries. Dropbox has been critical to helping the company scale its operations. After beginning with the Dropbox team of just five subscribers in 2011, Avison Young’s deployment has grown to over 2,000 subscribers today. Internal teams like graphic design, investment sales and project management all use Dropbox as a centralized workspace to organize and collaborate on content.
We’re also excited to announce that Trustpower, a New Zealand-based utility company, is now a Dropbox customer. Trustpower’s decision to deploy Dropbox was the result of an internal initiative focused on evolving the organization’s digital strategy. Dropbox will help Trustpower accomplish several goals, including strengthening data governance, consolidating digital tools, providing a cloud solution that is easy to use for employees and enhancing external collaboration. The company will also take advantage of our expanded infrastructure capacity in the growing APJ market that Drew alluded to earlier and host its data locally in region.
Before I move on to the rest of the P&L, I want to note that unless otherwise indicated all income statement measures that follow are non-GAAP and excludes stock-based compensation, amortization of purchased intangibles and certain expenses related to the acquisition of HelloSign. A reconciliation of GAAP to non-GAAP results may be found in our earnings release, which was furnished with our Form 8-K filed today with the SEC and in the supplemental investor materials posted on our Investor Relations website.
I also want to highlight that we adopted the new leasing standard ASC 842 on January 1, 2019, which resulted in the recognition of right-of-use assets of $431.7 million and operating lease liabilities of $502.4 million on the balance sheet.
Moving to the P&L. Gross margin for the quarter was 75%, an increase of one percentage point compared to the first quarter of 2018. The increase in gross margin was primarily driven by unit cost efficiency gains with our infrastructure hardware, including lower depreciation as a share of revenue, which was partially offset by higher compute costs. We continue to expect fiscal 2019 gross margin to be consistent with 2018 as we bring a new data center online to support continued growth.
Moving to operating expenses. First quarter R&D expense was $117 million, or 30% of revenue compared to 28% in Q1 a year ago. The increase as a percentage of revenue was primarily driven by higher headcount and investments in new product development and testing. As a reminder, we are temporarily incurring overlapping facilities related expenses for both our existing and new headquarters. And because R&D carries the highest proportion of our headcount, it carries the largest percentage of allocated overhead.
S&M expense was $94 million in the first quarter or 24% of revenue compared to 26% in Q1 a year ago. The decrease was due to lower spend on our global brand campaign relative to Q1 of 2018.
G&A expense was $41 million or 11% of revenue and one point higher than our G&A expense as a percentage of revenue in the prior year. The increase as a percentage of revenue was a result of higher headcount and outside services spend.
Taken together, we are in $39 million in operating profit in the first quarter of 2019. This translates to a 10% operating margin, which is one percentage point lower in Q1 of 2018. Operating margin in the first quarter of 2019 included our overlapping facilities related expenses as well as the impact from the integration of HelloSign and the associated purchased accounting write-down of its deferred revenue.
Net income for the quarter was $42 million, up from $31 million a year ago. Diluted EPS was $0.10 per share, up from $0.08 per share in Q1 of 2018 based on 418 million diluted weighted average shares outstanding.
Moving on to cash balance and cash flow. We ended Q1 with cash and short-term investments of $915 million. Cash flow from operations was $63 million in the quarter. Capital expenditures were $30 million yielding free cash flow of $34 million or 9% of revenue.
CapEx in Q1 included $21 million of spend on our new headquarters, of which $14 million was offset by tenant improvement allowances. Excluding the headquarter spend, net of TIAs, free cash flow would have been $41 million or 10% of revenue. In Q1, we also added $40 million to our capital lease lines for data center equipment. We continue to expect additions to our capital lease lines to be high-single-digits as a percentage of revenue on an annual basis going forward.
Now, let’s turn to our guidance. For the second quarter of 2019, we expect revenue to be in the range of $399 million to $401 million, non-GAAP operating margin to be in the range of 9% to 10%, which includes a 50 basis point headwind from planned spend which shifted from Q1 to Q2, and diluted weighted average shares outstanding to be in the range of 418 million to 423 million based on our trailing 30-day average share price.
For the full year 2019, we are raising our revenue guidance, which was previously $1.627 billion to $1.642 billion to $1.634 billion to $1.646 billion, I would note that similar to last quarter, this range continues to reflect the impact of currency headwinds. We are raising our non-GAAP operating margin guidance, which was previously 10.5% to 11.5% to a 11% to 12%. This range includes non-recurring expenses related to our new headquarters and HelloSign integration of approximately 2.5% of revenue.
We continue to expect free cash flow to be in the range of $375 million to $385 million. This range includes one-time spend related to the build-out of our new corporate headquarters. Excluding this spend, free cash flow would be $445 million to $465 million. We expect to generate approximately one-third of FY 2019 free cash flow in the first half of the year and two-thirds in the second half of the year.
Finally, we expect 2019 fully diluted weighted average shares outstanding to be in the range of 419 million to 424 million based on our trailing 30-day average share price.
In conclusion, we continue to be focused on delivering a healthy balance of growth and profitability and are excited about the road ahead.
I’ll now turn it back to Drew for closing remarks.
Thank you, Ajay. In closing, we had another great quarter. We continue to add product functionality and build best-of-breed partnerships that position Dropbox as a collaborative workspace for all types of content workflow. Our open ecosystem gives our users the freedom and flexibility to choose their preferred tools at work and we’re harnessing the extensive amount of metadata on our platform to provide a richer experience for all of our users across the world. We’re committed to our mission of designing more in line we’re working and I’m excited about the future we’re building.
On behalf of our management team, I’d like to take a moment to thank our customers, partners and the entire Dropbox team.
With that, I’d like to invite Yamini, our Chief Customer Officer, to join Ajay and me for Q&A. Operator?
Thank you. [Operator Instructions] Our first question comes from Heather Bellini with Goldman Sachs.
Great. Thank you. I was wondering, Ajay, if you can share with us, I know that you’ve got the deferred revenue write-down for HelloSign, but – just any color you could give about revenue that it may have contributed in the quarter versus your expectations? And then kind of what you’re thinking about for the year?
And then, the other question I had was related to – you obviously called out the FX headwind, which you talked about last quarter, as I believe, being about 100 basis point headwind for the year. I’m wondering, if you could share with us if that’s – if you think that’s gotten worse or if it’s staying the same in terms of the type of headwind you’re expecting? Thank you.
Sure. Thanks for the question, Heather. And as it relates to your first question on HelloSign. Certainly, the deal and the team there is performing in line with our expectations. The integration there is going really well. We continue to expect HelloSign to contribute just over a point of revenue growth this year. As you noted, that is net of the write-down of deferred revenue, part of purchase accounting guidelines and that’s also net of a partial year of revenue recognition just based on when we close that deal.
And longer-term, I would just reiterate that we are very excited about the opportunity we have ahead to drive revenue synergies together. Our HelloSign shares are lot of the same core design principles that allowed us to get to scale quickly and document workflow, certainly, a very natural category extension for us that serves the clear customer need. And as it relates to the second part of your question on FX and FX headwinds, our view there is consistent quarter-over-quarter. So, on a constant currency basis, our growth rate for FY 2019 and our guidance would be about one percentage point higher.
Okay, great. And I just had one quick follow-up then. Thank you for the HelloSign color and the FX color. One more question, given you had a fantastic ARPU growth number this quarter, given that the grandfathering is over, is there a way for you to help us think about how we should – how the shape of the year might progress in terms of growth in ARPU? And that’s it. Thank you.
Sure. I can provide a bit of color commentary there. And as a quick reminder for those on the call on our grandfathering process, we launched Dropbox Advanced in early 2017. And, at that time, we grandfathered all existing paid teams into our Advanced plan at their legacy price point. And as of the end of last quarter, we completed the renewal process for really substantially all grandfathered teams and while that process has been a tailwind to ARPU over the past few quarters, I would note that the primary driver of ARPU expansion continues to be strong adoption of our premium and teams SKUs by new paying users. And looking ahead to answer your question more directly, we remain confident in our ability to continue to expand ARPU over the course of the year. The only note I would make is that there’s always going to be some quarterly variation in the rate of expansion from factors like subscriber mix and deal timing.
Thank you.
Thank you. Our next question comes from Mark Murphy with JPMorgan.
Thank you, and congrats on the health of the results. Drew, I wanted to ask you at a high level, which opportunity is more promising to you currently or more tangible, the team collaboration content type of vector, in other words, Paper and Showcase and those kinds of products, or what you’re seeing in the transactional workflow side of things, in other words e-signature, contracts and forms and just where are you investing more heavily between those two opportunities?
We see those – both of those opportunities is related. I don’t know if I could quickly quantify one over the other, because we think about our roadmap on a number of dimensions. One is just, what is the life cycle of that document takes from concept to assigning event or to – or any number of activities. And so I’d say, we’re very focused on making it, so you can do more with the content in your Dropbox and we’ve shown a lot of examples of that in recent quarters with our extensions launched late last year, continue to strike new partnerships, the Google partnership is a good example, our G Suite partnership is a good example of that and so just making so we get more content in Dropbox, making it more useful, and then we’re also excited about the HelloSign roadmap, and that’s another angle of attack on some of these user challenges, where they started new signing but we see a big opportunity to do more to help us with a larger part of that life cycle. So, we’re focused on both and we think that there’s an overlapping and related opportunity.
Thank you. As a follow-up, Ajay, just given that you’re focused on converting your highest value users and I think you’ve been focusing that way for a number of quarters now. And this should provide a better retention profile, I believe. Are you able to tell us whether the aggregate dollar retention of the business has been improving as a result or whether you expect to see that in the future?
Sure. Happy to answer that question. At a high level, annualized net revenue retention isn’t the metric that we’re updating quarterly, but I can say that ANRR, for us, has steadily improved since we went public last year in 2018.
Thank you.
Thank you. Our next question comes from Justin Post with Merrill Lynch.
Thank you. Deferred revenue growth was 14% year-over-year, which is below your revenues and I think last quarter you mentioned some people are going monthly versus annual. The ANR question helps with that. But can you help us understand why that growth might be lower than your overall revenue growth? And do you see any – are you concerned about that or is that a good leading indicator of future growth? Thank you.
Sure. This is Ajay. Happy to answer your question, Justin. I think you answered it in the way that you asked it, which is that we have had success with a number of initiatives that have driven a higher proportion of monthly subscribers and some of these have been mobile initiatives, so iOS and Android-focused initiatives. These have been great for us, because we’ve been able to manage to a really attractive retention and LTV profile, and we’ve also been able to bring end-users that higher ASP and effective ARPU. So, you’ve seen that both manifest in our growing ARPU over the past year, you’ve also seen that manifest in our improved ANRR retention rates over the past year as well. And then that obviously has an impact on billings and deferred revenue as subscriber mix changes.
Got it. And maybe one follow-up. With the device limit changes, how has been the reaction from your paying customers on that? Any push back? And have you seen any uptick in people – percentage of people converting to paid? Thank you.
Sure, Justin. I can take this. Thanks for that question. Our focus is really driving – generating value for our users and wherever we see that we are generating value driving monetization initiative. So, in case of this three-device limit, what we are doing is actually getting our basic users that are our power users exposed to more high-value and paid – premium features, right? So, our paid users see the value in things like advanced data protection and so specifically with this device limit, when we look at basic users, when they have multiple devices, those are the power users and they also bring us into work. So for those users that bring us into work, imposing a limit actually helps them see the value of what we have in higher paid SKU. So, in terms of the initial reaction, it has been consistent with our expectation for this particular initiative and we’ll see how this develops in the next couple of quarters.
Thank you.
Thank you. Our next question comes from Richard Davis with Canaccord.
Hey, thanks very much. I’ve got two quick questions. So, a few months ago people were stressed about Google pricing and things like that. I guess I’m less concerned about that, a more important question I think is, how many – is there a tipping point in terms of modules that you need to offer, in which you therefore can then change the terms of discussion of competition from just, kind of storage and price to something that’s more orthogonal, in other words feature functionality? Yes, I’m just – and I know that’s a squishy question, but I feel that you’re trying to go that way with HelloSign and stuff like that. So are we a-third of the way there, are we halfway there, are we all the way there, that would be helpful? Thanks.
Well, in terms of how we can add value, I think we’re very early innings, because we watch our – we see no shortage of room for improvement with the experience of using technology at work. So, it’s a good question. And as you can see, if you look at our product roadmap over the last several quarters, a lot of it is just making the Dropbox experience fundamentally more useful and continuing to take friction and the experience of using a variety of different tools. And more and more people are – our customers are turning to Dropbox less for things like storage or space in, say, over the last several years, it’s been a trend toward sort of higher tier value where – and people turn to Dropbox to be more of a workspace that ties everything together more than just– more than storage.
And the Google partnership I mentioned is a great example of that, because we find a lot of our customers use Office, but they also use the G Suite tools and till now they haven’t had a great way to manage all that content and experience the seamlessness that Dropbox provides. So, we see a big opportunity to continue helping people tie all their different kinds of content together and then bring your content and the communication tools and coordination tools that you use closer together.
So, our partnerships with folks like Zoom and Slack, Gmail, others, remove a lot of the need to toggle between all these different apps. And so for sure, people are – our work users, we find that they’re buying Dropbox, because it saves them a lot of time and because it’s a place, where they’re getting work done, because obviously there’s a lot of places you can get cheap storage.
Got it. And just more of a technical question, look external third-party integrations are obviously important to your value proposition. this kind of ties into what you said, but also you need to be really careful with security and kind of integrations and things like that. Are you guys satisfied how you’re handling that, because that can be tricky. You got to make sure your partners are not going off the reservation into wrong ways and stuff like that? Thanks.
For sure. I mean, security is critically important to us and it’s the first thing on our customers’ minds, it’s the first thing on our mind. So, by all means, we have a security team that looks out for all of our product surface area, including our integrations and certainly, the integrations we promote, we’re thoughtful about making sure that the whole experience is secure and super important.
Super. Thank you.
Thank you. Our next question comes from Mark Mahaney with RBC Capital Markets.
Hey, thank you. It’s Zach Schwartzman on for Mark. Ajay, on the last call you mentioned that you’d expect the operating margins to expand again exiting 2019. Ever thought you change it at all and where do you see the greatest margin leverage? Just a quick update here would be helpful. And then I have a quick follow up for Drew and Yamini.
Sure. So, happy to take the first question there. We certainly plan to continue driving operating leverage over the course of 2019 and we will resume our trajectory of year-over-year operating margin expansion by the end of the year. So, thoughts there are very consistent with what we brought to market last quarter.
Thanks. And Drew or Yamini, can you talk more about the newer Communities algorithm? Is the difference here the ability to assign a probability for these groups within an organization that aren’t premium paying, but that likely will be? Just trying to get a better sense of this improvement in your user acquisition funnel strategy from a technical standpoint? Thank you.
Sure, Zach. I’m happy to answer that question. So, you’ve heard us talk about our outbound strategy, which is very much a data-driven strategy and this is an evolution of our data-driven algorithms. What we are doing is really identifying Communities of users that have the highest propensity to convert into a Dropbox team. And what we have found is that, teams that are 50 to 100 seats, they are the right kinds and profiles of teams that engage with our product, but also expand and drive towards the wall-to-wall deployment. And so these algorithms help us identify and help us prospect and qualify and this goes back to our focus of having a very scaled and efficient go-to-market model that is very data-driven. So that’s what you’re seeing in terms of this and we’ll continue evolving our data-driven programs.
Great. Thanks.
Thank you. Our next question comes from Sarah Hindlian with Macquarie Capital.
Hi, great. Thank you so much. One of the things I was hoping you could talk about is the announcement you made a few days ago on your blog in regards to your new cold storage technology. You talk a little bit on the blog about some potential cost savings. So, I was hoping you could tell us a little bit more about this and then I have a follow up.
So, for context, we announced, a few days ago that we’ve come up with a pretty interesting cold storage solution. So, for people that – a lot of content in Dropbox is accessed less frequent – less frequently. And so that – that’s often referred to as cold storage and we were able to, through some technical innovations, reduce the cost of doing that, while maintaining reliability. And Ajay can speak to the financial implications.
Sure. And this is something that we previewed at a high level. On last quarter’s call, we refer to it as our new storage tier. I certainly provided more details this week that Drew alluded to you just now. And we do expect to generate cost savings from the rollout of this new storage tier, those savings currently should have been factored into our view of gross margin and, again, just to reiterate we expect FY 2019 gross margin to be relatively consistent with FY 2018, but certainly to begin driving gross margin expansion across the second half of this year again after we bring in new data center online in the first half.
All right. Great. That’s helpful. And then a follow-up for Yamini. Yamini, you guys have done a significant number of partnership agreements over the past six months and I was hoping you could help us understand what you’re seeing in terms of that driving higher paying users?
Yes. Thank you, Sarah, for the question. So, our partnership strategy is really to provide more choice and reduce the fragmentation that our users see. So that’s really the focus of the partnership strategy. And as you pointed out, over the past couple of quarters, we have announced a number of partnerships one with Zoom, which drives a lot of value for both Zoom as well as Dropbox users, as well as this quarter with Google’s partnership and all of this is aimed at driving value for our users. What we end up seeing is, our users then engage much more with our platform and therefore, have better retention as well as expansion profile. So that’s the way we look at partnerships and we are seeing really good traction with the latest announcements as well as the initiatives to continue the engagement of our users.
Awesome. Thank you so much.
Thank you. Our next question comes from Jason Ader with William Blair.
Yes. Thanks. You guys mentioned on the call a steady improvement since the IPO in retention and then you also mentioned a focus on converting your highest value users to drive retention. So, I’m just wondering, does this mean you’re favoring ARPU in upsell a bit in the near-term over converting free users?
Sure. This is Ajay. Happy to take that question. And as you mentioned, absolutely, our focus from a monetization perspective continues to be on converting our highest value users. These are users that tend to retain and expand at higher rates. So, we just see a better LTV profile overall and better cohort value that we’re able to deliver with this kind of a focus. We don’t believe we’re sacrificing a near-term monetization by pursuing the strategy.
Though I will say at a high level, we continue to be focused on balancing growth and profitability. So, as we drive higher and higher rates of conversion and monetization, as we convert more users to our platform, we want to make sure that we’re doing that in a sustainable way and that we can continue to deliver on the margin expansion that we brought to market.
And we continue to drive conversion among free users and we can see that as – or we continue to see that as a big opportunity and another area of focus.
Okay. And then one quick follow-up just on profitability margins in particular. We’re at 75% gross margin right now, it sounds like we’re going to have some pressure given the new data center, but what is a good long-term, let’s say, I don’t know, two years out type of target for gross margin?
Yes. So what we’ve guided to in the past is that through the first two quarters of this year, gross margin will be slightly lower at roughly 75% as we bring a new data center online to support continued growth and then that we resume our trajectory of gross margin expansion across the second half of the year as we exit 2019 into 2020. The long-term gross margin guidance that we provided at the time of IPO was 76% to 78%. So, we are very close to that range and we aren’t updating that range at this time. But as we continue to execute on infrastructure efficiency initiatives and innovate on that dimension, we’ll continue to reevaluate whether or not it makes sense for us to change our guidance there, but 76% to 78% is still our long-term gross margin guidance.
Very good. Thanks.
Thank you. Our next question comes from Rishi Jaluria with D.A. Davidson.
Hey, guys. Thanks for taking my questions. Let me start with the HelloSign acquisition. Now that the acquisition is close, you’re working with the team. Could you just give us a sense of what is the overlap in the customer bases look like? And I think we all understand the cross-sell opportunities in terms of selling HelloSign to existing Dropbox customers, but just want to understand what does it look like the other way? Is there an opportunity to get Dropbox into existing HelloSign users that weren’t on Dropbox before, especially there is a replacement opportunity? And then I’ve got a follow up.
Yes. Thank you, Rishi, for that question. So one quarter into the acquisition, we are excited about the opportunity for cross-sell, we are much more focused on looking at getting HelloSign products into both our self-serve distribution channel as well as our outbound channel and those efforts are progressing really well. In terms of the other way looking at the opportunity to get Dropbox into the hands of HelloSign, we see opportunity there as well. They have been focused on and very different sales motion from an inbound prospective, which we can continue to leverage and there’s plans to make sure that the overall customers we are leveraging in terms of the combined value proposition. So opportunities on both sides, although I would say we are much more focused on getting HelloSign into the hands of the Dropbox sellers as well as into our self-serve channel.
Got it. Thank you, Yamini. And then Ajay or Drew or Yamini, on the ARPU side, look, it feels like it’s been a couple of quarters now that the biggest driver of ARPU, which has been expanding really nicely, has been number one from landing new users at the higher tiers and then maybe, number two, the grandfathered users kind of staying on board. Especially, now that factor number two is gone, how should we think about when the – I think, other two factors of potential ARPU expansion, converting existing users to higher paying tiers, and then converting free users to paying users. When do we think we can get back and become more meaningful in terms of driving ARPU uplift? Thanks.
Yes. This is Ajay. Happy to take the question. We certainly are focused on driving more and more paying user conversion to our paid plans as well as making sure that we’re driving high value conversion. So, on driving higher attach rates to our premium plans as you noted, the primary driver of ARPU expansion for the past few quarters and today, continues to be adoption of those premium – higher rates of adoption of our premium tiers by new paying users and we are also seeing a tailwind from folks that are moving from individual plans, team plans or upgrading – existing paying users, who are upgrading to higher tiers SKUs. So, you’ll see us continue to focus, a) on high-value conversions, b) on exposing existing paying users through our products services to some of the functionality of our higher-tiered plans and promoting and encouraging those upgrades.
I think they’re both going to be drivers of ARPU going forward. And the primary driver you’ll see will continue to be the uplift that we see from new paying users that manifest in metrics like gross new ASP. And so again, the metric we shared at the time of IPO system high level color commentary. Our gross new ASP, which is effectively ARPU for new paying users continues to meaningfully lead ARPU today. So, a fair amount of headroom there for us to continue to drive ARPU expansion in future quarters.
And I would just add that we’re always investing in this product driven conversion engine and when Yamini is talking about Communities using machine learning and data science to figure, that’s one example of many of addressing the opportunity we have, where in any given company there tend to be a self-serve Dropbox deployment and Dropbox business licenses, but then there is often a multiple more users, who are using either the free version or an individual subscription. So we are always interested in – we see a number of ways to continue to drive people along that journey from free use to individual paid to team subscription, and all of that increases ASP and lifetime value along the way.
Wonderful. Thank you so much.
Thank you. And our final question will come from Pat Walravens with JMP Securities.
Oh, great. Thank you very much, and congratulations on the quarter. So, I hear – Ajay, I hear the comment on balancing growth and profitability. What I’m wondering is, if I sort of step back, growth is decelerating, I think eight quarters in a row and the numbers are getting bigger. So, there’s definitely that, but the question is, is there something in your plan you guys think can reverse that where growth can reaccelerate? And if so, what would it be?
Sure. I can answer that question at a high level and at a high level, I would say we have a healthy steady and predictable business. The guidance that we’ve issued reflects our latest thinking, with respect to the quarterly phasing and ramp up of our growth initiatives. We’re confident in our ability to continue delivering leading growth at scale. As I said in the past, and this gets closer to the question that I think you are asking, we are structuring our business for consistent growth as we ext 2019 into 2020 and beyond. The impact of many of the initiatives launching this year will accrue across the second half of the year and this is a combination of both some exciting product initiatives as well as a handful of go-to-market initiatives.
And I would just add that, we’ve got some really great stuff on the product front coming later this year. So, we are still very early in terms of the roadmap that’s launching, so that we have a lot of reasons that we’re excited about, really substantially improving in the core Dropbox experience and providing a lot more value.
Awesome. Thank you.
All right. Well, thank you all for joining us today, and we appreciate your support and look forward to speaking with you again next quarter.
Ladies and gentlemen, thank you for participating in today’s conference. This concludes the program. You may all disconnect, and have a wonderful day.