Chit Chat Stocks - Dropbox (DBX) | Fundamental Analysis

Episode Date: January 10, 2021

Dropbox is this week's fundamental analysis. Dropbox has moved from storage to a collaboration platform. The company was founded in 2007 and is based out of California, USA. Subscribe to 7 Investing with the code "CCM": https://7investing.com/subscribe/ Subscribe to us on YouTube: https://www.youtube.com/c/ChitChatMoney Follow Chit Chat Money on Twitter: https://twitter.com/chitchatmoney Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investment. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are not financial advisors. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guest is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is the Sunday edition of Chit Chat Money, and we are doing the Fundamental Analysis Show. Disappointing, it's just me and Ryan for these ones if you are a new listener. So it's just going to be me and him. We're probably going to be talking about 25 minutes here, give you an overview of Dropbox.

But before we do that, we've got to talk about our partners at 7investing. Ryan, did you do it last time? Do you have any idea of the pitch here? I think I did the sales pitch last time. So I'll do it. Also, we're becoming good salesmen. Yeah. We're getting better. Getting a lot of subscriptions.

Customer acquisition costs. Well, thank you, everyone, for subscribing and using the code because, in all seriousness, it helps 7investing and it helps ourselves and it helps you. It's just us, though. It's not the product. It's not about the product. It's our salesmanship. Yes, it's exactly that.

But, no, in reality, 7investing is a quality product. I mean, they have a team of seven investors there that are a widespread of different analysts. You have someone like Matt who looks at the fintech companies and some of the more traditional quality names. And you have someone like Max Chatzkow who is deep into the biotech if that's your game as well. But the thing is, if you use our code CCM at checkout when signing up, your first month is only $7. You get to see their whole new picks from January. And then each month after that, you get seven picks every month. It really can help your research process.

If you're an individual investor and you want to learn about new companies, they can put new companies on your radar and try to find some new ideas for your portfolio. So I think with the price, it's worth it. Is that all? Yeah. No, that's our whole pitch. Okay. Get into Dropbox. Ryan, do you want to introduce the company?

Yeah. So it's like most people probably know what Dropbox does, but they're essentially a hard drive for the cloud. So you can easily access all your data from any of your devices. early on they were really trying to appeal to individuals that's who they were trying to sell to they kind of made the b2c to b2b transition so now they're more appealing to businesses uh that's sort of their focus but users can sign up for free with the basic plan uh that was really what built i don't want to say a network effect but it's kind of like uh on the uh guy raz used the analogy of walkie talkies like it's not worth buying one if you don't get someone on the other

side of it so that was sort of how it was adopted was customers or users would send it to other users and they developed i think a registered users like 600 million of them yes yeah correct by the end so it worked well but those aren't super easy to monetize so instead they've really transitioned to businesses uh and they charge per user for the businesses uh the standard business plan is 12 50 a month advanced is 20 a month and then they have the enterprise contracts which are negotiated. So they didn't give any rates on that. But 90% of the user's data is stored on Dropbox's own custom built infrastructure. So they have data centers in California, Oregon, Washington, and Virginia. And just as a note, that just means that they're not outsourcing to AWS or Azure or

Google Cloud. They're building this network on their own. 10% of their data is stored through AWS, but that's because that's, I believe, like the more international stuff that you get closer to them that way uh but yeah i think those data centers are where most of their lease liabilities come from i'd have to imagine uh but yeah i'm trying to think if there's anything i'm missing with the business you can access all your files i think you can work uh or upload work share all that stuff yeah they're trying to they're trying to transition more into a business collaboration tool a little kind of get into slack's um expertise there or microsoft teams and they also have hello sign which are those bots so they're kind of they're trying to make a little

hub for people to do file sharing and that'd be the the place that you know the digital file folder yeah stuff like that making it easy to collaborate across i think their pitch is like you can easily use and send google docs to each other and microsoft excel so their platform agnostic you're not stuck within like the google google drive ecosystem or like the microsoft you know ecosystem and drew houston was i guess there was technically co-founders but he came up with the idea at one point when he forgot his hard drive i think he was taking a train from boston to new york and he forgot his hard drive kind of a classic uh inventor story yeah we'll see if that uh i mean we'll never know but you know that's what he said on so he did an interview the how

i built this with guy raz he went on there and he talked about it so he came up with this idea and he's always been a coder he was like a game developer since he was really young uh and so he built this sort of hard drive for the cloud idea and he got into Y Combinator, which is sort of Paul Graham's thing where it's, you're supposed to like accelerate the business and make them grow faster. And one of their big catches is you have to have a co-founder if they're going to fund you. And so he got a co-founder, I'm blanking on the name. I think it's a J, you know, I'm not going to try. He actually just left in March to pursue something else. I don't, they, he wrote a letter like drew houston or houston excuse me i really did think it was houston he wrote a letter of

like thank you for coming along so drew houston just left no no drew is still there he is like the true founder the guy that had the real idea but the co-founder um ended up just leaving the company this spring um not really a red flag at all but just something to look for they uh he went to mit both of them went to mit so sort of i mean this is like the prototypical silicon valley story Like two MIT engineers in 2009 with Y Combinator, applied to Y Combinator. They got onto Hacker News before. That's how they got noticed, which was like the big news site where everyone just looked. I mean, listening to this interview, I felt like I was literally watching the Silicon Valley show.

But Drew is still the Dropbox CEO, and he said something that was kind of interesting during the interview. He said it's really easy to build something that kind of works, and keep in mind he is an engineer, but it's really hard to build something that's bulletproof. Now, unfortunately for them, they've demonstrated that because they've had numerous security breaches over the last decade, which is sort of what they've become almost infamous for. Because if you've ever watched the show Silicon Valley, at one point Ehrlich says now – they're like trying to get into file storage. And he says, now Dropbox is winning, but they should be considered drip box because of all the leaks. So that was sort of where the joke came from, and they do have sort of that – there's almost brand erosion in the security problems. Because if I'm a company, if I'm a financial company or if I have to store customers' financial documents and there's anything security-wise, it looks irresponsible almost to store your files there. But it seems like over the last, say, like 2010 to 2015, they got that bad reputation.

It seems like over the last five years, they've really fixed that because I haven't heard any bad things about them for a while. Okay. And the two co-founders still own about 64.5% of the total voting power. I guess a J or whatever is leaving. But that was of their last proxy statement, which was like a year ago. And they have Class B shares, I'm assuming. Yeah, it's dual class structure. And pretty much all their voting power is through their Class B shares.

That's all I've got. Do you want to get into the valuation? Yeah, so I'll get some of the numbers here. Not too many because I know it's just tough to read everything over and over. But yeah, these are from Coifin. So if any of them are off, you can yell at Coifin. The ticker is a DBX. If you're wondering, market cap is $9.3 billion and their enterprise value is almost identical. Last 12-month EBITDA sales is 5.1. EBITDA operating cash flow is 15.8 and

EBITDA free cash flow is 18.9. So not bad whatsoever. If you're just looking at it in a vacuum, you'd say it's a very reasonable valuation for their margin profile. They have no dividend, as you may expect and then their weighted average shares outstanding have gone from 412 million in 2019 to 420 million as of the end of last quarter so there has been some share dilution but not crazy amounts and then ryan will get into actually this year they've had a lot of stock-based compensation so i would expect if those i'm assuming their options you know stock options if those get exercised then the share dilution is going to continue to go up however they do have some buyback programs that have been able to offset that. So if they can do that, that might

not be a net negative for shareholders. It just might be net zero. But I mean, in reality, if you're spending all your free cash flow on buybacks that are offsetting share dilution, you're really not giving any value accretion to shareholders. So just watch out for that over the next few years. They have lots of deferred revenue on their balance sheet that gets their current liabilities a tiny bit inflated because when you have that liability on there, it's that you may have to pay it back. And with deferred revenue, it's likely not going to have to be paid back. I'd say there's a really high chance that they are able to recognize that revenue. They have almost $800 million in operating lease liabilities, which hopefully will go down a bit over time because

they did just announce a work from home if you want company policy. It's kind of a hybrid one where it's like, all right, we're not going to force you to do any whatever. We might hire some people from australia india or whatever you don't all have to move to san francisco but if you're there you can work so they're going to downsize that corporate office which i did say was um i mean they made a big investment into a large corporate office and that's going to hurt them a little bit but once that gets off the balance sheet that should help um at least their cash fall a little bit but i'll let ryan get into the business and how it's doing yeah it is worth noting that some of those lease liabilities are probably coming from the data centers as well but

They do have the headquarters there in San Francisco. I'll get into the earnings, though. Last 12-month revenue was $1.8 billion. I think the ARR, so annual recurring revenue, is like $1.9 something. But that is growing 17% year over year. They had 78% gross margins. Two years ago, they had 70% gross margins at the same time. So they have seen some steady gross margin expansion.

$587 million in operating cash flow over the last 12 months. That's an operating cash flow margin of 32%. And they had 494 million in free cash flow, so almost 30% free cash flow margins. Pretty impressive. Very impressive, yeah. And free cash flow is growing around 55% year over year. They have 15.25 million paying users. That's up 9% year over year.

And keep in mind, these users are actually worth a lot if you think about sort of, well, ARPU was $128 for the quarter. So they are paying a lot. These are typically businesses. There are individuals that pay for it as well, but the businesses are really the ones that are bringing in a lot of the money for them. ARPU is growing steadily. It grew 4% over the last year.

They have $1.3 billion in cash and cash equivalents. I don't think there's much long-term debt. No, they may have a small amount, but it's a very, very clean and conservative balance sheet. Okay. And they spent almost 16% of revenue on stock-based compensation. That's very high. Yeah, that's a very large amount.

And they also accrue a fair amount in depreciation because the estimated useful life of the data centers is only three to five years. Yeah. So that's where a lot of depreciation comes from. So if you see a large gap in EBITDA to net earnings, obviously take a look at it and see what's going on there. But I think a lot of that comes from the depreciation. Yeah, and you should probably look at how much EBITDA or whatever their adjusted EBITDA number they convert is to free cash flow. And then, yeah, with that data center number, I mean, reasonably you think that those data centers are going to last more than three to five years. There may be some maintenance capex on there.

So if they're overstating the depreciation, it can be similar to a cable company or a broadband company or a fiber company where the net earnings are going to look a lot lower than the cash that's actually being generated in the business. Anything else before we hit our ad break? No, I think that's it. Okay, we're going to hit an ad and then get to the second half of the show. Cox Panoramic Wi-Fi includes advanced security to help protect all your connected devices. You'll get real-time alerts. Oh, like this one. So you don't have to worry about malware.

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Next up is Digging Trenches. This is the 0, 1, 2, or 3 moat rating. This is just high-level stuff, or not high-level stuff. We're not doing some deep analysis here on this, but just looking at the company, our first overview, we've done a few hours of research. What do you think about their competitive advantages? Well, yeah, it's really tough because there's a lot of like product adjacent products.

So stuff that overlaps in certain areas but doesn't exactly do the whole same thing. But they do have that 600 million registered user installed base, which makes marketing to them really easy. That's true. Because you're not necessarily – you don't have to pay to advertise on another platform to go get them. They're already with you. So the cost to go get them is pretty cheap. Obviously converting free users to paid users or even like exist free users to – I mean a lot of these users are just old and they don't use it anymore is what I'm trying to say. And so trying to get them back onto the platform can be a little tough, but it is cheap.

So I think that does give them a competitive advantage. and the work they did and the time that they came out is a bit of a competitive advantage as well because they were one of the earliest ones to be the hard drive for the cloud, which gave them a lot of name recognition. Because, I mean, I feel like everyone's heard of Dropbox. They might not all know what they do, but they've all heard of it.

Yeah, it kind of inspired, I believe it inspired Microsoft OneDrive, it inspired Google Drive, which kind of ended up taking a lot of those that free market share has really been stolen by google drive i'm not sure i mean i'm confident in saying without looking at the numbers that dropbox likely has a better paid install base than google drive because it seems like that's really associated with just that free offering but with any other competitive advantage i'd say that the lifetime value of their customer once they get them on there and as long as the product is solid which you may want to look at that mps score you may want to look at customer reviews

stuff like that it seems like as long as it's fine that lifetime value is going to be i mean very very high because this is not something that's going to be companies doing and then going away it's going to be perpetual use of dropbox i mean i don't know it seems like the churn would be low there might not be super high switching costs like at like on face value but the time that it takes to switch and the slowdown of workflow is huge um like we have a lot of documents here that we share for the show and stuff like that and we have three people it would be a pain to switch i and i can't imagine an enterprise business how tough it would be so uh yeah i do think there is high lifetime value uh but to touch on all the competitors it's driven

i believe uh they talked about this in the interview with guy raz where he's like uh But he said that at one point Steve Jobs invited him in, and he didn't necessarily put a number on it, but he's like, you know, we are interested in acquiring you. And then they were like, well, we want to kind of build this business out ourselves. And he said, okay, well, we're going to launch iCloud and try to compete with you. And so basically he's like, we'll buy you. If you're not interested in it, we'll kill you. It didn't work, but I mean Dropbox is obviously still around. Yeah, it's not like iCloud failed, but Dropbox definitely didn't get crushed by them.

And I guess that goes into my further reading, which is kind of just something we're looking at. Like, I mean, if we're really going to do a deep dive and research this company, what is something we're going to want to research further? And I mean, the question that comes up is like, why didn't Google Drive, iCloud, OneDrive, Slack, Microsoft, Zoom, et cetera, kill them? And if they didn't kill this company, does that mean it is a lot better than the market is giving it credit for? And that's kind of what piqued my interest to do research on this. I don't know if I've answered it yet myself I still think I'm weighing it but that's kind of the broad question

I'm trying to figure out it's weird because Google Drive could technically be B2B but it feels B2C and it feels consumer facing same with I guess Microsoft Office might be a little different but

it's just very it feels kind of like a niche offering but everyone has their hands in the industry yeah i guess the big thing is why hasn't microsoft killed them like it seems like they should have i don't know 15 million paying users not a small amount it's not a small amount and they're not going anywhere no it's like they they must have some advantage and there is a bit of a moat there uh but yeah my further reading is the same like what's the difference uh how much overlap can

octa or uh slack or someone box they compete with box like how much overlap do they actually have Do they? Is Box, I mean, I don't know much about Box. Are they basically a competitor to Dropbox? I think so. I think they mentioned them on the 10K. Okay, okay. But, yeah, there's just overlap in a bunch of different things. I guess we should just get into the future growth opportunities.

What do you have? Yeah, so mine is Dropbox Spaces 2.0. This is a new thing that's, I guess it's the newest release that they've got for customers. So Spaces is a new product that they should have a large tail end with. It is a, quote, virtual workspace, this is how they describe it, that supposedly helps people collaborate efficiently. And I looked at all the demos, and it seems like that's what it is. If this is the case, Dropbox Value Proposition just won't, because they can take over things like, you know, they can compete on point with someone like monday.com or someone like, I mean, it's not necessarily Slack, because Slack is more communication, but it can compete with something like Google Drive very well. Atlassian?

Atlassian could be similar. I don't know much about Atlassian. But yeah, they are, I think, moving into a market with a lot of tailwinds and where big tech can't just crush them. So I think the key to them having success is that possibly this is platform agnostic. So, sorry, possible success because they are platform agnostic. You can add any type of file, whether it be a Google Doc, an Excel spreadsheet, which in reality those are really the only two most people need. you can add it to spaces without moving it from the original location. You know how it's

annoying with a Google Drive document at least if you have the free one where everything kind of has to be embedded with Dropbox it's not like revolutionary that they're doing this and I'm sure a lot of other people do it but making it so easy where you can use any sort of thing, whether it be Trello

Microsoft tools, Google tools, even Apple tools as long as you can make that so everyone can use whatever they want and it all comes to this one hub which would be spaces i think that's a large value proposition or a good value proposition yeah i don't think there's any one thing that's going to be like a magnificent value driver my future growth opportunity is hello hello sign so this is sort of the docu sign competitor they

acquired them in 2019 for 230 million dollars in cash they just had a press release actually that came out and said they're launching in 21 different languages cool this basically just It allows them to keep a DocuSign in the ecosystem so you can sign, send, receive documents. And like I said, it's not one massive value driver, but all these things in the ecosystem make it hard to leave. So all the functionality of these different products, all these different features is just another value add to the customers. It's a little bit like Cash App, how peer-to-peer was nice, but you really have to build on

top of it and add the additional functionality and what's nice is that once you have the users onboarded you can add these functions which make the switching costs higher and bring up your value proposition which therefore in the long run can help you raise your arpu and as we can see with the numbers they're able to do that consistently at least over the last you know few years here they had i mean i can't remember when dropbox went public uh but i know before that they were struggling quite a bit um but it seems like they've turned it around and gotten back to that growth story of transitioning to this collaboration stuff i think they were a silicon valley darling when they first came out because they got like a four billion dollar valuation pretty early on

yes yeah very early and now it's only nine right yeah and it was like two billion last time we analyzed them which was like a year ago or two years ago yeah i know we yeah don't listen to that one because that's when we were total amateurs but uh maybe more but yeah it was probably closer to four but yeah so i mean they've they've had a rough go of it i think a lot of that had to do with the security and maybe the transition from customers to businesses uh but yeah what do you have for highlights and lowlights uh highlights i mean highlight for me is they've survived this far i mean with the big tech really coming after them i mean they've gotten to the other side i think that's a big highlight they have great cash flow margins and the buyback plan

Although, again, like I said earlier, stock-based compensation is to be desired if they're diluting shares by that much. The buybacks almost are useless. I mean, I don't know. It's a balancing act. Yeah, it is a balancing act. But as everyone knows, has listened to the show for a long time, I really hate egregious stock-based compensation. Now, this might just be a one-time thing. So make sure to look at what their stock-based compensation is as a percentage of revenue over time.

If that drops below, like, 5%, it's probably not a big deal. I think that pivot to spaces and collaboration seems to be working, and I do like the founder. I think he's very smart. I mean, MIT, the founder-led thing here really, I mean, I think it's pretty important. Lowlights, you know, not sure if Salesforce, while they acquired Slack, and then you have Okta on their own will start eating into this market share

because I know Ryan and I both work other jobs at The Motley Fool, and they use Okta. Is it Okta or Okta? It's Okta. They use Okta as the secure sign-in system to everything. Now, it's not the same as collaborating with individual team members or on like a startup or something like that, but it helps it so if you have all the different services,

you can go through one login and do that. That might be eating into Dropbox's territory a bit on this where it kind of makes it so you don't need spaces or something like that anymore. Some of their products like secure file storage, which also seem commodity-based, although the switching costs are high. Really, though, it's all execution risk. There's not anything embedded into the price where you're going to be paying an exorbitant valuation.

What is it? The free cash flow yields above 5%? Yeah, I think so. Yeah, I don't know. What do you think? I do like it, and I think Drew knows what he's doing. He's going to die with the ship if it goes down because he owns a lot of shares. And he seems like a humble guy from that interview. I think it's pretty telling. Everyone, if you're listening to this and you're interested, definitely go listen to that interview.

That's how I built this, right? Yeah. And the switching costs for an enterprise team are insanely high. If you're on an enterprise, unless they do something catastrophic to ruin your files or some massive security breach from here, there's no reason to switch. So that's big. And 15 million users is not a small amount. Lowlights for me, though, they have endured a lot of brand erosion. and for you know for a company that has financial documents it does seem irresponsible like i said

to store them there and maybe it isn't irresponsible but if you're telling like like a hedge fund for example if you have clients where they're like all right where are you storing these documents and you say oh dropbox and all they have is that negative brand around security breaches, it can be a deal breaker for a lot of investors. So yeah, I guess they have to overcome that as long as they keep their 15 million users happy right now, they're generating a lot of cash flow. And like you said, 5% free cash flow yield is pretty high or pretty solid. So yeah, I mean, I guess more or less interested. Yeah. Yeah. I guess we're getting to the last question on the more or less interested thing. I'm definitely more interested again. This is not the more or

less or just interested does not mean at all that we would be buying shares. We're people that own about eight to 15 companies. So there's a lot of companies we're interested in, but not many of them actually make it down to the portfolio. I would say one note on the switching costs. A lot of people roll their eyes on that and talk about someone like Comcast or a cable company where they're like, oh, they have high switching costs, but the customer support is just terrible. However, if you marry high switching costs with an actual good product that people like, that is pretty magical and if dropbox can do that i mean the the value is there so that's really what has me more interested and the fact that they've weathered the big tech storm and

come out the other side also they i mean for these enterprise deals i was looking at some of the stuff they get it means 24 7 like you have a customer service wrap yeah constantly so and that might hurt your margins or whatever but it's worth worth it nominally uh when you have these big enterprise businesses um i'm more interested as well the only thing for me is definitely the competitive landscape you know it's a tough one out there i guess i guess it doesn't matter that much though because if you're i mean as it mattered three years ago and they've still grown users and 15 million users uh that's a lot and they're not gonna leave so i mean it looks like they're not going to leave i'd love for them to throw a churn number out there one of these

times but um yeah yeah and the installed base being so high and that easy sort of marketing funnel uh that's something to like as well yeah and they can roll up things like hello sign there's a lot of other things that are like that they could roll up into this to make it so that i don't know it feels to me similar to and i don't want to say this because adobe's been one of the best stocks of all time it feels a little bit similar to adobe if they execute right it's a random tangent, but there's also that HelloSign acquisition makes me realize how much of a commodity product DocuSign is. Sorry

to all the DocuSign shareholders. Yeah, I mean, yeah. That's even one that competes a little bit. It's tough. I mean, people might be, if you're an expert on this industry with software, B2B software, you might be saying like, no, no, that wasn't a competitor. This is a competitor.

And that's the whole thing is that I think there's a ton of adjacent competitors and some slightly overlap. There's like a ton of Venn diagrams here. and that's kind of the tough thing you know you got a lot of money flowing into the competition all right well that's going to do it

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