Since its inception, the total average annual return of the S&P 500 index has been just north of 10% (with dividends reinvested). And seeing as only a small percentage of professional investors are able to outperform the index over extended time periods, I think it's fair to say that double-digit returns don't come easy.
To consider any investment a "safe" double-digit return, I think it needs to possess three primary characteristics: a durable business model, consistent growth, and a significant margin of safety. Dropbox (DBX 0.82%) appears to have all three.
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Dropbox has a durable business
Dropbox is a leading provider of content collaboration and workflow software for both individuals and teams. And although file-sharing platforms are often thought of as a commodity thanks to the plethora of alternatives like Alphabet's Google Drive, Microsoft's OneDrive, or even Box, Dropbox has proved to be a sticky product.
As of its latest quarterly report, Dropbox was home to more than 600,000 paid teams on its platform. And with Dropbox, each of those teams can navigate each layer of the document workflow process all within a single platform. So whether a user wants to draft or edit a document, search for files within cluttered digital spaces, securely share, or even add a signature, Dropbox has the tools needed to span the entire lifecycle of any file type.
Not only would it be a pain to port over all of the work from one platform to another, but forcing an entire team to get acclimated to a new system can be laborious and time-consuming. For anyone still not convinced of the difficulty for deeply integrated teams to switch away from Dropbox, the results speak for themselves. Despite increasing prices by roughly 4% over the last 12 months, Dropbox's management team stated that it has seen churn improve each quarter throughout 2021.
Dropbox has seen steady growth
One common misconception among many investors is that Dropbox is a dying business. Likely due to the compelling bundles and discounts from Dropbox's competitors, investors seem to believe that Dropbox's customer base will dwindle away. But there are no numbers that seem to point to that.
In fact, over the last five years, Dropbox's total paying user count has increased by more than 11% annually. Coupling this with its steady price increases, Dropbox has compounded its total revenue by about 17% annually since the same period five years ago.
Additionally, Dropbox has undergone several cost-cutting measures, including reductions to its workforce, adoption of fully remote work, and the rollout of several hardware efficiencies. Taken together, these measures have helped drive greater profitability. Since Q4 2017, Dropbox's non-generally accepted accounting principles (GAAP) gross margin has increased from 71% to 81%, while its free cash flow margin has jumped from 19% to about 29%.
Dropbox has a margin of safety
In 2021, Dropbox generated $708 million in free cash flow and ended the year with just over $1.7 billion in cash and equivalents on its balance sheet. Comparing that to its current market cap of $8.7 billion, the stock trades at a price-to-free cash flow ratio of roughly 12 times.
With this seemingly attractive valuation, Dropbox's board of directors has authorized an aggressive share-repurchase program totaling about $1.5 billion. This means that if Dropbox completely stopped growing from here, and its market cap stayed exactly where it is, the company could reduce its total shares outstanding by 18% before including any future stock-based compensation. Said another way, if Dropbox doesn't increase its free cash flow at all, it could still increase its free cash flow on a per-share basis by 22%.
But as we already discussed, Dropbox isn't flatlining; it's growing. And management believes that by 2024, the company can generate $1 billion annually in free cash flow. Assuming Dropbox hits that target and exhausts the entirety of its buyback program, free cash flow per share would likely increase by at least 70% compared to its 2021 figure, or about 20% annually -- well within the double-digit target I'm looking for.
So for investors looking for a safe and durable place to put some cash, consider adding Dropbox to your portfolio.
