DropBox: Much More To Come

Jul. 02, 2018 12:50 PM ETDropbox, Inc. (DBX), FPXBOX, FDN, IPO, PNQI, SKYY, SNAP, VTI, XLK3 Comments

Summary

  • Dropbox shares enjoyed a short-lived rally on speculations of short covering.
  • We think a much more likely reason was speculation ahead of DBX being added to different ETFs.
  • DBX’s dual share class makes it unlikely the stock will be added to many funds, but could find a home with the smaller ones but effects will be de minimis.

Three months after its IPO and Dropbox (NASDAQ:DBX) finally made headlines thanks to a strong rally that sent its share price soaring from $30 to $42 only to see it come crashing back last week to settle at $33.72 by the close on Friday. The fact that up until now most media coverage of DBX has generally been negative and the lack of any obvious catalyst led some to conclude that the sudden spike was nothing but short covering. Possible yet but we think a far more likely explanation has to do with DBX's three-month trade anniversary and its eligibility to be included in exchange-traded funds.

All passive ETFs have a benchmark that is built around a series of rules governing things like stock selection and rebalancing with many follow the same basic template governing how IPOs are added to the benchmark. Three months is typically the minimum amount of time a stock needs to be publicly traded before it can be added in addition to being traded on an exchange and meeting certain liquidity conditions. With a market cap over $13 billion and 400+ million shares outstanding, DBX easily checked off all those boxes and since many funds use the end of a quarter as their reconstitution date, the stock should've made the roster at any number of ETFs. Note that we said it "should've" because the percentage of its market cap held by ETFs is well below what we would expect for a stock of this size and reputation.

Thanks to years spent building relationships with custodians, we have access to the daily constitution files for all equity ETFs in the U.S. which means not only can we track both changes in portfolio holdings on a daily basis and use that holdings data to track ETF ownership of individual securities. This would include the fact that we have detailed insight (updated daily - see here) in regards to equity ownership and Dropbox began last week in only one fund, the First Trust US Equity Opportunities ETF (NYSEARCA:FPX), which as a dedicated IPO fund has a unique set of rules governing its benchmark to allow for rapid inclusion of new names. Even then, the fund held only a small position in DBX, currently around $6.7 million or about .05% of DBX's market cap of $13.3 billion at the close of 6/22.

Since then, DBX has found its way into a handful of other funds from Vanguard with wildly varying strategies over the course of last week typically as a very small position, typically less than a tenth of a percent. In dollar and share terms, our system shows those Vanguard added over 2.3 million shares with a current market value of $70m to their portfolios, providing a significant boost to DBX's ETF ownership and although the current level is still low at around .5%. To see just how low we're talking about, compare it with one of DBX's competitors, Box, Inc. (BOX), another cloud stock with a market cap roughly 1/5th the size of DBX's.

BOX has long ETF ownership amounting to nearly $245 million or 6.5% of its $3.8 billion market cap including in both broad market and sector-specific funds and the impact on the two companies stock prices couldn't be more transparent. DBX enjoyed the first day pop as its IPO was priced above expectations at $21 and opened at $29, but the honeymoon was short lived and from April 1st to the June 8th (Friday before the big rally began), DBX was down 4.13% while BOX was up 25.69% and the First Trust Cloud Computing ETF (SKYY) was up over 11.59%.

There's no hard and fast rule that says ETF ownership above one level or below another is either good or bad and it can vary widely even between companies of a similar size or industry, but no one would deny that having broader ownership by ETFs is a good thing. ETFs are often viewed as liquidity providers as they buy when they must, regardless of whether the price is rising or falling, and while that can imply a degree of price, being included in a major index has an intangible factor as well. It means that you're a part of a broader investment universe, a necessary holding for other funds, especially actively managed ones looking for hot stocks while staying closely aligned with their sector benchmark. And being on the outside makes you a source of tracking error, something every fund manager is trying to avoid in these benchmarked times.

So why has Dropbox been consigned to sit on the pine while all the other kids get a chance to play? A small part is just bad timing. Even with a three-month trade history, passive ETFs benchmarks which have a strict set of rules for which stocks are eligible to be included and they must meet those by a preset date in advance of the reconstitutions leaving DBX to sit out another quarter even if it had met all the other eligibility which they didn't. Another problem for DBX is liquidity which for most benchmarks generally takes the form of free float to total shares outstanding with the floor being set at least 20% while DBX is currently only at around 12% according to Finviz.com (See full report here).

DBX will still be eligible for inclusion into a lot of funds later this year but a much bigger unforced error by DBX could keep it from enjoying the benefit of widespread adoption by some of the biggest funds around. When Dropbox came to market with a dual share class, something popularized by Google way back in 2004 as a way for founders and early investors to have their cake and eat it to. DBX has three share classes with the two relevant for today being the Class A being offered to the public and Class B being held by insiders. They have equal rights except that Class B holders have ten times the votes of Class A holders which allow the founders to control the direction of the company, enjoy the benefits of an IPO and active market for their stock and without having to be truly responsible to the larger shareholder base. Seems smart except for the fact that it flies in the face of every principle of corporate governance because by having a second, more senior share class, in effect it's still a private company and violates the principles of "one share, one vote." The Council for Institutional Investors has been taking a serious stance on corporate governance and pushing the SEC and index providers to take a serious stance on the issue (Click here for full article).

Does size really matter?

The ETF ecosystem may be complicated but between every passive ETF and the broad equity universe is an index provider that creates those benchmarks that drive funds. There are plenty of providers, but the three most well-known are MSCI, S&P Dow Jones, and FTSE Russell who are literally some of the most well-known names in investing and whose indexes guide an industry managing trillions in assets. Just think about how many hundreds of billions of dollars are tied to products linked to the S&P 500 or Russell 1000? Inclusion in the right index can shift billions in capital while exclusion can leave you dying on the vine, and for now, those big index providers have decided to exclude DBX from their most popular universes.

In fact, DBX wasn't even the first company to face this issue as Snapchat (SNAP) was excluded by the same index providers in 2017 for also having a dual share class system. There are periodic reviews to determine whether to include stocks with dual share classes and MSCI hopes to complete its review by the end of October (you can read more about it here (You can read more about it here).

Until then, SNAP can show us what happens when a stock is excluded from the larger sector or category funds. SNAP still has found its way into a number of funds with roughly 1.2% ETF ownership although that amounts to only $200 million compared to $240 million for BOX, roughly a fifth its size as SNAP is down over 25% during the last year while Technology Select Sector SPDR ETF (XLK) is up almost 25% and the broader S&P 500 is up 11.43%.

Like SNAP, DBX has already begun to be included in several broad funds that focus on market capitalization or total equity market exposure without the need for inclusion in a major index. The goal is typically to replicate exposure to an entire market cap range (Vanguard Mid Cap) or a total market fund like Vanguard Total Stock Market (VTI) which requires only that you be traded on an exchange. The only issue with trying to determine how much impact that could have on DBX's share price is that it's impossible to determine who else might want to add the fund and when, so, for now, it's better to avoid that on focus on the second class of funds where DBX could get chance to shine.

What to expect?

That other possible category is among more narrowly defined funds offering exposure to specific subsegments of the technology market, either cloud computing or software, or to "internet" funds where all you need is to have is a specific percentage of revenue derived online. There's been an explosion is such narrowly defined tech funds over the last three years and Dropbox, being synonymous with cloud storage, could be an easy fit for many if it can meet the inclusion criteria. The question that we need to answer is which funds and just how much money are we talking about?

With over 2,000 unique funds currently available, determining the exact number of funds and potential amount to be invested is quite literally impossible, but by looking at who currently holds BOX, we can at least start by looking at funds that focus on cloud storage, internet themes, or software. Then we spent A LOT of time looking through prospectuses and index construction methodologies to determine eligibility criteria where DBX would be automatically excluded for one reason or another. In fact, we spent so much time on this that one of the possible funds for DBX, the Renaissance IPO ETF (IPO) did add Dropbox to their portfolio.

Among the other contenders, the most common reason for leaving out Dropbox was the need to be included in another index (S&P, Russell, etc) or free float requirements above 20%. That left us with a short list that we trimmed, even more, to focus on just the largest five to estimate the potential trade impact and potential timing of any inclusion to the portfolio. So again, how much money are we talking about? As you can see from the table below, the answer is "not much."

The why is that these tend to be smaller funds with only the First Trust Dow Jones Internet Index Fund (FDN) ranking among the top 10 technology funds based on AUM and would provide over 80% of the possible ETF ownership if our estimates are correct. FDN is also a large holder of BOX although it provides a smaller percentage of BOX's ownership as the stock is included in the Russell 2000 making it eligible for a wider range of products than DBX. DBX was ineligible for most other technology funds thanks to either that lack of index membership or its low ratio of free float to shares outstanding. Only the Renaissance IPO ETF is outside the technology space and as the name implies, IPO focuses on, making it a natural competitor of FPX and giving it a much broader investment mandate. The remaining funds either have a focus on cloud technology or software in general along with more permissive inclusion systems.

Their smaller size was at least partially counteracted by these funds having either a modified market cap or unique weighting system focusing on liquidity that allows a wide range of possible allocations although it also complicated things by forcing us to often use a current holding of similar size to DBX to estimate the trade impact, increasing the potential error factor. The issue of timing is also something to consider with only one fund, the Invesco NASDAQ Internet ETF (PNQI), has an annual reconstitution with the others following the quarterly system to allow for more frequent portfolio changes. That could mean DBX would see a potential uptick in fund inclusions this fall although we need to stress that is dependent on the stock meeting the other inclusion criteria.

Extensive ETF ownership is not a guarantee to riches and glory and even the largest fund can't make a hero out of a company with weak financials stuck in a no-moat business. But by choosing to focus on founder control, Dropbox elected to forgo whatever benefits ETF ownership could have conveyed. And for investors hoping for price support, you might not want to hold your breath as ETFs aren't likely to become big acquirers of DBX anytime soon.

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