Dropbox: The Growth Engine Has Sputtered (Rating Downgrade) (NASDAQ:DBX) (2024)

Left and right, software companies are citing both tighter IT budgets as well as a slowdown in headcount expansion as key headwinds to growth. Companies that used to tout their ability to sustain double-digit growth are now backing down from those hopes - and those that struggled to notch impressive growth rates prior to this macro slowdown are having an even more difficult time, such as Dropbox, Inc. (NASDAQ:DBX).

The consumer file storage and sharing software company has seen its share price tumble by more than 20% year to date (while rival Box, Inc. (BOX) has seen mid-single digit gains). Confidence in Dropbox faltered even more after the company reported rather dismal Q1 results.

With Dropbox's growth trajectory so challenged, I'm dropping this stock to a sell rating

I last wrote a neutral opinion on Dropbox in February, back when the stock was still trading at closer to $25 per share. At the time, I had acknowledged the company's slowing growth but called out a cheap FCF-based valuation, even in the wake of the company's FCF guidance cut. And yet, with Q1 results now in the rearview mirror, I think Dropbox's path back to meaningful growth rates will be even more challenging, prompting my further downgrade to sell.

To me, here are the major red flags for Dropbox:

• The company is struggling to add new users at the same clip as in previous years, and growth is sputtering. In its most recent quarter, Dropbox added only 35k new users (a small fraction of a total ~18 million user base). Revenue growth has slid to the low single digits, and constant-currency growth is even lower than what the company is reporting.
• AI isn't a major tailwind for Dropbox. Though the company has released a smart-organization tool called Dropbox Dash, AI features haven't lifted the company's top line growth rates, nor is AI spend likely to be a major tailwind for Dropbox going forward.
• Dropbox is proving to be less sticky than originally thought. As churn rates have increased over the past year, many investors are re-evaluating the stickiness and value of Dropbox's subscription revenue base.
• Deep competition- Dropbox has always been in an eternal tug-of-war with competitors Google Drive (which has an advantage in pricing and integration with consumer email accounts) and Box, Inc. (BOX), which is better known for its enterprise-grade features and security.

The only "upside risk": valuation

This being said, I will still acknowledge that the only upside risk for Dropbox is valuation. Dropbox is dead cheap: at current share prices near $22, the company trades at a market cap of $7.24 billion (we note that competitor Box is at a ~$4 billion market cap, but Box's enterprise orientation, versus Dropbox catering to both enterprise and consumer, makes it smaller on a revenue basis). After we net off the $1.18 billion of cash on the company's most recent balance sheet, its resulting enterprise value is $6.06 billion.

Meanwhile, Dropbox has maintained its guidance outlook for the year, projecting $910-$950 million in FCF at a ~37% midpoint FCF margin.

This puts Dropbox's valuation at just 6.5x EV/FY25 FCF, which is an undeniable bargain. We do think, however, that Dropbox's sharp deceleration in growth rates, potential churn issues and loss of customers to competitors, and potential opex inflation from higher personnel costs may eat into the company's ability to sustain both top-line and FCF growth, which will make it difficult for the market to justify re-rating Dropbox back to a more normalized valuation multiple.

Q1 download: impressive profitability, but growth is now lagging Box

Q1 results, meanwhile, did very little to assuage investors that the company is on a positive momentum track. Take a look at the Q1 results below:

Revenue barely grew, at a 3.3% y/y pace to $631.3 million, essentially in line with Wall Street's expectations of $628.6 million. Notably, growth decelerated three points y/y versus 6.0% growth in Q4, and constant-currency growth rates were actually 10bps worse at 3.2% y/y (while most other companies are reporting a foreign exchange headwind, Dropbox's FX rates provide a tailwind for the company, which makes its "organic" growth story worse.

We note as well that revenue sequentially declined on a nominal basis by -0.6% (relative to $635.0 million in revenue in Q4), which is unusual for a software company that has a nearly pure recurring revenue basis with very little seasonality.

Another point of comparison worth noting: competitor Box grew at a 5% y/y pace in Q1, and 6% on a constant-currency basis. The implication that Dropbox is losing shares versus Box is an unfortunate reality for Dropbox.

The company is working on a number of initiatives to reinvigorate growth. In particular, it noticed that its emphasis on middle-priced SKUs was impacting top-of-the-funnel customer conversions (hence the weaker ~35k sequential customer add in Q1), so it's revisiting its go-to-market approach to try to boost conversion rates. Per CEO and founder Drew Houston's remarks on the Q1 earnings call:

Over the course of Q1, we continued our work on our go-to-market motion for our individual plans. And while our mobile channel hasn't yet fully recovered, we've seen some recent improvement in the top funnel, and we're confident we can further improve the efficiency of the mobile acquisition channel going forward. Moving on to a quick update on Bundles. As a reminder, we created bundled SKUs to offer multiproduct capabilities to new customers at a higher price point, reflecting the additional value we were adding to the plans. These SKUs include FSS as well as limited or introductory functionality across products such as Dropbox Sign, DocSend, and Replay. On our last earnings call, we noted that while we saw improved ARPU and higher multiproduct adoption rates for the introduction of these plans, we are also seeing reduced top-of-funnel demand and conversion challenges.

Based on our learnings, in late Q1, we elected to roll back the pricing of our bundled SKUs to prelaunch levels to counteract the potential price sensitivity that these plans introduced. We're currently assessing the customer response to these reduced prices, while we also work to optimize the features included with these bundles as well as the underlying product experience. We'll continue to iterate and drive towards an intuitive lineup of offerings for our customers, and we'll have more to share on our progress here in the coming quarters."

The one positive highlight for Dropbox is its monstrous operating margin. In Q1, pro forma operating margins leaped to 36.5%, up eight points from 28.4% in the year-ago quarter. We note that with 3.3% top-line growth and 36.5% pro forma operating margins, Dropbox's "Rule of 40" score of 39.8% still positions it well on the growth-profitability spectrum.

Key takeaways

Sadly, with sharply decelerating growth that is now lagging Box, plus conversion problems with new users that may take several quarters to fix (if at all), Dropbox will continue to be a challenging story, despite its bargain-basem*nt FCF valuation. I'd advise investors to continue steering clear here.

Gary Alexander