The Dropbox IPO on March 23 was big news, as the market welcomed the newcomer with a 35% surge on its first day of trading. The stock has been hovering around $30 ever since then, almost double the initial IPO range of $16-18, making it one of the most valuable publicly-traded enterprise SaaS companies. With the company’s first earnings call coming this afternoon, we decided to take a closer look.
While the IPO was a success, there remains some skepticism about the valuation, especially when compared to Box, Dropbox’s closest peer. Both companies operate in the field of cloud storage and file hosting. It’s no coincidence that they even share similar names.
Let’s take a look first at valuation metrics. For enterprise SaaS companies that are still rapidly growing, traditional valuation ratios like PE and EV/EBITDA are not as relevant, so we looked at Enterprise Value to Sales multiples, along with key operating metrics across a broad range of enterprise SaaS companies, using Sentieo’s Comparable Analysis feature:
Dropbox’s EV/Sales multiple comes in at around 9.6x 2018 forecasted revenue. Box, meanwhile, operates at 5.8x revenue multiple, well below the 9.6x median for its peers. This valuation gap could be justified if Dropbox is growing faster or has a higher margin business. FY 2018 growth for Dropbox is forecasted at 20.5% vs. 27% for Box and Dropbox earns gross margins of 71.2% versus 73.3% for Box. However, Dropbox enjoys much higher operating margins with a 21.4% adjusted EBITDA margin compared to -3.2% for Box.
By digging deeper into the operating margins, we find that the difference between the two companies seems to come down to the approaches of their growth strategies. Dropbox has grown primarily through a highly efficient marketing function and self-serve model, while Box has grown through a traditional, and more expensive, enterprise sales model.
This leads us to a key metric used in the SaaS industry: the magic number. The magic number is a ratio used to measure how efficiently a company grows its annualized recurring revenue relative to sales and marketing expenses. Here is the formula:
We can quickly find the numbers we need to calculate Dropbox’s magic number using Sentieo’s Document Search, and then export the table to Excel.
Here is the result:
As a rule of thumb, a SaaS magic number above 1 is good, and a number below .75 is concerning. Using the same process as we did for Dropbox above, we found that Box had a magic number of 0.38 in the most recent quarter, and 0.31 is the prior two quarters. This clues us in to why Box has such an abysmally low multiple for a SaaS company. But it doesn’t explain why Dropbox is priced at a premium to SaaS peers despite lower than average growth and margins.
We believe the secret lies in the Atlassian story. We first wrote about Atlassian right after the IPO two years ago in: No “High” in $TEAM: Why Atlassian Will 10X Or Get Acquired. Since then, the stock has been on a tear, almost doubling with quarter after quarter of revenue beats. Atlassian’s success has earned it by far the highest revenue multiple in its peer group at 16.9x 2018 sales. We believe this is primarily due to its efficient, self-serve, marketing-driven growth model and ability to upsell existing customers a broad suite of offerings. Atlassian had a magic number of 1.68 in the most recent fiscal quarter.
Dropbox’s IPO marketing materials make it clear that they want to be seen as the Atlassian of cloud storage, with many discussions of the benefits of the self-serve model, 500 million users, and individual accounts being upsold into enterprises.
Why Dropbox Is Overvalued vs. Box
This story hides some major issues with Dropbox. Their strategy for years has been to go after the consumer cloud storage market, which never made sense, as that market is highly competitive and has limited revenue potential. Box decided long ago to pivot to the enterprise, while Dropbox went through numerous failed acquisitions and internal initiatives, attempting to build products in everything from email to payments. They built a strong consumer brand in the process but ultimately decided to double down on enterprise. We think it’s too late.
The cloud storage and file hosting industry, including all the related services, doesn’t seem to be protected by a particularly wide moat. All of the major technology names are active in this field as well, including Amazon, Google, Microsoft, and Apple. All of these companies have the added advantage of pre-existing customer relationships. The main advantage Dropbox would need is the ability to provide differentiated services to enterprises. However, we haven’t seen evidence of Dropbox’s ability to effectively build differentiated enterprise products. As they are forced to expand their market, we believe they will face stiff competition that will make it more difficult to grow. On the other hand, the 500 million users may be the key to unlocking growth within enterprises that enterprise sales teams couldn’t effectively crack.
Meanwhile, Box’s stock has been on a tear over the past few weeks, especially after famous tech investor Chamath Palihapitiya gave a bullish presentation on the company at the Sohn Investment conference and the company has raised guidance.
We’ll be watching the language closely as Dropbox reports earnings today. The street seems to be expecting the company to beat estimates and raise guidance, leading to an increase in the stock as insiders come up on their lockout period. We don’t necessarily expect the company to disappoint in its first earnings call, but we’re bearish on the long-term outlook for the company.