Description

SUMMARY

Dropbox (Nasdaq: DBX or “the Company”) presents a very attractive long opportunity with multiple underappreciated short-term catalysts and a longer-term transformation opportunity. A largely stale short report and sell rating from a leading bank has created an attractive contrarian setup. We see growth reaccelerating in 2H’22 on the back of a recent 20% price increase which should validate both the stickiness and differentiated nature of the Company’s platform. Additionally, we see a path for a return to double digit sales growth and believe consensus estimates are far too low (they remain below the mid-point of Managements LT guidance). While the macro environment remains challenging, Dropbox’s defensive business should remain resilient as a low-price ticket item and system of record. Lastly, we believe a take-private scenario is underappreciated and see recent developments that appear encouraging. DBX presents a very attractive risk/ reward; our base case estimate of intrinsic value is $38 by Dec-22 (76% upside). 

CATALYSTS

1. Q3’22 revenue acceleration as June price increases flow though (improves valuation multiple)
2. Contribution from Dropbox Backup (upside to consensus)
3. Growth initiatives: Replay, Capture, & Shop to be released over the next 12 months (upside to consensus)
4. Take-private candidate, supported by a push from activist investor Elliot Management
5. Achievement of $1 billion free cash flow guidance (upside to consensus)

INVESTMENT THESIS

1) Underappreciated Revenue Acceleration Story and Call option on Growth Bets

Starting in Q3’22, Dropbox should report its first quarter of accelerating Y/Y revenue growth on a constant currency basis of over 9% (high-end of guide). Originally, Management had guided for revenue growth to reaccelerate in 2H’22 on a GAAP basis, but the loss of Russia and adverse F/X rates have been an offset. However, we suspect the reported US segment should be unaffected by these headwinds and still show growth acceleration. 

“We expect the cumulative impact of these efforts to translate to monetization momentum, culminating and accelerating revenue growth in the back half of the year.” – Timothy Regan, Dropbox CFO – Q4’21 earnings call 

Dropbox’s slowing revenue growth and perception as a mature category has been a key overhang on the stock. However, we see 2H’22 as an opportunity for investors to re-evaluate this growth trajectory as Dropbox begins a new phase of its growth plan. For example, we have seen Box reaccelerate its growth with the upsell of Suites over the past year and a steady improvement in its valuation multiple (BOX +1% YTD vs DBX -11%).

Additionally, we see the successful execution of this 20% price increase as a catalyst to improve Dropbox’s suppressed terminal multiple as it helps to debunk the short thesis that cloud storage is a commodity product while Google, Apple, and Microsoft are giving it away for free. As many investors wonder how Dropbox competes with these offerings, we suggest attempting to sync files across multiple devices using Microsoft OneDrive and the comment below should ring true:

“But if you've ever used anything like, OneDrive in particular, it is terrible. It is infuriating to use. I use it right now at my current employer, and I used it back in consulting at Bain. And there's just so many random things that go wrong with it. And, you just don't get that. I had the red x on my lower right icon all the time. It's a bit better now, but there are still random annoying things about it” – Former Team Lead, Business Strategy at Dropbox

Call Option on Growth Bets + Upside to Consensus

We see several paths for upside to estimates that have the potential to push Dropbox back to double-digit revenue growth (earnings plus valuation multiple upside). Our analysis does not include a build out of the very lean sales team as the business is 90% self-serve, but we suspect this could represent a possible upside scenario as well. The most immediate contributor being Dropbox Backup (detailed below) which we see as an underappreciated opportunity. Next, we have the General Availability release of “Growth Bets” Replay, Capture and Shop to begin to take hold in 2022. Upon general release, we believe Management is likely to articulate the path to monetization for these opportunities and see them as a key driver to convert free to paid users of the creative community.

2) The 700mm Freemium User Opportunity and Dropbox Backup

The hidden value of Dropbox is that only 3-4% of its >500mm high-value accounts are paying users. However, Dropbox has long been a freemium monetization opportunity. We believe the separation of Dropbox Backup as an independent SKU for $4.99 a month is a game changer. Dropbox Backup has already been adopted by “millions” of Dropbox’s paid users, so only assuming that level implies >3 million users or 17% penetration of its 17.4mm paid user base. Similarly, if Dropbox can monetize another 3 million of its unpaid, but high-value account base with Backup, this would translate to 22% upside to 2022 earnings. In our view, this is a key rebuttal to investor fears on TAM penetration as it requires Dropbox to monetize existing users rather than needing to acquire new ones.

This opportunity might be more tangible than it may sound. As we have been monitoring first-hand, Dropbox pushes notifications to its installed base (hundreds of millions of users) and asks if they would like to back up their device to Dropbox. This model is similar to that of Norton Antivirus or McAfee, where users are converted from a free, pre-installed version to paying subscriptions through notifications. Just as users do not typically convert to anti-virus software until they have been infected with a virus, we suspect users do not convert to Backup until they have lost a file. Backblaze (BLZE) is another example of a platform that has been successful with the rollout of its backup product. Bottom line: the market potentially is far larger than investors are giving Dropbox credit for at this time.

3) +24% Upside to FCF Estimates as Sell-Side & Investors overly Skeptical on $1B FCF Guide

From what we have observed and heard, investors and the sell-side are skeptical of Management’s guidance for $1B of FCF in 2024 with current consensus estimates suggesting DBX misses by nearly 20%. However, consensus estimates (excluding JMP Securities) on gross margin and EBIT margin appear to be below the mid-point of guidance. We feel this is overly conservative, especially given Management’s history of exceeding the high-end of its guidance.

We see gross margin as the largest area for upside (120bps) and suspect analysts are not appropriately giving Dropbox credit for the scalability of its in-house infrastructure and the declining per GB storage costs. The remaining 30bps of upside will be driven by Dropbox’s push to hire engineers in lower-cost geographies and its Virtual First model that includes a significant downsizing of its real estate footprint. We see the potential for further upside from share buybacks and the seven potential growth drivers outlined previously. 

Assuming Management can hit the high end of its guidance and F/X rates are stable, we see a reasonable path towards $1B of FCF as more achievable than investors are giving Dropbox credit for right now. Below is the bridge from 2022 FCF guidance to 2024 FCF guidance.

4) The Long-Term Transformation Opportunity: We provide more value than a digital box for your files

Dropbox continues to transform from cloud storage to workflow, desktop to mobile, and office workers to the creative community. The Company has made significant progress in this evolution, but it is still in its early inning in terms of potential. We believe that as this potential is realized it will remove the negative investor perceptions that this is a commodity product.

Workflow

Most notably, the HelloSign and DocSend acquisitions have expanded Dropbox into workflow. This has made the product more sticky and pushed Dropbox into new verticals. Further integration with HelloSign will be the next leg of growth. Primary calls with distributors indicate Dropbox still lags on workflow. This also makes Dropbox a competitor to DocuSign where consumers can receive eSignature and cloud storage for the same price as DocuSign’s offering. This was in fact noticed on DocuSign’s recent earnings call.

Mobile

Dropbox’s positioning within Mobile is overlooked and currently represents the majority of its new customer acquisitions. In the Apple App store, Dropbox has been ranked as high as #5 within Productivity while Box and OneDrive are not in the top 20.

Creative Community & Growth Bets

Since the pandemic, Dropbox has found a new user base within the Content Creator economy, known as Creatives (i.e. media & entertainment). Dropbox’s newest offerings, Capture, Replay, and Shop are in beta but appear targeted at better monetizing this emerging base. We suspect Replay and Capture will only be included in the paid version of Dropbox and therefore drive freemium user monetization. Dropbox Capture is competing with Frame.io, which has a $15 per month paid version; so potentially users could get Capture, Passwords, eSignature and Cloud Storage for the same price.

Most notably, we see Dropbox Shop as having the potential for being a standalone product. Similar to Shopify in many ways, it allows users to set up a digital storefront that integrates with PayPal to monetize virtual content. This is an attempt to in-house the monetization of files that were being shared through Dropbox links onto 3rd party platforms like Etsy and GoFundMe. The most common examples are course content from teachers, instructional yoga videos, and photos. With the beta only recently launched, we find this to be an exciting opportunity for Dropbox to expand beyond cloud storage and create more value for its users.

“Step aside, Shopify! Ecommerce merchants across the world are getting a new set of tools from a fairly unlikely Dropbox” – source: techradar, April 2022

5) Take-Private Scenario Appears Underappreciated and Potentially Timely

We believe CEO & Co-Founder Drew Houston has been transitioning to more of a Chairman-like role over the last few years. We suspect this would make him more open to a take-private than investors generally perceive given his >70% voting power (Slack CEO & Co-Founder had >40% voting power, so it’s still possible anyway). Mr. Houston is well respected in Silicon Valley and has a reputation for hiring top engineering talent. Lately, we have become more encouraged a take-private could be a real possibility based on:

• On 7/1, Dropbox released an 8-k highlighting that Mr. Houston had recently married and would be selling ~$70mm of stock beginning in October (first time since IPO ex, tax-based selling) in order to purchase a home. In this new chapter of his life, where he appears to be thinking of liquidity, it would seem his timing might have a perfect alignment with a potential buyer given the valuation, low-hanging fruit opportunity, and improving financials.
• On 6/2, TheDeal.com reported a consultant had approached Dropbox for sensitive information on behalf of a potential buyer, according to person familiar with Dropbox.

We are further encouraged by Elliot Management’s behind-the-scenes position as an activist investor. It was reported in June 2021 that Elliot had taken a >10% position in DBX. Although the exact specifications and status remain unclear, it appears to have largely been executed through derivatives. They have deep experience in the space and currently in the process of taking Citrix Systems (CTXS) private.

WHY THIS OPPORTUNITY EXIST

1. Legacy views highlighted in a sell rated report by Goldman Sachs and activist short thesis (focused on Microsoft & Google risk). However, we believe Dropbox continues to prove it is differentiated and improved its QofE significantly. None of which is reflected in its stock price yet.
2. Q2’22 earnings and guidance created confusion on the change in F/X methodology and “Other non-GAAP” earnings, which were not in sell-side models. In our view, results showed more momentum and upside than the headline print/guide implied. Shares are down 9% since the Q2’ER despite a beat/raise to earnings.
3. A tech and interest rate driven sell-off. However, DBX has a less terminal value risk given its GAAP profitability and its low-ticket, mission critical attributes that have made it macro resilient.

VALUATION

For our Base Case Analysis, we believe Dropbox will achieve $1B of FCF in 2024 which translates to $574mm of FCFE available to shareholders. Assuming a 25x multiple and 9% discount rates implies a $38 Dec-22 PT or 75% upside.

The most often criticism we hear on Dropbox is “What about stock-based compensation?” Below is a bridge to GAAP earnings available to shareholders. We believe Dropbox generates high-quality of earnings, especially when compared to its higher-growth SaaS peers.

RISKS: WHERE WE COULD BE WRONG

• Exposure to SMB and consumers as these are typically higher churn and might be under pressure with an adverse macro backdrop. We believe this risk is mitigating by relatively low cost and the critical nature of DBXs service.
• International accounts for ~48% of Dropbox revenue with ~30% European exposure which could have an adverse F/X impact exposure in a strengthening USD environment.
• The product roadmap for Amazon, Google, Microsoft, and Apple could accelerate development of a competing offering.
• CEO Andrew Houston (age 38) has majority voting control (+70%) through Class B stock.
• Margin profile is at or near Management’s long-term targets, which suggests further scaling opportunities are limited and earnings growth should predominately come from sales growth.

Catalyst

1. Q3’22 revenue acceleration as June price increases flow though (improves valuation multiple)
2. Contribution from Dropbox Backup (upside to consensus)
3. Growth initiatives: Replay, Capture, & Shop to be released over the next 12 months (upside to consensus)
4. Take-private candidate, supported by a push from activist investor Elliot Management
5. Achievement of $1B FCF guidance (upside to consensus)