The Market May be Underestimating Dropbox

As most people know, Dropbox is a cloud storage and smart workplace solution built on the premise that everyone should be able to access their important files from anywhere on any device.

Led by owner-operator Drew Houston, Dropbox is at an interesting inflection point in its growth story. Unlike other cloud players, the stock has seemingly been left out of the “work from home” rally over the past six months. Up only 5% this year and trading for around 15x normalized free cash flow, the company looks undervalued. Attractive upside exists if the company can come anywhere close to hitting their 5-year performance targets.

Business Overview

When Dropbox was founded in 2007 they strictly focused on enabling users to store files on the cloud. They have since evolved into facilitating sharing and collaboration between business teams and individuals while also expanding their storage offerings. Dropbox went public in March of 2018 and is currently priced slightly below its initial offering of $21/share.

Dropbox offers both individual and team plans with different pricing tiers for each. Contrary to what most people think, Dropbox derives 80% of its revenue from business users rather than individuals. As you can see, even higher tiered plans are modestly priced in relation to the value they provide.

Historically, Dropbox has catered to small and medium sized businesses, but has recently started to strike deals with enterprises such as the University of Michigan, a large medical campus, and European luxury retailer, each licensing thousands of “seats”.

In 2019 the company launched a desktop app focused on connecting all of a user’s cloud apps and allowing collaboration and syncing across teams. For example, a team working on a product design can manage design documents housed on Google Drive and Microsoft Office and collaborate all at once while maintaining clear version control and backups. They’ve recently inked partnerships with Slack and Zoom for easy integration to share and present between groups.

In addition to their core business, Dropbox has a host of other applications such as Dropbox Passwords (encrypted storage of passwords), Vault (securely stores passports, tax documents, etc.) and HelloSign (newly acquired and integrated e-signature tool, much like DocuSign but focused on smaller businesses).

Business Model

Dropbox makes money off of subscriptions, so their growth is tied to their paying subscriber base (subs) and the average revenue per user (ARPU). The paying subscriber base is fed by the overall registered user base. The vast majority of users utilize the free version of Dropbox and the company aims to convert a small percentage of overall users to paying subscribers. The company currently has over 600 million registered users, of which 15 million are paying. Here is what the company’s user base looked like as of this August:

Since 2016, the company has expanded its overall registered users from 500 million to 600 million, or ~5% annually, and its paying users from 8.8 million to 15 million, or ~16% annually. Dropbox has global reach with users in over 180 countries.

Interestingly, the company makes little effort on the direct sales front, as 90% of sales come from self-serve channels, speaking to the products popularity and word-of-mouth adoption. A great example is University of Michigan’s recent conversion to Dropbox for both students and faculty. U of M decided to partner with Dropbox after wide scale bottom-up adoption among staff and students for things like collaborating on group projects, tracking deadlines, and organizing lectures. The proof is in the pudding and it’s clear users see value in Dropbox’s applications and interface.

When users convert from registered to paying, it provides sticky and recurring revenue for Dropbox. Management has indicated that retention rates are somewhere in the mid-90’s, and subscriptions typically run yearly. The stickiness makes sense as once a business houses their files on Dropbox it’s a pain to change over to another cloud storage competitor for what is likely negative incremental value.

Competition

The biggest question I had initially is – why does Dropbox need to exist with Google Drive and Microsoft OneDrive offering similar services? Is there some risk that Dropbox is totally obsolete sometime in the future because all users migrate to Microsoft and Google platforms? This question is likely creating an overhang on the stock.

While the risk is certainly worth considering, there are a couple of points that may provide some comfort. First and most importantly, Dropbox’s key advantage is that it provides an “open ecosystem” compared to a “walled garden”. In other words, Google and Microsoft want to keep users inside their ecosystem, and make it difficult to collaborate on documents created outside their platform. Dropbox is platform agnostic, and works seamlessly with Google docs, Microsoft office documents, and integrates with Salesforce, Zoom, Slack, and others. Business teams utilize all of these applications, and providing an easy way to connect them should provide staying power.

Second, as discussed above, Dropbox benefits from widespread bottom-up adoption. In a recent Yet Another Value Blog podcast, (where I was first introduced to the bull/bear thesis on Dropbox - I highly recommend listening) Elliot Turner described his discussions with IT professionals whose organizations utilize alternative cloud storage systems. One of them elegantly stated that Dropbox is like herpes, and no matter how hard they try to stomp it out in the organization, it keeps popping up. Clearly users are buying in to what Dropbox has built.

Third, Dropbox doesn’t compete with Google and Microsoft as directly as it would seem. While Google and Microsoft have somewhat more compelling free offerings with more storage space for individuals, 80% of Dropbox’s revenue comes from business teams, who need the functionality they are paying for. If a business wants the functionality they are getting with Dropbox, there is no major cost advantage from Google or Microsoft. Any comparable version of competitors cloud storage comes at a comparable cost, which is modest in the grand scheme of things anyways.

Finally, I’m not sure that cloud sharing/collaboration has to be a “winner take all” space. Dropbox was the first real player in this arena, and despite Google and Microsoft entering almost a decade ago, Dropbox continues to be the only prominent pure-play company in the space. The number of people storing documents on the cloud and collaborating remotely is only going to increase and the market is large enough for Dropbox, Google, and Microsoft to coexist.

Here’s a summary of what Dropbox believes sets its offering apart from others.

A sub-point here is that Dropbox solely exists to make cloud storage and collaboration easier, whereas at their core Google is an ad business and Microsoft a software company. Dropbox’s future depends on being successful in growing its user base, while it’s more of an added benefit for the other big players. This in and of itself is not a reason why Dropbox will remain relevant, but don’t underestimate the power of a focused business.

The company doesn’t have an indefensible moat around its product, so investors need to weigh the risks here. I’m mostly comfortable with their competitive position, particularly over the next 5 years or so.

Management

All else equal, I heavily favor management teams with skin in the game who are aligned with shareholders. CEOs who operate with an ownership mentality have historically delivered superior results, and owner-operators by definition fit this bill. Dropbox is led by Drew Houston, who founded the company in 2007 and still owns roughly 25% of the business. Shown below, Houston is eligible for nearly $600M of stock awards based on how the company’s share price performs. Each milestone dwarfs his reasonable $700K annual salary.

Other named executives are similarly incentivized to drive long-term shareholder value, with 90% of their pay “at-risk”.

Also, legendary Silicon Valley venture capital group Sequoia Capital owns 20% of the voting shares, sits on the board, and are long term shareholders alongside Houston.

While not a guarantee of long-term success, it’s safe to say shareholders are aligned with a management team with skin in the game.

Transition from Hyper-Growth to Cash Flow Story

Much like many of the hot cloud stocks today, Dropbox was an explosive growth story leading up to its IPO, with revenue growing ~30% annually from 2015 – 2018. Also like many of today’s growth darlings, there wasn’t much in the way of profits or free cash flow until recently. The company has yet to report GAAP earnings, mostly due to stock compensation flowing through the P&L (which is a legitimate expense if thought about correctly), but has begun to show its impressive cash generation ability.

In February, the company came out with a long-term operating model, shown below.

The management team believes they can drive substantial cost out of the business and deliver $1B+ of free cash flow by 2024, well over double 2019’s result. Currently Dropbox has an $8B market cap, meaning if they can deliver on $1B in free cash flow, investors who buy now are only paying 8x 2024 free cash flow – a huge discount to where businesses like Dropbox normally trade.

Oddly, the market has not reacted kindly to this new framework. The market is struggling with Dropbox transitioning from a hyper-growth stock to a more stabilized and profitable, though slower growing, enterprise. Analysts have questioned if management is too focused on cutting costs and should instead be plowing more money back into the business to drive higher topline growth. However, management has communicated that they believe they can hit this margin framework while still growing revenue solidly in the double-digits for many years. In many ways they are bucking the Silicon Valley trend of “growth at any costs” and trying to rationally balance growth and profitability.

The real question is, how realistic is this guidance? The company has historically, albeit over a short time period, been conservative in giving guidance. While the headline 2024 numbers seem audacious, taking a bottom-up approach using the company’s unit economics helps check the feasibility of the projections.

Growth Projections

Dropbox’s growth is a function of paying subscribers and revenue per subscriber, which have grown 16% and 4% annually since 2016 (through June of this year).

While the trends have been moderating, there are no stark warning signs that these will all of a sudden turn negative. The company thinks that 350 million of its registered users are “high value” targets, and it only needs to convert a small percentage each year to drive meaningful growth.

ARPU has shown no signs of slowing down, and there doesn’t appear to be any pressure on price. Management has strategically shifted product mix towards more business users, a trend that should continue to bolster ARPU growth. If and when the company moves into more large enterprise deals as discussed above, there would likely be pressure on ARPU because large-scale deployments come with a discount. Even so, this would push paying subs higher because those deals come with thousands of new paying subs.

After reading the company’s filings, transcripts, and browsing product reviews, it strikes me as unlikely that either of these growth drivers pivots negative. But, in the tech space I suppose anything can happen. Overall, management’s double-digit revenue growth target seems well within reason. For our purposes, I think mid-single-digit paying sub growth and low-single-digit ARPU growth is conservative and achievable, which would amount to ~7% topline growth.

Turning to margin, the company should generate ~ $530M in free cash flow this year, after adding back expenses for a new headquarter build, which is legitimately a one-time expense (FCF is closer to $475 including this cost). This amounts to a ~28% FCF margin for 2020.

Walking through the mid-point of managements estimated margin improvements, the company plans to add 1200 bps to its adjusted operating margin by 2024. Most of this should fall to free cash flow as their targets are after stock comp. They seem confident in their ability to hit these numbers and have increased their savings estimates over the last year. The savings are coming out of R&D, sales and marketing, and general and administrative, most of which are discretionary spending. The company still plans to spend a healthy 24% of revenue on R&D, so it’s not as if they are slashing innovation in the name of higher margins.

They are making progress already, and I’ll conservatively give the company credit for half of these savings spread out evenly until 2024 resulting in a 34% free cash flow margin.

Here’s where I land after what seem like reasonable assumptions (5% sub growth, 2% ARPU growth, and 600 bps margin expansion).

I’d love to hear from any readers that have studied Dropbox particularly if your view materially differs on what might be achievable over the next several years.

In this scenario I get ~$850M in free cash flow by 2024, within striking distance of management’s $1B+ goal. If they come close to revenue or cost targets I can easily see north of $1B in free cash flow.

Valuation and Returns

Using a 10% discount rate, at 15x normalized free cash flow the market is implying 3% long-term growth for Dropbox, which seems far too conservative. If the fundamentals continue as I think they should for the foreseeable future, the business should be able to grow mid/high single-digits in a normalized state (once margins have stabilized and paying subs and ARPU drive growth). This would imply somewhere between 20-30x as a fair valuation for the business. This is before considering the high quality nature of Dropbox’s model as revenue is sticky and recurring and growth is capital-light.

The last important component of valuation is share count. Dropbox has historically leaned heavily on stock comp as a form of employee retention, resulting in a growing share count (and diluting per share results). This is not uncommon in fast growing businesses like Dropbox, but the trend seems to be at an inflection point. The company announced a $600M buyback authorization earlier this year, and according to their guidance share count should be roughly flat from 2019. Because this is the first year without meaningful dilution, I’ll err on the side of continued dilution going forward, albeit at a lower level, and bake in annual share count increases of 5%.

Slapping a 20x multiple on 2024 free cash flow, summing up cash build over the next four years (including the current cash on the balance sheet), and assuming a 5% annual share count increase, I get $41 in economic value per share, for roughly a 20% annual return. If management hits their projections, returns could exceed 30% annually.

Of course, this assumes that the board and CEO can capably allocate excess cash, which I think they will. Drew Houston has substantial skin in the game and the board is high-quality and they have not yet made any major value-destroying moves. That doesn’t mean this will continue to be the case. I’m not sure exactly what the mix between repurchases, strategic M&A, and organic growth investments will look like going forward but I think a dollar retained in the business will be worth at least as much as a dollar distributed to shareholders. If your view on this differs, the $4B of cash build can’t be taken at face value.

Summary

Dropbox is going through growing pains two years after going public. The company has transitioned from a growth darling to a more mature, free cash flow generative business competing with legacy tech titans. The market is treating the company as a “show me” story as it executes on balancing growth with profitability.

While the lack of an enduring competitive advantage gives me pause, I lean towards giving the management team credit in their ability to deliver after studying the underlying unit economics. Led by a an owner-minded CEO who is swimming against the tide among Silicon Valley cloud players (emphasizing profitability and cash flow) it seems Dropbox is poised to reward patient investors in the coming years.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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