Description

This is idea undeniably skews more towards the “growth” side of the growth/value spectrum. If you are not into that, sorry for the wasted "click".

Introduction

Dropbox (DBX) was founded in 2007 by current CEO, Drew Houston, and Arash Ferdowsi to tackle the difficulties associated with file storage, synchronization, and security. The origin story goes that Houston was traveling on a Chinatown bus between New York and Boston and became frustrated with his inability to access his files after forgetting his thumb drive. Over the ensuing years DBX quickly rose to Silicon Valley unicorn-status becoming the fastest SaaS company ever to reach $1bn in sales. The company came public in March of 2018 at around $30. Since then the stock has been a dud, currently trades at a wide discount to peers, and, in my view, presents an attractive GARP-y risk-reward at ~$24.

The Business

             The core functionality of Dropbox’s platform allows users to save and store content in the cloud and access it from anywhere on any device. This enables geographically dispersed teams to organize work in a single cloud-based location and for larger organizations to get rid of the unwieldly traditional “lettered” file server. Over the years, the company has evolved from focusing on just cloud storage to broader business use cases and collaboration functionality. Longer term the company seeks to address the problem of content fragmentation, i.e. it is easier to search all human knowledge on Google than it is to find a sales proposal buried away somewhere in SharePoint. From the company’s S-1:

“According to a 2016 IDC report, more than half of companies ranging from 100 to 5,000+ employees use at least three repositories for accessing documents on a weekly basis”

“The combination of scattered content, fragmented tools, and fluid team structures has led to decreased workplace productivity. According to a report by McKinsey & Company, knowledge workers spend approximately 60% of their time at work on tedious tasks such as searching for content, reviewing email, and re-sharing context to keep team members in the loop—what we call “work about work.”

             The company rapidly took share in the $5bn file, sync, share market due to its lightweight but powerful product with an intuitive and elegant user experience. DBX has since rolled out several new products to expand into the larger collaboration and productivity market. These include:

·        Paper- a collaboration workspace that enables lightweight task management and co-authoring functionality.

·        Showcase- a professional sharing product that provides users a way to present their work to clients and business partners through a customizable, branded webpage.

·        Smart Sync- a feature that allows users to access all of their DBX content on their computers without taking up storage space on their local hard drives

·        Admin controls- team administrators can customize security settings, such as sharing permissions, remote device wipe, audit log, device approvals, tiered administrator roles, directory restrictions, disabling download links, and network control

·        HelloSign- DBX just announced the acquisition of HelloSign for $230m. HelloSign is an e-signature tool and competes with DocuSign and Adobe EchoSign. This deal adds a nice product to the platform and demonstrates DBX’s ambitions to become a broader business workflow technology company.

The company utilizes a freemium model with several different price plans for individuals and teams.

Today, the company has 12m+ paying users and over 500m registered users across 180 countries. The platform houses over 400bn pieces of content and 1.2bn files that generate over an Exabyte of data. More than 80% of paying users use DBX for work cases. The company counts global brands such as Expedia, HPE, Adidas, and News Corp as customers and has over 56% of Fortune 500 paying for DBX Business. Business Teams account for 30% of the overall user base, up from 20% three years ago. 40% of the 300k Team customers have at least 1 member that was previously an individual subscriber.

Issues since IPO

             There are a few factors aside from general market volatility that contributed to the stock’s underwhelming performance since the IPO. First, the company came public at a valuation below where it raised money in 2014. This likely fed the perception that the company was running out of steam. Second, coinciding with the company’s 2Q earnings release, DBX reported that COO Dennis Woodside was stepping down. It is my understanding that Woodside felt that he accomplished what he set out to do at DBX and had ambitions to move to a role where he could run the show rather than be a COO. In the same earnings release the company flubbed messaging around its lock-up expiration making it seem like it was changing and pulling forward the expiration date. In the S-1, the company explains that the lock up period will last 180 days unless that date falls within a quarterly blackout period in which case the lock up would end ten trading days prior to the start of the blackout period. That is indeed what happened, and the company could have done a better job explaining the disclosure. These items weighed on sentiment and overshadowed a couple quarters of strong fundamental performance. I think these items will prove transitory and are more than baked into the current price.

Why own the stock?

Benefits of Scale             

The company’s scale provides a significant advantage both in providing an opportunity for upsell/conversion and for providing insight into customers workflow for new product development. My thesis rests on DBX’s ability to monetize and upsell its massive user base. The company’s consumer-grade and easy-to-use product led to viral adoption across 500m active users. The huge repository should provide fertile hunting grounds to convert free users to paid and upsell paying users into higher priced SKUs. DBX has real-time insight into how its users are engaging with the platform and the company can use this data to optimize its conversion engine and sales efforts. For instance, DBX’s software can identify that a user is also a Salesforce customer and then deploy an in-product prompt about the advantages of DBX/Salesforce integration available in paid tiers. The immense free user funnel enables the company to run hundreds of data science experiments to identify patterns in usage that may lead to conversion opportunities. Examples of experiments span from simple things like changing search engine key words or changing the color of the buy button in the Dropbox app to more sophisticated incentives to convert or up-sell users. The company believes that 300 million of its users have at least one characteristic (i.e. registered using a business domain email) that makes them a qualified target to pay over time. Compared to the 12.3m paying users currently, this is a very large number and strikes me as a bit pie in the sky, but nonetheless the free user base should provide a very long runway for conversion opportunities.

             DBX has a unique sales process. Adoption in an organization typically begins organically. Drawing upon its consumer roots, the company markets and sells to end users rather than corporate IT departments. It can then detect once the platform hits a certain threshold usage within an organization to warrant an outbound sales effort. The sales pitch is then like getting the ball on the opposing team’s 20-yard line. The conversation with the IT department/CIO starts with, “All these people in your organization are using the product, upgrade to a Team SKU to get better admin control and security features” rather than “Here is why you should think about implementing this in your organization…”.    The company notes that it has at least one paying individual in greater than 90% of the Fortune 500 which provides a solid beachhead for broader expansion. The below graphic illustrates the company’s adoption trajectory.

             In addition to appreciating the “how” of conversion, it is important to discuss the “why”. Based on my research, users generally upgrade because of the more robust feature set and productivity tools. Requiring more storage is low on the list of reasons to move into a paid tier. This is an important point since part of the bearish narrative on DBX is that cloud storage is a commodity with ever declining pricing. Administrative and security controls, which are only available in paid tiers, are a critical aspect of the transition from a consumer-focused product to a legitimate enterprise application. Furthermore, unlimited API access is an increasingly valuable feature of paid tiers. DBX integrates with a wide variety of partners including Microsoft, Google, Salesforce, Adobe, Autodesk, Hubspot, Slack, and Zoom. More than 75% of DBX Business Teams have linked to one or more 3rd party applications. I believe DBX’s broader value proposition is reflected by the company’s growing ARPU which stands in contrast to trends in cloud storage pricing.

             Longer term, I believe DBX’s scale, both of users and data, positions the company well to capitalize on the large and growing market for content collaboration and productivity tools. Big trends like the rise of the gig economy and more fragmented and geographically dispersed workforces are creating a need for software that enables teamwork and enhances productivity. IDC estimates the TAM for collaborative applications, content management, project and portfolio management, and public cloud storage at over $50bn. Given that DBX has real time insight into how its 500m users access and share files and content, I think the company is uniquely positioned to develop new features and products to serve this end market. As an example, the company added the ability to embed rich media (i.e. InVision graphics, Spotify tracks, Vimeo Clips) in its Paper product after observing how its users engaged with various types of content. New products drive increased engagement which eventually drives conversion. Users who utilize Paper convert to paid at twice the rate of those who do not.

Efficient High Margin Distribution Model

             DBX’s viral, bottom-up selling model enables a highly efficient go-to-market strategy and attractive margin structure. Over 90% of the company’s revenue comes through digital channels. The company maintains a very small salesforce that is only deployed once the company’s algorithms identify a critical mass of users within an organization. This distribution model is reflected in DBX’s margin. The company spends ~25% of revenue on sales and marketing versus the ~40% average for the broader SaaS group. Piper Jaffray’s DBX initiation has an interesting table which highlights the total return advantage digital distribution models have enjoyed versus SaaS comps and the XLK. Note- The report was published in April 2018, so it’s not up to date.

Strategic value

             Given its large user base and cash generative financial profile, I think DBX could attract a nice multiple in the event Drew decided he wanted to sell. Steve Jobs reportedly tried to buy the company in 2009 for a nine-figure sum. Salesforce made a $100m strategic investment into DBX during the IPO. Sell-side analysts have listed Google, Microsoft, Oracle, SAP, and Cisco as logical suitors. While I am certainly not betting on M&A, I do think the possibility can provide some valuation/downside support.   

Key Debate- Competing with the Big Boys

             The pivotal debate around the DBX investment case is where the company fits in the evolving software marketplace. The file storage, content collaboration, and business productivity space is undoubtedly competitive and DBX competes against some players with extremely deep pockets (MSFT/GOOG). That said, I think DBX’s product and competitive positioning is stronger than the market appreciates for a couple reasons. First, the company has a maniacal focus on user experience and has invested significantly to make the product intuitive, easy to use, and frictionless. DBX consistently ranks in Gartner’s leader’s quadrant for content collaboration platforms. Competition from Google and Microsoft is not a new phenomenon and has not impaired DBX from scaling to half a billion users. Second, DBX’s platform neutrality and interoperability is a differentiator. The product works equally well across any operating system or device. DBX operates as an open ecosystem and integrates seamlessly across a wide variety of 3rd party applications. The company see 50 billion API calls per month and has 500,000+ developers registered on its platform. This is significant because the winner in collaboration is not likely to be someone who has a vested interest in the success of a given platform or bundle. Users want to have access to best of breed tools and DBX’s ambition is to be the fabric that ties them together.

              It is important to understand that it is not DBX’s intention to displace work platforms like G-Suite or Microsoft Office. It instead wants to be the orchestration layer where files are stored, accessed, and collaborated. The relationship with MSFT and GOOG seems to be moving more towards co-opetition. The company recently announced a partnership with GOOG, where DBX users can open Google Docs, Slides, and Sheets directly within the Dropbox app. The company has a similar partnership with Microsoft.

Financials

Revenue

             Revenue is 100% subscription-based and is a function of number of paying users and ARPU. Since the IPO, upside versus estimates has primarily come from ARPU growth. There have been two primary drivers- new adoption of higher priced premium plans and, to a lesser degree, renewals for teams that were temporarily grandfathered into the premium SKU. Management has advised that in any given period the company may lean more on ARPU or user growth depending on its conversion initiatives. For example, user growth slowed in 2018 as the company emphasized its higher ARPU premium plan.

The subscription metrics disclosed by the company at the IPO are middle-of-the-road for a SaaS company but should improve over time. User retention is in the mid 80%s while dollar-based revenue retention is in the mid 90%s. Notably, dollar-based retention for DBX Teams customers is over 100%. Teams represent 30% of the paying base up from 20% three years ago. This shift should be a driver of improved customer LTV going forward. Indeed, on the 3Q call, management said, “given the higher Team subscriber mix that we're driving over time, you can assume that we're improving our net revenue retention and that's something we're certainly seeing with the business. And then as it pertains to churn, a component there, overall, across the business, those rates, again, remaining very stable over the past few quarters.”

For the next two years I model 1.7m net adds (about consistent with 2018) and 3.5% ARPU growth (a moderation from 2018). This translates to growth of 18% and 16% for 2019 and 2020.

Margins

             Gross margins have ramped considerably from 33% in 2015 to mid-70%s in 2018. This was mainly driven by DBX insourcing its cloud infrastructure from AWS to its own customer-built data centers. The company expects gross margins to continue to improve, albeit much more gradually, towards its long-term target of 76% to 78%. The company recently became the first major tech company to deploy shingle magnetic recording (SMR) technology in its storage architecture. This should be a driver of gross margin expansion as it reduces the physical space needed to store a given amount of data. It is also worth highlighting that costs related to free users run through COGS and are a ~1000bps drag on margins. Given the company’s funnel conversion strategy, I certainly don’t expect it to turn off free users, but it could, at least in theory, be much more profitable.

             In the below projections, I model modest annual expansion in gross margin and operating leverage primarily from S&M and G&A. My estimates work out to roughly a 30% incremental operating margin for the next two years. I think this is appropriately conservative and a moderation from the ~40% range of the past two years.

             The company finances its data center investments though capital leases which are not included in the capex number on the cash flow statement. I deduct additions to capital leases from free cash flow while the company’s reported number does not. This seems to be handled inconsistently by the sell-side hence the wide range for FCF estimates. In total, I model additions to capital leases plus capex to be 9-10% of revenue. Offsetting this and driving the positive variance versus operating profit is the subscription nature of the business with annual contracts paid up front. My projections are below. Variance versus consensus comes a bit from revenue but mostly from margins.

Estimates versus consensus:

o   Revenue 2019/2020: +2%/ +4%

o   Operating Profit 2019/2020: +14%/ +14%

Valuation

             DBX currently trades at 5.3x EV/2020 revenue and 21x EV/2020 FCF on my estimates. While the multiples aren’t “cheap” on an absolute basis, I think this is a pretty good bargain given the fundamentals and outlook. The below comp table shows how DBX compares versus peers. I tried to assemble a reasonable comp group- nothing projected to grow over 30% or below 10% and all are expected to be FCF positive. DBX ranks at the top on a revenue growth + FCF margin basis yet trades at a 2x turn discount on revenue and a 40% discount on FCF versus the peer median. As the company continues to execute and demonstrate the viability of its growth and margin story, I expect this discount to close. If we put a 30x multiple (still a ~20% discount to peer median) on my 2020 FCF estimate the stock would trade at $35 for 45% upside. Below table is as of 2/1/19.

Risks

Competition

As I noted in an earlier section DBX competes against some formidable competitors. While the dynamics between DBX and GOOG and MSFT appear to have trended more towards co-opetition it is certainly possible that could change. DBX must continue to innovate and offer an easy-to-use, feature rich product to differentiate versus its competitors.

Sales model could limit growth

             While DBX’s viral, digital based model provides a highly efficient and profitable sales motion, it could at some point limit the company’s growth opportunity set. In order to more formally target large enterprise deals, the company would need to make investments in R&D to boost security and governance features and would need to build out a more comprehensive sales infrastructure. This transition would be costly and would negatively impact the long-term financial model. Ultimately, I think there is plenty of opportunity with teams in large organizations and SMB customers so that this is not going to be a problem anytime soon.

Transition to business collaboration platform presents new challenges

             While DBX’s evolution towards a broader collaboration platform substantially increases the company’s TAM and should drive higher LTV, it also positions the company against a new group of competitors such as Slack, DocuSign, and Atlassian. The success of this strategy will depend on the company’s ability to introduce compelling products and expand customers’ perception of Dropbox beyond file, sync, and storage.

Dual Share Class

             CEO Drew Houston and Sequoia Capital own most of the Class B shares which have 10 voting rights per share versus 1 voting right of the Class A shares. This could prevent or discourage an acquisition of the company. Sequoia or Accel selling down their position could also be a temporary pressure on the stock.

Disclaimer: The views and opinions expressed in this report are those of the author only and do not reflect the views and opinions of the author’s current employer. This material is being provided for informational purposes and is not to be considered an offer to sell or a solicitation of an offer to buy any investments referred to herein.

Catalyst

Earnings/2019 guidance

Continued growth in ARPU