Dropbox: A Broken Box Or A Magic Box?

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About: Dropbox, Inc. (DBX)
by: Olive Tree Investment
Summary

Dropbox share price has gone through a wild ride since its IPO, and it's currently back to its IPO level. Is Dropbox a worthwhile long-term investment?

In this article, I will first discuss the possible reasons for the negative price actions and why a long-term investor should look past the short-term uncertainties.

I will then dive deeper into Dropbox's business fundamentals to prove that it's a wonderful business with favorable long-term prospects.

I will then perform a valuation on Dropbox based on long-term growth expectations and discuss the potential risks.

Finally, I conclude that Dropbox could potentially be a good investment idea for a patient long-term investor with a five- to 10-year investment horizon.

After a wild IPO run-up to the 52-week high of $43.50, Silicon Valley unicorn Dropbox's (DBX) share price made a round trip back to its $21 IPO price range and remained depressed for the past few quarters. Most recently, after its 4Q 2018 earnings report, its shares went down 10% the next day on disappointing 2019 guidance. So is Dropbox a broken box (pun intended) that should be discarded, or a magic box that could bring years of high compound returns to a patient long-term investor?

Chart Data by YCharts

Upon looking deeper into Dropbox's business, I'm leaning toward the latter scenario.

In this article, I will first address the concerns that led to the depressed price. I will then cover Dropbox's business fundamentals and growth prospects from a long-term investor perspective and explain why I think Dropbox could be an attractive investment idea.

Market Reaction to Short-Term Uncertainties

It's quite normal for a post IPO high flyer to come back to earth after the initial hype. The question is whether such price movement was driven by bad business fundamentals or by a market that was being emotional with unreasonable expectations.

During 2018, Dropbox grew its revenue by 26% to $1.4B while more than doubling its non-GAAP operating margin from 5% in 2017 to 12% in 2018. It also generated a free cash flow of $362M (26% of revenue). Hence, Dropbox's business was doing just fine.

Dropbox Financial Highlights (Source: Dropbox Investor Presentation)

As for the 10% price drop post 4Q 2018 earnings report, investors were mainly spooked by Dropbox's guidance to a smaller operating margin for 1Q 2019. As management explained on the earnings call, it was a temporary effect caused by its recent acquisition of HelloSign and the office move of its San Francisco headquarters, and that the operating margin should be back to 11-12% range in the second half of 2019.

Hence, Dropbox's negative price action is likely a case of market overreaction to short-term uncertainties, which will have minimal bearing on Dropbox's long-term prospects.

Dropbox As an Investment Idea

As a long-term investor, I look for wonderful companies with solid fundamentals and a long runway for sustainable growth. Such investment ideas will likely play out in years, with attractive potential returns and manageable risks. At times, I may consider short-term negative market price actions an opportunity for a good entry point.

I believe Dropbox could be one of such wonderful businesses.

1. Product That Customers Love

A wonderful business should have a product that captures the hearts and minds of its customers. When we see customers love a product so much that not only are they willing to pay for it and buy more over time, they also tell others about it - that's when we know the company has found the true product-market fit.

According to Dropbox's 10-K, "Dropbox is a digital workspace where individuals and teams can create content, access it from anywhere, and share it with collaborators." With its SaaS (Software as a Service) based content collaboration software and an open ecosystem that tightly integrated with many popular cloud-based enterprise applications, Dropbox enables business teams to seamlessly collaborate on the cloud and hence greatly reduce process friction, making these business teams more effective and productive. Enterprises love productivity gain through cost-effective software solution and they are happy to pay for it.

Dropbox Operating at Scale (Source: Dropbox Investor Presentation)

On the website Software Advice, more than 10,000 people have rated Dropbox with 4.5 stars, with 88% of users recommending Dropbox to others. Reading through the comments, it comes across that Dropbox provides a delightful user experience.

Dropbox's operational and financial metrics demonstrate an increase in its product acceptance and a widening of its product appeal. Dropbox has rapidly grown from 300,000 business teams at the IPO time to a just reported 400,000 teams in its 4Q 2018 result, a 33% growth in less than a year. Dropbox also widened its reach to more verticals. Dropbox CFO Ajay Vashee mentioned in the 4Q 2018 conference call that, in the quarter, Dropbox "had a number of wins across a range of verticals including transportation, insurance, and health care."

Additionally, Dropbox also has seen a nice ARPU expansion (a 5% increase from $113.39 a year ago to a recent ARPU of $119.61) as more teams moved up to higher level premium plans to unlock more value from Dropbox's product.

When more customers sign up and are willing to pay more, it's clear that Dropbox's customers love its product.

2. Powerful Go-to-Market Strategy

A wonderful business also should have a powerful go-to-market strategy that drives healthy sustainable growth.

Contrary to the traditional top-down enterprise software sales approach, Dropbox has adopted a different bottoms-up approach that has been proven to be more powerful and cost efficient.

Dropbox's Chief Customer Officer Yamini Rangan described Dropbox's unique go-to-market strategy as one that "starts with viral adoption, lands with self serve and then continues to use the outbound team as a very targeted team." Dropbox's 10-K further explains this powerful approach.

As users share content and collaborate on our platform, they introduce and invite new users, driving viral growth. We generate 90% of our revenue from self-serve channels, which reduces customer acquisition costs.

We complement our self-serve strategy with a focused outbound sales effort targeted at organizations with existing organic adoption of Dropbox. Once prospects are identified, our sales team works to broaden adoption of our platform into wider-scale deployments.

As part of this go-to-market strategy, Dropbox has developed a conversion and up-sell engine that follows the customer journey and moves them to the appropriate price plans at the right time.

With 12.7M paying customers and more than 400,000 business teams generating $1.4B revenue (26% year-over-year growth) and an expanding ARPU, Dropbox's go-to-market strategy is working wonders. More interestingly, Dropbox sales and marketing expense is only 25% of its revenue, comparing to Box (BOX), one of its rivals, whose S&M expense accounts for more than 45% of its revenue. Dropbox sales approach easily wins as being more cost effective.

So far, Dropbox has identified 300M high-value target users from its 500M registered users to be likely converted. This provides Dropbox a deep pool of potential leads for future customer acquisition, paving a long runway for growth.

Dropbox Growth Driver 300M High Value Targets (Source: Dropbox Investor Presentation)

3. Healthy Financial Performance

A wonderful business should be financially healthy and profitable.

Dropbox has a very healthy balance sheet. With nearly $1.1B of cash plus short-term investment and minimal debt, Dropbox has ample liquidity to support its operations and to invest in growth. It has generated a free cash flow of $362M during 2018, a good sign that its business already is self-sustainable, greatly reducing its need to raise additional debt or equity. It also means Dropbox is well equipped to survive a potential economic downturn. This is attractive to a long-term investor.

Though Dropbox is not yet profitable on a GAAP basis, it's already profitable on an adjusted basis, and as mentioned before, free cash flow positive, something that many high flying cloud-based software companies haven't been able to achieve.

Dropbox also achieved 7% operating margin expansion, driven by gross margin improvement paired with lower S&M spend. Following its decision to move off Amazon (NASDAQ:AMZN) AWS onto its own hosting infrastructure, Dropbox was able to replace a huge variable cost that could severely erode its margin with a fix cost that can be optimized with scale, allowing it to continue to improve margin over time, from 54% gross margin in 4Q 2016 to 75% by 4Q 2018. As it continues to scale up its revenue while optimizing its infrastructure, I believe Dropbox gross margin can be improved to over 80%, further enhancing its profitability.

Overall, Dropbox's path to profitability is very clear. Management has done a great job of balancing healthy growth with profitability, leading to a more sustainable growth trajectory.

4. Winning the Competition

A wonderful business should dominate its market or have great potential to do so by winning the competition.

Though Dropbox is still a long way from dominating its market, it has competed favorably and has gained market share from its rivals. Here's why its competitive strategy is working well.

First of all, Dropbox has positioned itself strategically to focus on a white space in the enterprise productivity software market: Content management and team collaboration. By pivoting away from the pure cloud storage market, Dropbox is making the competition with powerful rivals like Apple (NASDAQ:AAPL), Amazon, and Google (GOOG)(GOOGL) less relevant, as they are less competing in the enterprise productivity market, leaving Dropbox with fewer formidable competitors to deal with.

Secondly, Dropbox has delayed competition by taking the playbook from PayPal (PYPL) and Netflix (NFLX) - make friends instead of enemies. By choosing to partner with its would-be competitors, like Microsoft (MSFT), Google, Atlassian (TEAM), and Slack, not only has Dropbox enhanced the user experience of its open ecosystem but also has greatly defused the tensions and reduced the competitive threats, buying more time for it to become stronger and more established.

Thirdly, as previously mentioned, Dropbox has a superior product and a more powerful go-to-market strategy. Such a powerful combination is helping Dropbox win market share from its competitors.

In a recent CNBC interview, Dropbox CEO Drew Houston mentioned that its growth strategy was working well, and Dropbox was taking business away from its competitors. Incidentally, Dropbox competitor Box recently reported disappointing quarterly results that showed signs of troubles, and its share price plummeted as a result. It's very positive that a company is taking market share from its competitors.

5. Run by a Talented and Honest Management Team

A wonderful company should be run by a talented and honest management team. I prefer a founder-led management team or a reputable management team with vested interest in the long-term success of the company.

Both Dropbox's co-founders are still actively leading the company with Drew Houston being the CEO and Arash Ferdowsi remaining as a member of the board of directors. The two co-founders maintain a total of 35% ownership of the company, making them deeply vested in Dropbox's long-term success.

One aspect of great management skills is effective capital allocation. Dropbox management has been able to balance growth and profitability with a healthy balance sheet. This has demonstrated financial competence and discipline for effective capital allocation, and will likely lead to future shareholder value creation.

Another aspect of great management is the ability to create a great company culture that inspires innovation and creativity, and as a result, attracts and retains talent.

Dropbox is recently ranked No. 42 on the Fortune magazine Best Companies to Work For list and No. 59 on the Best Workplaces for Diversity list. Also on Glassdoor, Dropbox is rated 4.3 out of 5 stars with 83% of people recommending Dropbox to families and friends. CEO Drew Houston receives a 92% approval rating.

Finally, a great management team should have a compelling and audacious vision that inspires excitement and greatness from its people. Here's Dropbox's mission statement. Pretty compelling, I must say.

We're here to unleash the world's creative energy by designing a more enlightened way of working.

It's clear that Dropbox is led by a talented and honest management team with co-founder and CEO Drew Houston at the helm.

6. Favorable Long-Term Prospects

As a long-term investor, it is paramount to me that a business has a favorable long-term prospect for sustainable growth. This can be seen when a business has 1) favorable secular trends, 2) a large addressable market with optionality for expansion, and 3) durable competitive advantages (moats) to defend its market position.

Dropbox, along with many cloud-based software companies, is benefiting from a huge secular trend: The digitization of the enterprise business processes and the migration from traditional on-premise software to cloud-based software. Businesses and enterprises can now clearly see the benefit to reduce costs and increase productivity, and they are eager to get onboard. Such a great trend is still at its early stage and will likely last for the next 10-15 years.

So, how big is the potential market for Dropbox? Dropbox projects its total addressable market for content collaboration to be a $50B opportunity. With its $1.4B revenue in 2018, Dropbox is barely 2% into its TAM.

Dropbox Market Opportunity (Source: Dropbox Investor Presentation)

Dropbox recently acquired e-Signature provider HelloSign, effectively getting a foothold into a new adjacent market that's also benefiting from the digital migration trend. According to HelloSign's competitor DocuSign (DOCU), which is the current dominant player of the e-signature market, the TAM for e-signature can be as big as $25B, most of which is still untapped.

Dropbox's move to expand its TAM shows the kind of optionality it has. Once Dropbox secures its position as the central digital workspace for business teams to collaborate, it has many options to enter other enterprise productivity areas, expanding its TAM as a result.

Though it's still early, Dropbox is building up a few strong competitive advantages.

First of all, it has a powerful network effect working in its favor. Its 500M register users and the billions of pieces of content that are being created and shared on its platform are creating a powerful flywheel effect, as explained in its 10-K:

These elements reinforce one another to produce a powerful flywheel effect. As users create and share more content with more people, they expand our global sharing network. This network allows us to gather insights and feedback that help us create new product experiences. And with our scale, we can instantly put these innovations in the hands of millions. This, in turn, helps attract more users and content, which further propels the flywheel.

Additionally, Dropbox's platform and open ecosystem can be very sticky. As business teams implement their collaborative processes on Dropbox, it becomes harder for them to migrate off such platform because it offers so much value, and it is so ingrained with their daily routines (group habits are hard to break). Such stickiness creates a large switching cost, which is another powerful moat.

Other potential moats could be a strong brand name and the ability to constantly innovate with new technologies and new business strategies, which is especially critical to companies in the fast-evolving tech sector.

One important sign for the existence of durable competitive advantage is the demonstration of pricing power. Dropbox shows its pricing power by the successful introduction of higher tier pricing plans and its continued ARPU improvement.

With a strong favorable secular trend, a huge untapped TAM and optionality for expansion, and gradually developing competitive advantages, Dropbox is at its early business lifecycle with a long runway for sustainable growth.

Valuation

Valuation is more of an art than science. As a long-term investor, I tend to look five to 10 years in the future to get beyond short-term volatility. I prefer simple valuation models based on fewer variables and like to apply a margin-of-safety to account for the uncertainties that are inherent of such exercises.

Quick Gut Check

First, let's do a gut check. Can we reasonably expect Dropbox to double its market capitalization in five years? This implies an annualized growth rate of 15%. With $9B in market cap (6.5X its $1.4B revenue), Dropbox is still a mid-cap company with a relatively reasonable revenue multiple comparing to many of its cloud software peers. With all the qualities discussed above, I believe Dropbox has a very good chance to double its size in five years. So, the answer is "yes."

Valuation Model: Discounted Growth Projection plus Margin-of-Safety

I like to project earnings 10 years out based on an assumption on a plausible revenue growth rate and profit margin. I will then apply a reasonable earnings multiple and discount it back with a 15% minimum expected rate of return to get a fair price before applying a margin-of-safety to get my ideal price. At the fair price, it implies we can reasonably expect 15% CAGR if the business grows as expected. With the margin of safety applied, the ideal price gives us extra protection on the downside.

The base case for Dropbox yields a fair price of $38 and an ideal price of $18.80, with a 50% margin-of-safety applied. Note that the ideal price for the base case is close to the fair price of the bear case as the margin of safety absorbs some downside risks. At the ideal price, the further downside risk is much smaller than the potential upside. Dropbox's current share price is trading at a range somewhere close to the ideal price, making it fairly attractive at this level.

Dropbox Valuation Model w MoS (Source: Author's Own Model)

Risks

Competitive risk is the biggest risk for Dropbox, especially when Dropbox is still in the midst of building and strengthening its moats. A powerful competitor like Microsoft can turn its focus to the team collaboration space and put in tremendous amount of resources to build up its competitive offerings, including the possibility of acquiring its rival Box, presenting a huge competitive threat to its market position. Dropbox needs to push hard to fortify its competitive advantages to better able to defend itself before this happened. However, with a $50B TAM, the market appears to be big enough to support multiple winners in the foreseeable future.

I'm also not a fan of excessive stock-based compensation that could erode shareholder equity and impact a company's profitability. It's understandable to see a substantial increase in stock-based compensation during the IPO year, but I hope this will be under control in the coming years.

Conclusion

Dropbox has done a great job to transform itself from a cloud storage company to a SaaS enterprise productivity software company. It has successfully developed a compelling product that meets its target customers' needs and a powerful go-to-market strategy. With a good management team that has been able to balance healthy growth and profitability as well as a large potential market with a favorable secular tailwind, I think DBX has a good chance to succeed in the long run.

Dropbox's current depressed share price could present a nice entry point for a long-term investor who understands the potential risks and who has enough conviction and patience to sit through the inevitable short-term volatility.

I do expect the stock continues to be under pressure in the near term due to its 1Q 2019 guidance.

I have offered my thoughts above from a long-term investor perspective. Now, you will have to make your own conclusion based on your own investment objectives and your own situation.

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Until next time, just let it GROW!

Disclosure: I am/we are long DBX. 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.