The Dropbox IPO: A hard thud or soft landing?

By Rohit Kulkarni, SharesPost

With an estimated $750 million offering, Dropbox’s IPO might be the largest in 2018 so far. As we have written in our previous analyses, we continue to believe that Dropbox could become a leading cloud storage and enterprise software company. Dropbox is the only unicorn to generate free cash flow. It also enjoys double-digit EBITDA profitability while generating $1 billion in annual revenues.

A strong IPO later this week would no doubt cheer Dropbox employees in the San Francisco Bay Area and early investors Y Combinator, Sequoia Capital and Accel Partners.

So why is Dropbox facing a down round IPO?

1. Dropbox competes with lots of large companies, including Amazon, Google and Microsoft. So Dropbox might not be able to distinguish its products from the pack.

2. Dropbox is late to the enterprise market. The company still generates most of its revenue from individual subscription plans.

3. Dropbox’s financials contain some unpleasant surprises. Revenue growth has been slowing: Year over year growth decelerated from 34 percent in first quarter last year to 28 percent in the fourth quarter. Dropbox also did not disclose a whole lot of information about its enterprise customers and revenues.

4. The market values of other storage software firms have not fared well. Almost three years after its IPO, Box shares still trade below the closing price of its first day as a public company. Tintri conducted a 50 percent down-round IPO. Pure Storage stock only recently rose above its IPO price. Hewlett Packard Enterprise acquired both SimpliVity and Nimble Storage at prices roughly 40 percent less than their peak valuations.

While these companies may not be completely similar to Dropbox, investors should remain skeptical about the long-term prospects of a pure-play online storage company versus a diversified tech giant, such as Google or IBM.

Despite such a negative backdrop, why invest in Dropbox now?

1. A down-round IPO doesn’t necessarily spell doom for VC-backed tech firms. In fact, some down-round IPOs have traded well so far. Square, Box, New Relic and Apptio all went public below their private valuations, but are now trading above their IPO prices. Apigee also suffered a down-round IPO, but Google eventually bought the company at a solid premium. According to our data on the past 21 IPOs, we estimate down-round IPOs have traded about 28 percent higher during the 90 days following their IPOs. A relatively efficient public market at correcting valuations is a good thing for investors in the long run.

Post IPOs valuations compared with previous private funding rounds. (Assuming Dropbox IPO price of $18) Source: SharesPost Research
Post-IPOs valuations compared with previous private funding rounds. (Assuming Dropbox IPO price of $18 a share). Source: SharesPost Research.

2. Surprisingly, Dropbox has managed to convince users to pay a healthy fee of $9 per month and more. Furthermore, the company’s gross profit margins have consistently increased and are approaching levels similar to that of software-as-a-service firms. Finally, overall company profitability has far exceeded our expectations: EBITDA margins are above 20 percent, and free cash flow margins are above 30 percent.

3. Dropbox remains an attractive acquisition candidate, with a strong track record of forging industry partnerships. The company is pursuing a large, addressable market. However, for Dropbox to succeed over the long term, the firm needs a large platform to back it.

Rohit Kulkarni is a managing director and head of research at SharesPost.

Photo illustration of DropBox logo. Reuters/Thomas White.