Top-line numbers may not tell the whole story

Companies that sell software as a service enjoy some of the raciest valuations among the technology sector’s growth stocks. Forget profits measured on a conventional basis: even Salesforce.com, the sector leader that is now more than 15 years old and worth nearly $40 billion, is still in the red.

Investors are quite happy to see sales and marketing costs eat up half or more of revenues as long as they believe that, one day, profits will flow. The rest of this new industry owes Salesforce.com boss Marc Benioff a vote of thanks for the years he spent persuading Wall Street to forget the losses and instead learn to love the long-term customer relationships he was buying. But what happens when the music stops?

A reminder of the predicament that lies ahead for many of the so-called SaaS companies came with the initial public offering for Box. The company sells file storage and collaboration tools to companies and raised some $550 million from the private markets in a dash for growth. Its sales and marketing costs were equal to its total revenues in the latest nine-month period.

The company was a casualty of the first wave of doubt that spread over the SaaS sector’s heady valuations in early 2014. It was forced to suspend plans for an IPO when the revenue multiples of other recently listed companies — such as Workday, Splunk and ServiceNow — contracted sharply.

With the SaaS sector riding high again, Box is back — and with lower expectations, including an indicated valuation some 40 per cent lower than the one it was given by private market investors last year. It also has found a more effective way to tell its story, peeling back the curtain to reveal the profits it makes from repeat customers (in its case, those dating from 2010).

But even if investors are reassured by this — and can be persuaded that Box’s business is defensible in a highly competitive corner of the SaaS market — how will they value the company?

Stripping out sales and marketing to look at the “underlying” economics of existing customers is one possibility. This is what Groupon sought to do when it filed for its own IPO in 2011. The formerly high-flying daily deals company argued that it should be judged without consideration for marketing spending, which ate up 55 per cent of its revenues.

But the Securities and Exchange Commission had other thoughts and forced it to add the costs back.

True, most SaaS companies have a far more robust and proven business model than Groupon’s. But shutting off the sales and marketing booster rockets still has significant implications for investors who are trying to assess a sector that has been wedded to growth.

Box responded to its IPO delay last year by easing back on spending. To judge by the headline numbers, this has done little to damage its enviable growth rate: revenues jumped 80 per cent in the latest nine months, compared to 110 per cent the previous year.

As the SaaS companies never tire of pointing out, however, top-line growth is a faulty way to assess them. Instead, they should be judged on billings — a combination of revenues and any increase (or decrease) in sales that have been booked but deferred to a future period.

On this measure, things look far less exciting. Box’s growth rate tumbled to only 46 per cent, from 109 per cent the year before. Put another way: the increase in its deferred revenue was only equal to 7 per cent of the revenues it booked, compared to 32 per cent in the previous period. That means more jam today, less tomorrow.

One way to see this is the direct result of lower spending on marketing. Another is that Box is billing customers on a shorter time frame to generate more cash from operations, reducing its needs to tap the markets for money.

This looks like good management discipline. But it leaves investors with the problem of how to value such businesses as they start to move beyond their protracted growth phases. Salesforce itself is facing similar questions as it finally contemplates life as a more mature company.

Box is a reminder that the future tends to look bright as long as investors are prepared to keep funding their own heady expectations with large dollops of extra cash. But when the spending slows and the limits to a business’s growth come into view, the excitement can quickly fade.

— Financial Times