- Cloud storage company Box Inc. delivered solid yet unspectacular Q3 results.
- The company's marketing expenses remain very high while its gross margins have been shrinking.
- Is there any hope for Box stock?
2015 has proven to be a low point for tech IPOs, with the ongoing bloodbath for new market entrants suggesting that the easy money in IPOs has already been made. Cloud storage company Box (NYSE:BOX), is one of the tech unicorns that have been punished in a market that has increasingly soured on tech IPOs. Box stock has seen a drop of close to 40% of its value since its late January IPO.
Box Stock Returns (Post-IPO)
Source: CNN Money
Box and the ubiquitous Dropbox sport pretty similar revenue models, the biggest difference being that Box is more focused on the enterprise segment while Dropbox is more consumer-facing. Box recently delivered pretty solid, if unspectacular, Q3 2015 earnings that met consensus estimates while revenue topped estimates. The company reported revenue of $78.7 million, good for 37.9% Y/Y growth and $1.94 million above consensus estimate. EPS of -$0.31 was in-line with estimates. The top line growth for the quarter was a pretty dramatic slowdown compared to the Q2 when growth clocked in at 45%.
Box reported that GAAP operating expenses were up 23% Y/Y to $110 million with sales and marketing expenses, the company’s biggest line-item, clocking in at $64 million, or 81% of revenue. Gross margin fell 190 basis points from the previous quarter, and 820 basis points Y/Y to 69.9% The company issued operating margin guidance of -46%, slightly better than its earlier guidance range of -47% to -49%.
Box’s billings rose 37% Y/Y to $89.4 million, better than Q3 revenue. The company finished the quarter with a paid customer base of 54k, up from 50k during the second quarter. Meanwhile registered users increased by 2 million to 41 million.
The quick takeaway from that report is that Box’s revenue is still growing at a pretty healthy clip, though it’s slowing down. Meanwhile, the company’s margins continue being under intense pressure mainly due to high levels of spending. With such high marketing expenses, is there any hope that Box will become profitable?
Ultra-high Sales and Marketing expenses
Box’s S&M expenses are very typical of a SaaS cloud company. The company spent a whopping 81% of its revenue, or 58% of operating expenses, on marketing functions. Box is a much younger company than cloud titans such as Salesforce (NYSE:CRM) and Workday (NYSE:WDAY). Yet the two companies have remained GAAP unprofitable.
Cloud companies tend to be given plenty of leeway by investors when it comes to showing a profit. Companies such as Salesforce are rarely GAAP profitable, yet have remained in investors’ good books. The cloud subscription model involves a young business first expanding its customer base as much as possible so as to guarantee itself sufficient cash flow to cover its operating expenses.
Unfortunately this model also means that cloud companies spend very heavily on marketing functions as they continue chasing after new customers and working hard to keep their existing ones happy in a bid to minimize churn. High marketing expenses place a lot of pressure on the bottom line and, consequently, most SaaS companies are not profitable.
Salesforce and Workday are more mature cloud companies than Box, yet they both spend more than 50% of their revenue on marketing expenses. In fact most SaaS companies on average spend around 50% of their revenue on marketing functions. That figure is bound to be even higher for a young cloud company. About two years ago, Box spent more than 100% of its revenue on marketing functions, which means that whereas the current reading is still high, it’s been gradually coming down, and is likely to continue doing do so as long as the top line keeps growing faster than the company’s operating expenses.
But just like is the case with your average SaaS company, investors can expect Box’s marketing costs to remain high.
Falling gross margins
The second part of Box’s profit narrative points to an inexcusable trend: falling gross margins. Box’s gross margin has fallen a jaw-dropping 820 basis points in the space of one year. So what’s going on here? In one word: competition. Box competes head-on with the likes of Microsoft (NASDAQ:MSFT) OneDrive and Alphabet Inc-C (NASDAQ:GOOG), both of which are dirt cheap. The dramatic gross margin contraction by Box is the aftermath of the cloud pricing wars that happened about a year ago.
Cloud storage for Microsoft and Google is a tiny part of their business, and they can easily afford to cut prices to keep growing their customer bases. But cloud storage is the lifeblood for a company like Box, and deep price cuts can badly harm its business.
The cloud pricing war has been on a ceasefire ever since the last round of price cuts by cloud titans about a year ago. This is probably because the market leaders have been enjoying robust growth, and therefore see little need to cut prices any more. But there is a long-term risk that the pricing war will resume once the cloud market starts slowing down.
Investors can give Box a free pass for its high marketing costs, but until it demonstrates that it can maintain healthy profit margins, Box stock is likely to remain very volatile. More mature cloud companies find it hard to turn a profit; Box with its shrinking margins might find it little more than a pipe dream.