Dropbox (NASDAQ:DBX) is a free cash flow powerhouse. I wrote about Dropbox stock last month and the effect that its steady free cash flow (FCF) would have as a catalyst for the stock price.
However, the stock is down $1 per share, or 5% since that article was written.
Now, on Nov. 5, Dropbox came through as promised. The company reported its Q3 earnings and it produced fantastic profits and FCF growth.
I believe that this provides an unusual opportunity for deep value investors to take a meaningful stake in this FCF powerhouse company.
Fantastic Finances at Dropbox
For example, the company not only expanded its gross margins from 76.7% to 80% over last year (non-GAAP), but its net income went turned positive. This past quarter, on a non-GAAP basis, it made $110 million in net income on revenue of $487 million. That represents a very high margin of 22.6%.
However, its FCF of $187 million for the quarter was even higher than the net income of $110 million. That implies it “converted” more than 170% of net income into usable FCF.
Moreover, the FCF margin is now an astounding 38.4%. That means that out of the quarterly revenue of $487 million, $187 million of it, or 38.4% becomes freely usable cash. It can be used for things like debt reduction, dividends, buybacks, or cash accumulation.
And that is exactly what the company did. It paid down $21.5 million on principal amounts of finance leases. In addition, and very importantly, it used FCF to buy back $37.5 million of its shares.
I have written many articles about the beneficial effects of stock buybacks, both on InvestorPlace and Seeking Alpha.
For example, in this article, I wrote last year I described the six main benefits with companies that do share buybacks. But remember, all of these benefits come to companies like Dropbox, that not only have FCF but also do the buybacks.
Dropbox’s Valuation
The bottom line with Dropbox stock is that it is severely undervalued. One of the favorite ways I have to determine this is to look at the FCF yield of a stock.
That ratio is seen by dividing the run-rate FCF of a company by its market capitalization. Right now Dropbox has a $7.98 billion market cap. We can see what the FCF yield is by dividing the annualized Q3 FCF by the market cap.
For example, during Q3 Dropbox made $187 million in FCF. I pointed out above that this was a high percentage of its sales. If it continues for the next four quarters (i.e., even with no growth), the annualized FCF would be $748 million.
Therefore, if we divide $748 million by $7.98 billion, the FCF yield is 9.5%. Moreover, let’s assume that the company has a minimum of 5% growth in FCF over the next year. That means it would reach $785.4 million over the next year. This implies the FCF yield is 9.8%.
This is extremely high for a tech stock. The typical type of FCF yield for fast-growing companies is more like 3 to 4%. But let’s assume that even over the next year the FCF yield falls to 6%.
That implies that the market cap should be $13 billion (i.e., $785.4 billion divided by 6%). This represents a potential gain of 64%. That also means that Dropbox stock is worth at least $38 per share.
What To Do With Dropbox Stock
Other analysts tend to agree with me. The TipRanks.com site reports that five analysts have an average price target of $28.50 for Dropbox stock. That represents a potential 49% rise in the stock.
Similarly, Marketbeat reports that 11 Wall Street analysts have a consensus target of $28.22, or 48.4% higher than today’s price. In addition Yahoo! Finance reports that 10 analysts have an average target of $27.80.
Therefore, the market should soon realize how extremely profitable Dropbox now is and how much FCF it produces. Expect to see Dropbox stock rise significantly from here.
On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Mark Hake runs the Total Yield Value Guide which you can review here.
