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Morningstar | Dropbox Valuation after 3Q 2018 Continues to Look Rich; $14 FVE Maintained; Shares Overvalued

Dropbox’s second quarter as a public company came slightly ahead of our expectations, but we maintain our $14 per share fair value estimate and no-moat rating. The firm reported revenue of $360 million and non-GAAP EPS of $0.11 per share, both modestly better than anticipated. However, guidance for fourth quarter with a range between $367 and $370 million fell short of expectations and the guided fourth-quarter share count between 417 and 422 outpaced our expectations as well. We believe Dropbox benefited from converting users to premium pricing plans in the near term. However, longer term, we think investors underestimate potential for top-line deacceleration over the next few years and overestimate the potential for GAAP operating margins. We reassert Dropbox’s closest competitors in both storage and collaboration include Apple, Amazon, Google, and Microsoft, the four largest companies by market capitalization. We would caution investors from opening a position in this name. We see better risk and reward opportunities in undervalued wide-moat names such as Salesforce, ServiceNow, and Adobe.

The firm expanded its paying users to 12.3 million paying users, up from 11.9 million paying users last quarter. ARPU expanded to $118.60 from $116.66 in the last quarter, with part of that uplift continuing to emanate from shifting from legacy pricing plans to new pricing models. Management mentioned on the call that approximately two thirds of legacy customers have been migrated to the new pricing plans. While we like the ability of Dropbox’s Advanced and Professional plans to upsell enterprise clients, we think Dropbox has already pulled some of the easy growth and ARPU expansion levers. Longer term, we see challenges to converting Dropbox’s massive 500 million users to paying users, especially at the enterprise level where Dropbox lacks a formal salesforce and where Microsoft applications are already utilized by hundreds of millions of white-collar employees globally.

In terms of the financials, we were modestly impressed with the firm’s cost discipline as Dropbox kept its general and administrative costs lower than we expected. However, R&D and S&M expanses grew from 61% of revenue to 63% of revenue as expected. We believe as Dropbox invests in new products, the firm will not be able to realize GAAP operating margins that many investors seem to be anticipating. As Dropbox expands, we will be closely tracking long-term margins.

Our thesis remains that Dropbox’s growth is a double-edged sword from a margin perspective. Dropbox could either build out a salesforce in an attempt to gain share against wide-moat competitors such as Google and Microsoft, leading to margin compression, but faster top-line growth. Conversely, the firm could rely on self-serve adoption leading to more robust margins, but tepid revenue growth on the enterprise side. Dropbox affirmed it will not build out an enterprise salesforce at this juncture, and we struggle with the notion that individual subscribers will succeed in evangelizing Dropbox’s offerings such that their employers will use the service at the enterprise level.

This quarter we have witnessed Dropbox expand its integration ecosystem, adding Zoom as a partner. Dropbox announced new products that connect with Zoom to allow users in video conferences to better share documents. The firm already has an impressive partner ecosystem with the likes of Adobe, Autodesk, Salesforce.com, and DocuSign. While we think Dropbox benefits from a “Switzerland” approach, where they try to integrate with as many partners and other vendors as possible, even competitors such as Google and Microsoft, we have to wonder if those partnerships are actually limiting Dropbox’s market opportunity. We think it is within the realm of possibility that many of Dropbox’s partners are the ones providing the differentiated service, while Dropbox is the commodity. Essentially, we would conjecture that all these partnerships might limit Dropbox’s ability to expand its product lines, as current partners might baulk if new launches encroach on their territory. We believe this is critical to Dropbox’s story, because the now commoditized nature of storage applications means that Dropbox has to differentiate itself through other outlets, such as Dropbox Paper, its productivity app. However, products like Paper compete with entrenched competitors such as Microsoft Office and Google Docs, Sheets, and Slides. Since Dropbox has gone public, we have yet to see substantial new products that would change our assumptions around what midcycle upsell and cross-sell rates would look like, which in turn, drives our year-over-year revenue growth assumptions.

For more information on Dropbox, its valuation, and our take on Dropbox’s competitors, please see our March 2018 Ad-hoc report, “We Would ‘Drop’ the idea of Buying Into No-Moat Dropbox’s IPO.”