Why Dropbox's Growth Is Hurting It

Summary

• Dropbox is financially strong and has a massive user base.
• However, it risks not fulfilling its potential due to its inability to fully monetize its user base.
• Its other strategies are also limited in part due to this inability.

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On March 23, Dropbox (NASDAQ:DBX) made its debut on the U.S. stock market. Two weeks later, on April 6, the stock closed at $30.24 -- 44% above its initial offering. To put things in perspective, of the FAANG stocks, Apple (AAPL) (+2%) was the best performer during this period. In fact, it was the only company out of the five to be up for this period. Stretching this back to the start of the year, only Netflix (NFLX) and Amazon (AMZN) have achieved double digit returns, with the remaining three companies down for the year. However, despite Dropbox's fantastic performance during this admittedly short period, I don't believe the company is a good investment at present.

Financially Strong

As a company, Dropbox has many strengths. First and foremost, it is strong financially. The company's revenue has been increasing faster than its cost of revenue. While its revenue growth dropped slightly in 2017, it was still almost 6x the increase in the cost of revenue. Over the past three years, Dropbox's net loss has steadily decreased, from $326 million in 2015 to just $112 million in 2017. If this trend were to continue, Dropbox will be able to post a net profit in the near future.

Source: Figures obtained from DBX Form S-1

Additionally, the company turned free cash flow, or FCF, positive in 2016 (or 2017, depending on which metric you look at). This indicates the company has sufficient cash left over to continue to grow its business. This positive FCF was in part due to a reduction in the company's net loss.

Source: Figures obtained from DBX Form S-1

Large User Base

Apart from its strong financials, one other key strength of Dropbox lies in the number of users it has. The company has over 500 million users, with 100 million alone added since 2017. That's a 25% increase in growth in just over a year. It's a fantastic number, no matter how you look at it, and goes to show that the company is still growing. Of these 500 million users, though, just 11 million or 2.2% are paying users. This represents an astonishing 97.8% of its client base which remains untapped. Even without increasing its client base, the company has over 489 million users it can "sell" to in order to generate revenue.

In fact, that's one of the company's key growth strategies. Dropbox has identified 300 million "high value targets" which it could potentially convert into paying users. If even just 1% of these users sign up for the cheapest individual plan ($99/year), the company can generate an additional $297 million in revenue. To give this number some context, Dropbox's revenue in 2017 was just over $1.1 billion. In other words, the company will be able to boost revenue by close to 30% simply by converting 1% of its "high value targets." Clearly, Dropbox has great room for growth.

Source: DBX March 2018 Investor Presentation

Failure to Monetize

While the numbers above paint a rosy picture for Dropbox, with strong financials and a large user base, it's worth taking a closer look to see if everything is as good as it seems. In 2017, Dropbox generated over $1.1 billion in revenue. At the same time, its cost of revenue was close to $370 million. In other words, the company's revenue of $1.1 billion came from only a small percentage of its users, but its cost of revenue includes all users. Since its inception just over 10 years ago, the company has managed to build up its user base to an impressive 500 million.

Despite this, the company has only managed to monetize a paltry 2.2% of its users. Take a moment and think about this - if users are still using the free version of Dropbox after a decade, why would they switch to the paid version now? Granted, probably only a fraction of these 500 million users have been using Dropbox for a decade, but the question still remains. After all, these users are clearly comfortable with the free 16GB of space provided (it starts off at 2GB, but goes up to 16GB after all the incentives).

Frankly, I believe 16GB of data is more than enough for most individuals. The only reason I can think of for an individual to require more than 16GB of data is to store photos and videos. After all, memories are precious (and they take up too much space as well). As seen from the numbers above, Dropbox does not face an issue of a lack of growth. Rather, the issue is this. If Dropbox is unable to properly monetize its existing users, the increasing number of non-paying users will only serve to increase its cost of revenue and act as a drag on profits.

Many Alternatives

Since most of us use our phones to capture memories, and considering how iPhones have consistently been among the top-selling mobile phones, I'll use iPhone users as an example to demonstrate how difficult it is to convert existing users into paying ones due to the plethora of alternatives out there. As an iPhone user, I can store my photos on iCloud. Apart from the convenience it provides, since my photos are automatically uploaded from my iPhone onto iCloud, it's cheaper as well. Apple offers 2TB of data for $9.99/month, while Dropbox offers only 1TB for the same price.

As an iPhone user, why would I switch over to the paid version of Dropbox when I can store my photos and videos on iCloud and use the free version of Dropbox for my documents? Therefore, it seems to me that Dropbox holds no discernible advantage for individuals. When it comes to business users, there are also many alternatives out there at comparable prices. Thus, the difficulty of converting non-paying users into paying users can be imagined.

Even assuming that Dropbox is able to convert its "high value targets" into paying customers, is this 300 million a realistic figure? From its Form S-1, the company states that these users have "characteristics - including specific email domains, devices, and geographies - that make them more likely than other registered users to pay over time," and goes on to add that "substantially all of our paying users share at least one of these characteristics." To me, this process of identifying its targets doesn't instill much confidence. Adding this to my earlier point that users who would have already converted to paid plans would have done so long ago, it seems to me that this 300 million has been massively overinflated.

Analyzing Other Strategies

Apart from converting non-paying users into paying users, the company has two other approaches in its growth strategy. These two strategies are to upgrade its paying users, and to "apply insights to build new product experiences." For the former, while it is certainly a sound business strategy to upsell your services, this approach has limited potential if the company is unable to increase its number of paying users as there is only so much revenue it can generate from existing paying customers.

For the latter, it simply means adding new features to Dropbox to differentiate it from other similar services out there in order to build its user base. The company cites Dropbox Paper as one such feature. However, I struggle to think of any other successful feature Dropbox has introduced recently which would fulfill this purpose. It seems to me that the company has not made much headway in this approach.

Source: DBX Form S-1

A Closer Look at the Financials

Dropbox is in a position of financial strength, having turned FCF positive in recent years and slowly reducing its net losses. However, a closer observation of the company's financials show that 2017's FCF of $305 million (or $170 million after accounting for lease obligations) was in a large part due to the reduction in capital expenditure. Dropbox's Form S-1 attributes this reduction to a decrease in expenditure for infrastructure equipment and leasehold improvements. However, this seems to be a one-off as the company has indicated it foresees capital expenditure to increase in subsequent years. Thus, it remains to be seen whether the company can continue to maintain a positive FCF going forward.

Apart from questions surrounding its ability to be FCF positive, more attention has to be paid to its revenue and cost of revenue. As mentioned above, Dropbox's revenue is growing faster than its cost of revenue, thereby reducing its net loss. However, a failure to properly monetize its user base would lead to revenue eventually stagnating while the cost of revenue continues to rise. While this may not be an immediate problem, it is worth paying close attention to as it can impact its future finances.

Conclusion

Clearly, Dropbox possesses lots of potential. There's no disputing this, and it is evident in the sheer number of users the company has. However, the fact remains that the company continues to be loss-making, and may continue to do so in the future. In fact, the company has made a warning to that effect, stating "We have a history of net losses, we anticipate increasing expenses in the future, and we may not be able to achieve or maintain profitability." Thus, until Dropbox shows an ability to successfully monetize its user base, it risks not being able to fulfill its potential and I'll be staying clear of it.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.