Dropbox, Inc. (DBX) is on the Hedgeye Technology Best Ideas List as a SHORT.
THOUGHTS ON THE N-T:
There is a certain amount of linearity in the core DBX model. Even Drew Houston recently commented on the smoothness of the underlying business, which we take to imply linearity. Looking at the linearity of the model is the kind of thing that can make you see beat and raise on 2H18 revenue but still be bearish on the stock and the company. First off, the Street is modeling a non-linear progression in revenue and billings growth for DBX which either totally under-states the business model or they have just kept the bar really low. The former is something that you can maybe go long, the latter is just classic old-wall stupidity. We don't love shorting stocks into EPS that have positive estimate revision ahead however we remain confident in our Short thesis.
Another key point on linearity that is both short term bull and m-t bear: the incremental rate of capture on paid conversion, and the rate of change increase in pricing implied in 2Q18, clearly show a model that is taking price against a declining incremental user base. Playing both trends forward will imply major upside on ARPU in 3Q18 and 4Q18, but ongoing slippage in the rate of the conversion. At 10-15x FCF (clean FCF adjusted for cap leases) the former would be bullish enough to sustain valuation. At its current level it is shortable even if the ARPU beat causes a short term spike in the stock because it implies a model running out of room despite only converting some ~12m paid users out of a potential ~300m unique users.
What would change our view? 1) If DBX can accelerate paid conversions from ~0.5MM per Q towards 1MM+ per Q it would shift estimates up high enough to offset multiple erosion, 2) If enterprise becomes real in terms of good plan, good evidence, contributing bps of revenue, and a roadmap of the offering rather than just competing against commodity participants, and 3) A re-positioning of the business model entirely, or 4) A degradation of the stock to the teens on a FCF multiple.
For now, the most likely course is that DBX uses its newly public status to march towards (funky, out of the way, zen-like) enterprise software acquisitions which help them close the enterprise roadmap and street cred gap, and give investors something new to worry about.
DBX SHORT Thesis:
- Commodity core business that even they don’t like and the path of ‘taking price’ is the LOGM path of churn, capped upside on user growth, and circumscribing a once large market into a much smaller paying user base.
- Path forward into enterprise has the right partner, but maybe too hopeful in terms of dollar signs…the partnership was announced in March, why haven’t we seen PR after PR telling us about the amazing innovation/go-to-market coming from that?
- Path forward into Atlassian…is ridiculous or moving at a ridiculously slow speed, either way it serves as a distraction for a company that desperately needs to fix its business model.
- Even above Street and giving a rich 35x growth multiple to DBX gets $28 on 2019 FCF (adjusted for cap leases). I’d call that a best case multiple for a company that will soon find itself in the quicksand of high teens growth and limited progress into new territory
THE SLASHIE:
Dropbox is a consumer file storage company with a strong user base and exceptional technology who is trying to take price against a freemium user base. The road is painfully slow in spite of rising advertising dollars and S&M expense likely because prosumer file storage is a commodity business. Dropbox might have the best offering but they are still vulnerable to outside pressures from Google, Microsoft, and a whole host of others.
Making matters worse the company really wants to be someone else. The board seems to want the company to be BOX, but bigger and more successful. Meanwhile, the CEO wants the company to be Atlassian.
WHERE THE BOX DREAM FALLS SHORT
The transition to BOX is under way. The company is making the necessary admin controls efforts, adding powerful search functionality, and is teaming up with Salesforce. But the dream is sort of weird; nearly 100% of Fortune 500 companies have Dropbox users in house. The hope/dream seems to be that administrators will want to control access to 3rd party storage for security reasons, thus enabling CRM-DBX to come in and say ‘stick-em-up’ and raise the current user price from $20 per month to $millions per year for enterprise ELA. At first this sounded good to us, but…security tools have become so robust we wonder if enterprises already have tools to enable this kind of file storage discovery. Will they agree to 10,000x increase in price for more or less the same functionality?
WHERE THE ATLASSIAN DREAM FALLS SHORT
The transition to Atlassian is also under way thanks to a novel product called Paper that is taking the world by storm. Isn’t everyone already using Paper? Are you? There is a difference between adding useful collaboration features (like the Zoom partnership announced in early October, HERE) and pretending to be something you’re not (i.e. Atlassian). Collaboration is a nice dream but the pace of transition into this domain is so painfully slow that the targets keep moving deeper and deeper into outer space.
IF WE SAT ON THE BOARD, WE’D SUGGEST:
This whole time, DBX could have been/still could be one of the best challengers to AWS in IaaS, if only they re-tooled in that direction and dropped the Atlassian aspirations. They could even keep their ‘adopt as you will’ business model with a sales-lite approach and let customers create custom usage on their platform with the right architecture. Too bad.
DREAMS ASIDE, WHAT WE (mostly) LIKE ABOUT DBX TODAY:
- FCF growth
- SMR drives margins
- Innovation
- New Search functionality is for real (and it helps to solve a very real problem)…but another example of ‘unicorn’ tech without the right go to market to make it a winner
GETTING PAST EPS, KEY Q IS ‘WHY WOULD YOU GET LONG DBX?’:
The best answer is they generate good FCF (although it’s still expensive on those numbers) and the second is they have great technology (although wrapped in a bad business model with no obvious M&A buyer). The other point from the bulls is that DBX is 'still' growing. We agree… But for now, they have locked themselves into a growth cage via their business model of converting a freemium user base to a paying user base, with enterprise contribution and collaboration SW contribution still too far out to get us excited.
Please call or e-mail with any questions.
Ami Joseph
Managing Director
Yosef Vaitsblit
Analyst
