Chit Chat Stocks - Why We Own Dropbox (DBX)

Episode Date: May 30, 2023

This is our monthly Arch Capital episode. About once a month we will publish an episode that covers a company in the Arch Capital Investors Fund. These episodes will be modeled after our Not So Deep Dive episodes and will also be available on YouTube. Dropbox Inc. (DBX) provides cloud-based file storage and collaboration services, empowering users with enhanced productivity and data security in a competitive market. Brett and Ryan dive through Nintendo and outline the investment thesis for why we own the company in our Arch Capital limited partnership. ****************************** What is Arch Capital? Arch Capital is a concentrated, long-only equity fund aiming to compound capital at an above-market rate. Arch managers are perpetual learners with a long-term focus that strive to build wealth with our partners through intelligent capital allocation. Learn more here: https://www.archcapitalfund.com/ ****************************** Timestamps Company Background | (2:54) Differentiation | (9:43) Performance | (14:36) Acquisitions | (34:35) AI Risks | (55:58) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not So Deep Dive episode on Chit Chat Money. My name is Brett Schaefer, and I'm joined as always by my co-host, Ryan Henderson. But to mix it up this

week, we are doing our monthly Arch Capital episode where we go through any sort of stock we've been looking at in the fund, which for anyone that doesn't know, Ryan and I run a small, concentrated, long-only hedge fund. And if you want more information on that, we're not going to be talking about any details of the actual fund today,

but if you want any more information on that, you can go check the link in the show notes. But we do these once a month. Ryan, anything to add there? I'll also say we've gotten some reach-outs because of the fund. If you're more interested in that or you want to learn more about it,

or you think we should talk more about certain aspects of it, just any curiosity on it, let us know. We're still trying to gauge, I think, what listeners want to hear. And I know some people get curious about that stuff. So these shows are pretty flexible.

We can do a lot of different stuff with the fun shows. So reach out, let us know, chitchatmoneypodcast at gmail.com or you can find us on Twitter. Yep. And again, the link will be in the show notes for the fund website a lot of them that we're doing are going to be stock analysis shows and today the episode title is why we own dropbox now this is not the sexiest

name like maybe nintendo or spotify or match group literally um but we're going to go through why we think this is a good investment why we've held it for quite a long time and why we think it is underappreciated by the market. And I would say after the recent quarterly report performance one of our, and especially because the stock, we'll get to the valuation later, but I'd say it's really up on our rankings. It's rising up on our rankings because of its recent performance. But let's get through the first question here. We have no advertiser today. So for anyone that hasn't listened to these, we basically just co-interview each other where I'll ask a question, we'll start a discussion topic, and then we'll flip back and forth until we

finished the episode we got about seven or eight of them for this one so the first one what does dropbox actually offer its customers ryan what are the pros and cons of the platform and how has it changed since launching i believe in 2011 with its nope you're going to correct me there with its file storage service 2007 wow earlier than i thought yeah um so i guess prefacing this this show. I've tweeted about Dropbox a number of times, and there are a lot of common responses. And anytime I talk about them that we're going to try to touch on throughout the episode, one of them being it's kind of lack of innovation. That's something that I've heard a number of people mentioned that it hasn't changed a whole lot. If you want to see the visual of how the

platform has changed, just, I guess, for context, I don't, I think it has changed and I'll show you why. We're sharing our screen right now for anyone that watches the videos, or I've got two screenshots of what the platform looked like in 2007 and what it looks like today. You can also check those out the news or on the newsletter just up chit chat money substack you'll find it but dropbox is today it's a file sharing and content collaboration platform for both individuals as well as teams um and they're really trying to be dropboxes they're trying to be the dashboard or kind of the workspace for the digital workspace for all of their users digital needs to kind of be aggregated into one place. So whether that is jumping into a Zoom meeting, messaging on Slack,

editing a file together, editing a Word document together, editing a Google document together, editing PowerPoint, watching a video, editing something on Adobe, you can do that basically all in one place. That's the goal of Dropbox is to kind of be the aggregator. um however that is not what dropbox was in its early days early days dropbox and i've listened to a number of interviews now kind of dating back to the old dropbox it was focused solely on helping individuals sync or upload their files to the cloud that includes photos was a big one videos, documents, presentations, uh, drew house and the co-founder and CEO today, his original use case was he was saving his own code on Dropbox. So, um, and, and they weren't

the first to market. Apparently it was a really crowded market when Dropbox was trying to launch. Um, he, he mentioned that I think there was like 20 different, there was like a, uh, what's it called TechCrunch article that said like 20 best cloud storage platforms to use. And that was like an article in like 2007. So they were not first to market. However, Drew Houston basically used, tried a number of these solutions because he wanted to use one and found that they all kind of sucked. And he thought he could do it better. They also did some of that affiliate marketing that a lot of kind of early digital companies had success with.

PayPal kind of pioneered it, I think. So that really helped. They had sort of this program that said basically, if you invite a friend, we'll give you two gigabytes of extra storage space. So that was the goal at the start. However, when some of the well-capitalized competitors began to undercut Dropbox on cost,

that's when Dropbox is focused on, focus began to shift. In an interview, Drew Halston directly called this out. There was a point where Google launched this, I think it was like photo storage application where within Google Photos, you could upload as many photos as you wanted for free. And that was pretty much Dropbox's entire business model being given away for free by the platform that probably has one of the most, maybe the most eyeballs. let's say, sum it up, a clear distribution advantage. Yeah. And so this was kind of, you know, that's obviously a very concerning risk if you're running

Dropbox. And at that time, he basically, they were going into that, like prior to Google launching that, they had a whole bunch of different initiatives they were trying out. They were acquiring companies left and right, a whole bunch of disparate businesses, basically. Um, and it was kind of this come to Jesus moment when he said, okay, you know what? It's time to rein in our focus. And he actually had an interview or he had a conversation with an employee at SpaceX where he was like, you know, it's really cool what you guys are doing. You guys are really like literally trying to get to Mars.

Um, nice callback to that. This finally relates to our defense and aerospace theme. Just a slight connection for the month. Yeah. And he, and he asked, uh, he said, you know, how do you guys like collaborate? How do you communicate? Cause obviously you guys must be working like, you know, uh, must be pretty efficient as a business.

And the, the person, whoever he was talking to said basically a lot of emails and a lot of files. And so that was apparently, and he, maybe he'd been working on this in general, but Genesis moment where he realized it's not enough just to be a storage place. If you can really get teams and groups to collaborate in this place, it becomes habitual and it's a lot harder to switch or churn off of that. And so that was when they really started to begin that migration towards helping groups work better together. I've got a picture showing kind of what the platform looks like today, there's a lot of different functions or features that you can use if you're a Dropbox

user that are fairly unique. Obviously, Google has done its best to copy a lot of these projects, copy a lot of Dropbox's platforms, same with OneDrive, and it's cheaper. So this is not to downgrade Google Drive, OneDrive in any way, because we use Google Drive, we're using it right now. And they've probably done well. Yeah, our business runs on Google Drive. But plenty of businesses run on Dropbox and there are some perks. So I guess just in terms of differentiation, Dropbox is a little different in some ways. So for starters, and this is kind of a big one, at least in some of the people I talk to, they're file type agnostic. So if you're, if you're working in Google drive, I, and maybe it's evolved over the

years. I haven't done this as much anymore because I had a bad experience with it initially, but it's hard to import a word document. You have to like convert it to a Google doc, um, or it can be difficult to like just embed a different kind of file type of word, uh, one drive file type, whether that's an Excel sheet or a PowerPoint as opposed to a Google presentation. It's hard to import that and just edit immediately. With Dropbox, it does not matter whether you're coming from a Google Drive product, a OneDrive product, a Dropbox native solution. So they have their own solutions

as well. I think it's called Pages. You can instantly start editing and communicating and collaborating on these different files with your team members. Additionally, there are some nuances to Dropbox's platform that I think are pretty unique. So Dropbox has templates for legal documents. I know a lot of law firms actually use Dropbox for a lot of work. They got their FormSwift acquisition. That's a great way to kind of get up and running if you're trying to use any of those. they have a native signature solution within the platform. So any documents that you're

exchanging between team members, you don't have to use DocuSign to go out of the platform. You can just boom, sign through that document, whatever you need, because Dropbox acquired HelloSign, they integrated the tech, and now it's this native solution. Last one I'll mention is there are a lot of different sharing capabilities. Some of these have kind of been copied by Google Drive and OneDrive, but you can add password protections to certain files. You can have your sharing time expire for certain files. So you don't have to come back in and remove someone's email. You can basically say they could get access for two weeks, that kind of thing. And then you get also kind of superior file analytics. You can see where

people spent time, how much time they were looking at the document, that kind of thing. Basically, that all came from the DocSend acquisition, which is really popular in venture capital realm. None of these are, in my opinion, one singular differentiator that makes the platform better. But added together, for one, it consistently enhances the value for the users, which if you're a Dropbox user, that's what you're hoping for. And it makes some of those habits, it increases the chances of retaining that user by consistently adding that value. So, um, we've, we've, you've seen Dropbox, uh, add pain users every year for the last, I want to say eight, maybe probably a decade. Um, and with, I think no down quarters,

right. Am I wrong? Quarter over quarter growth, maybe one flag. We should have checked that beforehand. Do not, that's not year of year though. Every year has grown. I'm pretty sure it's been every single quarter. We've seen sequential growth. There was one where a lot of that was inorganic, um, from organic. Okay. Yeah. But, um, yeah, I mean, they've consistently grown today in terms of pricing. It really varies whether you are, uh, how much you need, how big your team is kind of how much storage space you need. Um, but for a standard small team in the United States, it costs $15 per month per user. Um, today Dropbox touts more than 700,000 team customers. And I believe, I want to say 18 million total paying users. So

the platform is big. I think people underestimate how many people are willing to pay for this. And prices have gone up over time for the average revenue that the users are paying to Dropbox have gone up over time. So I would say anyone listening or thinking about the stock for this year for tracking the financials, they're absorbing probably, I think, their most significant price hike in the last 10 years for one of their most popular plans. And that's why their average revenue per paying user is going up. Ryan will probably show that chart later, or maybe I will. So yeah, watch that.

That's a very important thing going on at the moment. Okay. I think that hopefully lays the groundwork for what Dropbox is. let's talk more about its performance over the years. Why has Dropbox been able to grow users and raise prices despite the obvious competition? And then this one's kind of a simple question, but is Dropbox a good business? Yeah. So thank you, Ryan. These questions both relate to each other, I think, because I would define a good software business as one that can profitably grow, which means growing the revenue while having a positive operating margin or cash

flow margin, which Dropbox does, and retaining their users while also raising prices. It all kind of interconnects. For context, as Ryan mentioned before, but I want to say it again, Dropbox competitors are large and wieldy platforms. The main ones include OneDrive from Microsoft, Google Drive or Google Workspace from Google, as anyone can guess, and iCloud from Apple. These companies all have a billion, I think Microsoft has a billion users on their operating system. If not, it's quite significant and it is an advantage for them around the globe that offer a very similar base product as Dropbox for free, which is the file storage up to a certain gigabit level. They all have the same, maybe a different level of gigabytes,

but all have the same basic feature where they say, okay, if you're free, everyone knows this for google drive i think that's probably the most popular free one you get you can sign up with an email you get 15 gigabits of free storage and after that you either have to delete stuff or kind of go through some clear clearinghouse and or pay for the upgrade so why has a dropbox been able to properly grow since hitting the public markets when in theory all four of these and other competitors like maybe box who i guess is more enterprise and some of these other non-big tech competitors have the same thing. We really asked ourselves the same question as our instinct was to think like every other investor who we talked to who

just throws aside the stock because, quote, it is a commodity with huge competitors that will crush them. I bet a large chunk of you have thought that exact same thing during this episode when I was previewing some of our charts on Twitter. Someone, and this is before I even wrote this down for the episode, ask that exact question. So I think it comes down to a few main reasons why Dropbox succeeds. First, Dropbox went viral out of the gate and created this category, or as Ryan mentioned, maybe not created, but popularized this category. It has over 700 million registered users that got comfortable with its service that it can easily upsell once they hit a file storage limit or want to start a small business. I think that's sort of important,

But the second point, and I think more importantly, is Dropbox is focused much more on workplace software than these three other companies. Again, Alphabet, Apple, Microsoft. In fact, I don't think the Dropbox competitors even sniff the top 10 in strategic priorities at Alphabet, Apple, or Microsoft. I mean, right now, they're all focused on AI, Apple's focused on this VR headset, Alphabet and Microsoft are focused on the cloud. They don't want to get disrupted by, Alphabet doesn't want to get disrupted by Bing, who

also microsoft is investing heavily in ryan anything to add there yeah and is it you know i think people see that say that a lot which is you know why hasn't having the big competitors been able to disrupt kind of the smaller player they don't care and it's not necessarily even drew houston was asked this in an interview and he says listen google has lots of good engineers probably better than we have. However, the best engineers are not recruited to the 11th most important project. You're getting the bottom tier engineers at those companies. So even though they might have some of the top tier, when it really isn't a priority, the results aren't going to be there, that you're not going to get as much resources. I mean, you might have access to

more resources, but you're not going to have as good of engineering talent and commitment and focus from your staff. And especially the upper management there, you're going to have less direction. You can see that what Google Drive and OneDrive and iCloud have stagnated over the years. Now, I think this is what allowed them to improve their service to make it better than the competitors, even though they have a much smaller workforce. Ryan said that, summarize that. And then I think taking it a step further, Dropbox has worked to expand greatly out of the traditional file storage stuff offerings with the products Ryan mentioned above.

To summarize, the important ones would be something like the security features, the password keys, the e-signatures, the new one with the form swift acquisition, which has a bunch of form templates, which is very important for certain businesses. And then also the document analytics. This is something I think we're going to be personally watching to expand over time as Dropbox adds on even more features, either internally or from acquisitions. Because when they want to offer these individuals or families or small businesses, right now they have basically the core workplace collaboration, file storage, file collaboration features. But they add on e-signatures, security features, document analytics.

And then hopefully five years from now, they have those three things, but five or six more things that separates themselves out from Google Drive. Now, I think third, and another thing Ryan talked about is Dropbox is platform agnostic. Plenty of people or small businesses share files across different devices and software power by more than just one company. I would say almost every small business is going to have exposure to Apple, Microsoft, and Google enterprise software services or operating systems simultaneously. I can tell, right, Ryan, we're one, we have a team of three, and we are all mixed up with Apple, Microsoft, and Google for separate operating systems.

Each of these companies have Dropbox competitors that don't want to talk to each other. for example, the classic one is uploading Microsoft Word and editing that within a Google Doc. It's very wieldy. It's very complicated. If you have Dropbox, you can work pretty much simultaneously with these with a lot less friction, and it works a lot more nicely together. Now, why are they able to raise prices? We think it's because, and it's important for us when we talk about a company that we own, if it's going to be a company that is going to be in our, you know quote unquote i never know how to define it the compounder category the concentrated you know never sell category um or you know theoretical never sell category which dropbox is in for us

it needs to have a competitive advantage we think dropbox has one key competitive advantage and that is switching costs changing the backbone of your workplace software is a pain and there's little incentive for someone to spend six or even more i'm just using eggs as an example here ingratiating boring hours switching to a competing service just because Dropbox raised your subscription fee by $25 a year. Yeah. And think about it like this. Yes, it wouldn't actually be that difficult to switch. It would be boring. It would suck to wake up and spend a whole day just basically porting all this stuff over. But we're a good example. There's alternatives to Google Drive. and I've never once switched.

There are better bank accounts than the one I have. And I just have never really wanted to go through the pain of switching. I think it's very similar to that, honestly, because it's not necessarily that you're lacking certain functionality if you move over, but you have to retrain, relearn, kind of you have sort of an order system

for where your files are. You know where everything is. It's just this really painful process to switch. It's much easier to just pay a little more. Yep. And what we like about this moat as well is that this should only expand over time because if you're a person or a business and you use Dropbox and then you use it for another year, you're going to have more files, you're going to have more habitual usage of the product, and you're going to increase the storage, which you might have to pay more for each and every year. So we think that

that moat will only steadily widen over time as they got to spend on R&D, they got to update the service. They got to add more features and stuff. And then also a small benefit, which is not as big as the switching costs, but I think it's one that can also expand over time that the big platforms are not really investing in at all. I mean, they could, like Ryan mentioned, if they put a thousand engineers on it, but they're not going to. Especially for a small business is Dropbox can bundle things like document analytics, e-signatures to increase its average revenue per user. And if you think about it, some small businesses really need e-signatures depending on what type of business you are, or it could be a medium business, but small to medium is

Dropbox's bread and butter. Some people really need e-signatures. Some people really need document analytics. Some people really need these forms. If you are one of those companies, it's much more likely now that they can bundle these services that you're going to choose Dropbox over someone else. I'm sure there's people listening to this because they're always this with Dropbox whenever we talk about it, doubting the company. I just want to have some evidence here that it's actually worked, that their key performance indicators, their KPIs have been growing over time. So I'm going to share the screen. I'll describe it here. They're very, very simple charts. First one is their Q1, which we're using Q1 just because it is the latest

quarter uh paying users since 2018 look at q1 2018 we're just a little bit below 12 million and pretty darn i mean if we put a linear extrapolate linear uh whatever it's something on there i'm forgetting the word um the r squad would be pretty staying strong it's just been linear growth over time for their paying subscribers and if we look at q1 2023 we're just under 18 million. So we've gone from under 12 million to just under 18 million with a very steady linear growth since 2018. And if we look at average revenue per paying user, which excludes their free users, it's been not as linear because one, they'll have price increases aren't every quarter or every year. And also foreign exchange can hurt this as well. It's gone again, grown

every year since 2018 to 2023, I think that just shows that yes, things can change. And yes, we'll talk about the risks, but the evidence is there that I think we are correct on our assumptions on this business model. All right. Unless you have anything else, Ryan, on this, let's talk about management. Who runs this company? Let me add one more thing. And you mentioned the linear growth. I'll share my screen real quick as well. And zoom in here. You did the basically year over year. Here's the quarter over quarter. If I can zoom in. This is basically the quarterly growth in paying users over since Q1 2017. And it has just been really, really, really steady. They have a pretty simple

formula for how to grow. And the other part that's, I think, important to call out here is you're not selling to a CIO, like a typical software business. You're not hoping that he evaluates the software budget and says, yeah, you know what? We can squeeze you in. We're going to start trying you out and implementing you across the organization. They're not selling to large enterprises, vast majority of the time. Yeah. Well, in some cases, it's groups within large enterprises, where what you have is a couple of people within a big company decided to start something at Dropbox and it kind of spreads within the business. That is a good recipe for growth because it's a lot easier to just simply add seats when it's a part of a lot of these large

organizations. And every time a new team member gets added to that group, you're able to just tack on an additional new seat. So as those organizations grow, you too can kind of just grow the paying user base. So I like that. And I think that potentially bodes a little better or does a little better in a recessionary environment than software where you're trying to sell into the CIO or the CTO. Yeah, that's a good point. All right. Next topic, Ryan, who runs the company? How has Drew Houston evolved as a leader? Who again? who runs the company, what's management's capital allocation philosophy? Yeah, you mentioned Drew Houston, and he really is kind of the main event,

if you want to call him that. There is one other person I'll probably call out, Tim Regan. He's the CFO. He stepped in in 2020 after the previous CFO stepped down, and he was the chief accounting officer at Dropbox for the four years prior to that. So he's been with the company for a while. So far, so good. I mean, throughout his time, he's already helped institute a big price increase, staff reductions, and a continuation of their large buyback program. So it's a little, I don't think it's enough time to assess his

performance yet, but so far, so good is what I'd say. But yeah, Drew Houston is the most important person here, co-founder, really kind of a bright guy. And the reason I say he's the most important is Houston owns 90 million shares and 75% of the voting power. So even though the other CF, the CFO and the, I think they really only have five executives in total. And one of Those are the chief legal counsel and one's like a chief people officer. I mean, he dictates the decisions. So if the CFO performance isn't great and he recognizes that, it's up to Drew Houston basically because he has all the voting power to choose a new CFO. So he really does run this business.

And honestly, I like him. And I think, I know that's not like that helpful in terms of investment context, but he's obviously a bright individual. So he attended MIT. He dropped out after launching a fairly successful SAT prep business. Then he got into Y Combinator and co-founded Dropbox in his early 20s, mid 20s, I guess. and he was, you know, he was writing the code at the start. It isn't one of those kind of mercenary CEOs who steps in and doesn't have an understanding for the tech behind the business. Um, and kind of after he, he also kind of has this self deprecating side, I think where it's, he, he realizes who he is. He realizes Dropbox's role. He doesn't think the business is more than it is maybe at one point he did prior to the google kind of coming attacking his moat or attacking his castle he maybe was trying to be he wanted dropbox to be more than it is

today but i think he's very rational and he's pretty candid when he sees issues and he's someone that's continuously trying to improve um i've listened to a lot of interviews with him like i mentioned earlier, and it's been interesting to see how he's evolved. Apparently, a couple of years ago, I don't know if it was one of those CEO coaches or whatever, but there was probably consultants or something that came in and he wanted to be analyzed essentially. What am I good at? What am I bad at? And they gave him a whole bunch of compliments. And then they said, one big problem is that you're very conflict avoidant and you don't like to have to have convert bat like hard conversations. And he said, that's been something he's really strived to improve on since

because it, and he really, I encourage everyone to go listen to his interview with Harry Stebbins on 20 BC, because you get this sense that he, he kind of transitioned to this person who, it doesn't benefit anyone to have an organization with more employees than it needs. If you're not helpful, if you're not useful, it's better that you go find somewhere else where you're more valued. That was really his focus. And he even says this in a quote, he says, people don't usually want to join companies where the people there are less talented than them. So talent density is really important. That's kind of a Reed Hastings concept. And in the last three years, you've really kind of seen him demonstrate that focus with his actions. He's done two layoffs now that were pretty sizable. In 2020, he reduced the workforce, I want to say by 11%. And then last month, they announced another workforce reduction of 16%.

And on both occasions, without kind of explicitly stating it, it was basically a, we no longer need this large of a staff. So I don't know if it's because he's on the meta board and he saw the impact that it can have when Facebook or Meta instituted some of these staff reductions, or maybe it's because he's seen that Dropbox is increasingly easier and easier to run. But Houston seems very focused on increasing the per share cash flow. He's obviously the largest shareholder, so has clear incentives aligned with us minority shareholders. I like him. And I mean, as far as I can tell, he has one goal in mind, which is to really drive per share free cash flow. Yeah, no big red flags. I would note that they've done another layoff as well. So there have been three, but the most recent one was 16%. Really? I must have missed that. But there's a chart here that shows just the free cash flow that's occurred and when the layoffs happen. And you can see it usually takes a quarter or two, but there's this step change typically in the free cash flow. obviously you're reducing operating expenses, but that you have to have the one-time severance charges. So he seems very hell-bent on reaching a billion dollars in free cash flow. You read through the conference calls and it's like, basically they've said, the macro economy has

worsened a little bit and it looks like it might get harder to reach that billion dollars in free cashflow, but we're going to do it. And we might just have to take bigger steps in order to do it. Yeah. Foreign exchange, they say they've used that as a cop-out as well. But again, that's something they can't really control. But yeah, nothing else to add there. Okay. Let's talk about the acquisitions side of things, because that is kind of a pillar of their strategy. I forgot to mention this, but they've instituted a huge buyback program. That is how they return capital to shareholders. You'll hit that on evaluation though, right?

I mean, you get details on that. Houston has basically said, there's three areas we deploy. If we see investment within the organization where we can generate an attractive return, that's the first place. Then we'll satisfy share buybacks, make sure we're buying back.

And then if we still have excess cash and we think there's an acquisition that would be accretive to the business, we'll buy those as well. Do you want to talk about I guess, what acquisitions they've made, how it's maybe benefited the business. And then what do you think, I guess, of the acquisition strategy overall? Yeah. So Dropbox has stated numerous times it plans to acquire software companies that it can

bundle into its workplace platform. And it's really backed that up through its actions as well, which I'll go through. And you should expect more of these in the future. Essentially, it wants horizontal software functions that it can upsell to existing Dropbox customers. So when I say horizontal, that means not for a specific industry. It's a function that can apply to a lot of different small businesses or individuals. This can also work vice versa with customers of the software program it acquires. It can say to those customers, hey, we'll bundle in the actual Dropbox functionality, and then it'll be cheaper, but they'll earn more revenue from them. Management also mentioned it believes it

sees more opportunities to acquire software products on the cheap because we're in a current software bear market. So I think it might even become more important to the thesis going forward and making sure that they're rational, smart with their capital allocation decisions. Since 2018, these are the major acquisitions. FormSwift, December 2022 for $95 million. DocSend March 2021 for $165 million and HelloSign in February 2019 for $235 million. So three big ones over the last four to five years. They're not constantly doing these, but you should maybe expect one per year to pop up. That's kind of been their cadence.

There've also been a lot of smaller acquisitions that are more of a acqui-hire to accelerate development on the products they're already building. So if you combine these three acquisitions, Dropbox has spent around, let's say, rounded up just below $500 million to bring digital form software, FormSwift, document analytics and tracking, DocSend, and e-signatures, HelloSign, to its platform. Plus, there was already existing revenue there from these businesses. Were these acquisitions worth it? I think we can discuss that. I'm maybe curious to your opinion, Ryan, but I think they were generally. I mean, they're not home runs.

I didn't turn to the giant returns on invested capital here, but I believe this is a smart strategy to widen Dropbox competitive position and value proposition versus someone like Google Drive or iCloud. If you are a small business, I've used this example already, that uses a lot of digital forms, you are going to choose the Dropbox FormSwift bundle for your storage needs, especially if you already use one or the other. um on the ai point it looks like i think we should just note this that dropbox is going to be accelerating its development of ai tools that they've already been working on uh he just sent or excuse me houston i have to say who it is just sent a letter to employees announcing a 500 person layoff uh in the letter i have a key quote from there that'll be in the newsletter but i won't read the whole thing on this episode he first says that our business is profitable but growth the slowing and he says that the ai era of computing has finally arrived and that they

need to transition resources from you know to that but they don't want to and some of the people and some of the people that are working there uh aren't gonna you know that's not their specialty so they're gonna you know lay off 500 people and then they want to invest more of those resources into engineers tools and stuff like that they're actually going to help with these ai stuff um And yeah, I mean, I think that can mean we could see an AI acquisition, maybe an AI partnership. I doubt that they are going to do something with Google or Microsoft because those are their key competitors. But I could see them easily, you know, partnering with another startup to add on a large language model functionality to the Dropbox platform. I don't think they're going to build their own because they're probably not big enough to do that. I think that could be helpful though it's definitely you know there's a lot of organization that needs to be going on

right that's their whole point and if AI can help with that you know maybe that can improve the value proposition of the service I the one concern here though and this is more of a note to the management team is I don't want to get too bulled up and overpay for a startup during a bubble

so Ryan before we get into it curious your thoughts on the acquisition strategy and their recent transition of resources to more AI development? Yeah, that's maybe one of my few concerns is the acquisitions have been helpful and additive to the platform for existing users or whoever ends up signing up or adding those onto their subscription. However, they've been poorly timed.

So they bought HelloSign, I believe, right at the heart of COVID. Maybe it helped a lot of customers during that time period. But they've said without explicitly saying it, volume at HelloSign has declined quickly. Yeah, I mean, they could have gotten cheaper now, but I think that would have opened them up more. Their products suite would be less robust from 2019 to now if they didn't have that. And I think it was definitely worth it. But yeah, that's a good point. I mean, that company would be struggling right now.

Yeah. Yeah. And I mean, they have DocuSign as like an integration partner that maybe it isn't a native solution, but it's easy to just kind of, it's not that much more friction. I think basically if you ask them whether or not they would have made that acquisition, they probably either would have required themselves to pay less or said no would be my bet, but I could be wrong. I think I'm going to disagree about it. I'm going to disagree with you, but I could be wrong as well. I guess the only concern is that they've stopped talking about it a whole lot, which sometimes with these acquisitions, you can't really assess the return on them when they stop talking about them. DocSend, they kind of did that at peak bubble, especially in VC world. And because there's such a big VC customer demographic for DocSend, when you're trying to raise money, a lot of companies will use DocSend.

And that's been a huge headwind for their business because there's been just a lot less rounds raised. So both those were kind of poorly timed. That's my concern. You talked about the AI and them making an acquisition. An analyst asked a question about that. Are you going to make an AI acquisition? I wish they wouldn't have asked that because I hope they don't start to feel pressure to

do so. They've timed too poorly. I would hate for them to do it again is kind of my concern. Form Swift, I kind of like that. It seems like having those templates and having a good place to start, it kind of reminds me of Wix's website templates where it gives you a base layer and then you can kind of edit from there. So for certain use cases, Form Swift can be really helpful, I think, in being a part of Dropbox. but overall no they've been small enough that it doesn't concern me too much and they do seem to prioritize this the uh buyback first so it's not too concerning yeah they haven't destroyed the

business doing it all right ryan let's get to the meat of the bone here why do we think the stock is cheap i will go through some of the numbers verbally but it's always hard to follow this so i'm gonna try to explain as best i can if you're really really interested in the numbers and i do too poor too poor of a job explain it feel free to check out our newsletter um there There'll be a visual in there that has our little or my little evaluation work. But for the purposes of kind of estimating what Dropbox can earn, I tried to be conservative. I know every single analyst and probably the history of the world says my estimates are conservative, but even these numbers, I think they can, honestly, if I had to bet, it would

probably be higher than some of the stuff I put in, but I want to know what kind of return we'd get if these were the numbers that came out. So here's some of the assumptions I put in. 4% annual paying user growth. This one's kind of hard to know what it's going to shake out at. It's obviously somewhat dependent on the overall economy. If there's a lot of layoffs at organizations, that's going to potentially reduce seats for Dropbox. If it's back to big tech growth, maybe we'll see more higher paying user growth, but it's been at 9% over the last six years. So this is a significant reduction in the go-forward growth rate compared to the past. The second one I put in here is 2% annual growth in average revenue per user.

There will be a big spike this year because of those price increases that they instituted, as Brett mentioned, but they've historically increased their average revenue per paying user at 3% to 4%. So this is kind of a fraction of that. But the reason I do that is because they had the big spike this year. So moving forward, they're probably not going to double down and do another price increase. And it'll probably be a little slower than you will see kind of leading up to this year. So 2% annual revenue per user growth, 4% user growth annually.

Third assumption, 35% free cashflow margins in 2025 and beyond. they've guided for 34% this year, and the layoffs won't even show up completely until next year. So it feels very achievable. They have very clearly said, we're going to do what it takes to get to a billion dollars in free cash flow. It seems like 35% free cash flow margins is a safe assumption. And then the last one here is reducing share count by 6% to 7%. I will go ahead and call this out right now. Whenever I tweet anything about Dropbox, instantly the comments come back and they say, what about stock-based compensation?

That is an important factor to value in here, but it's just that. It's a factor and you can easily, it's a number in the equation. So I assume that they will spend 90% of free cashflow on buybacks from here on out. Over the last two years, they've spent, I think, 150% of free cash flow because they had a bunch of debt that they took on and did a levered buyback. But I think on a go-forward basis, 90% is probably safe to assume. If they do that, they will – well, let me talk stock-based compensations first. Sorry. And I know this is kind of windy.

Hopefully, everyone's still following me. I expect that stock-based compensation will increase by about 3% a year over the next five years. The reason I assume 3% is because they just had the staff layoffs. So that's going to reduce the operating expenses, reduce the stock that they pay out to their employees. However, historically, that's grown over time. And there's also a little less pressure, I think, in terms of the competition for talent right now. You probably don't have to pay as much in stock-based compensation to attract people given just sort of where the economy is at. So I think 3% growth in stock-based compensation is fair and safe to assume.

If you take the difference between buybacks and dollar volume of stock issues or stock-based compensation, you get to basically 6% to 7% share count reduction annually in total if the market cap stays where it's at. So if the market cap changes, obviously how much they're able to buy back, it will fluctuate, but that's based on today's current market cap. And then the last thing I assume is just a multiple of 10 times in the later years. So kind of valuing it on that basis. If these end up being accurate, obviously they won't be exactly accurate, but I think

it's possible that they're over that. We'd end with about a 14% five-year rate of return, annual rate of return. We usually aim for 15%, but this feels like a much safer 14%, much more predictable than some of the 15% IRRs we try to get. Was that too much numbers? I was tracking it, but I was reading it. But I think anyone that's confused on that part won't harp on too many numbers for the rest of the episode.

And if you want to read through all the assumptions, go subscribe to the newsletter. The link will be wherever the show notes are or where you're listening. I do think the one thing I'll call it is I think you are very conservative on average revenue per paying user. I think they can increase that by a lot, but who knows? Maybe they don't flex that for a while. Yeah. But besides that, I think those are not like, I think that one's too conservative. Yeah, potentially.

potentially. I think the only part of my rationale for that is they raise prices at a time when everyone seems to be contracting their software budgets. And they even mentioned there was maybe a little more churn than they were expecting with the price increases, or some people kind of hesitating to increase their subscription price. It might leave them a little reluctant to try a big jump like that again. So that's kind of why I factor in that 2%. Sure. Yeah, makes sense. All right.

We wrote a research piece outlining our thesis on the stock more than a year ago. Do you still agree with that analysis? Do you think anything's changed since? All right. Well, I'm not going to read all these full quotes,

but I'm going to kind of summarize them and then we can maybe agree or disagree. This will be fairly quick, but I just want to look at what we were thinking a year ago and whether anything has materially changed from now until then. If you want to read the full quotes, we'll have a link in the newsletter to the write-up and the quotes will be in there. So the first one was that the unit economics of the

business, you have 80% gross margins, 20% spent on marketing, bring it down to 60%, 10% spent on GNA, bring it down to 50%. And then we kind of had an assumption that 50% would either be spent on R&D or would follow the bottom line to get a return to shareholders or spent on acquisitions. do you think that that has materially changed uh ryan or do you kind of see that as the same thing here where they decided to spend about 35 of that 50 excuse me 35 of revenue on r&d so the vast majority of that 50 that is left over um do you agree or disagree you kind of see the business in the same spot as it was now let you know very small amounts of marketing spend yeah i think it's fairly similar maybe they reduce some of the they may have reduced some of the employees associated

with the general and administrative and marketing side of things but there's the possibility that more of that goes to r&d as they've laid out that they want to kind of invest in some of those ai initiatives the ai super cycle yep i agree with that as well the union economics have not changed the other one is we've discussed this already but the classic argument about dropbox being nothing special big tech is giving away an equivalent product um but in fact our poo paying users have grown in the face of google drive onedrive apple icloud and that they have survived the moat test so far do you agree that or disagree that that is still the case today yes every quarter that they add more paying users and don't pay an egregious amount to do so um

uh confirms kind of that assumption for me yep i agree as well every quarter that the moat you know attack doesn't work uh their moat strengthens i think and i think every quarter confirms that right which is great because the stock price hasn't moved um all right oh let's see the next one is basically a quote around how our goal for a stock that we own is for 15 compounded returns Has anything changed today to maybe improve or do you agree or disagree that we can still get 15% returns? Because personally, I think the opportunity is even higher because earlier we were kind of pricing and saying we could get 15% returns if we get multiple expansion. But I think we can get 15% returns now without multiple expansion because the business hasn't improved so much and the stock price hasn't moved. What are your thoughts? Yeah, I think we can get upwards of 15%. I put in that those kind of safe assumptions and we got to 14. So I think there's certainly the possibility that it's higher than that.

The other thing is we're recording this when it's trading at about $22 a share. Just prior to earnings, it traded down to like $18 or $19 a share. This is going to be an obvious statement, but the returns are much higher at those levels in my opinion um and it seems to have done that now a couple times so people will sour on this stock periodically i i think it gives good entry points i mean hey once they realize it's an ai stock this thing's gonna just go to the moon no that's not a part of our investment thesis at all at all okay last one and this was going over the risks which kind of probably leads into the last section as well. I laid out, or I guess we, but I was writing the piece,

the biggest risk for forward returns as really increasing capital expenditures because of, I guess now you could say like AI costs so much or just because commodity prices are up. And then I also said a second risk was inflation in employee compensation. And the third one was how they would do during an economic downturn because they have never, as a more mature company, experienced a true economic downturn, COVID doesn't really count and actually probably helped them a little bit. Agree or disagree that those are your three risks you're watching or it has one of those kind of gone away. I think the customer attention is something I'm always trying to monitor. Now, churn in and of itself will not show you necessarily

the customer attention because they have, like Spotify, they have a lot of free trial periods, stuff like that to kind of attract users. But it's something really, you got to pay more attention. If they're paying more and more, like if you're seeing operating expenses go up and you're seeing de minimis growth in the paying users, then that's kind of more the cause for concern for me. Yeah, I agree with that. I think one word for me that has gone down as a concern is inflation and employee compensation,

because when we wrote that, that was near to the peak of the software bubble. And I think now that market has gotten a lot more rational. Employee compensation of that is normalized. And what they do is pay up for people and then don't have a really large employee base compared to everyone else. So I think that one's gone away. But as we move to our major risks that we're watching, I think I'll just kick it off with talking about that recession stuff and why I think it's a risk I'm watching, but I'm not too concerned. So yeah, the major one I'm watching is that you know how this company goes through a major recession especially as small businesses turn down as freelancers might turn down um economically how they get impacted will they

you know uh will churn really really rise um and again like i mentioned they have not gone through an extended economic downturn as a mature company however i do believe that file storage is not the first software product you drop when finances are tight um right because you you need it for your everyday tasks you need it for especially for an organization with yeah yours and it's not going to be let's say you're a small business that might cost you around a few hundred bucks a month if you have a very small business or oh for all your place yeah yeah i'm saying yeah not per but for everyone if you have 15 people on using dropbox maybe and you have some other features it might cost a thousand bucks a month but if you're using some of these upsell features

you have a 15 person business, it's going to be like the amount of time or that would be wasted and money that would be lost by switching off of it and canceling your Dropbox would be much more than a thousand dollars a month. If you're a 20 person team, that's paying for a lot of these features. Um, my second risk I'm here thinking here is, I don't know, maybe I was overplaying this cause I did get nervous about the company earlier this year. I did tell Ryan about that, is the AI capabilities at Microsoft and Google leapfrogging, increasing the value proposition for users. I think it's a big time to be determined on this one,

especially when Dropbox is investing in AI and especially when they really are one layer above Google Docs and Microsoft Word where you could have AI capabilities within Google Docs where you have a large language model helping you out, but you're still going to store that file within Dropbox. what are your thoughts brian and then we'll move to maybe what we're thinking about on when we would sell our shares yeah it might hurt in terms of new new customer growth just that

they're that google and microsoft's ai is so much better that or their whatever whatever they can integrate into their like existing g suite and uh one drive products that that sort of help, that might make them just a better solution for new customers, but I don't see any reason why that would encourage existing customers to turn off. That is the biggest risk for me. I mean, just keeping an eye on customer attention, making sure they grow paying subscribers and grow them profitably. That's really the primary thing we're looking at, and that's going to determine basically the results of this investment. Other things I'm looking at-

You never know, Ryan. It's going to trade down to three times cashflow eventually at this point. If that's the case, I think the buyback will be quite helpful. Yeah, that's true. Other things that I'm monitoring though, I want to make sure I'm right about Drew Houston.

He is selling shares on a regular basis. I don't read into that too much, but he also gets paid fairly well it's just gonna um making sure that he does care about shareholders as much as i kind of think um that's just something i continuously kind of watch and i i think you get a good sense of how he thinks when you listen to a lot of the interviews that he's done um second one uh just watching stock-based compensation if if they uh They used to grow stock-based compensation by like 9% a year. So if anything like that continues and it's enough to offset the buyback so much so that

the IRR is significantly worse, that could be bad because they're really fixated on hitting this billion dollars in free cashflow figure, but they don't say how much in free cashflow per share because- And you can do the easiest way we've seen people cheat on their cashflow targets is by increasing their, their stock-based compensation. Yeah. I agree with you there. And I mean, it's, it's a fair concern that people call out. I think right now, even if you factor it in,

you still get a good return, but if it continues to worsen, especially during a period when there's layoffs that would be cause for concern for me. All right. Let's wrap things up. the last question we have here is why we would sell our shares. I'm going to outline what I'm thinking because Ryan and I do have, you know, we have written down kind of when we would sell and we've talked about it, but it's something that, you know, can be updated because the

business changes. So I think this will probably be our update that we're kind of doing publicly as the podcast here. So from my perspective, given that this is a low growth, predictable story, lots of buybacks helping us at a low earnings multiple, I would want to sell Dropbox fairly quickly and I'd have high conviction in selling if the valuation got out of hand, which again, would be a good thing because the stock will go up. I think 20 times free cashflow gets hit and the forward returns look pretty bleak here. To be fair, that's very far away from here because with today's, or excuse me, this year's earnings guidance of about $820 million in free cashflow, that is roughly a $16.4 billion market cap. Current market cap is $7.9 billion, so more

than a double from here and i would also look to be sell if they made an expensive acquisition for some ai startup i'm talking like 500 million dollars or something like that or like ryan mentioned the paying users in our poo deteriorate what i like about this though is it's a very very simple story we'll know when we're right we'll know what we can sell curious though ryan if you have any other thoughts on that as we wrap things up no i it's not in the never sell bucket it. And to be clear, this is not one of the widest moats we've ever looked at. I do think a lot of their customers use it because it's habitual and it's easy to use and it's a good product. But this is not a Google-like moat. This is not an Amazon-like moat. There is something

that could come along and disrupt them over time. So yeah, if the valuation got to 20 times cash flow, the returns don't look that good. So valuation get it out of hand at sell. And then if we really saw something start to eat away at their paying users, or if we saw declines in average revenue per paying user to kind of trying to retain those customers, it's not necessarily an instant sell, but it's certainly something to watch. Yeah. And that one's more harder or that one's, excuse me, harder as I can't have grammar there. All right. That's going to do it for this episode. Thank you all for listening, watching, or however you listen to the podcast. You can do so on Spotify, Apple, or YouTube, which we'll have, as we've mentioned, the share screen that you can interact with the episode. I would say, again, reiterate, subscribe to the newsletter. There are free additional show notes for each episode, not just the Arch Capital ones. You get it every week in your inbox on Tuesdays. I think it's a fantastic resource to help get you up to speed on the company.

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