Today, cloud computing stocks are seeing a rally like never before. However, cloud-based storage solutions player, Dropbox (DBX), has not been a major beneficiary of these windfall gains. The average YTD return in the cloud computing industry, represented by Global X Cloud Computing ETF (CLOU), is 41.33%. Dropbox has risen only by 26.97% YTD, significantly lower than the average cloud player and nowhere near the gains posted by leading industry players.
The shortfall has not been without a reason. Investors remain concerned about the commoditization of the company’s main offering which is cloud storage. However, there are definitely many redeeming qualities in this stock. I strongly believe that the pros significantly outweigh the cons. Hence, Dropbox can be that overlooked opportunity that investors crave for in the very overheated cloud computing market.
Dropbox is increasingly focusing on profitability.
Dropbox has now prioritized the goal of becoming GAAP profitable by end of fiscal 2020. In the first quarter, the company reported a non-GAAP EPS of $0.17, ahead of the consensus by $0.04. The company has also guided for a long-term operating margin target of 28% – 30% and annual FCF (free cash flow) target of over $1.0 billion by 2024.
The chances of the company not only hitting these targets but even surpassing them seem pretty high. If history is any indication, we can take some confidence from the fact that the company’s actual performance has surpassed consensus revenue and EPS estimates for 12 quarters straight.
Many factors seem to be working in the right direction for Dropbox. The work-from-home trend is fast becoming a major secular tailwind for the company, both in the short run and long run. Since mid-March, the company saw a 40% rise in daily Dropbox business team trials as compared to those reported at the beginning of fiscal 2020. Dropbox business is an offering that is currently being used by 450,000 businesses.
Dropbox also reported a 25% increase in daily trial starts for Plus individual plan, the company’s paid premium platform priced at $11.99 per month, in the same time frame. The company also reported increased engagement and collaborative activity.
The company has more than 600 million registered users, of which only 14.6 million are paid users. However, the current paid user base is significantly up considering that there were only 13.2 million at the end of the first quarter of fiscal 2019. Further, almost 80% of subscribers use Dropbox for work purposes. Hence, there is a huge growth opportunity available for the company to further expand its paid user base in its own subscriber pool.
In addition to growing paid user base, the company also stands to benefit from cross-selling opportunities. This trend seems to be in progress even now, considering that the company’s average revenue per paying user was $126.30 at end of the first quarter of fiscal 2020, higher than $121.04 at end of the first quarter of fiscal 2019.
Dropbox has been consistently working on product enhancements and product innovations.
Dropbox has also been exploring attractive opportunities in adjacent areas. The company’s $230 million acquisition of HelloSign marked its entry in the booming e-Signature space. In June 2020, the company launched multiple new features for increased document security. These include a password manager called Dropbox Passwords to store passwords, and a secure place to store sensitive documents called Dropbox Vault. The company has also introduced a unique backup feature that can automatically save documents from your PC on Dropbox. All these add-ons can significantly improve the customer experience and can result in increased paid membership and brand loyalty for Dropbox.
Investors should consider these risks.
The biggest risk haunting Dropbox’s share price has been the commoditization of storage services. The company’s products have been facing increasing pricing pressures as big players such as Google, Microsoft, and Apple are offering free or very low priced storage products. But, Dropbox Spaces can now make a difference in this equation. Space is a platform to integrate core Dropbox storage offerings with other corporate software like Zoom, Google’s G Suite, Slack, and Microsoft Office. Hence, Dropbox is now offering a platform-agnostic storage solution, a major redeeming characteristic in a market where other cloud players are trying hard to restrict customer’s use only to their products.
Dropbox has been consistently working to transform its cloud storage business. Although the plan is ambitious, it definitely relies heavily on the company’s ability to implement it. Much of Dropbox’s growth plans depend heavily on customers getting hooked to Dropbox Spaces. Hence, investors are definitely exposed to significant execution risk.
Further, in case Dropbox Spaces fails to covert a major chunk of the company’s free users into paying users, the company may find it difficult to adhere to its long-term double-digit revenue growth target.
In the first quarter, Dropbox’s revenues grew by 18.18% YoY to $455 million. Although the number does not seem to be a weak one on its own, we should remember that the company’s YoY revenue growth has trailed down from 39.91% in fiscal 2016 to 18.46% TTM. Accepted that increasing revenue base has been one of the many reasons for this growth rate decline, but investors are definitely not pleased. The future topline growth hinges heavily on the success of Dropbox’s new product offerings.
What price is right here?
According to finviz, the 12-month consensus target price for the company is $27.73. The company is currently trading at a forward PE of 25.81x and PS multiple of 5.46x. Although not cheap, these valuation levels are pretty low when we consider other prominent cloud stocks. The current trading price is close to the company’s IPO price of $21. In this backdrop, I believe that the consensus target price of $27.73 is a better reflection of this company’s growth potential in the next 12 months.
At end of March 31, 2020, Dropbox had cash of $1.01 billion, CFO (cash flow from operations) of $53 million, and a free cash flow of $25.0 million or 6% of the quarterly revenues. The company also carries a total debt of $1.08 billion on its balance sheet.
Analysts have a mixed opinion about this software infrastructure stock. On June 24, Goldman Sachs analyst Heather Bellini raised the target price to $22 from $19 and reiterated Sell rating. On May 15, Citi analyst Walter Pritchard initiated coverage with a Buy rating and $27 price target. On May 8, Jefferies analyst Brent Thill raised target price to $22 from $20 and reiterated a Hold rating.
On May 15, Gordon Haskett’s Don Bilson highlighted the possibility of activism at Dropbox, considering that Nomura Securities owned almost 7 million shares in the company. He believes that activists generally opt for Nomura’s swaps when they are interested in any particular company. This again is a good sign, considering that increased investor activism can lead to higher market value for the company.
With work-from-home becoming the new norm, Dropbox is well-positioned to come out even stronger from the pandemic. Dropbox stands to benefit from its strong brand positioning, huge addressable market, and increased focus on product enhancements and innovations is this work-from-home universe. Investors stand to benefit from the company’s reasonable valuations. While there remains a significant element of execution risk for the company as it takes on the software biggies, Dropbox offers a favorable risk-reward proposition. Hence, I believe that this stock can be a solid pick for retail investors with above-average risk appetite and investment horizon of atleast one year.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.