Understanding Dropbox's Infrastructure Strategy

Generally speaking, when most companies that offer cloud services reach a certain size, it makes financial sense to start investing in cloud infrastructure. Popular cloud storage start-up Dropbox has recently filed its S-1 Registration Statement with the SEC, opening its books to the public for the first time while sharing incredible detail about its business.

Here's what prospective investors need to know about Dropbox's infrastructure strategy.

Image source: Getty Images.

Taking infrastructure matters into your own hands

Like broad swaths of the internet, Dropbox's storage platform is built partially on top of market leader Amazon.com's Amazon Web Services (AWS) division. Years ago, Dropbox relied heavily on AWS as the primary place to store users' data. As mentioned above, investing in first-party infrastructure becomes financially pragmatic at a certain point, and Dropbox started to shift away from its third-party infrastructure provider in late 2013 under its Infrastructure Optimization plan.

In addition to financial considerations, there are strategic ones. Companies that take control of their infrastructure are able to better customize their product road maps, tailor their engineering resources more efficiently, and broadly call their infrastructure shots better. It's a massive undertaking, but well worth it in the end.

For example, Dropbox had duplicated all user data on its internal infrastructure during the transition, which temporarily translated into higher storage costs. Dropbox had to move a mind-boggling 500 petabytes (PB) of data from AWS. For context, 1 PB is 1,000 terabytes (TBs), which translates into 13.3 years' worth of HD video. Dropbox had to move 500 PB, or the equivalent of 6,650 years' worth of HD video.

Image source: Getty Images.

The company completed the data migration in the fourth quarter of 2016, removing the need to duplicate data between first-party and third-party infrastructure, helping to bring down costs ever since. Dropbox still uses other AWS services to a lesser degree, including on the international front in order to localize data storage in markets like Europe, where AWS has data centers but Dropbox does not.

These days, 90% of all users' data is stored on Dropbox's custom-built infrastructure, which is based in leased co-location facilities in California, Texas, and Virginia.

Cloud scaling 101

For cloud services companies, these infrastructure costs are baked into cost of revenue in a couple of ways. Payments for third-party hosting costs are recognized up front as incurred, while the bulk of first-party infrastructure investments are capitalized and subsequently depreciated and amortized over time. Leasing costs for those co-located facilities are recognized up front, too. Dropbox attributes its Infrastructure Optimization plan with keeping costs in check, declining modestly as revenue continued growing.

Data source: S-1. Chart by author.

The net result is operating leverage, and gross margin has expanded significantly in recent years, coming in at a strong 70% in the fourth quarter.

Free cash flow is king

Two other financial metrics deeply impacted by the infrastructure strategy are capital expenditures and free cash flow. Dropbox spent heavily on building its infrastructure through 2016, but once the transition was mostly complete, that spending plunged in 2017, allowing free cash flow to more than double last year.

Data source: S-1.

Dropbox's infrastructure strategy is precisely what cloud service companies looking to scale are supposed to pursue.