Dropbox Hasn't Built a Moat

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With Dropbox set to start trading, I'm here with Billy Fitzsimmons, he's an equity analyst at Morningstar. He'll be covering Dropbox for us.

Billy, thanks for joining me.

Fitzsimmons: Happy to be here.

Glaser: Let's talk a little bit about what Dropbox is. I think most investors are probably familiar with the service. What should we know about the company?

Fitzsimmons: Dropbox is a cloud storage and collaboration platform. If users want to share files, videos, photos with their friends, they'll use Dropbox to do that. Dropbox reports a user base of 500 million free users, and 11 million currently paying for the product.

Glaser: That's a big user base, but there's a lot of competitors in this space. How do you think about the competitive positioning of Dropbox?

Fitzsimmons: We're initiating on the company with a no-moat rating. A lot of that is because you have these wide- and narrow-moat competitors who have entered this market.

When Dropbox was founded back in 2007 it had a very innovative offering. Lately you've seen Google, Microsoft, Amazon, and Apple--those latter two to a lesser extent-- enter this market offering products. Right now Dropbox doesn't offer the most free storage, doesn't offer the most storage per paid subscription, and arguably doesn't have the best collaboration tools that go on top of that.

Glaser: What are some of the big risks then facing the company? That they're going to get squeezed by these bigger firms?

Fitzsimmons: I think there's two risks on our mind. One, they indicate in their S1 that they really want to go after the enterprise market. That we see as moaty because businesses are handling a lot more data than individual users. Right now Dropbox reports 90% of its sales are through self-serve channels, which we interpret as, it's still primarily a consumer company. If you look at its SG&A costs and how they compare to a company called Box, very similar name, and Box is primarily an enterprise storage company. Dropbox has twice as many sales, but they spend the same dollar amount on SG&A. We think those costs are going to go up as Dropbox targets big businesses and tries to integrate.

The second problem is just lack of a differentiated offering. As all these competitors have come into this market, they've commoditized the storage. That's the easy part. It's now become what can you bundle in on top of those products. For Microsoft you can pay the same amount as Dropbox and five Office 365 accounts. We see that as a challenge going ahead. We don't think Dropbox right now has the best collaboration tools to do that.

Glaser: Are there any areas where the company could surprise on the upside?

Fitzsimmons: I think it really comes down to executing on the enterprise front. If they show that they can integrate themselves with large businesses who will continue using the product, we think that could create some switching costs down the line and really help them financially.

Glaser: Pulling it together, where'd we come out with valuation? How much do you think the shares are worth?

Fitzsimmons: We launched at a $14 per share fair value estimate. That is materially below the current IPO range of $18 to $20. We could see shares popping on day one, but we think long-term, we look at the long-term time horizon, and we think there's going to be margin pressure, increasing SG&A costs, and competition from these wide-and narrow-moat competitors that are really going to weigh on the firm over the ensuing years.

Glaser: Billy, thanks for joining me today.

Fitzsimmons: Thanks, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.