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Morningstar | Our Long-Term Thesis is Still Unaffected by Dropbox's 2Q Results; Shares Significantly Overvalued

Dropbox's second quarter as a public company came within our expectations and we are maintaining our $14 per share fair value estimate and no-moat rating. The firm reported revenue of $339 million and raised its guidance range to $1.366-$1.372 billion for the year, with paying users expanding from 11.5 million to 11.9 million over the last quarter. On a positive note, Dropbox experienced ARPU expansion as business customers were migrated from legacy plans to new pricing models, some of which were more expensive, resulting in an ARPU uplift to $116.66. Longer-term, we reassert that 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.

In terms of our modeling, we believe the firm can grow revenue at a 15% five-year CAGR, placing our estimates at the upper end of consensus. We think the business can achieve GAAP profitability in 2019, but we "only" think GAAP operating margin can expand into the low-20% range over 10 years, below peers. Dropbox's growth opportunity is a double-edged sword. 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 enterprise revenue growth. 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. Additionally, while Dropbox drove ARPU growth through new pricing on the enterprise side this quarter, we posit that commodification of the firm's storage technology will inhibit the firm from driving growth through price increases ahead.

Longer term, we believe Dropbox's key differentiators are their collaboration tools, such as Showcase and Paper. We think these represent "moatier" products, as tools utilized in the workplace can be much stickier. While we were pleased with the updates and changes in an effort to improve both offerings, we still note that Dropbox directly and tangentially competes with Microsoft Office, Google Docs, Sheets, and Slides, and Atlassian's Jira tools. Our problem with Dropbox remains that Google and Microsoft's applications are so ubiquitous in an individual's personal and professional lives that getting someone to pay for storage is a logical next step. In contrast, Dropbox does not have that advantage. We note that a Microsoft Office 365 subscription would provide the customer and four other users with Microsoft office and 5 TB of cloud storage for a same price as a Dropbox storage subscription for a single user. We see a disconnect in that regard.

A couple of additional announcements came out of the quarter. First, Dropbox announced some management changes, with COO Dennis Woodside stepping down from his role in September, while serving as an advisor the rest of 2018. The company does not plan on replacing Woodside. Second, on the technology front, the big announcement of the quarter was the implementation of shingled magnetic recording technology that allows the firm's hard disk drives to increase storage density. Shingled recordings can write tracks that overlap with part of a previously written magnetic track, leading to higher capacity and a better cost structure.

We want to remind investors about Dropbox's lockup expiration, which was previously set for Sept. 19, 2018, as insiders in an initial public offering are typically prevented from selling their shares until 180 days after the IPO. In the press release, management iterated that due to Sept. 19 falling in the blackout period that begins Sept. 7, the restricted period will now end Aug. 23, 2018. While it can certainly vary by company, in general we would assert that even well-run businesses can, in some cases, experience a decline in the stock price once insiders have the opportunity to cash in their chips. While we have yet to see if the lockup expiration will affect Dropbox in any way, we believe investors should remain cognizant of these dates.

Our thesis at initiation still stands and we continue to believe that Dropbox's current market valuation fails to account for increased competition in consumer and enterprise cloud storage, slowing growth, and an undifferentiated offering. On a multiple basis, Dropbox's enterprise value to revenue of 10 times projected 2018 sales places is at the higher end of the enterprise software space, which we do not believe is justified due to the firm’s lack of a moat or competitive advantage. We can contrast this with our Best Idea software name, ServiceNow, which trades at a similar multiple. ServiceNow has a market cap almost three times as large as Dropbox but is still projected to grow at a higher CAGR over next five years, while benefiting from a Wide Economic Moat due to robust customer switching costs.

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."