Box: Foundations Of A Moat Are Forming, Investors Should Still Be Cautious

Summary

• Box shares have seen nice growth over the last year, although laced with high volatility.
• Box's focus on large enterprises allows them to take advantage of customers with complicated IT architectures with several cloud providers.
• If Box wants to create a moat, it will need to start offering additional products to expand its value offerings to customers.
• Doing so will allow Box to take advantage of vendor lock-in, or becoming operation critical, which will allow them to begin seeing competitive advantages.
• Risk-averse investors should wait until Box has released value expanding additions before entering into a position.

Box Inc. (NYSE:BOX) has seen the large share price fluctuations that are typical of growth companies that are not profitable but also around a 15% growth in share price. Valuations for growth companies are not always easy, but valuation is not the first step. Investors need to understand the business model of the company. Is the growth sustainable? What must they do to survive? All of these questions need to be answered for Box.

There is not going to be quick and clear answers for Box. However, I hope to outline how Box has the foundations created to start building a moat and what still needs to be accomplished before risk averse investors should begin to consider valuating and entering into a position.

Customer Base

Box already has their foot-in-the-door for several large enterprises. They support over 85,000 businesses and 69% of the Fortune 500 companies. Large enterprises will be the key for Box to succeed. A study by Veritas suggests that enterprises will continue to rely on multiple cloud providers. Multiple cloud providers are a key factor for vendor-neutral solutions, such as Box. Vendors tend to offer several products that coexist with their cloud, but most of these solutions are only available once you already use their cloud infrastructure, and their add-ons only work for their vendor-specific products. This means a company may need to pay for the same product twice, through two different cloud providers. This allows vendor-neutral Box to survive and grow.

Source: Veritas (Study)

The study also found that customers rely on these cloud providers for data management. However, this should not be the case. Most cloud agreements push these responsibilities on to the consumers, which allows Box to coexist with these cloud vendors. Although the cloud vendors themselves may offer another product for this, Box provides a vendor-free solution, allowing storage to occur in one place.

Source: Veritas (Study)

Business Model

Box operates on the SaaS model, which also has a foot-in-the-door element. Box’s main product is a cloud content management service called Box Platform. From their website,

“Box Platform enables you to use Box as the content management platform for your entire business, helping content flow seamlessly across every part of your organization. With our easy-to-use APIs, you can integrate Box with other apps and systems, run scripts to manage content, users or settings in Box programmatically, and interact with content in Box as part of your custom workflows and processes.”

The highlights of Box’s business model are that they offer a vendor-neutral solution, which provides a single interface for a business to interact with all of their cloud and software service providers, as well as industry specific solutions, which allow for product differentiation but also lead to higher specialization costs.

But this is their current business model. Box’s future will depend on how they can expand their business model. With a large customer base already, Box will need to become operation critical for a customer. By offering one software solution, they leave themselves open for a large cloud provider to create their own solutions, or for another start-up to create a similar offering at a better cost. Add-ons will be the key for Box. Additional features that add value for their customers, raise the prices that Box can charge, and take steps to become operation critical to their customers. By operation critical, I mean that their customers will rely on Box’s products to the point that there will be operational disruptions if a customer were to decide to end their Box partnership, aka vendor lock-in.

Reliance on New Product Offerings

In order to become operation critical, Box will have to rely on new products that expand upon Box Platform. Some of the current offerings are listed below.

Source: Box IR (Presentation)

Box KeySafe and Box Governance are both security additions, with the former providing encryption tools, and the latter providing regulatory services. When combined with Box Zones (service to store data in certain geographical areas), which expanded due to a Microsoft (MSFT) partnership, these offerings provide customers with solutions to the General Data Privacy Regulations rules and allow customers to embrace new data privacy regulations as well. Entrusting these services to follow new regulations is an excellent first step towards becoming operation critical.

Box Relay is a solution to streamline processes, and the GxP offering is for healthcare consumers. But the product offering that investors need to follow is Box Skills.

Box Skills is Box’s offering to incorporate AI and analytics to their ecosystem. This is their first product offering that truly expands their main business of content management. Box handles a lot of data from their consumers, and the basic value proposition is that by using Box Skills, you have one analytics tool that analyzes data from all sources, rather than relying on vendor specific tools. Box Skills is still in beta and is partnered with IBM (IBM) and Microsoft to leverage their AI capabilities into one tool. Between Box Skills’ data access, and IBM’s and Microsoft’s additional analytics technology, Box Skills has a good foundation to be the first product offering that truly expands beyond content management.

It also has the benefit of not needing to beat similar solutions such as Alteryx (AYX) and Qlikview, vendor-neutral solutions, because Box Skills can be sold as an additional feature to the customer’s current Box partnership. Since data is already integrated inside Box Platform, Box Skills can analyze data as it moves through Box Platform, whereas competitors such as Alteryx would need to create a data pipeline that goes through their own applications. As long as Box Skills is as good as these competitors, Box should be able to see respectable acquisition rates. Please note that since Box Skills is not released yet, some features may be changed.

Box also sells themselves as an easy, one platform solution. As Box expands, they will also need to focus on quality products that are not only valuable to their customers but also provide simple integration with all types of data sources, along with an easy to use UI/UX component as well. Box Skills will only be the first step though. Box will need to add more features to continue their path towards becoming operation critical, which will be what they need to create a moat.

Risks

Investors should note that Box will be relying on innovations to grow, which presents several risks, such as wasted R&D spend, product offerings that don’t provide value, other companies offering innovative solutions faster etc. Although Box has mitigation plans for these, it should still be noted that investing in a company that needs to create new products to grow (and survive) carries high risk, especially when the company is not profitable yet.

Box can also see one of the major cloud providers begin to target market share of the company. Just because cloud providers have not yet made a major push to create vendor-neutral solutions does not mean this will continue. Vendors have tried to get their customers to use their platforms and their add-ons while offering limited flexibility to other vendors, but if this changes, then Box will likely lose market share.

Also, if Box cannot grow their product offerings fast enough, they will be at risk from other start-ups that can offer cloud management solutions as well. They are also at risk of similar companies, such as Dropbox (DBX), becoming direct competitors as well.

As mentioned throughout this article, Box will need to continue to add product offerings to expand their ecosystem. If they are unable to do this, they will not be able to have a moat and will likely not be able to fend off current or new competitors.

However, Box has made some interesting deals in the past. Their partnerships with Google (GOOG)(GOOGL), Microsoft, and IBM may give investors a hint that cloud providers may be deciding that the capital spent to create a solution similar to Box is too great, and they’ve decided to cooperate and partner with Box instead. Microsoft becoming a partner with Box Skills, when they have their own Power BI product is particularly telling.

Financials – Growth

As mentioned before, Box is not profitable. However, investors still have a few key metrics they should consider for high growth, negative earnings companies. The metrics that I believe are critical are revenue growth, gross margin (path to profitability), FCF positive, P/S (valuation), and churn rate. Outstanding numbers in any of these categories will not make investors bullish, but bad numbers should worry investors.

Revenue Growth (YoY)	Gross Margin	FCF Margin	P/S (TTM)	Churn Rate
20%	75%	5%	6.77	4.50%

Click to enlarge

Source: Box IR, Yahoo Finance for P/S

As you can see, Box gives us no warning signs in its financials for a company in its situation. Revenue growth remains high, which gives investors an idea of the base growth of the company with their current products, outside of the yet to be released Box Skills. Billings and deferred revenue are also growing steadily, with billings increasing by 17%, and deferred revenue is up 28%. With their current product offerings, growth numbers are representing Box’s ability to continue to establish their customer base using their Box Platform offering, which will increase the potential market for Box Skills and other future add-ons.

Financials – Path to Profitability

Gross margin is above 70%, which measures the future path to profitability for Box. However, Box is still seeing a negative GAAP operating margin of – 34%. Box’s focus is to grow revenue, and they plan on shifting to earnings growth in the next few years. It should be recognized that investing in companies that aren’t profitable on a GAAP basis is inherently risky, and investors should understand this risk before diving into their expenses and financial strategies.

With this said, Box’s financials support their goal to become operation critical to their customers. As explained above, Box’s key to success will be based on their ability to expand their value offerings and creating an ecosystem that moves beyond cloud content management. In the financials, we will either need to see large cash reserves, or large R&D spend to support this. The reason is that new products, or innovations, will require either development time (R&D) or acquisitions (cash balance). Although Box has been able to create several partnerships with mega-cap companies, they will still need to have the core development of new add-ons in place. For Box, we see their strategy will be R&D expenses.

Box will likely focus on internal innovation rather than acquisition. Box currently holds slightly above $200 million in cash and has very low, yet positive, FCF margins (5%). Box is likely choosing this strategy either because they believe it will be cheaper to develop new products in house and through partnerships, or that there are little opportunities to acquire other companies with their current resources. Regardless, we see a core reason for negative operating margin in R&D.

	Q1 2019	Q1 2018
R&D Margin	27%	29%
Sales/Marketing Margin	55%	60%

Click to enlarge

Source: Box IR, Calculated by Author

R&D margin will remain high for the next few years, but investors will be expecting new product releases to accompany these expenses. Although investors would not be able to measure R&D efficiency, they should be expecting new product announcements on a semi-regular basis in order to justify this spend. With the current rate of product offerings, I do not see R&D margin being a risk as of yet, but this can change quickly.

Sales and marketing expenses are extraordinarily high, over 50% as a percent of revenue. Investors should expect to see this number decrease over the next few quarters, as sales expenses are cheaper when adding products to a current subscription, versus getting new customers. With a customer base and business model that rely on large enterprises with multiple cloud vendors, these marketing expenses reflect the costs associated with converting large companies into customers.

Investors should expect R&D margins to remain relatively stable and sales and marketing margins to decrease YoY. Else, investors will need to hear a good reason why these costs do not align with the corporate strategy.

Financials - Valuation

With growing companies that are not profitable, valuations become tricky. Investors cannot rely on P/E or PEG ratios and are left with comparing P/S and quarterly revenue growth YoY values. Below, I will compare these multiples with other vendor-neutral companies, which include Dropbox, Alteryx, and Okta (OKTA).

Company	Market Cap	Revenue Growth YoY	P/S
Box	3.59 billion	20%	6.77
Dropbox	12.7 billion	28%	10.81
Okta	5.87 billion	60%	20.14
Alteryx	2.76 billion	50%	18.94

Click to enlarge

Source: Yahoo Finance

Box’s current P/S ratios don’t stick out as being greatly undervalued, as they reflect a good value for current revenue growth. However, Box’s future will depend on product add-ons and innovative offerings. Success from Box Skills should see revenue growth increase, along with the release of new product offerings. Because there have been very few new offerings released with Box’s platform, I expect the valuation to increase closer to a 10 P/S (similar to Dropbox), assuming a successful release of Box Skills, and the associated increase in revenue.

But there are a lot of assumptions for investors to have. As it currently stands, a 6.77 P/S does not suggest an overvalued thesis but also not currently undervalued enough to present an opportunity. However, bullish investors that expect Box to see continued success with product add-ons and the establishment of an operation critical platform, should be excited to see this valuation, as a successful implementation could increase revenue growth, along with a rise in the P/S metric as well.

Again, investors likely will not be determined to buy or sell based on Box’s financials, since there are no clear warning signs, and no signs of undervalued opportunities. The main focus on Box is outlined above, which is, what do they need to do to build a moat, and can they create product offerings that position themselves as operation critical for their customers before another company enters into their market. And this all needs to be done relatively quickly, before alternative enterprise software solutions can be created, or the company needs to switch strategies due to continued unprofitability.

Investor Takeaway

Without positive earnings, investors are left with very few metrics to value Box. This is where business model analysis comes in. For most investors, waiting to see Box achieve some success in expanding their product offerings is likely the best move. For long-term investors, waiting for the release of Box Skills, along with how it performs, could provide a sign that Box can survive in the industry. This should be seen as an investment where you wait to see the moat start to take shape, not just see the foundations. Basically, better to be late than to be wrong.

But for investors that are able to take on the extra risk, or are firm believers that this vendor neutral solution will greatly reduce IT complexity and want to bet that Box will be able to expand their offerings, I believe their current valuation allows for nice risk/reward investment and should start considering starting a position on a drop.

Disclaimer: The above references an opinion and is for information purposes only. This information is general in nature and has not taken into account your personal financial position or objectives. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. Past performance is not an indicator of future performance.

Analyst’s Disclosure: I am/we are long OKTA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.