April 09, 2020 - 2:44pm EST by
2020 2021
Price: 18.08 EPS 0.70 0.85
Shares Out. (in M): 418 P/E 26 22
Market Cap (in $M): 7,635 P/FCF 12 11
Net Debt (in $M): -1,159 EBIT 325 400
TEV ($): 6,476 TEV/EBIT 20.5 16

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Dropbox (DBX) is one of the rare businesses that benefits in the current environment and still has an attractive valuation in addition to a cash rich balance sheet. Management has guided to $1B+ in FCF by 2024, which compares to a current EV of $6.5b. What the market seems to be missing is that the current “WFH” trend could provide not only a short-term boost to sales but also a long-term improvement to new user growth. With a cheap valuation and the potential for improving fundamentals, it’s not hard to imagine significant upside over the next year or so.


Dropbox is a leader in file sync and share. I’m assuming that most folks know what Dropbox is or (better yet) are current users. For those of you who don’t, Dropbox is what over 600 million people use to store, backup, sync and share their files. Of these 600 million plus, 14.3 million are paying users as Dropbox has long been a freemium model. The vast majority of these paying users use Dropbox for work. For further background, I would refer you to bulldog2013’s write-up from February 2019. 


The longer-term bull case on Dropbox is that the penetration of paying users at 2% is a mere fraction of the registered user base. As they add new features and improve the product, it creates a long runway for potential growth. This also speaks to the immense strategic value at Dropbox as other “best of breed” players like Slack and Zoom (both of which Dropbox is deeply integrated with) don’t have nearly the same registered user counts.


The nagging bear case has been that it’s a commoditized offering that competes with Microsoft (OneDrive) and Google (Google Drive). The key difference is that Dropbox is platform agnostic (an important selling point) and integrated into a number of other cloud applications. In addition, it’s competing more with itself (trying to convert registered users to paid) than it is with other services. Paying users - myself included - tend to be very loyal and enthusiastic about the product and I’d tell you that Dropbox almost certainly undercharges me for what I get.     


This is further apparent in the numbers. Dropbox grew constant currency revs 26% in FY18, 21% in FY19 and I’d bet that FY20 growth is similar, if not better than this past year. This strong top-line growth is paired with an incredibly efficient business model as Dropbox is almost entirely self-service. Gross margins are nearing 80% and FCF margins are close to 30% with minimal share creep. To put this into perspective, Dropbox should produce ~$1.25 in FCF/share this year (normalizing for 1-time HQ spend), ~$1.05/share if you deduct capital leases and ~$0.85/share if you further ding them for repo. That compares to an EV/share of $15.50.  


I was long DBX before the coronavirus took us all by surprise and I would have told you then (as I would now) that Dropbox is an incredibly attractive, cash generative business where the market is underestimating the duration and durability of its growth. In addition, I would have suggested that the Street was meaningfully mis-modeling the margin potential given a number of transitory items in 2019. And I would have finally noted that Dropbox had just started taking steps to more proactively monetize its user base following a 20% price increase in June 2019 and the unveiling of a new look and feel titled Dropbox Spaces. For all of these reasons, I thought it was a very compelling situation. 


What makes this even more interesting now is that Dropbox’s Q4 earnings report was particularly positive - it validated these points and then some, suggesting that Dropbox might be at an important inflection point. However, earnings were on 2/20 and, as we all know, the market nose dived from that point forward. DBX jumped ~30% on earnings and then sunk with the rest of the market. After reaching almost $24/share that day, the stock got as low as $14.55 during this sell-off and closed today at $18.29. Given almost $3 in net cash/share, that means the EV has contracted 27% post-earnings (and an amazing 45% at the lows). It bears repeating that this is a recurring revenue business (that benefits in the current environment!) with strong free cash flow and no balance sheet risk.


Let’s come back to Q4 for a moment. Not only did DBX beat on revs and EBIT, they also guided FY20 EBIT 25% ahead of what Street was expecting, calling for step function change in margins. Dropbox called out FY20E EBIT margins of 17.5-18% vs FY19 margins of 12.3% and Street expectations at 14%. As noted before, there were a number of transitory items in FY19 (dual rent and acquisition accounting most notably) that were masking the underlying profitability and causing investors to underestimate Dropbox’s true earnings potential. 


To this point, Dropbox also used the Q4 earnings report to significantly (and unexpectedly) raise its LT targets through 2024. Dropbox is now targeting 28-30% EBIT margins, up from 18-20% at the IPO (April 2018) and 20-22% at the analyst day (September 2019). So in under two years management has somewhat amazingly raised the EBIT margin outlook up by 1,000bps. In addition, they are now calling for >$1b in annual FCF in 2024. Again, that compares to a current EV of $6.5b.


If that wasn’t enough, DBX also announced a $600m repo at Q4. At the current price, this equates to 8% of the current share count. Last but not least, Q4 also coincided with a key new hire, Oliva Nottebohm as COO. She was previously at Google as VP of SMB Sales Operations for Google Cloud and is very well respected in the industry. This was a big hire for Dropbox and I suspect that some investors think she could become the future CEO.  


Despite all of this good news, the market quickly shrugged it off as stocks started to nose dive. This was particularly strange as Dropbox has many of the attributes that are being bid up in other pockets of the market (recurring revenue, net cash, a self-service sales model and an ongoing repo to name a few). The stock seemed to sell-off with everything else and yet it hasn’t really bounced back in the same way during the subsequent rally.  


This is even a bit stranger because Dropbox appears to be seeing a notable improvement in its business. At its core Dropbox is a collaboration service that helps people work remotely. Most people use it to share files and coordinate projects. One third of the users are on “teams” (what Dropbox calls business accounts) and an estimated 80% of paying users use Dropbox for work. This is the perfect environment to sign up new users and compel existing users to ask their firms to pay up for a business account. 


This is what we’re seeing in the data as well. It appears that Dropbox’s sales trends accelerated from around +5% YoY in the first week of March to +25% YoY ever since. If this continues it would imply sales growth well ahead of what’s currently expected.


Dropbox’s initial guidance for FY20 called for CC sales up 15%. For their part, Street is currently modeling 13%. However, this initial guide reflected management’s normal conservatism (Dropbox has beaten its own revenue guidance every quarter since being public) and also excluded the positive impact from new products that Dropbox planned to launch later this year. Management said “these initiatives will be incorporated into our outlook as we develop more signal throughout the year.” Inclusive of the new products and current influx of business, it’s not hard to imagine FY20 sales growing 20-25% or even better.


In sum, Dropbox is viewed as and valued like a business with decelerating growth. In reality, the business appears to be accelerating. Even before the coronavirus arose, sales growth was stabilizing in the high teens and there were a number of very positive catalysts afoot on the margin front. I have FCF/share of $1.25 this year and $2.40 in FY24 based on management’s target of reaching $1B+. That compares to an EV/share of $15.50 or $16 inclusive of capital leases, representing 13x current year FCF and 7x FY24. If Dropbox traded at 20x current year FCF, it would suggest a $27 stock or 50% upside from current levels.

This report (the “Report”) with respect to Dropbox Inc. (the “Issuer”) has been prepared by the author (the “Author”) for informational purposes only. The Report contains certain forward-looking statements and opinions which are based on the Author’s analysis of publicly available information believed to be accurate and reliable. While the Author believes that such forward-looking statements and opinions are reasonable, they are subject to unknown risks, uncertainties and other factors that could cause actual results to differ materially from those projected. The Author has no obligation to inform readers of changes in such forward-looking statements and opinions and no warranty is made with respect to the accuracy or completeness of any of the information set forth herein.


As of the date the Report is published, the Author and/or certain entities (the “Entities”) affiliated with the Author hold a long position in the securities of the Issuer and therefore have a financial interest based on changes in the price of the Issuer’s securities. The Entities may increase, decrease or otherwise change their position in the securities of the Issuer based on changes in market conditions or other analysis. Neither the Author nor the Entities undertake any responsibility to inform readers of changes in such position.


Nothing in this Report constitutes investment advice. Readers should conduct their own due diligence and research and make their own investment decisions.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Accelerating sales and user growth driven by WFH and improved pricing

Better than expected FCF as margins continue to improve

A takeout by either a strategic or financial buyer


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