Tag: Software

Is Dropbox a GARP Stock or a TRAP Stock?

Perception around Dropbox stock is eerily similar to Facebook. To be clear, investor perception of what is going on with the company seems to be different than reality.

Whenever I used to pitch Facebook stock I would hear things like,

  • “Oh well I don’t use that anymore – does anyone?” Well yeah, Facebook is growing users still and don’t forget Instagram and WhatsApp (the latter of which is very under-monetized to this day).
  • “I’m not sure some of the risks are priced in yet” despite the company trading at 10-12x EBITDA for an extremely high ROIC company growing 20% per year and with no debt.
  • “What’s the terminal value of Facebook? Isn’t it just the same as Myspace?” Let’s not compare a company with like, a third of the planet as monthly active users, to Myspace…

All of this added up to a great GARP stock – growth at a reasonable price. And I still think Facebook is somewhat underappreciated… but that is why I continue to hold. I think over time, they will outperform low expectations.

Today it’s harder to find value across some of these tremendous powerhouses, but there are some pockets of value. Dropbox seems like a name where there are a lot of doubts and a lot of concerns. This could be another GARP stock, but it could also be a value trap.

Common questions I had coming in to analyze Dropbox are:

  • Are they still growing users? And if so, are they monetizing it effectively while also balancing the risk of people leaving?
  • How do they compare to a name like Box?
  • Why has the stock floundered since IPO?
  • If I’m convinced the stock is worth taking a risk on, what’s my downside?

Is Dropbox still growing?

Yep.

Let’s not forget, they were pretty early into the cloud storage game – I think Dropbox might personally be the first one I had ever heard of.

This is an industry that is benefiting from increased storage from mobile devices, while wanting to reach those documents anytime, anywhere across devices. At the same time, companies want to seamlessly collaborate and the cloud is a great solution.

Dropbox is estimated to ~658MM users by Q3’2020, though only 15MM (~2%) are paid. This tells me that there’s room to convert customers to a paid model. And when you look at the growth rate of customers, it’s clear they are converting.

But importantly, they are growing paid customers and extracting more and more value from them (i.e. ARPU is going up). Another thing to note, Dropbox closes inactive accounts after a period of time so these numbers aren’t counting a large swath of ghost accounts or anything like that.

On the topic of increasing value with existing customers, Dropbox has really interesting cohort analysis that they’ve shared twice now, first in the IPO and second for their 2019 investor day.

Here’s what they said at their IPO:

 “We continuously focus on adding new users and increasing the value we offer to them. As a result, each cohort of new users typically generates higher subscription amounts over time. For example, the monthly subscription amount generated by the January 2015 cohort doubled in less than three years after signup.“

And then at their investor day in September 2019:

“So for example, for the 2013 and 2014 segments, we looked at all users who signed up over the course of those 2 years, we then compared their ARR shortly after sign up to their ARR today, which is quantified in the 8x expansion multiple on the right-hand side of the chart. The same logic applies to more recent segments with whom we’ve driven 4x and 2x ARR expansion, respectively, and our cohorts really underpin our highly predictable business model. From the moment a group of users begins their journey with Dropbox, we have a high degree of visibility into their monetization patterns over time.”


I think Dropbox may be an interesting acquisition target.

For example, how much more valuable do other one-trick ponies like Zoom and Slack (with now huge market caps, the latter of which is double DBX’s) get by buying DBX?

They can go to their customers with a much more valuable proposition – “buy the premium version of Zoom and get your document solutions taken care of as well. We’ll integrate everything.”  Supposedly, Dropbox looked at acquiring Slack for $1bn, and that deal makes sense, but was turned down by the board. Now Slack is around $16bn market cap, so now the opposite could happen.

Dropbox historically focused on the consumer end market, not enterprise. I see a risk here that a would-be acquirer may already want someone entrenched in enterprise, but if anything, having ~650MM customers, 15MM of which pay, may help the sale. It may help both of them win with enterprise.

DBX is trying to move into enterprise and it just announced it won a contract with the University of Michigan for its school services, which is a huge enterprise win.

How does Box compare to Dropbox?

The longer-term risk is obviously competition from big platforms already out there. Microsoft has Onedrive, Google has Drive, and Apple and Amazon also offer storage. There’s nothing really sexy about storage, it’s really just how the consumer likes to interact with it. In fact, Dropbox outsources the storage to AWS….

However, I would say Dropbox’s offering is the best I’ve seen for collaboration and while the Michigan contract is just one data point, I do like that the company is growing users, growing ARPU and we’re seeing signs of wins on the enterprise side against incumbents. It seems like Dropbox will win Michigan at a cost (seems like Michigan was unhappy with Box trying to move price and limit storage), but the IRR to DBX is likely high (see LTV/CAC below).

I can’t visibly see where DBX is retracing yet, though obviously the tailwinds in the market are strong, so growth in users not being higher maybe is a concern? Its true that the vertical cloud players are growing 15%+ vs. Dropbox’s 10% growth rate.

If I think about whether their product is getting better or worse, I think it also is clearly getting better. Some of their new add-ins are things like HelloSign, essentially a DocuSign competitor, but one that works seamlessly across platforms (such as integration into Gmail). They also seem to have a password manager, similar to Lastpass.

But this also makes me wonder how they compare to others. I would say Box is actually Dropbox’s main competitor and I think the two will be fighting for the same customers now that Dropbox wants to grow in enterprise.

Perhaps I am biased because I work for a large firm that is concerned about security, but I see little odds they choose a Google product for enterprise. My firm actually uses Box. Maybe we’re not using all the functionality, but it’s nothing to write home about. I did think Dropbox’s Spaces looked very similar, but had some cool features anyone curious should check out. Onedrive is the real competitor if it can make its capability more seamless and allow people to collaborate easily with Word, Excel and Powerpoint. This is what truly scares me….  How do you compete with someone who is fine giving away your core product away for free… But again, Dropbox’s win with U Mich implies they beat Microsoft as well.

Google search trends aren’t that inspirational either, though the tough part about this data alone is that DBX has clearly been growing.


Turning to the financials side, I took a look at some recent figures. From this alone, I would say Dropbox > Box.

For one, Dropbox generates a ton of FCF and much better LTV/CAC. Thinking back to HelloSign and the Lastpass competitor I mentioned, I do think Dropbox’s FCF also provides it room to acquire technology and bolt it on to its existing system. In that case, the acquiree instantly gains a lot of users for that technology and it’s scaled, while also providing a positive feedback to existing Dropbox customers who gain more benefits.

Why has the stock floundered since IPO?

Funny enough, the company has beat analyst expectations every quarter since IPO. They actually made a slide about this in their investor deck. However, I think in DBX’s case it IPO’d with too high of expectations. At one point it was trading at 8x EV/S and 31x P/FCF… now it trades at 4x 2020e sales and 17x P/FCF.  In sum, the stock has stayed roughly flat while the company has grown into the valuation.

 If I’m convinced the stock is worth taking a risk on, what’s my downside?

Buying a stock with low built-in expectations is how I think you outperform. Unfortunately, I’m still not that convinced if DBX is a stock worth the risk (i.e. that expectations are low enough).

On one hand, the company guided to a $1BN of FCF by 2024. At 10x FCF, that would mean there is upside in the stock (maybe 20%, though there will be dilution from now until then, but 10x FCF is a cheap multiple). At 15x FCF (still cheap relatively speaking), it has 75-80% upside.

But I do wonder how investors get over the terminal value question (i.e. it generates cash, but am I just left with a stub piece here? Should I value this like a NPV of a declining annuity?). I don’t see Microsoft going away anytime soon and clearly their stock is ripping due to growing annuity like businesses (the cloud).

Also, when I do some analysis of what the LT operating margin the company should operate at, I get a rate that isn’t much higher than today (LTM op margin is ~20%).

With SAAS companies, generally the new business is negative margin, but it’s all about the renewal business which is very high margin (i.e. you spend all the money to acquire new customers and once they’re locked in, you can figure out the churn math and costs to serve your existing base). That’s why it’s hard to value traditional, early stage SAAS businesses by just lapping a P/E multiple on them.

Here’s my math on Dropbox’s long-term margin potential.

Offsetting this analysis is that management is guiding to much higher operating margins over time – in the high 20s to even 30% range.

That’s great, but when I read how they get there, I have some concerns for the long-term trajectory of the business.

“And so this year, as well as longer term, we plan to drive more efficiency and higher levels of productivity across really each of our operating expense categories. So across R&D, we’ll be prudent with headcount expansion as we drive adoption of the new Dropbox and optimize some of those team-oriented conversion flows that are associated with it and then also as we invest in new high ROI product launches. And then across sales and marketing, we’ll be focusing our spend to support adoption of the new Dropbox. We’ve been doing this already this year while prioritizing our most strategic growth and monetization initiatives.

And I would note that as we execute to our expense targets, we won’t be reducing our investment in our growth engine and new product development. We’ve really carefully considered where we can drive material efficiency improvements across the business while preserving investment in our highest potential product and growth bets. And if you look at our execution over the course of this year, I think that’s emblematic of that philosophy.“

No question, I should be happy when a company is financially prudent, but this is a serious question to ask when you have several 800lbs gorillas. Is this GARP or is this a value trap? I do like how they’ve stated that they aren’t reducing spend in the growth department and like I said, I could also see them just shutting off opex and ramping M&A (the Valeant of SAAS stocks LOL).


I think I’m going to hold off for now on Dropbox, but I am watching it carefully. I think they have a good product and I’m sure I’ll kick myself when I see the M&A announcement eventually come through, but I don’t really see a rush to come in yet or any misunderstanding of the business. Unlike Facebook, I can’t count on Dropbox being a category killer in present time. Facebook concerns were centered around some “known unknown” whereas we know a lot of competitors that could chip away at the company.

If there’s another area where I’m probably wrong, its management. Drew Houston is the founder / CEO of Dropbox (and also a recent addition to Facebook’s board). He seems like a sharp guy. There’s been some mgmt turnover at Dropbox (COO and the CFO). That’s either bad – the company is sinking and everyone is moving on. Or its good – Drew is unhappy and a big shareholder so he’s shaking things up. I guess we shall see. We don’t know who the next CFO is, but the new COO came from Google and was at McKinsey prior to that. Seems positive so far.