Too Early for Profits, But Not Forever

03/26/2014 11:00 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

Despite the fact that profitability may be a long way off for this cloud storage company, MoneyShow's Jim Jubak thinks it is too early to simply dismiss the company as just another sign of another Internet bubble.

The timing could be better.

News that Box, a cloud storage company, is looking to raise $250 million in an April initial public offering, broke the same day (yesterday, March 25) that Google (GOOG) announced that it was reducing the price for its cloud services by 30% to 85%.

Hard to see how Box, which was valued at $2 billion in its last round of venture capital, could possibly be worth the $3 billion to $5 billion post-IPO figure that's being thrown around Wall Street. Especially because Box's filing with the Securities & Exchange Commission, released yesterday, makes it clear that this company is a long, long way from seeing any profits. Sales climbed to $124 million in the fiscal year that ended in January 2013, from $59 million in fiscal year that ended in January 2012. But net losses in the same period climbed to $168 million from $112 million.

In its prospectus, Box says it does not expect to be profitable “for the foreseeable future.”

Sure plays into the current cynicism about profitless tech companies and market bubbles, right?

I'm not willing, however, to dismiss Box (which will trade under the ticker BOX after it goes public) as just another sign of another Internet bubble in the current market. The problem with valuing the company is that the cloud market is real and growing fast, but that it hasn't yet shaken down into clear segments with winners and losers (and clear criteria for what distinguishes a winner from a loser).

Consider this post more an attempt to sketch in what those criteria might be, than a rave or pan on Box and its IPO.

The public cloud market—the one you probably use yourself to storage photos or share documents—is forecast to grow to $31.4 billion in 2017, from $6.2 billion in 2012. That's a compounded annual growth rate of 38.3%.

This is the part of the cloud market where Google competes—and where Google cuts prices. The public cloud sector is dominated by Amazon.com (AMZN) with Microsoft (MSFT), Google, IBM (IBM), and Rackspace Hosting (RAX) competing for the Number Two slot.

But the public cloud, as you know it, isn't where the action is.

The big growth in the coming decade will come as cloud companies penetrate the business market. Selling into that market is a very different proposition from running ads on the Internet to reach consumers. And the question of who can come up with the killer competitive advantage in the business market is still very much an open question. That's why the Box IPO marks only the beginning of a wave of cloud IPOs. Next name up that you may have heard of is likely to be Dropbox.

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Of course, pricing counts in the business segment of the cloud market—and, in fact, it's the potentially huge savings that cloud-based storage, applications, infrastructure, and services promise that constitute the initial attraction to business clients. But especially as you go up the ladder into larger and larger companies, price isn't the only or even the key part of the selling proposition.

Big companies—the kind that have IT departments—want to know about security; they want to know about downtime; they want to know that all their existing and potential software will work with the cloud; they want to know that a workforce that increasingly uses desktops, notebooks, tablets, and smartphones will be able to access the cloud from all those devices.

Cloud companies such as Box and Dropbox have built their initial market presence on a freemium model—users might get 5GB of cloud storage for free. If you want more space or enhancements that might include better security, for example, you have to actually pay for it. The first step up on Box is to $15 a month per person. As of a March 2013 story on Forbes, only 3% of Box's customers were paying that fee.

That doesn't mean business customers won't. In its prospectus, Box says 225,000 organizations use its cloud products, with 34,000—that's about 15%—paying for extra storage space and added features.

But winning business customers is much more labor intensive than getting a consumer to sign up for free service. It took Box, for example, 18 months to sell Procter & Gamble (PG) and then to customize Box's services for the company. The pay off was huge—Procter & Gamble has 18,000 employees, but the costs of adding those kinds of customers are what make it so hard to say when, if ever, Box might become profitable.

Spending on sales and marketing climbed to $171 million in 2013. At the end of 2013, the company had 972 employees, up from 700 in March. And that headcount was twice that of a year earlier.

One of the biggest questions about the cloud market—and one with huge implications for profitability—is what the final mix of cloud segments might look like. The result is likely to be some mix of public cloud storage and services (with commodity pricing), and private cloud hardware and services at the customer's site, and private cloud hardware and services hosted off-site, with security and control part way between the public and on-site private segments. Pricing for each of these segments will be very different and it's unlikely that the companies that now dominate the public cloud space will be those that build the most profitable share of the private on- and off-site segments.

And then, of course, there's just the tiny little issue of who will figure out the formula for building the most profitable share in those two cloud segments.

It's early days yet.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any other stock mentioned in this post as of the end of December. For a full list of the stocks in the fund see the fund's portfolio here.

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