These days, as the market's enthusiasm toward highly-valued tech stocks continues to wane due to stretched valuations and rising rates, finding good deals in the software sector has been harder and harder to find. Last week's rout in tech stocks showcases the importance of rotating toward more value-oriented stocks that are less susceptible to a broader market downturn.
In that regard, Dropbox (NASDAQ:DBX) fits the bill perfectly, and it's a stock that I have doubled down on as valuations come more into focus. The popular file-sharing company may no longer be growing as quickly as it has in the past, but it has cemented the strength of its recurring revenue base, is continually rolling out new features and strengthening its platform, which is the leading paid consumer service for file storage.
Gains in Dropbox have trailed behind peer software companies over the past years. Year to date, the stock is flat; over the past twelve months, the stock is up only ~10%. Though no longer as exciting of a company as it was during its IPO (where it opened for trading at $29/share in 2018, and has fallen steadily since), I think Dropbox's steady subscription business plus its recent trend of dramatic margin gains will continue to find more favor among investors.
Data by YCharts
The chief appeal to Dropbox is its ultra-modest valuation. At current share prices near $22, Dropbox trades at a market cap of just $9.35 billion (less than the "decacorn" valuation that Dropbox enjoyed as a private VC-backed company), and after we net off the $1.12 billion of cash on its balance sheet, Dropbox's enterprise value is just $8.23 billion.
Meanwhile, Dropbox has guided to $2.095-$2.115 billion in revenue next year - which would put Dropbox's current valuation at just 4.1x EV/FY21 revenue. Valuations this low are almost unheard-of in the software sector.
Figure 1. Dropbox FY21 outlook
Source: Dropbox Q4 investor supplement
Dropbox's outlook also calls for substantial improvement in pro forma operating margins (from 21.4% in FY20), and against the $650 million midpoint of Dropbox's FCF guidance, Dropbox trades at just 12.7x EC/FY21 FCF.
In mid-February, Dropbox also unveiled a new $1 billion stock buyback authorization, indicating that the company intends to use its cash-rich balance sheet to buy back stock at a very opportune and cheap time. This authorization covers more than 10% of Dropbox's current market cap (a substantial portion compared to typical buyback programs), and will help to put a floor under Dropbox's stock price.
In my view, in 2021 we'll see a shift in sentiment to favor steady, reasonably valued stocks versus incredibly expensive growth stocks. Rotating more of your portfolio toward stocks like Dropbox is a good way to get ahead of a potential stock market crunch. Shares of Dropbox are currently at ~15% off all-time highs, making it a great time to enter into the name.
Q4 download
Let's now cover Dropbox's latest quarterly results in greater detail. The Q4 earnings summary is shown below:
Figure 2. Dropbox Q4 results
Source: Dropbox Q4 earnings release
Dropbox's revenue grew 13% y/y to $504.0 million, beating Wall Street's expectations of $498.6 million (+12% y/y). The company more or less sustained its 14% y/y growth rate from Q3.
What I like about Dropbox is that the company continues to fuel growth through both a mix of adding new users and continuing to upsell existing ones. The company ended Q4 with a paid user base of 15.48 million, adding 230k net-new users in the quarter and seeing 8% y/y user growth. Management noted as well that ARPU also grew to $130.17, up 4% y/y from $125 in the prior year - reflecting Dropbox's success at selling more expensive subscription plans. As seen in the chart below, the percentage of Dropbox users who pay for either Dropbox Professional ($17/month) or Dropbox Advanced ($20/month) has grown dramatically over the past several years.
Figure 3. Dropbox premium upgraders
Source: Dropbox Q4 earnings deck
Dropbox also noted that it ended Q4 with an ARR (annualized recurring revenue) base of $2.022 billion. It's important to note that Dropbox's existing ARR already covers ~96% of its revenue guidance for 2021. For a company that is seeing 8% y/y user growth and 4% y/y ARPU growth, this puts Dropbox in a very favorable spot to exceed expectations this year.
Profitability has also soared tremendously at Dropbox. In light of growth slowing to the mid-teens, the company has placed much greater emphasis on raising its margin profile. Pro forma gross margins rose 250bps to 80.1%, reflecting both a higher mix of premium plans and economies of scale. Pro forma operating margins, meanwhile, grew to 25.3%, nearly ten points better than 15.6% in the year-ago quarter, and driven in large part by a reduction in sales and marketing costs as a percentage of overall revenue.
Tailwinds for further margin expansion in 2021 are in place. In early January, the company announced that it was planning to cut 11% of its global workforce. The company also noted that it would lean more on its self-service marketing channels and selectively stop pursuing enterprise deals that would bring low spend/high customization, which should lead to greater sales efficiency overall. As previously noted, Dropbox's 27-28% pro forma operating margin guidance for FY21 represents a massive six to seven-point improvement to 21.4% in FY20.
Dropbox also managed to grow free cash flow by 25% y/y to $490.7 million in FY20, seeing a two-point bump in FCF margins to 25.6% as well. The company's $645-$655 million FCF guide for FY21 implies further 32% y/y growth - and note as well that Dropbox has committed to achieving $1 billion in annual FCF by FY24.
Figure 4. Dropbox FCF trends
Source: Dropbox Q4 earnings release
The fact that the company has a $1 billion annual cash flow target in its sights within a few years serves to further highlight how cheap Dropbox's current ~$8.2 billion enterprise value is.
Key takeaways
While it's far from the fastest grower in the software sector, Dropbox has a lot of merits for a stock market that is beginning to grow tired of expensive growth stocks. This is a company with a massive ARR base (covering 96% of its FY21 revenue guidance), is succeeding at selling premium subscription plans, is continually rolling out platform updates, and at the same time is achieving tremendous profitability expansion. Trading at just over 4x FY21 revenue, and at just under 13x FY21 cash flow expectations, Dropbox is a rare opportunity to own a software stock at bargain prices.
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