Few investors came out of 2022 unscathed by the bear market. Technology stocks are down almost 30% this year, the S&P 500 is down over 15%, and many individual stocks are down over 80% from recent highs. This is especially true for software stocks, which went through a huge bull market run in 2021. Now, in 2022, valuations contracted considerably, with the majority of popular software stocks down over 50% since the start of the year.
But not every stock is trading down 50% or more. Oft-forgotten software company Dropbox (DBX -2.44%) is trading only down 6.5% in 2022, beating the returns of almost every software stock as well as the broad market over that time period.
Will this stock outperformance continue in 2023? Let’s investigate.
Why Dropbox beat the market in 2022
Dropbox was one of the most talked-about start-ups 10 years ago. With hundreds of millions of free users, the cloud storage company revolutionized how individuals share, send, and store files on the internet, spurring huge competition from technology giants like apples, Alphabetsand Microsoft. But since going public in 2018, many investors forgot about the company and instead focused on hypergrowth software. Frankly, it is likely that people were just not that excited about a business that helps individuals and small businesses manage their digital files in the cloud.
So why did this sleepy file storage and workplace management software stock hold up so well while the rest of the industry sank? A few reasons. First, the company put up consistent growth throughout 2022 amid a looming recession. Revenue grew 9.9% year over year in the first quarter, 7.9% year over year in the second quarter, and 7.4% year over year in the third quarter despite fears of a recessionary period that could impact small businesses, Dropbox’s core customer base. This indicates that Dropbox’s software might be recession-proof as its customers need its tools to organize their digital lives.
Second, Dropbox — unlike the majority of high-flying software stocks — was able to grow while also generating a profit. Over the last 12 months, Dropbox generated $736 million in free cash flow (FCF), a number that steadily rose over the past few years. This connects to my last reason why Dropbox has held up so well in 2022, and that is its cheap valuation. At the start of 2022, Dropbox’s price-to-free-cash-flow (P/FCF) was around 13, which was well below the market average at the time. This discounted valuation, combined with a growing top line, is a recipe for success and is why Dropbox’s stock is only down 6% this year.
What’s in store for 2023?
It would have been smart to hold Dropbox shares through 2022. But what about investors looking at shares today?
I think it will be more of the same for Dropbox in 2022, meaning steady growth of both revenue and free cash flow. The company has consistently grown its customer base, going from 16.5 million a year ago to 17.55 million in the third quarter of this year. Management just implemented a price increase on its standard subscription plan that went into effect in July of this year. As customers renew their Dropbox subscriptions over the coming quarters, these price increases will help revenue continue to grow. Investors should watch closely if these prices hike impact customer churn, but so far, that hasn’t been the case.
In 2024, Dropbox is expecting to generate $1 billion in free cash flow. At a current market cap of just $8.25 billion, that would give the stock a P/FCF below 10 if this goal was met. An earnings ratio below 10 is cheap, no matter what market environment we find ourselves in.
With all this free cash flow, Dropbox started to return cash to shareholders through share repurchases. The share count is down 13% over the last three years, and if this decline continues, it will benefit investors who hold shares of the stock over the long term by increasing growth in FCF per share. With steady growth in FCF, consistent buybacks, and a cheap valuation, Dropbox looks like an easy stock to own at these prices.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Apple, and Microsoft. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.