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Dropbox's prospectus offers encouragement to a weary IPO market

By Kevin Kelleher , written on February 26, 2018

From The IPOs Desk

Dropbox's prospectus offers encouragement to a weary IPO market

Dropbox is not only the largest IPO since Snap, it's the company likely to have the biggest influence on this year's IPO market.

Despite the abrupt market correction two weeks ago, there's reason to expect that the public market the IPO will launch into will be more welcoming to a well-known tech company. New corporate tax cuts will leave companies with more capital for stock buybacks, while money exiting the bond market is looking for a safer place to invest.

Also encouraging is that a few recent brand-name tech IPOs have been holding up above their offering prices. StitchFix is trading 31% higher than its offering price, while Roku has nearly tripled. Both stocks have been volatile in their early months of trading but overall are performing stronger than some preceding IPOs. Even Snap is (just barely) above its offering price, having rebounded following a surprisingly strong earnings report last month.

A few months ago, Dropbox filed confidentially to go public, a move that left its financials enshrouded in mystery. The common fear surrounding confidential filings is that the motive is to conceal warts while underwriters court institutional investors. And so Dropbox's imminent IPO faced more questions than answers. What was the company's valuation? How effective were its efforts to cut costs? Dropbox had maintained it was profitable (before interest, depreciation and amortization), but how much was it really losing on the bottom line?

Now that the company's prospectus has been filed, Dropbox's outlook is clearer -- and the hidden parts are nowhere near as bad as some thought. The warts are the same ones common to unicorn IPOs. There is a net loss, natch. There is the competition against Amazon, Google, and other well-funded giants, a reality in tech these days. And there is the question of how to spend more to maintain growth.

These issues are important considerations that could make or break Dropbox's long-term success. Amidst all those concerns, however, Dropbox has also made a strong case for success. It has nothing to do with the talk of cupcakes and roving ice-cream carts (these cute details have become rote in tech prospectuses, subversive in intent but always hamfisted in execution).

Like everyone from Microsoft to Slack, Dropbox is capitalizing on the rise of workers collaborating in the cloud, drawing on its roots as an online-storage platform. Dropbox is zeroing in on a key weakness in cloud collaboration – the fractured nature of it all. Access is fractured as workers move from mobile to desktop to tablet. Teams are fractured into offices, remote workers and outside freelancers. Projects shuffle between companies, clients and outside partners.

“The combination of scattered content, fragmented tools, and fluid team structures has led to decreased workplace productivity,” Dropbox says in its prospectus, citing a McKinsey report that estimated that workers waste “60% of their time at work on tedious tasks such as searching for content, reviewing email, and re-sharing context to keep team members in the loop—what we call 'work about work.' This means they spend just 40% of their time doing the jobs they were hired to do.”

That figure seems like a stretch, but Dropbox has designed its interface and its infrastructure to remove as much of this tedious friction as it can. Dropbox is built to work openly with products from Slack, Google, Amazon, Autodesk, and others. The company has also backed away from relying on Amazon Web Services, designing instead its own infrastructure.

That latter move is helping Dropbox save money in two ways. First, it reduced operating costs by $75 million during the past two years (and offered a compelling argument of why larger cloud services might want to wean themselves off AWS).

Second, the company claims, it offered frictionless, seamless access to scattered content that, when shared with others, became free, viral, word-of-mouth marketing that brought in new users at little cost. More than 90% of Dropbox revenue comes from users who purchased a subscription through Dropbox's app or website, rather than via outside marketing.

“As users share content and collaborate on our platform, they introduce and invite new users, driving viral growth,” Dropbox said in its prospectus. Sales and marketing costs fell to 28% of revenue last year from 32% in 2015. That has left more money for R&D, which has held steady at around a third of revenue and is the biggest area of spending: About 47% of Dropbox's 1,158 employees are in R&D.

This focus on lowering costs makes Dropbox a different IPO candidate from Snap. Dropbox is going public with a 67% gross margin, where Snap had a rare negative gross margin, thanks in part to its continued reliance on outside infrastructure from Google. Dropbox's financials also compare favorably to those of Box. Dropbox saw a $111 million loss against revenue of $1.11 billion. Box is expected this week to post a larger loss on less than half as much revenue.

Like Box, Dropbox is a small player competing against better-funded giants. Box CEO Aaron Levie recently downplayed the competition between the two companies, arguing the shift from legacy systems will benefit both for some time. Box is trading 71% higher than its 2015 offering price. That bodes well for Dropbox, as does the company's stated plans to spend proceeds on growth and possible acquisitions rather than compensating early shareholders.

The risk for Dropbox is that, despite revenue growth last year above 30% and a focus on holding down costs, the company will need to spend much more than it has to keep growth going. With 500 million registered accounts already, future growth may slow. That means expanding the paid user accounts beyond the current 11 million. Dropbox has relied on word of mouth to gain users and in-app marketing to push free users to premium accounts.

But as the prospectus warned is its risk-factors section, “Our word-of-mouth and user referral marketing model may not continue to be as successful as we anticipate, and our limited experience selling directly to large organizations through our outbound sales force may impede our future growth... Adding more sales personnel would change our cost structure and results of operations, and we may have to reduce other expenses in order to accommodate a corresponding increase in sales and marketing expenses.”

In other words, Dropbox may not reach profitability as soon as its recent financial suggest. To maintain or grow market share means spending more on marketing than it has to date, and that means higher costs with no guarantee of reviving growth rates. The worst case for Dropbox is at once unlikely and not so grim: an acquisition by a bigger player that wants Dropbox's user base if not its user-friendly platform. HP Enterprise, a close Dropbox partner, would be a likely suitor.

Right now, however, Dropbox looks like a strong IPO candidate that could revive investor appetite for other tech IPOs waiting in the pipeline. It's outlook depends on two things: The valuation of the offering (estimated at between $7 billion and $8 billion, below the $10 billion valuation of its last private round). And how it manages its marketing spending to leverage future growth. All in all, Dropbox's risks are not unusual for a tech IPO. In fact, they are risks that other companies may wish they could have when they go public.