We introduced DROPBOX into our GLOBAL EQUITY FUND in the 4th quarter of 2020.

Dropbox Co-founded in 2007 by Drew Houston and Arash Ferdowsi (current CEO and Chairman, respectively),Dropbox is a collaboration platform that allows people to work together online.

Born an underdog in 2007 in a highly competitive landscape when there were hundreds of online storage products, the co-founders found all of them sub-standard. Dropbox was built out of their own frustration, making the co-founders the first customers. Despite being funded by Y-Combinator, Dropbox faced significant skepticism that existing tech giants would crush the company. However, the key to Dropbox’s success has been the relentless focus on its own strengths, as opposed to focusing on incumbents’ strategies.

Early on, Dropbox wanted to scale customer acquisition through the traditional route of partnering with large companies for distribution. However, the founders soon realized that this would be extremely costly, time consuming and that by using a large partner, Dropbox could disadvantage itself. The company turned down Steve Jobs’ offer to partner with Apple, which consequently resulted in Jobs threatening that Apple would crush the company.

Dropbox decided to flip the playbook of selling to businesses by deploying to end users first and only then onboarding businesses. Traditionally, enterprise software is sold to the Chief Technology Officer. With a CTO’s stamp of approval, the software will then be deployed. The only way for Dropbox to be able to achieve direct-to-consumer distribution was through virality. The company offered a free trial and additional storage for referring new users. This strategy worked, with user growth doubling to 200,000 in 10 days after launch. Seven months later, the company had one million users.

Today Dropbox has over 15 million paying users, generating US$1.8 billion revenue. While the business and revenue model have been proven, skepticism remains. Since its IPO in Q1 2018, the company’s share price has dropped 22%, largely due to growth concerns and worries over increased competition.

After its listing, Dropbox spent heavily on marketing to attract enterprises. This strategy, however, negatively impacted Lifetime Value (LTV)/Customer Acquisition Cost (CAC) ratios. While we expect CAC to continue to decelerate, LTV values should increase.

With regard to competition, Dropbox has continued to play to its strengths and shifted away from pure storage and backup solutions to become a collaboration platform.

(Key differences shown right)

The most important differentiator is Dropbox’s open ecosystem, allowing for collaboration across different organizations, operating systems and devices. Large incumbents’ services tend to be walled gardens, purposefully set up to lock users in their ecosystem while monetizing with other offerings.

While the incumbents’ strategies make sense, Dropbox is superior for collaboration and it would be counterproductive for incumbents to follow suit.

At the company’s IPO in 2018, market expectations were for the company to become the dominant personal cloud storage player. Since then, however, hopes have been diminished despite Dropbox having found a niche in a large market, which we believe it can dominate and thus grow over time.

The main driver of our valuation is the growth in free cash flow over the next few years as Dropbox scales. Management have guided for free cash flow to double over the next four years, reaching US$ 1 billion by 2024. Currently trading at a 6% free cash flow yield, this would imply 19% CAGR over the next four years, providing a significant margin of safety.

Despite the favorable free cash flow growth, Dropbox trades at undemanding multiples, similar to banks, pharma, mining and construction companies.

We see significant upside presented by a cheap valuation, as well as the free optionality. Dropbox is going back to its roots of designing products for its own use. The company has decided to allow for 100% remote working for the long term, creating solutions to improve this transition. Dropbox is essentially using its internal processes, quantified as operating expenditure and expensed through its income statement. This operating expenditure is essentially R&D; a source of innovation to create new products to distribute to the company’s 500 million registered users. Amazon did this successfully with AWS, although it took years for the success of AWS to be recognized by the markets.

The valuation difference between the pure collaboration companies versus “storage” companies is significant.

In conclusion, many of the market concerns around the derating of Dropbox since its listing are valid. However, we believe that these concerns are overblown and more than priced in, thereby valuing the company at multiples that don’t reflect the company’s true potential. The tailwinds from the shift to working from home and the significant expected growth in free cash flow provides a positively skewed risk versus return investment proposition.