Box: Stay On The Sidelines This Year

Summary

• Box is a leader in the highly competitive cloud content management market segment.
• Revenue growth has been in decline for several years, and with lower guidance this year, the stock price has taken a hit.
• The company fails on the Rule of 40, gross profit margin is falling, and SG&A expense is too high.
• For these reasons, I have assigned a neutral rating for this company.

Box, Inc. (NYSE:BOX) is a leader in the highly competitive cloud content management market with a platform that allows secure access, storage, and sharing of content on the cloud. BOX has more than 95,000 paying organizations, and the application is offered in 24 languages.

(Source: Box)

While Box grew revenues by 19% in the last year, there are several negative factors, including a low score for the Rule of 40, declining gross profit margin and high SG&A expense relative to sales. The declining profit margin is likely a result of increasing competition plus longer and more expensive sales cycles. I don't see the situation improving this year. For these reasons, I assign Box a neutral rating.

Box has had a rough 2019 so far. The last two quarterly reports in March and June were not received well by shareholders, with the stock price dropping 18% and 8%, respectively, amidst lowered guidance. The company hired new sales staff in 2018 with plans to hire more this year and has recently hired a new Chief Revenues Officer (CRO). Box is also introducing new functionality to the platform in an attempt to increase retention rate and cross-selling.

While the above are positive factors for the company, I don't expect to see any real results from these initiatives this year. And, given the competitiveness in cloud content management, I think it is prudent to see how the new products perform before considering an investment in Box.

Company Fundamentals

When it comes to software companies, I don't rely on traditional value factors; instead, I focus on other measures, such as the "Rule of 40" and relative valuation. Relative valuation is a concept that I recently developed that compares forward sales multiple versus estimated sales growth.

Relative Stock Valuation

It seems logical to me that high-growth companies should be valued more highly than slow-growth companies. To illustrate this point, I created a scatter plot of enterprise value (EV)/forward sales versus estimated YoY sales growth for the 75 stocks in my digital transformation stock universe.

(Source: Portfolio123/MS Excel)

The sales multiple in the vertical direction is calculated using the EV and "next year's sales estimate" mean value based on all analysts from the Portfolio123 database. The estimated YoY sales growth is calculated using "current year's sales estimate" and "next year's sales estimate" also provided by Portfolio123.

The reason for using analysts' estimates is because SaaS stocks tend to make a lot of acquisitions which can muddy the results of the scatter plot. The analyst estimates account for these acquisitions, and the estimates are updated frequently. This makes for a cleaner chart. The sales estimates, unlike EPS estimates, are usually quite accurate for most SaaS companies, except that they tend to be a little on the conservative side.

I use an exponential best-fit trend line as it appears to be more appropriate than a linear trend line for this application. As sales growth goes up, the valuation goes up exponentially. The trend line was calculated using MS Excel. I consider the stocks sitting above the trend line to be overvalued, while stocks lying under the trend line are undervalued.

As can be seen from this scatter plot, Box is positioned below the trend line, suggesting that its EV/forward sales are lower than its peers, given its estimated future revenue growth rate. My interpretation is that Box is undervalued relative to the average stock in my digital transformation universe.

The Rule Of 40

A rule of thumb often applied to software companies is the Rule of 40. This metric helps SaaS companies balance growth and profitability. There are different ways of calculating the Rule of 40; some analysts use EBITDA, and others use the free cash flow margin. I use the free cash flow margin as I believe that is the most meaningful factor from an investor perspective.

The Rule of 40 is interpreted as follows: If a company's revenue growth rate plus free cash flow margin adds up to 40% or more, then the SaaS company has balanced growth and cash flow resulting in financial health.

Revenue Growth

In 2015, Box had an annual sales growth of more than 80%. But since then, growth has fallen steadily and now sits at 19% for the most recent trailing twelve months (TTM).

(Source: Portfolio123)

Free Cash Flow Margin

Box's free cash flow margin TTM had been improving, going from negative 55% in 2016 to positive 8% now.

(Source: Portfolio123)

Rule Of 40 Applied To Box

Box's YoY revenue growth was 19%, while free cash flow margin for the trailing twelve months was 8%. Therefore:

Revenue Growth + FCF margin = 19% + 8% = 27%

Since the calculation comes out much lower than 40%, I conclude that Box is not in a good shape financially.

Another bone of contention that I have is Box's gross profit margin, which has been steadily decreasing since 2016 and now sits at 78.5%. 78% is not bad, but the steady decrease is a bit disturbing. I believe that this phenomenon is likely due to increasing competition and change of product mix towards cloud content management, which tends to be longer and be more expensive. The lower gross margin makes it more difficult for Box to get back to becoming a high growth company.

(Source: Portfolio123)

SG&A Expense

As an investor, you want to make sure that, if a company doesn't score well on the Rule of 40, it is at least not burning cash. Unfortunately, Box is, in fact, burning cash. You can tell by examining the SG&A expense relative to sales. In the case of Box, the SG&A expense is 92% of the total revenues. This figure is quite high for a company growing revenues of less than 20% per year.

Note that SG&A includes Sales & Marketing, General & Administrative, and R&D.

(Source: Portfolio123)

Given that Box doesn't meet the Rule of 40, has declining gross margin, and is burning cash, I have to give this stock a neutral rating.

Summary

Box is a leader in the highly competitive cloud content management market segment. Revenue growth has been in decline since 2015 and is now 19% form the most recent twelve months. I don't expect to see business picking up this year as new product introductions will take time to catch on, and new sales staff need to be trained before they can hit the street. Box fails on the Rule of 40, and this is made worse by very high SG&A expenses. The gross margin is falling, likely due to competition and longer sales cycles. For these reasons, I have to give Box a neutral rating. It is worthwhile checking back at the end of 2019 to see if the new applications are gaining traction.

Keep an eye out for my soon-to-be-launched Digital Transformation marketplace service!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.