Box CEO Aaron Levie is a genius, investors just don’t realise it

By Tien Tzuo
16 May 2014 View Comments
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When Box filed its long-awaited paperwork to become a public company, it set off discussions about the financial health of the company and the long-term viability of its business model. Now, amid a sudden weakening of demand for technology stocks, Box has been forced to delay its plans to IPO.

Where high company growth rates were once enough to convince investors of the potential of businesses, the market has begun to lose confidence in the technology sector and cloud software businesses have been hit particularly hard. High-profile companies, including ServiceNow and Workday, have seen their shares tumble amid concerns of excessive valuations, causing cloud computing and software companies like Box to change their IPO strategy.

Further reading

Box's recent addition of General Electric to its already extensive range of Fortune 500 clientele might encourage the doubters to reconsider their views on Box's valuation; however, I believe that investors' bearish approach is in large part due to a lack of understanding of the business models that operate within the tech sector. There has always been significant value in cloud companies, but even 10 years after the IPO of Salesforce.com as the first public software-as-a-service (SaaS) company, Wall Street still doesn't seem to understand the subscription - or recurring revenue - business model.

So what makes Box different to a traditional software business and what allows it to thrive in this Subscription Economy?

1. Subscription businesses care about Annual Recurring Revenue

Smart subscription businesses look at Annual Recurring Revenue (ARR), which consists of only the subscription revenue from customers for an ongoing service. For a subscription business, more so than cash or revenue, ARR is the true indicator of your company's health.

If we make an educated guess that Box's consulting revenue is in line with Salesforce.com's and plug in five per cent, based on that, we see that Box started its most recent quarter at $148m ARR, double what they were at one year ago. That's pretty good growth.

2. It turns out cloud storage is not that expensive

One common refrain is that Box's costs must be high, since they are storing a vast number of files and have to purchase so much storage space. Correct?

No, because to be able to compare expenses to ARR, you have to take out the cost of goods sold that are tied to the professional services and the stock option expenses that are reported in the filings. Using this calculation, Box's gross margins are in line with others in the SaaS industry. As a result, it actually doesn't cost that much to offer storage in the cloud.

3. Recurring Revenue Margin: the real story

If Box stopped all sales and marketing today, it wouldn't grow any more, but it would have an intrinsic 20 per cent margin business. Box isn't currently as profitable as Salesforce.com or Netsuite, but when you look at its recurring revenue margin over the last four quarters, the trend isn't bad.

It's no secret that Box is spending heavily in research and development. I would speculate that this is Levie betting on the future - Levie probably believes he has a big market that is growing fast, and he needs to invest in R&D with more features to outpace Dropbox or Microsoft SharePoint.

4. The genius of going for growth

It has been widely noted that Box spends about 137 per cent of its revenue on sales and marketing. This is three times the average of 42 per cent of revenue found across all other publicly traded SaaS companies at this point in their lifecycle.

In the quarter ending 31 October 2013, Box spent $46m in sales and marketing to grow ARR by $20m, net of churn. That means Levie spent over $2 to acquire $1 of growth. Compared to other public SaaS companies, that's on the high side. Although if Box expects that $1 to recur for the next five or 10 years, that's still a pretty good deal.

Levie has built a business with strong fundamentals that is intrinsically profitable, if looked at in the right way. By recognising that he's in a land grab in a fast-growing market with multiple players, Levie is showing he has the courage to bet big and spend big to acquire as many customers as he can.

If, one day, Levie decides to cut R&D back down to 15 per cent, and sales and marketing down to 15 per cent, he'll have a 25 per cent margin business. If he's a $1bn company at that point, that means he can throw off $250m in cash. That's a great business. And that's the genius of Aaron Levie.

Tien Tzuo is the founder and CEO of Zuora, a cloud service founded in 2007 that provides accounting and billing services for other cloud computing companies. Before Zuora, Tzuo spent 9 years at Salesforce.com where he was employee No. 11 and its former chief strategy officer.

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