Description

Disclaimer: This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment. 

Overview:

Dropbox (NASDAQ: DBX) was last pitched in August 2022 by deerwood 1.5 years ago. Since then, the company has nearly reached its $1B FCF guidance in 2024 and hit a plateau. The company guided for $957M to $997M in the last earnings call, inclusive of $47M in add-backs, some of which was due to R&D amortization law changes and the other due to one-time lease expenses. After factoring in $340M in stock-based compensation, this results in over $620M in FCF on a $8.1B equity, with no net debt (7.6% earnings yield). This compares to Box (NYSE: BOX), at a 5.4% earnings yield with similar growth characteristics, which is also half the market capitalization of DropBox. I also push back on the claim that Box is a higher quality business, as the product has a worse UX in my opinion and 35% of DBX paying users are also enterprise teams. At Box's multiple there is 40% upside in DBX's equity today.

Background:

On weak guidance, the equity dropped by 25% and shedded over $2.6B in equity value on Feb 16th, creating this opportunity. Street estimates are now for a 2% revenue increase in 2024 and 2025 from 7.6% in 2023, showing that the growth for the core product has stopped. In fact, paying users dropped slightly between Q3 and Q4. Additionally, long-term margin profiles have been met.

This pitch doesn't investigate growth levers, since most seemed to have been pulled since that pitch - mostly in price taking to increase ARPU and reduced GB minimums to 2GB versus 15GB in Google Drive to drive paying users. Rather, the product is quite sticky given integrations with HelloSign and DocSend and a slick mobile app with active users matching DBX's paying users. Additional development in HelloSign and DocSend should continue reducing churn. 

"Stickiness" Moat:

DropBox users typically have several GB / TB of files on the platform, and at ~$140/year, the time investment required to download these files and upload them onto an alternative platform and learn a new workflow isn't worth the tradeoff. Despite the SMB / non-enterprise exposure, I think churn should remain limited as long as price increases remain minimal. Unlike something like an internet plan which can be quickly swapped and replaced, this "stickiness" is underappreciated and has resulted in an 8% increase in paying users from 2021 to 2023 despite post-covid headwinds. Additionally, DropBox has an underappreciated UX due to fantastic engineering on the core product, putting it leagues ahead of competitor Box in terms of usability and alternatives like Google Drive and Microsoft OneDrive. To put it in other terms, the company serves commoditized object storage (i.e. Amazon S3 Buckets or Cloudflare R2) with a slick interface that users have become very accustomed to across devices.

Catalyst:

One of the big drawbacks is that the CEO Drew Houston continues to believe in the long-term growth prospects of the company rather than running the core product for cash or engaging in M&A (i.e with Box) or investigating strategic alternatives. This resulted in a 5% increase in R&D from 2022 to 2023, nearly matching pace with revenue growth due to increased investments in AI engineers. This mainly has been driven by a product called "Dropbox Dash", which shows a dashboard with AI search across integrations with DropBox, Google Drive, Microsoft Outlook, and Gmail.

After trying this product for a few weeks, it seems quite speculative and seems unlikely to garner significant product traction. Unlike HelloSign or DocSend, this seems further from the core value offering of DropBox and more of a foray into what's hot in the Silicon Valley scene. I am underwriting no improvement in growth prospects in my valuation from "Dropbox Dash", similar to Meta's VR spending. In fact, the CEO is also on the board of Meta, showing a similar philosophy on product investments. One positive is that the company went fully remote in October 2020, resulting in a $160M gain being booked in Q4 2023 from buying out some of the remaining office leases, which dropped a 2% return to equity holders and should result in structurally increased margins in the long run.

I see the path to return as eventually Drew getting fatigued after 3-5 years after limited traction on AI products and lack of growth, with continued share repurchases in the meantime. At the rate of current repurchases, Drew should own a third of the company from a fourth today in 2026. This could open up an opportunity to take-private and address costs and add some leverage, since at the current equity value there is plenty of meat on the bone on a $30 - $40 share price acquisition, for a 25% - 66% 3-5 year return target. As mentioned previously, this also matches Box's multiple.

The company spent a staggering $940M on R&D in 2023, which is one of the highest in publicly listed technology companies relative to DBX market cap. Cutting 70% of this spend, similar to what Musk did with X, would result in an incremental 8% yield or a 15.6% total yield on equity based on 2024 numbers. This cut would also put Dropbox's research and development expenses inline with competitor Box. Drew has shown a willingness to cut back on spend, with 16% of employees laid off in April 2023 (despite being overly replaced with AI expertise). This avenue opens up an opportunity to also maintain the current yield if growth turns slightly negative by decreasing headcount year over year.

Disclaimer: This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment. 

Catalyst

• M&A with competitor Box
• Slashing 70% of R&D to open up a 15-20% FCF yield in 3-5 years.
• CEO recognizes that revenue growth will be too difficult and/or costly to obtain