Dropbox Drops Its Unicorn Status With a Shiny New S-1

This week, two huge tech unicorns, Spotify and Dropbox, filed their S-1s. In this episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu take a dive into Dropbox's filing and what we know about the company's business so far.

Find out how Dropbox has been growing its user base, and how that differs from competitors such as Box (BOX 0.11%); how much Dropbox should be worrying about cloud storage offerings from players such as Alphabet (GOOGL -0.30%) (GOOG -0.21%) and Apple (AAPL -1.92%); and why so many tech companies severely limit shareholder voting power. And, of course, the hosts give their take on whether they'll look into investing in Dropbox after the company goes public. Be sure to catch next week's show for a look at Spotify.

A full transcript follows the video.

This video was recorded on March 2, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, March 2. We're doing a deep dive on Dropbox's S-1. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist, Evan Niu. Evan, to borrow a phrase from Chris Hill, the news fairy has been pretty good to us in tech over the past week.

Evan Niu: Yeah. This day has been a long time coming through Dropbox.

Lewis: We got news last Friday that Dropbox's filing was going to become public, and we also got news earlier this week that Spotify is going to be going public. So, two huge unicorns that a lot of people have been wondering, when's the day going to come when I'm going to be able to get my hands on some of these shares? We still have to wait for that, but we can at least start talking about the business and get a good sense of what's going on with these companies. We're going to touch on Spotify next week, next Friday's show. We're going to talk about Dropbox today. For those that might be unfamiliar with the business, Evan, do you want to do a little rundown on what Dropbox does?

Niu: Sure. Dropbox was one of the first companies that really specialized in cloud storage. I was actually a very early user of Dropbox a long time ago. Back when they first started, I was one of their early users, and they used to have all these referral programs where if you refer people to sign up they would increase your storage quota. I think that helped them grow, that referral, word of mouth-type marketing, which they still use to this day. 

It's basically just cloud storage. They have a lot of free plans for small storage, and then you can also pay for higher storage. It allows you to sync files across devices, have mobile access, you can also collaborate in enterprise, all sorts of stuff.

Lewis: The way they make their money is through the subscription business. You mentioned those free tiers. If you were to sign up right now, you'd get a free Dropbox account and 2 gigs of storage, and also maybe some email support or something like that. You go one tier up, you get 1 terabyte of storage for about $10 a month or $100 a year. They have another tier of individual accounts beyond that. For a long time, they've been a company that's been kind of focused on the individual side of the business. They've been shifting that over the last couple of years to having more of a business focus and looking at the enterprise market a little bit more.

Niu: Right. They've historically been very focused on the consumer market, which is kind of a weird thing for a company like this, because there's always more money in the enterprise. In contrast, we'll talk about this more in depth later, Box is another pure play cloud storage company that's always focused heavily on enterprise. There's some interesting distinctions. We'll cover that a little bit later.

Lewis: And then, over on that enterprise side, the plans, just to give people an idea of what they're pulling in, they range from $15-$25 per month per user, or businesses can pay $150-$240 per year per user. So, it's one of those very scalable, pay-per-head-type businesses that we've seen be very successful in the business world. I think something that's kind of interesting with Dropbox is, this is a freemium model, and they are a company that had pioneered the idea of freemium and really popularized it in a lot of ways, where you get people in the door with a very basic version of your product and hope that you can slowly upsell them to premium content tiers.

Niu: Right. I remember back in the early days, with these referral upgrades, I had gotten my account up to 10 or 15 gigs for free based on referrals. They had run these promotions. So, definitely, they're able to grow a lot of users, but also at that free tier. They're pretty generous to their users, even on the free side.

Lewis: This is a company that has been kind of a focus of a lot of IPO speculation for a very long time. It's been around for over a decade right now. It's one of those prized unicorns of Silicon Valley and the tech start up scene. It's also the first company to go public from the Y Combinator family. This is this very popular, very well-known incubator. They have this impressive portfolio of private businesses. They have early stages in Airbnb and Stripe. So, a lot of people are trying to read the tea leaves here and say, "Dropbox is going public, maybe that's something that will foreshadow Airbnb eventually going public, too." I think that might be wishful thinking for a lot of people. I don't know how connected those might be. But, this is a watershed moment for the Y Combinator group, because it's the first major company going public.

Niu: I think it's also a big step for Dropbox itself. The co-founder, Drew Houston, famously turned down an acquisition offer from Steve Jobs nearly 10 years ago. Not everyone says no to Steve Jobs. Certainly, if you're going to say no to a big acquisition offer, ultimately the goal is to grow the company on your own and ideally take it public at some point as a standalone business, in which case, you'll get paid at that point as well. So, it's a pretty important milestone. 

Like you said, they've been around for so long that people have been wondering, "When are you going to go public?" There's this really good quote from that story where, when pitching this acquisition, Steve Jobs was like, "Dropbox is a feature; it's not a product," as a way to be like, "Come on, sell to Apple and we can integrate." Of course, now they have iCloud storage. It's just another reason why it's an interesting IPO.

Lewis: It's a feature to Apple, given the large scale of their overall business. But, it does seem to be something that you can build a pretty impressive business in and of itself on. You look over at some of the core business metrics for this company, 500 million registered users as of the end of 2017. That's up from 400 million in 2016. We talked about that freemium model, though. A very tiny portion of those registered users are actually paid users.

Niu: Right, just about 2%. I think that also speaks to, like we mentioned, their focus on the consumer side, too. 500 million registered users, only 11 million are paying, which shows you how many free consumers there are. And the real challenge for them, the task going forward, is going to be converting those to paid users. Whereas, if you make a comparison to Box, for example, Box has about 60 million registered users and about 10 million paid users. You can see that their penetration of paid users is much higher. Their paying user base is comparable, but the total user base, Dropbox's is massive, 500 versus 60. But both have about this 10-11 million paying users. Which is a result of this focus on enterprise versus consumer.

Lewis: I guess the difference there is, Dropbox has to support a much larger group of people in order to get to that 11 million. The counterargument there, there's two ways to look at that 2% of registered users are paid users. You can say, one, people get enough for free that they don't feel compelled to move up market. Two, the counter is, Dropbox has a huge monetization opportunity in front of it, just with people who are already existing customers, let alone having to go out and acquire more customers and pay for sales marketing to make that happen.

Niu: Exactly, that's a great point. Dropbox spends very little on sales and marketing because they rely heavily on word-of-mouth, referrals, and this grassroots marketing, versus Box, which has these salesforces of enterprise, trying to really target enterprise. To put some numbers to compare, last year, Box's revenue was much smaller, about $500 million vs. Dropbox's $1.1 billion. Of that total, Box spent about 60% of revenue last year on sales and marketing, which is a huge proportion of your revenue to be spending on sales and marketing. For Dropbox, that number is less than 30%.

Lewis: I think the idea of Dropbox really comes down to grassroots. Everything about them is developmentally grassroots, that's the mission. You think about the freemium model getting people using it, that's part of it. But then, they also have this next phase vision for monetization where you get people in the start-up world, or people that are running their own businesses, using Dropbox for business purposes and then slowly growing their business, needing more storage, needing more support as they add people to it. And they move up the service tiers and wind up paying more. That's really the broader vision for this company.

Niu: They mentioned in their filing that, a lot of times that happens is, you have these individuals who are using Dropbox, either for personal use or for work. In some cases, those are paying users. Then, what they'll do is, if they work at a bigger company, they'll basically pitch at their company. So, they have this bottom-up approach of user acquisition because they have this really large, loyal base of users that really like the service.

Lewis: The company is really, as you might imagine, in creating buzz for their business, and hopefully creating a big market for their stocks, championing this approach and talking about the opportunity that's still in front of them. They say that, of the 500 million registered users they currently have, 300 million of them currently have some characteristic that makes them similar to current paying users. Some of those are device and geography-specific. One of the ones they point to, though, is having signed up using a business email. That's not the entire group, but that's a leading indicator for them, to say, someone at an office is using this. They might be able to evangelize and get other people on it, and it might become the enterprise solution for their office.

Niu: Exactly.

Lewis: Another core metric I think is worth keeping in mind if you're looking at this business is ARPU. This is something that we are familiar with with a lot of the social-media businesses. It's an important one here as we talk about this large base that they're looking at. The ARPU is specific to paying users. It does not look at that 500 million number we were talking about before. It's currently around $111.91. That's actually down from where it was in 2015, around $113.51. The company blames some currency fluctuations for that. It's improved since 2016, but it hasn't really moved up meaningfully. The growth there isn't that great.

Niu: Right, and I also wouldn't expect it to be going forward, either. Cloud storage in general as a market has been undergoing this ongoing price for for literally years. The past two or three years, there's been consistent cuts across the board. That boils down to a little less than $10 per paying user per month, on average. That's a pretty solid revenue base.

Lewis: The best way for them to get that going, and in the right direction, is to get people on those higher-priced enterprise plans, which, they can only get so many folks doing that. It's going to be a challenge. 

One last number I think it's worth mentioning is specific to this business. It's their annualized net revenue retention rate. This figure is basically a comps number that looks at the dollar-value captured from a cohort of customers from one year ago to the next year. You'll see this with a lot of subscription businesses. Actually, Twilio has something similar. The blended average across their individual and business accounts for the metric was 90% as of Dec. 31, 2017. So, if you want to think about this a different way, if the company didn't add any new paying customers over the course of the year, they would have posted 90% of the revenue that they did a year prior. It's kind of a wonky number, but if gives you a sense if what's going on with customer retention, churn, and their ability to move people to higher priced products.

Niu: And that's a strong number, 90%. I think it goes to show how loyal these users are. Dropbox's user base is pretty fanatical about it. They have a really strong brand among individual users.

Lewis: And actually, what's incredible is, that's a blended number I talked about. That's individuals and business. If you go specifically to the Dropbox business segment, that figure was 100%, which is amazing.

Niu: Yeah, that's unheard of.

Lewis: Looking at how all of these things work their way into the company financials, in 2017, the company posted $1.1 billion in revenue, which was good for 31% year-over-year growth, down a little bit from the 39% growth the company posted in 2016. But the top line is moving along there. I think looking at all the numbers on their income statement, the thing that is most encouraging to me is the huge expansion that they're seeing in their gross margins. Evan, we saw them go from 33% in 2015 to 67% in 2017.

Niu: And the real driver of that is Dropbox pursuing their own infrastructure. In the early days, Dropbox, like many other internet companies, relied heavily on Amazon Web Services to do all the back-end cloud infrastructure and hosting. But starting in about 2013, Dropbox got to this scale at which point they were like, it makes financial sense for us to do this ourselves. So, they kicked off this infrastructure optimization project back then, this was, again, 2013. It took them about 2.5 years to complete. Basically, they're built up their own infrastructure, it's all custom built, and they migrated all of that information data from AWS onto their own infrastructure. And that took many years, hundreds of millions of dollars of capital expenditures. It's a huge initiative, but ultimately it pays off. 

They completed the transition at the end of 2016, and what you see is, immediately, capital expenditures fall off a cliff because they were spending very heavily to build their infrastructure. Once it's mostly done, you don't have to spend that money anymore. Then your margins start to really grow as you're scaling, as you're leveraging the economies of scale here. So, that's a huge part of it. They still use AWS to a smaller degree, but at this point, about 90% of all user data is held on their own servers and infrastructure.

Lewis: Looking at the bottom line now, Dropbox lost $115 million in 2017, though losses are narrowing there. In 2015, losses were over $300 million. I see this as a business that's not profitable now, but given the gross margin expansion and the infrastructure strategy they've chosen, I could see them being profitable in the near-term future. I don't think this is a company that's going to be losing money forever.

Niu: They definitely have the potential, particularly because that infrastructure piece is huge -- it's hard to overstate how important that is financially for a company like this. They're doing all the right moves on the cost side. I definitely think, as they continue to scale, there's some definite light at the end of the tunnel.

Lewis: All right, we're going to talk through some listener questions and weigh in on what we think of Dropbox's business over on the back half of the show. Evan, we mentioned we were going to be talking about Dropbox today on Twitter. We put it out on our @MFIndustryFocus handle. We asked listeners to hit us with any topics that they'd like to have discussed on the show. We have a few questions here. Michael asked, "Can you talk about the tech IPO trend of non-voting shares and 'may never be profitable?' Seems like Snap started it, and Dropbox and Spotify are running at it like me after an ice cream truck." Do you want to start that one off?

Niu: I would say that the broader trend about tech IPOs not giving public investors a whole lot of vote or say in the business really started back 15 or 20 years ago with Google. Google is probably the best example, poster boy of doing this where they gave their insiders a huge amount of control, and public investors really didn't get much vote. 

And that trend has unfortunately been accelerating over the past 15 to 20 years. It's now commonplace, it's more like the rule than the exception these days, which is a bad thing in terms of corporate governance, but what can you do. Snap was really unique in the sense that they gave public investors zero votes, which is just adding insult to injury. Whereas most companies, it's very common these days for insiders to have these super voting shares to where they can still maintain majority voting control. While public investors do technically get a say and a vote, they shouldn't have any illusions that they have majority voting. It's kind of a technicality. 

And just to clarify for Dropbox, Dropbox's public investors will get one vote per share. The Class B shares that insiders hold have 10 votes per share. So, same thing there, they're going to have consolidated voting power. But, public investors will get one vote.

Lewis: And there are some non-voting shares that will be in the mix for Dropbox. There are going to be some Class Cs pending authorization, or maybe they have been authorized already.

Niu: Right. The Class C shares, they're basically creating the share class. There are no Class C outstanding shares, and there won't be any after the offering. Dropbox says they're basically reserving this class for future issuance to give to employees for stock compensation, potentially maybe like currency in acquisitions if they want to do that. But, as of right now, after the offering, there will not be any class shares outstanding immediately.

Lewis: And as for that language, "may never be profitable," Evan, my read on that is, that's legalese that you're going to see in a lot of filings. I've noticed that a couple of outlets have run with it a bit because Dropbox is such a big issuance, but I don't think there's anything particular to read in there specific to this company.

Niu: Right. That's pretty generic, boilerplate legalese that a lot of companies use. I wouldn't worry too much about it. Any time you look at risk factor legalese, companies kind of go overboard. You know how lawyers get with liability. [laughs] They want a tight ship so there's no legal liability. That's overly broad, in my opinion.

Lewis: OK, we have two questions that are getting at the same thing here. Casey asks, "What is Dropbox's unique selling point which differentiates it from other companies in the market? Especially Microsoft, which has fully integrated Office bundled with OneDrive? Also, where would they like to deploy money raised from the IPO?" Oren asks, "How is Dropbox going to compete with Google Docs or any other behemoth tech company?" Both of these questions are raising this very real concern of, there are a lot of players in this space that have really deep pockets. Apple's there, Google's there, that's just two. Microsoft's there. What's going to set Dropbox apart?

Niu: Honestly, I don't think there is a whole lot of differentiation, fundamentally, with cloud storage. It's a commodity. Which really kills pricing power and undermines any pure plays that rely on this as their main business. Dropbox is very easy to use, it's very intuitive. They do have that going for them. But that's also very easily copied, and that's not something that's a sustainable advantage. 

Speaking of Microsoft, from personal experience, that's actually why I stopped using Dropbox. Once I signed up for Office 365, they bundled in a terabyte of free cloud storage in addition to Office. So, for me, that killed the need to even have a free Dropbox account, because now I got way more for what I was already paying for Office 365. 

And another thing of differentiation that they look at is integrations. But I would also argue that these third-party integrations with other services and software, that's all also pretty much table stakes at this point, so I don't think that sets them apart, either.

Lewis: Listeners that have been following and listening to some of the most recent shows know that I was in India recently and went to a wedding. The bride and the groom sent out a Dropbox link asking people to upload pictures there so they could go through them and share them with everyone, but my friends were using Google Photos to share pictures among the people that were traveling on this mini trip. And I have all my stuff backed up on iCloud. So that right there is the big players in this space, in one anecdote. It's a very fractured space, and I think there's room for all of these companies to exist, but I don't know that that sets up Dropbox to thrive and really add a meaningful number of people. You look at the offering that comes from Google, they give away 15 gigs for free, 100 gigs for $2 a month. That's pretty tough to compete with, especially when you consider the suite of stuff that comes with Gmail and how robust it is.

Niu: And that's the thing. All these large tech giants can basically offer this stuff at cost. As costs come down over time, the prices come down, and they're basically offering it for more or less break even on the side just to support their primary businesses. Whereas, companies like Box or Dropbox, they're pure plays on cloud storage. And if you're a pure play, you have these giant companies cutting prices, your pricing power goes out the window. You have to cut prices in response to competition, and then depending on how you're managing your cost structure, it's really hard to squeeze out a profit. That would be one of my concerns, that these pure plays, it's going to be really hard to compete with these giant companies.

And really quick, as far as the question about what the proceeds will be used for, they mentioned general corporate purposes, which is also, again, standard boilerplate legalese. But, they did mention one specific thing that they'll use the IPO proceeds for. They're going to pay down part of a revolver that they have that they're going to tap ahead of the IPO to cover some RSU settlement costs, these restricted stock units. There's some costs associated with settling those, so they're going to borrow some money to cover these costs. They're going to use some of the IPO proceeds to pay back that money. They also haven't specified how much.

Lewis: I guess we'll just have to see. Evan, one last commenter, from someone on Twitter, Wei, hearing that we were going to be talking about an upcoming IPO, said, "Never will Dylan ever buy an IPO offering." So, I guess people are listening to the old shows, because that goes back to Never Will I Ever Week in mid-2017. I think that generally wraps things up for us. We love doing these prospectus shows. It seems like we always come to this conclusion at the end where, even if the valuation looks great when it starts trading, we want to see several quarters of good results and a sense of how management handles the scrutiny of being a publicly traded company.

Niu: Right. I never participate in IPOs directly, because they're so risky, there are so many factors, they're so volatile. I'm in the same boat. I want to see a couple quarters, I want the market to calm down a little bit. A lot of times with IPOs, there's a lot of hype, and sometimes they drive the price up and maybe it's not justifiable. I also wait a couple of quarters to let things shake out and settle down before I make any decisions.

Lewis: As we get closer to an actual IPO date for Dropbox, we will definitely follow up and do another episode, particularly once we get a good sense of what the valuation might be. Evan, anything else before I let you go?

Niu: No, I think we're good.

Lewis: All right, I just want to do a quick announcement. I'm going to be in Austin starting next Friday for South by Southwest. Going to be making that trip with Chris Hill, Dan Boyd, and a couple of other Fools. We're going to be having a listener meetup happy hour on Monday the 12th. If you live in Austin, we'd love to have you come hang out. If you email [email protected] or tweet us @MFIndustryFocus. I will be happy to get you all the details that you need. 

Of course, if you're looking for more of our stuff and you want to subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts, we would love that. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Shout out to Austin Morgan for all his work behind the glass. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!