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BOX: With Capital Productivity Improving, It's Time To Reach For Growth And Differentiation

|Includes: Box, Inc. (BOX), CSCO, PMLDY

I've long been critical of Box's (NYSE:BOX) valuation and the BOX business model - dating back to June 2015 when the equity traded at an adjusted pricing of $17.50. Today though, post-FQ1/2017 earnings and trading at $11.71 I'm not so sure that the valuation bear case OR the BOX business-model bear case aren't a bit long in the tooth. While BOX hasn't yet proven out to me, or the industry more importantly, that it isn't what I've called a "commodity" it has shown that the long talked about, long forecasted higher capital-productivity levels of the model can in fact create leverage; and that matters. It's actually a really important start to reclaiming some of the shareholder value the BOX equity has destroyed.

While nobody doubted that if BOX could 1) retain customers at a high enough rate (it has - actually, it has surpassed expectations), 2) see anything but obsolescence become as perverse as possible (obsolescence has worked its way into parts of the BOX model but it's in no way as perverse as the space once thought it would/could be) and 3) develop "over the top" technology/capacity (over the top of the actual storage and sharing infrastructure that is the base of models in the space) that BOX could "survive" (however that's defined on a person to person basis). But few thought BOX could ever achieve long-term sustainability in the face of commoditization. When I say "few" I mean few that I talked to that were actually investing their own money - not "other people's money" being thrown at a superbly overpriced IPO (this is exactly what BOX's IPO proved out to be). BOX, however, again with its much better than expectation retention prowess (BOX continues to report less than 3% customer churn - which is definitively incredible for a SAAS-like business and is paramount to the achieving of ultimate, model-sustaining, higher capital-productivity levels) has done all of the above. And that too matters.

But ironically, just as BOX reports that it has nearly matured its way to free cash flow breakeven - fighting tooth and nail against skeptics like myself the entire way - I think now is the time that BOX should be reaching for growth; that now is the time, again having proven its model to a large extent, that BOX should be reaching for market share and long-term differentiation. For while I'm no doubt impressed with the operational prove-out BOX has executed into, it still hasn't proven it's NOT a commodity (SEE: all my prior write-ups on the name) and the equity markets themselves (which are much more important to impress than any singular market participant short of Warren Buffet) aren't exactly convinced (SEE: BOX equity is down huge from IPO and in the grasp of a nasty technical downtrend that will take volume and consistency to break out of). As I've said since "Day 1", BOX can do this a number of ways but the easiest way is probably to simply spend - to buy best of breed "over the top" technology/capacity and/or to buy customers.

Again, BOX is positioned right now to justify such opportunistic spending. BOX reported significant Y/Y operating leverage, obviously reflected in the impressive free cash flow advances noted above, for lines including Sales & Marketing (20% leverage Y/Y), General & Administrative (5% leverage Y/Y), and Research & Development (4% leverage Y/Y). Additionally, BOX noted a major overhead contributor and negative capital-productivity driver, the cost of servicing BOX's army of freemium (or non-paying) users, fell 6% Y/Y (via ancillary cost of goods deflationary drivers like "cost of storage", etc.). ClearlyBOX maturation profile moving towards the right, or getting older by cohort year on average, has been huge for driving capital-productivity. Right now, I believe it's at a point of something of sustainability (assuming no major changes to the status quo - e.g. product pricing deflation, cost of storage inflation, etc.). Again, this for me is a "green light" on spending. Don't look to go free cash flow positive this early in the game, BOX. Run the business at breakeven or at a slight negative and spend into any capital-productivity upticks. (BOX has plenty of liquidity with $211 million in C&CE on hand and with de minimis CAPEX expectations and direct model spend expected into the mid-term). Because right now (and forever and ever) the economics of the model matter less than the ability to not be commoditized by larger and/or more immature market entrants (this ranges from enterprises as big as Apple, Google, and Microsoft to enterprises as small as startup entrants).

One name in the space, to give a particular example and to evidence that the "spend" heavy strategy is realistic and can be synergistic, that BOX might consider is ASX listed Covata (ASX: CVT) (OTCPK: OTCPK:PMLDY). Covata has been hot as of late with international-market wins at Cisco (NASDAQ:CSCO), Barmer GEK (one of Germany's largest public health insurers), and with granted acceptance by the UK Government to its hard to access (as an enterprise) "G-Cloud" (this is the equivalent to BOX's big Department of Justice win). Covata is also an active partner of TPG Telecom (ASX: TPM) and Colt Technology Services (LSE: COLT), again two big, early wins for this $118 million (Aussie-dollar) market cap international player. Equally important to a potential bidder like BOX, Covata just executed a $13.2 million Aussie-dollar all-equity, private placement fundraise (200% it's at the time on balance sheet cash count) in which 1) it's two largest shareholders (Fidelity International and TPG Telecom) both participated (increasing respective stakes in Covata from 7.44% to 9.91% and 13.49% to 14.49%) and 2) in which Covata took buys from five new U.S. institutional funds with technology and data security investment expertise. The point is, cheaply BOX could add the following by way of taking on a fast growing, healthy junior player in the space:

  • Major international clients: BOX is clearly making "international" a priority and it's finally ready to do so with international "reseller" partners in place (SEE: Microsoft (NASDAQ:MSFT) and IBM (NYSE:IBM)) via partnerships and with its newly launched Box Zones product. Acquiring an international player like Covata with access to nearly impossible to access segments of business wouldn't just be smart - it would be a value-add to the overall model.
  • Larger customers by seat count: One glaringly negative portion of BOX's recent period reported was the noticeable downtick in large accounts (BOX closed 17 deals over $100,000 versus 20 a year ago). BOX wrote this off as a simple shifting of its pipeline but the fact is the market didn't respond well to this (fair or not). While buying Covata's enterprise accounts wouldn't entirely justify the hundreds of millions of dollars (using the Aussie-dollar in call out) it would be a positive. Especially considering the premium the market is currently putting on these large accounts and especially considering the next bullet point.
  • Additional domestic, international, and large customers to leverage for cross-sell/uplift opportunity: A major, major focus for BOX going forward as well as a key focus of the FQ1/2017 investor call was this idea that, with a range of driving factors behind it, BOX should see ample cross-sell (or "uplift" as the company calls it) from its existing book of customers in the mid-term. Led by its additional over the top capacity from Box Zones, expanded facilitation of Box-synergistic workflow via the newest evolution of Microsoft's Office 365, and IBM's early but overwhelming partnership support BOX has seen a significant uplift creation. BOX even made a point to note that its larger "shared customers" with IBM and AT&T, or its "partner created" uplift, was a huge driver to the quarter reported financials and should be on a go-forward basis. BOX does "big" well and now it can do it well from a saturation standpoint - this means greater and greater leverage. Again, Covata is a small enterprise but its reach and its customer base is unusually top-heavy. I think BOX could do well to "buy" this book and to optimize it by going over the top with its services/capacity.

All told I was impressed with BOX's operations and its operational progress reported. Does BOX still, in my opinion, have existential concerns? Yes - absolutely yes. Has BOX proven out that it won't ultimately be commoditized? No - absolutely note. But BOX did well to put the "capital-productivity" bear to bed and that's more than just a moral victory; that's half the bear case. While the market still wants more, so do I, I think there are levers for BOX to pull now that it's right at free cash flow breakeven that can help negate the final bear thesis (and the most important one) on the board. We'll just have to wait to see if BOX pulls these levers.

Good luck everybody.