The Dropbox (DBX) IPO is well-trod ground at this point. The deal is expected to price on 3/22 and open for trading Friday, 3/23. The company raised the range to $18-20 so we are using the $19 mid-point in our analysis.

To add to the general pomp and circumstance, Salesforce (CRM), stepped up to buy $100M of the deal at the IPO price. Here are some of the key points that appeal to investors:

  1. Revenue growth of 31% to $1.1B and gross margins have doubled from 32% in 2015 to 66% in 2017.
  2. Although not profitable DBX generated $300M in cash flow last year which is up more than 2x from the year before.
  3. Dropbox has a “sticky” mostly recurring revenue base which has some built-in growth from converting “freemium” clients to paid plans.

Putting the basics together in our first cut analysis suggests a $27 potential IV for the shares post IPO. After what we saw with Zscaler (ZS) last week maybe DBX shares will get there.

Challenges

Yet there are some reasons to be uncertain of their future success. They have done a great job of using a “bottom-up” strategy to capture the consumer and SMB market for a cloud-based file system that handles backup, synchronization, and sharing of files.

But going forward the growth of Dropbox will depend on being able to make some big changes:

  1. Shift technology platform from files to teams.
  2. Move the business model from consumer to enterprise.
  3. Move development focus from objects to workflow.

None of these are trivial and they are likely to impact the financial model as well. For example, much has been made of their low relative cost of sales. That will change as the company goes after larger customers.

As they move into teams and workflow their position relative to their partners and competitors will change along with it. Sure Salesforce (CRM) is a partner and is making an investment on the IPO. That’s good news.

But other companies like Slack, Microsoft, Google and Atlassian (TEAM) that view Dropbox as a partner today might not see things the same way if Dropbox strategy is based on launching products that compete directly with these companies.

As a small business, we love Dropbox. We use it to manage all our files internally (although we use Amazon AWS for our client-facing content.) Paper even seems like a great new lightweight collaboration tool.

But now Dropbox is entering the big leagues where things will be tougher – growth will come at higher costs, partners could turn on them and investors may become worried about the growth strategy, competition and the material dilution coming as “excluded shares” come into the market over the longer term.

Looking at Valuation Scenarios

We’ve played around with our IV model and looked at a few scenarios.

No matter how you look at the deal looks good at the IPO price. The question is how to handle the aftermarket. Again look at ZS, you could have chased it at $33 on the first day of trading. But ZS has an IV of $30 it seems better to wait.

Here’s the basic IV, there’s definitely upside based on this model. But below we show the same model including the “excluded shares.”

There’s always been a big debate in the investment world on how to handle “stock-based compensation.” Nobody smart things it should be ignored or excluded. It doesn’t typically demand special attention but in the case of DBX the numbers are fairly large.

If you account for all the incremental shares the IV shrinks from $27.25 to $19.47.

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