Technology

Once Upon A Time In Tech: Dropbox Edition

By Akram's Razor:

Dropbox (DBX) recently announced 'the new Dropbox'. Here is a link to the video which everyone investing in cloud/SaaS space must watch. But before I discuss the new Dropbox, a little financial snapshot of what's going on with the company is needed.

Dropbox currently trades at a TTM EV/revenue multiple of 8.8x. They have non-GAAP operating margins of 11% and have provided 2019 revenue guidance of 17% growth and FCF margin guidance of around 28%. Now, I wouldn't call the stock cheap based on these numbers, but relatively speaking in this bubbly SaaS tape, it almost looks like a value play.

So, what gives?

Here are Dropbox's key operating metrics:

2015 2016 2017 2018
Revenue 604 845 1107 1397
40% 31% 26%
Paid Users 6.5 8.8 11 12.7
35% 25% 15%
ARPU $113.5 $110.5 $111.9 $117.6

On the surface, these metrics look okay, but there is some cause for concern here. Dropbox's trailing revenue growth of 31% at IPO listing was organically-driven. That changed drastically in their first year as a public company. Paid user growth trends are going in the wrong direction pretty quickly, and 15% for 2018 and 13.7% for the most recent quarter is definitely enough to warrant being viewed as a 'discount' multiple in this tape. When viewed within the context of Dropbox's recent business decisions, the trend in operating metrics gets a lot more interesting.

Dropbox has made three notable business moves in the past couple of months:

Unlimited device linking on the free Basic tier was replaced with a three device limit as of March 2019. Basically, going forward, if you need more than 3 devices, you need to upgrade to at least the paid $9.99 a month ($99 a year) Plus tier. Effective June 2019, Dropbox raised pricing on the Plus tier by 20%. They upped the plan from 1tb to 2tb of storage and raised the cost to $11.99 ($119.99 a year) a month. They announced the new Dropbox in early June of 2019.

These are actually some very bold moves, and to appreciate how bold (super-risky would be another term), you need to dig deep into the Dropbox story.

Dropbox: A history lesson

2008-2014: The Cinderella Story Years

In many respects, Dropbox is the original SaaS 2.0 company. From an MIT dorm room to Y Combinator alum, when they launched at TechCrunch Disrupt in 2008, few people could have envisioned how big of a problem they were solving. The launch didn't go smoothly as WiFi issues got in the way, and Yammer ended up winning that event as the judges grilled them on Apple (AAPL)/Microsoft (MSFT)/Google (GOOG)(GOOGL) etc. risks. Yeah, that was a concern in 2008, but Dropbox's CEO stuck to his guns and reminded the judges that, despite all the tech giants' resources, his small team had cracked this difficult problem first. According to the CEO, Dropbox wasn't trying to change the way you work, but rather was providing something with speed and ease of use to hit all your major pain points. And, he was right! Dropbox was a perfectly-timed product. A super FRICTIONLESS file-sharing multi-device syncing application for a world no longer dominated by Windows. The explosion of the Apple/Android device ecosystem virtually ensured Dropbox success as a collaboration tool. With the big three not ready to play nice with each other, Dropbox had to simply be Switzerland to win. And win they did….

In less than 3 years, Dropbox had 100 million users. Steve Jobs made an offer to acquire them in 2011. Dropbox's CEO passed. By the end of 2014, Dropbox had 300 million users and a $10 billion valuation. That was peak Dropbox.

2015: Dropbox Doomsayers Arrive

I remember 2015 well as the point that startup mania valuation concerns started to emerge in tech, and no company was more discussed than Dropbox. The market now had ten proper decacorns, and skeptics were trying to predict the first to fall. Dropbox was always at the top of the list, and for good reason. The landscape had started to shift.

While iCloud had launched in October of 2011 and Google Drive in April of 2012, both took some time to get to critical mass. Sure, they slowed Dropbox's growth some, but the lack of interoperability amongst the big three ecosystems remained an issue. It wasn't really until 2015 that this started to change with the first notable move being Office allowing users to save files on iCloud. This notable move, combined with the growing scale of these services and commodity pressure they were exerting on storage pricing, was enough to get investors talking about Dropbox's $10bl valuation problem. Make no mistake, Dropbox was still the dominant frictionless tool in the market, but they had so far shown little evidence of an ability to diversify their offering enough to dissuade concerns on the closing gap in file storage. And, it's not like Dropbox was not trying to address this issue. After Drew Houston had turned down Steve Jobs nine-figure acquisition offer, Jobs had famously told him Dropbox was a "feature not a product" and that he was going to have to kill it. So, Dropbox management had a very good reason to be paranoid and try to expand their offering. And try they did…

In 2013, they acquired Orchestra (est $100ml), the creators of Mailbox, a super-hyped mobile app with a clever approach to organizing email on the go. But despite all the hype and long wait lists, Mailbox never took off. Dropbox shuttered the app at the end of 2015. This is the explanation they provided…

"Over the past year and a half, we've learned the vast majority of our users prefer the convenience and simplicity of interacting with their photos directly inside of Dropbox."

Of course, the reality of the situation was in the time in between the Mailbox acquisition and this announcement, Gmail and Outlook's mobile clients adopted the same type of UX approach.

In March of 2014, they acquired workplace chat app Zulip. A little over a year later, they relaunched it as an open source project.

In April of 2014, they bought Hackpad a note-taking collaboration tool that was seeking to compete with Evernote. They open-sourced it a year later and started testing their own proprietary Dropbox Notes app which would eventually become a part of Dropbox paper. In 2017, Hackpad was discontinued.

In June of 2014, they acquired another aspiring workplace chat tool named Droptalk.

Here is fitting excerpt from the blog post by the Droptalk team announcing that acquisition.

"Droptalk joins Dropbox!

We are thrilled to announce that today Droptalk will be joining Dropbox. About a year ago we set out to end the unnecessary friction around communication and collaboration by killing "the work email." The world deserves a better way to do business and an integrated sharing product, which our team rapidly created is the answer."

I couldn't find much detail on what happened with Droptalk, but it seems the team was folded into the Paper project as Slack (WORK) exploded onto the scene and Dropbox's workplace chat strategy hit a wall.

Anyway, as you can see, there was no shortage of material for Dropbox skeptics by 2015. They were trying to expand their offering and making little progress. This does not mean the likes of HipChat or Evernote were necessarily doing something right to fend off Dropbox's ambitions, but rather the strategy of consolidating a collaboration productivity suite around the feature of file sharing wasn't necessarily working. Still, most Dropbox critics focused on the increasing threat from the big three, and less on their failures elsewhere. But one Dropbox doomsayer did make a very compelling case against Dropbox based entirely on Slack.

In article titled, Dropbox: The First Dead Decacorn, startup founder Alex Danco, laid out a brilliant argument:

"So who will be the first Decacorn to fall? My bet is Dropbox. But not - as has been the worry for years - because of Google Drive, or Skydrive, or any cloud-hosted file storage solutions at all. As we've seen before, it isn't your direct competitors that are the scariest.

Dropbox will die at the hands of Slack.

You may not have considered Dropbox and Slack to be competitors, because they're not - in the typical sense. In fact, 'We integrate with all the services you use already, like Dropbox' was part of Slack's pitch early on. That's because Slack and Dropbox aren't really peers: they're neighbours along the workplace stack:

To me, Slack feels like the first truly internet and mobile-native productivity platform - especially as it expands beyond messaging and into workflow automation, helper bots, and who knows what else. Dropbox might be the pinnacle of file management, but Slack is the beginning of what comes next.

Basically, in the author's view, Slack is a collaboration integration platform that ultimately makes Dropbox obsolete. And, from a business enterprise sense, I think he's clearly been proven right. (Interestingly enough, the author ended up joining notable Slack investor Social Capital a few months after this post)

But did Slack really kill Dropbox?

Nearly four years have passed since this article was written and Dropbox is still hovering around its $10bl valuation. In an absolute sense, that's a victory, it definitely isn't dead (yet). However, relatively speaking, one simply needs to look at the rest of collab software to appreciate the argument. In the same time period, Atlassian (TEAM) went from $5bl to $33bl. Microsoft from $300bl to a $1 trillion. And, Slack from a billion to $20bl.

What Slack has clearly done well is essentially limit Dropbox's enterprise collaboration ambitions. Dropbox never launched a pure play workplace chat app. It appears management made a decision in 2015 to try and thwart Slack by open sourcing Zulip vs. directly competing, but they never really went all in on this. Today, Zulip exists as a Kandra labs-backed commercial open source alternative to Slack for both hosted and on-premise deployments. It's got a niche though on-premise focused (and now ironically Ycombinator backed) Mattermost seems to have exploited that opportunity better.

Dropbox has survived thus far because frictionless file sharing and device syncing has proved far stickier than expected. This stickiness has bought management time to continually try and evolve their offering. Dropbox Paper was the next big bet made by management in that evolutionary process. Officially launched in January 2017, Paper was Dropbox's first full-fledged attempt at creating a document creation/collaboration tool for their existing user base.

For those of you who have never played around with Paper, it is somewhat of a unique tool. Clearly aiming for simplicity, Paper lives up to its name. It is essentially like one long continuous sheet of paper for users to create and share content in. I actually played around with it quite a bit when it launched as you can embed just about anything media wise in its actual form within the document. Also, the linking preview function between documents is pretty cool. And it seems Paper did find some appeal amongst designers with its related integration with Invision, Sketch, Figma, and Framer. My favorite part really has been the simplicity with which you can clip videos into one document and mix in slides and written content if you are trying to make a pitch. It hits a pain point in PowerPoint that I have always found limiting. But like most things Dropbox has tried, it doesn't completely crack the problem. You can't turn the sheet into an organized slide show. And despite the time line elements, linking previews, commenting, sharing etc., I eventually stopped using it.

Why?

"At Paper teams can create, review, organize content in a flexible work space…..it's one part online document, one part collaboration, one part task management tool, one part content hub."

- Rob Baesman, Dropbox Head of Product

Paper's biggest problem, as far as I was concerned, was that in trying to 'organize content into a flexible work space' it actually didn't end up doing anything exceptionally well. Like the word processing element of the application didn't need to be Word, but it also didn't need to be one font with a few sizes and headers and no spell-check. Also, while I'm not taking app power user, I couldn't see how anyone would favor this over the popular note taking tools. As for the collaboration/project management element, there simply are better tools focused on the space. So, really I got the feel Paper was trying to take on Office/Docs without actually taking them on. Like the rich media integration element in a content creation application was the most differentiating feature. Simply focusing on building a true presentation application around that would have made me happy. But look this is just my personal user experience take. You can argue that the they want the word processing element to be bare bones because they believe it should be deemphasized. Which is fine if you've managed to do one thing exceptionally well that I just can't live without, but then again, reinventing stuff like that at this point is tough. There are plenty of other wide-ranging views on Paper's issues. From it being a Medium/Google Docs, a Quip with a better designer, a twist on Confluence, and many more other opinionated views. Whatever the criticism, the overall consensus at this point is Paper missed the mark. Of course, that mark for Dropbox is the big problem. It's the 12bl EV company mark and not the nice little potential 200-500ml niche software tool maker mark. Like I think if Paper was a standalone product it has a niche group of power users, and if focused on properly maybe monetizes by pricing that right. But Paper being developed as a solution for the mass Dropbox user to engage more with the product doesn't resonate. At which point one has to wonder how long Dropbox, which has now developed a long history of shuttering their experiments, sticks with it. Which brings us to today...

Meet The New Dropbox

The new Dropbox, which was officially launched on June 11th, is a collaboration workspace. (I strongly recommend everyone stop reading here and watch the new Dropbox video before continuing because words can't replace that experience as far as I am concerned.)

This is all in bet on Dropbox evolving into the central nervous system for team content creation and collaboration. The goal appears to be to make sure you never have to leave Dropbox to get any of your work done. Office/Google Docs content can be launched from within the App. Team comments and notification tracked inside the app. And naturally highly touted integrations with the super hip collaboration darlings of today in Slack/Zoom/Atlassian. Sharing to Slack or starting a Zoom call can all be done straight from inside the app. The goal appears to be becoming Windows for the Cloud Collaboration business world. And to be frank, in typical, Dropbox fashion the design and UX are pretty slick.

But will it work?

The knee-jerk answer here is no. This is because the new Dropbox is aiming to be a business cloud collab OS over essentially some sort of new application, and to win in a battle like that, you need a massive business install base to spring something like this on. Dropbox is basically going the integration as a platform cloud collaboration route here as this has been the strong suite for the likes of Slack/Zoom, but it just feels like it's too late. Like what's the benefit of me being able to one click share something into Slack if you're already going to notify me when a team member commented on some project task or made some file change? Those notifications seem like an awful lot of added noise to an already noisy environment for a product whose pitch is noise reduction and simplification.

And these changes are coming at a cost. That cost being Dropbox's main existing strength. When you decide to focus on expanding functionality, well you also are taking on friction. This non-stop back and forth between being super frictionless and providing functionality is a tricky balancing act in the collaboration space. Jobs may have been right about Dropbox maybe being nothing more than feature, but it's a super frictionless one its core base has always loved.

Now you have these types of reactions…

The new Dropbox highlights that you can work on Google Docs from right within the app, but it turns out to allow that to happen your browser needs to enable cross-site tracking. So, seamless integration here actually leads to slowing down something that was celebrated for being frictionless.

And here is Dropbox's response to this issue:

"Unfortunately, many browsers don't offer an option to enable cross-site tracking for just a specific integration. When that is the case, users can not give permission to specific cross-site integrations. It's all or nothing and we agree there should be more granular permissions for users. Of note, Firefox and Chrome do allow white-listing of specific sites when enabling cross-site tracking. An alternative would be to use our new shortcuts feature to create links to your Google Docs, Sheets and Slides within Google Drive. Shortcuts don't involve cross-site tracking."

- Dropbox Spokesperson

So, back to linking for an app that is selling you on not having to leave it. Clearly, this is not going over as smoothly as expected. Then, you have the price increase element…

Dropbox USA's price increase on Plus is 20%. Some Australian users have posted 54% increases, and in Canada some have shared 45% increases (I looked into this and according to Dropbox on the Community Support it's a limited amount of users on legacy pricing being hit with these outsized increases). Regardless it would appear the aim here is to bring Plus, which I estimate at about 65% of total paid users, to a global average around $120 USD a year. Customers are not happy obviously and you can get on Reddit, Twitter, or threads like these to see the countless cancellation posts.

Which raises the question what is management thinking? They obviously have done their homework and have access to plenty of usage data as well as external consultant analysis. Raising prices on the popular individual plan tier as you reinvent your app with a business team focus seems a bit odd timing wise. Or is it?

The device cap limit on free users is a logical move here to try and boost paid conversions. If you have ten devices on Dropbox and are paying nothing, your hand is now being forced. The minute you upgrade a single device you need to get down to that three-device limit or move to a paid plan. At this point, a heavy device user whose still not paying is not worth the cost to Dropbox if this won't convert them. So, worst case scenario maybe you get some revenue out of this move by forcing some hands in the free power user base.

Then you have the iCloud problem. Shared folders are coming to iCloud drive with iOS 13 and macOS Catalina in the fall, and Apple is now providing the same files API for Windows that is used across its own devices. It's no secret that Dropbox has thrived off the rise of Apple ecosystem. The iPad probably wouldn't have taken off as quickly as it did if so many people couldn't use Dropbox to write on the iPad. Thus, I assume management expects this new iCloud update to cause some churn and is getting out in front of it.

Users are clearly aware of this…..

And for some, the new Dropbox seems to be a reason to take super late to the game Apple a lot more seriously now…

One thing is for certain, Dropbox management knows that, for most people, cancelling Dropbox is a painful exercise. They are banking on that not changing much, but it's possible they have miscalculated. The web is currently littered with blog posts of users venting on all this, one particular article did stand out. The article is aptly titled," How I Dropped Dropbox", here is fantastic excerpt from it:

"Of course, part of the reason I stuck with it for so long was because the prospect of untangling Dropbox from my life had daunted me for years. That's the genius of services like these; at first you think you're just buying storage, but little by little it finds its way into everything you use.

The only way to kick a habit though is to start kicking it. I logged into the Dropbox site and then opened the "Connected Apps" section of my settings screen. That displayed a list of over three dozen apps and services that I had hooked into the service over the past decade or so of usage. That's when I realized that surprisingly few of them actually seemed all that critical anymore, if they ever even were. Many of them I hadn't used in ages, and most others could easily be replaced by iCloud Drive. A very few would be difficult to use without Dropbox, but I realized that the actual storage they required was effectively de minimis and that they could easily reside on Dropbox's free tier, if necessary.

As with any file system in continual use for nearly a decade, my Dropbox account had accumulated a ton of cruft. All in all, it took me three weeks of persistent pruning, bit by bit, to whittle it down from nearly a terabyte to just seventy-eight megabytes. It was annoying, and not at all the way I wanted to spend even a little bit of my life, but then again I had a very nice feeling of satisfaction when I was able to cancel the pending auto-renewal of my Dropbox account, which was set to happen this coming week.

More to the point, disconnecting from Dropbox was time consuming, but it wasn't difficult. Which is to say that although the process was high friction it was relatively straightforward, and not at all technically challenging. At the outset I had expected that switching away from Dropbox would break many parts of my workflow; in practice, very little of it has been disturbed at all, even though the iCloud Drive features that are ostensibly allowing me to switch are still in beta. I'm certainly not extolling the virtues of leaving Dropbox if you find it indispensable in your own work-it's still the best option if you need to share files across non-Apple platforms. But the relative ease with which I was able to leave it illustrates well Steve Jobs' famous criticism that Dropbox is a feature, not a product. We often mistakenly believe that software features are irreplaceable but they rarely are, especially in categories as well commoditized as storage."

Leaving Dropbox for most people is tantamount to a major decluttering/deep cleaning exercise. It's just something that you tend to put off until you have been forced into it, but then, after you do, it you feel a sense of relief. I think an extra $20 a year at this point is not enough of a reason (somewhat more debatable though as Dropbox was still relatively expensive cloud storage before the hike) for most people to migrate off, Dropbox because the core service has been reliable. However, the new Dropbox introduces performance elements at the expense of the loyal core consumer user base that might just be enough to get a lot more users than management is expecting to finally proactively address their cloud storage tools/expenses in a manner that reflects the landscape changes of the last several years.

So, Should Investors Short Dropbox?

Despite all I have written, the answer to this question is a bit more complicated than one would expect. Dropbox's last earnings report preceded all these moves, and to be frank, it wasn't very hard to make a relative value case for the stock then. The combination of 28% FCF margins with their 17% top-line guide wasn't exactly a jump off the page short at the 6x EV/2019 EST Rev multiple it was trading at then. The slowing growth picture was something that was being priced into the stock for sure, and simply executing on that guide without any notable surprises for the year I think made the name potentially appealing to some as a value SaaS long in this tape. But these price changes combined with the new Dropbox launch and iCloud Drive looming folder sharing update have muddied the waters considerably. Like, at this point, you have some important questions to answer, and this on the back of a 25% rally in the shares over the past 3 months. Is Dropbox value SaaS or a massive value TRAP?

One place to start is by trying to determine how much pricing is factored into their current guidance?

This table of Dropbox's Revenue/Organic Paid User/ARPU growth over the last five quarters as well as sellside estimates for the rest of year.

2015 2016 2017 2018 Q12018 Q22018 Q32018 Q42018 Q12019 Q22019(est) Q32019(est) Q42019(est)
Revenue 604 845 1107 1397 Rev growth yr/yr 28% 27% 26% 23% 22% 18% 17% 17%
40% 31% 26% Paid user growth yr/yr 23.7% 20% 18.3% 15.5% 13.7% 12.6% 12.1% 11.8%
Paid Users 6.5 8.8 11 12.7 ARPU growth yr/yr/ 3.1% 4.9% 5.8% 5.5% 5.9% 3.5% 3.0% 3.5%
35% 25% 15%
ARPU $113.5 $110.5 $111.9 $117.6

The Plus price hike essentially starts kicking on billing cycle renewals starting in Q3 and continuing through Q2 of 2020. Doing the math based on the Plus plan share of total users and factoring some downgrades from professional, you are looking at 2-3% of quarterly pricing as this works through. This is basically a follow-through on the pre-IPO plan when they introduced Advanced Business with a 60% hike with 'unlimited storage' and limited storage on standard business. That was launched early 2017 and the pricing was left to kick in starting in Q2 2018 to boos metrics ahead of IPO. This tailwind rolls of in Q2 and now set to be mitigated some by the Plus hike. The thing that is a bit perplexing is user growth estimates going forward look way too bullish. Between the backlash on Plus for individuals, Apple's iCloud update, the ETR survey data on business intentions in Global 2000 for H2 2019 with respect to Dropbox, and general trends in cloud collaboration software; I can't see how net adds don't start to drop a faster clip due to higher churn. So, I think it's pretty clear Dropbox guidance is counting on pricing to mitigate paid user trends.

This is pretty reflective of the difficult spot the company is at today. I often see people posting why doesn't Dropbox offer a lower priced tier for individuals. Like a value 200gb or 500gb option somewhat on par with the cloud giants? Surely, so many free users would go for that right? Wrong. Dropbox doesn't disclose avg storage usage metrics for Plus subscribers, but I think it's safe to say an overwhelming majority of them would fit on a 500gb plan. You need to simply model the mix between Plus and Professional to get that. So, adding an extra 1tb to Plus costs Dropbox pretty much nothing as the aggregate user base on Plus is far below a 1tb avg. Introducing a lower tier between 2gb free and $120 a year 2tb Plus would actually reduce revenue as far more Plus users would downgrade than the amount of free user upgrades. And your cost of goods sold would basically remain constant thus hitting margins hard.

Also, as I previously mentioned, the raw data on Dropbox's enterprise ambitions doesn't exactly look good. ETR just shared 2H2019 Technology Spending Intentions Survey data on the productivity applications sector. With over 900 CIOs in the Fortune 2000 reporting, no application in the report scored worse than Dropbox. Of the 17 productivity applications they shared data on, Dropbox was one of only three with a negative H2 2019 reported net spending intentions score, and at -17% by the far the worst. Respondents indicating a decrease/replace intention for Dropbox in H2 2019 were 44% for July which is up from 33% in April.

Put this altogether and Dropbox upcoming earnings report which looked like a non-event a few months ago now should be a heck of a lot more eventful. You also have buyout rumors on the name making the rounds for the first time since last summer. I have to say I'm a bit skeptical. The name being tossed around lately is Microsoft, which just makes little sense. I've seen both a value driven case and one on Microsoft wanting the free user base. Both arguments are not compelling. Microsoft has been making strategic moves that are product and pro growth oriented. Yea, Dropbox has some decent revenue, but the organic picture going forward doesn't look good. And really if your buying something like this the FCF that's coming from stock comp is not something you are going to get excited about. As for the users, Microsoft has LinkedIn and Office. They don't need to buy reach. Dropbox's free users likely one way or another touch the Microsoft ecosystem, so they don't need to be 'acquired'. The same goes for Apple, Google, Facebook (FB), and other giants. The value to those players in Dropbox's free user base would come from shutting Dropbox down.

I think one can make a compelling case that Dropbox's effective pricing power doesn't look good from here on out, and that the name is going to be on a very short leash from here on out. I think the HelloSign acquisition and the new Dropbox launch really amounts to more of the same strategy wise, and that something far bolder is needed at this point in time. Otherwise, investors simply need to accept the reality that Dropbox management high expectation valuation that is increasingly looking less tenable. With that and mind and barring some seemingly crazy savoir, I expect the shares to trade down to 5x sales multiple before they year is out. Anyway, I think that's enough Dropbox for now (onto the far more interesting Slack)!

See also SaaS Day Of Reckoning on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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