Description

Xero Limited

Xero offers cloud-based accounting software for small businesses and their advisors.  Xero is based in New Zealand, and the financials in this report are as reported in NZD.  The company has over one million subscribers in more than 180 countries, is the largest cloud accounting software provider outside the United States (market leader in Australia, New Zealand and the U.K.) as it continues to grow its presence in North America and globally.  Xero is still led by its Founder / CEO Rod Drury, who owns 15% of the company: an owner-operator well aligned with shareholders.

Xero announced FY2017 (ending 3/17) results on 5/11/17, and that it was free cash flow positive (CFO (net of stock-based compensation)-Cap Ex) in the second half the year (which was well received by investors).  However, net of capitalized development costs, Xero is not yet cash flow positive, but should reach breakeven cash flow from operations net of all development costs over the next couple of fiscal years.

Note that for residents outside of New Zealand and Australia, Xero shares can be purchased through an NZX or ASX registered broker or a broker with a relationship with an NZX or ASX registered broker.  Interactive Brokers allows purchase of Xero in Australia (XRO.AX; currency AUD).  So there is currency risk associated with the shares (if the dollar strengthens, particularly as U.S. interest rates increase) which can be hedged.  70% of Xero FY2017 revenue was from Australia and New Zealand (49% from Australia, 21% from New Zealand), 17% of from the U.K., 8% from N. America, and 4% from ROW:

Based on The Investor’s Guide to the New Zealand Technology Sector, Xero is now the largest technology company in New Zealand in revenue.

Variant Perception

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue.”

-Jeff Bezos

I do not expect it to take seven years for Xero to outperform, but the philosophy of time-horizon arbitrage is a benefit in this case, because the spread on time-horizon arbitrage is significant for SaaS companies with negative net churn and for companies that benefit from increasing returns via network effects as Xero does.

1. Underappreciation of the Metrics of SaaS Businesses

Xero is not a cigar butt..  The company is unprofitable on a GAAP basis, and trades at what might appear to be a high multiple of revenue and ARR.  Conventional wisdom is that SaaS companies that fit that description are too expensive.  However, that conventional wisdom can be wrong, depending on the company and the health of its key metrics, most of which do not appear on GAAP financials or automated valuation screens, so can be underappreciated by the market.  

Many investors focus only on GAAP reported net income and multiples on a GAAP basis, but for SaaS companies, other metrics that require some digging through the filings give a better indication of the health and future profitability of the business (see links at the end of this document for more discussion).

Many SaaS companies invest aggressively in sales and marketing when adoption is high, even though it puts pressure on current profitability.  The real assessment for investors to make is not just whether current multiples are too high, but whether the investments SaaS companies are making today (which depress near-term earnings and cash flow) are being made appropriately and thus will result in true free cash flow generation over time.

Once a SaaS company has generated enough cash from its installed customer base to cover the cost of acquiring new customers, those customers can stay for a long time.  Ultimately, they will experience the reverse of what occurred in the startup phase of the company: all the costs of acquiring that customer were incurred up front and long ago, and now the company gets to harvest nearly all the incoming cash flow from its customers as profits.

Key metrics to track are the following:

Annual Recurring Revenue (ARR): the subscription revenue for an ongoing service

Churn: the best situation is “negative churn” (when revenue expansion from existing customers is larger than revenue lost from churned customers)

Customer Acquisition Cost (CAC)

Customer Lifetime Value (CLTV)

CAC Payback (in months) or CAC Ratio (1x = 12 months to get to break even)

Recurring Profit Margins: ARR minus cost of sales, R&D, and G&A, but before spend on S&M (which are not ignored, but drive growth: today’s sales and marketing expenses to acquire customers are matched with future revenue recognized from those customers over their lifetime, which often can be 3, 5, 10 years or more.  GAAP does not allow such an allocation, which more accurately reflects the economics of the business. (see Tien Zhuo’s articles below)).

Xero’s metrics are best in class relative to benchmarks in Bessemer’s State of the Cloud Report and Credit Suisse 2017 Software Outlook:

Xero’s Metrics for Comparison:

• CARR Growth:  39%, net of all churn (Note that the metrics above are for companies with US$15m ARR, so the growth rate at Xero’s scale (i.e., US$248mm ARR) should be considered in that context.)

• CAC Payback:  12.8 months

• Churn (monthly): 1.13% overall; 0.865% in Australia/New Zealand.  Churn has been steadily decreasing across all geographies, and I expect continued improvements in net churn due to expansion revenue over time from both growth in existing customer accounts and additional applications, and that Xero’s net churn will eventually turn negative (i.e., net expansion): see below.

• Cash Flow (New ARR/Monthly Burn): 2.3x (Xero announced they are now “free cash flow positive” net of Cap Ex, but excluding capitalized development costs.  Based on FCF net of Cap Ex and all development costs, New ARR was 2.3x Monthly Burn in 2H FY2017)

• CLTV/CAC: 5.7x overall; 10.8x in Australia/New Zealand (Xero’s more mature markets).  Best in class based on comparables:

2. Underappreciation of the “Competitive Advantage Period” of Network Effects

DCF’s using a traditional forecast period typically undervalue companies with network effects that experience increasing returns like Xero.  As discussed in Michael Mauboussin’s “Competitive Advantage Period “CAP” The Neglected Value Driver”: “in spite of CAP’s importance in the analytical process—which we will attempt to demonstrate below—it remains one of the most neglected components of valuation.  This lack of focus appears attributable to two main factors. First, the vast majority of market participants attempt to understand valuation and subsequent stock price changes using an accounting-based formula, which generally defines value as a price/earnings multiple times earnings. Thus CAP is rarely explicitly addressed, even though most empirical evidence suggests that the stock market deems cash flow to be more important than earnings, holds true to the risk/reward relationship over time, and recognizes cash flows many years into the future.  Second, most companies use a forecast period for strategic planning purposes (usually three to five years) that is substantially different from their CAP. As a result, investor communication is geared more toward internal company-based expectations rather than external market-based expectations.”

Increasing returns are still represented as an aberration in the textbooks and are generally not fully appreciated by investors, so many financial analysts build DCF’s using the assumption of diminishing returns even for companies with increasing returns.  An example of the issue with that approach: when Google when went public in 2004, a DCF for the company that projected over ten years a reversion to the mean of Google’s competitive advantage would have significantly undervalued the company at the time, given that its moat in 2014 was actually far wider than it was in 2004.

Potential Catalysts

• Continuing improvements in net churn, eventually crossing into negative net churn.

The company has steadily reduced its monthly net churn, which in March 2017 was roughly 1.13% overall, and 0.865% in Australia/New Zealand.  

Xero currently has three pricing tiers—starter, standard, and premium—and increases in usage and connected employees drives moves to higher pricing tiers.  Now that Xero has built a horizontal global accounting engine, they plan to continue to add additional front office applications to further support its small business customers.  These additional applications should lead to steady revenue expansion in its accounts, with a meaningful impact on revenue over time.  I expect continued improvements in net churn due to expansion revenue over time from both growth in existing customer accounts and additional apps, and that Xero’s net churn will eventually turn negative (i.e., net expansion).  

The power of negative churn is described in detail here, and is underappreciated by the market:

• Increasing presence in the US, which will raise visibility from US-based investors as the company continues to grow.  Xero has expanded to the U.S. and now has offices in San Francisco, New York, Denver, Los Angeles, and Seattle.

Xero’s Competitive Advantage / Moat

Xero has a meaningful and sustainable competitive advantage that continues to grow over time.  The key elements of Xero’s moat are the following:  

1) Effective low cost global marketing approach that confers Cost Advantages and is difficult to replicate,

2) Network Effects, and

3) High Switching Costs

1) Effective Low Cost Global Marketing Approach

Cloud-based applications are increasingly attractive due to their lower cost base and speed of new product delivery.  Cloud platforms such as Amazon Web Services (Xero completed its migration to AWS this year) are enabling unprecedented growth and serviceability of global SMB (and enterprise customers) for cloud-based businesses.  

The “consumerization of IT” trend is relevant with cloud companies selling to SMB, as these businesses often look more like consumer startups than enterprise software startups because of the nature of the market.  In order to be able to reach global scale effectively and at low cost, an SMB cloud product must enable a “product-driven” purchase (as opposed to a “sales-driven” or “marketing-driven” purchase): the product must speak for itself, without any detailed description by a live person, and it must be able to be purchased without any involvement from the vendor.  Xero offers a 30-day free trial period for product testing and feature evaluation.  The free version lets businesses start using the product risk free and can be set up and used on a self-service basis without having to talk with a company sales rep, which requires an easy onboarding process.  Companies can also upgrade their plan on a self-service basis, so they never have to talk to anyone at Xero.  By letting individuals and teams use their core product for free, company can acquire users at scale, which then help marketing for mass adoption of their product.  Traditional SaaS accounting vendors cannot reach every small business globally, because their inside sales model makes it cost prohibitive to do so.  A cloud-based, self-service model with a free trial is the most effective way to reach SMB globally.  Xero has onboarded 500,000 customers in the last two years.

The product development cycle for cloud SMB applications also differs from enterprise software.  Without enterprise customers, there are no enterprise commitments, no promises to customers about releasing features on particular dates or paid upgrade cycles.  It is all subscription.  The most successful SMB SaaS products typically offer a 2-step value proposition: an initial value proposition to the end user and a longer term value proposition to a manager/decision maker.  The end user value proposition drives press and word of mouth sharing, which increases marketing budget effectiveness.

Cloud application companies also have a long-term cost advantage vs. perpetual license businesses in R&D.  In a perpetual license business, the R&D (and support) teams are often maintaining multiple versions of the software, with multiple versions running at customer premises.  In contrast, all Xero customers are running on the same hosted version of the software: one version to maintain, one version to upgrade, one version on which to fix bugs, and one physical environment (storage, networking, etc.) to support.  

Xero’s product also benefits from naturally viral growth (i.e., using the software exposes others to it each time it is used, giving exponentially increasing awareness for the product as customers use it).  There are >1 million Xero subscribers, >2.5 million employees paid by subscribers (since the launch of Xero Payroll product), >20 million unique connections have been done business on the platform (unique recipients of an online invoice since launch of online invoicing), and >40 million connections on the platform (unique contacts on Xero since 2006).  Each of these exposures helps to market the product to people who may not yet be customers.

2) Network Effects

Xero has clear network effects (i.e., it provides a better experience to customer “n+1000” than it did to customer “n” directly as a function of adding 1000 more participants to the market) which are more valuable than mere economies of scale, and can lead to increasing returns over time rather than reversion to the mean as a company’s competitive advantage gets stronger over time, not weaker.

A description of this type of advantage is in Brian Arthur’s paper Increasing Returns and Two Worlds of Business.  Certain technology businesses, rather than being exposed to diminishing marginal returns like historical industrial businesses, are actually subject to “increasing returns”:  gaining market share puts them in a better position to gain more market share.  Increasing returns are particularly powerful when a network effect is present and the value of a product or service increases for each user as more people that use the product or service.

Xero is integrating with an increasing number of bank partners connected via bank feeds, large enterprises are connecting to their customers with Xero, and small businesses are connecting with governments via Xero.  The company processed >$1.4 trillion of transactions in FY2017, which makes it important to large enterprises and government who need Xero to interact with small businesses.  Xero has also invested heavily in integrating its products with the major banks and other financial institutions (e.g., over 110 financial institutions worldwide, including HSBC, Capital One, Wells Fargo, Silicon Valley Bank) allowing customers’ latest bank transactions to be entered automatically in Xero.  There were >220 million bank feed transactions in March 2017, and banks are starting to emerge as Xero’s next channel, and large accounting firms (e.g., KPMG) have also partnered with Xero.

Xero now has an ecosystem of over 800,000 small business owners and over 100,000 business advisors (accountants, bookkeepers, or advisors who have worked with their clients’ data on Xero in March 2017).  Each additional Xero customer makes the platform more attractive to potential bank partners and enterprise partners, while each additional bank partner and enterprise partner makes the platform more attractive to potential small business customers.

Xero presents its network with the following graphic:

In addition, Xero is integrated with over 500 third party applications (business applications like inventory, CRM, payroll/HR, invoicing, payments, expenses, etc. offered in the Xero App Maretplace), giving Xero a unique ecosystem of cloud software solutions for small businesses. Integrating with Xero as an app partner is free, which reduces the barrier for potential app partners.  While the partners apps do not currently contribute directly to Xero revenue, they enhance both Xero’s network effects (i.e., more apps as part of the ecosystem increases the value of the platform for potential customers, and more customers on the platform increases the attractiveness of the platform for potential app partners) and increases Xero’s switching costs (i.e., the more apps a customer has connected to Xero, the less likely they are to switch accounting software vendors).

 
Finally, as a result of the network of companies connected to the platform, Xero manages a unique global graph of business transactions, enabling the development of machine learning to create new experiences for small businesses which can increase productivity for accountants, bookkeepers and small business customers.  Accounting is an ideal match for machine learning: 1) access to vast amounts of training data, 2) high value domain, 3) a clearly defined target structure, 4) many scenarios to apply machine learning.  Xero has a unique data set to apply machine learning to accounting, with >$1.4 trillion of transactions processed in the last year, and is using the AI/machine learning capabilities of AWS.  So additional customers and usage of the platform also increase the value of the platform for all customers because of the machine learning.  Xero gets smarter based on this machine learning, and now suggests accounts based on what a customer has entered before, and can automate transactions and code transactions, simplifying the process for small businesses.  It can also drive insights related to things like likely timing of payment, comparisons relative to industry peers, sectors of the economy that are growing or shrinking, small business that are adding jobs, etc.

3) High Switching Costs

Xero benefits from tight integration with its customers’ businesses, which leads to high switching costs.  Its accounting software becomes embedded in its customers’ daily operations, and decoupling it to start fresh with a new accounting package involves risk and cost that customers would prefer to avoid. Moving to a competitor’s product entails migrating data, changing internal processes, re-training employees, and possibly changing accountant.  Xero represents a small percentage of their customers’ overall cost base, so there are also not large benefits from the possibility of switching vendors, and customers are unlikely to bear the costs for such little potential benefit.

In addition, because of Xero’s increasing integrations with bank partners, large enterprise / customer connections, small businesses / governments connections, and the App marketplace discussed above, a company that decides to switch from Xero will have to port both its data and reconnect a new service with its bank partners, enterprise/customer connections, and integrated apps, all of which increase the switching costs.  

Potential Real Pricing Power

These high switching costs lead to potential real pricing power, a lever Xero could potentially pull in the future.  As Buffett has famously said, “the single most important decision in evaluating a business is pricing power.”

The price increases by MYOB (an Australian Xero competitor) before and after its acquisition by Bain Capital provide an example of the pricing power in accounting software.  The following are samples of actual MYOB customer price increases:

It appears that part of Bain’s investment thesis was that MYOB’s legacy customer base is sticky and price inelastic, and would absorb aggressive price increases, and that thesis was correct.  Given competition in the market, price increases that are too aggressive would likely impact future growth, but the customer stickiness MYOB demonstrated with its price increases is evidence of the level of switching costs in the business.

Market

Xero operates in a global market where it can service millions of businesses worldwide.  The global accounting software market size was an estimated $8.9 billion in 2016, and is expected to grow to $15.1 billion by end of 2022 (CAGR of 9.1%). Small and medium business represent 99.7% of all employer firms in the U.S., and employ about half of the country’s private-sector workforce (source: Small Business Administration).  

The SMB accounting software market is underpenetrated, and there are many small businesses who are currently using nothing more than a spreadsheet (or paper) to manage their books.  Like many application markets, the accounting software market is increasingly embracing the cloud and moving away from traditional desktop solutions, and accelerating adoption of cloud software is a tailwind for Xero’s business.  Xero has been expanding the market, with nearly half of its customers being first time cloud accounting software customers.  

The cloud accounting transition is still at an early stage, with a large proportion of small businesses yet to adopt a cloud accounting solution:

SMB SaaS companies sell to a highly fragmented market. The table below compares the enterprise and SMB segments by number of firms and employment.  In the most recent census, there were about 102,000 companies with greater ≥100 employees, compared to 29 million companies with <100 people (>280x difference in target companies):

U.S. employment in companies ≥100 employees was 76 million, compared to 63 million in companies with <100 people: both large target market segments for enterprise software in terms of potential seats, but they are two very different segments.  The challenge is to reach such a huge group of small potential customers in a profitable way.  SMB SaaS companies targeting companies with <100 employees need a different sales process than the one-on-one approach of enterprise sales reps using a personalized approach for each client.  Direct sales, powered by quota carrying, relationship building sales people, are not profitable at this scale. Instead, mass media channels and partners must be used.  SMBs often lack in-house IT expertise and rely heavily on consultants and value-added resellers when deciding what products and services to buy. 

Xero has been expanding its addressable market by entering new geographies, offering additional financial web and data services applications, and via machine learning, which will open up new segments.  They are also moving to code free accounting, which expands the TAM even more than the move to cloud accounting.

Many startups start out targeting SMB, then move upstream to go after larger customers (e.g., Box initially targeted SMB, but today they are an enterprise solution, and there are many similar examples), which is a potential growth opportunity for Xero.  After building out its functionality and adding ecosystem partners, Xero now offers a credible competitive solution for medium-sized businesses, and over time can continue to move up market.

Target and Dominate A Small Market First, Then Expand From Position of Strength

Xero pursued the strategy of targeting a small market initially (New Zealand) before expanding to dominate a bigger market (Australia, then the U.K., and now expanding in N. America), which is discussed in these three articles:

• Andy Rachleff (Benchmark Capital co-Founder): "Oddly, to get big you must first start by addressing a small market…First, you develop a focused product that appeals to a small, passionate audience. Over time, you build a whole product that attracts a broad one…Companies must first dominate a niche of early adopters and expand from a position of strength to succeed.”

• Peter Thiel: “Thiel insists that every startup should start small, because it's easier to dominate a niche market than a larger, pre-existing one…Once you've monopolized your own, small market, you can "gradually expand into related and slightly broader markets." 

• Paul Graham (Founder of Y Combinator): "Your target market has to be big, and it also has to be capturable by you. But the market doesn't have to be big yet, nor do you necessarily have to be in it yet. Indeed, it's often better to start in a small market that will either turn into a big one or from which you can move into a big one. There just has to be some plausible sequence of hops that leads to dominating a big market a few years down the line."

Xero’s initial market focus was New Zealand and Australia, where they are now the market leader in small business accounting, and continue to win share from incumbents.  One third of New Zealand’s small businesses are on the platform, and Xero is now the clear market leader in Australia.  They have built a strong advisor channel, with over 90% of subscribers connected to a business advisor, and have the broadest account feed coverage from major banks.  67% of Xero subscribers and 69% of their ARR are from Australia and New Zealand.  

Building on its success in Australia / New Zealand, Xero has extended its market leadership in subscribers and ARR to the U.K., where they are also now the market leader, and Xero is outgrowing the major incumbent rival in the market (Sage) by a substantial amount. Xero now has almost 9x Sage One’s ARR (of £22 million). Xero also has 15% more subscribers than Sage One across the U.K.

The U.K. represents 20% of current Xero subscribers and 17% of FY2017 revenue.  Xero has the highest number of banking integrations in the U.K. (Barclays, HSBC, RBS, Santander, NatWest, Metro Bank, etc.), and have technology collaborations with the U.K.’s three largest accounting practice software vendors:  IRIS, Wolters Kluwer, and Thomson Reuters.

Xero is now expanding to N. America (currently 9% of subscribers, and 8% of FY2017 revenue), where they are building scale and recognition in accounting channels with leading advisors such as H&R Block and Carr, Riggs & Ingram, and with new and strengthening relationships with key banking partners, Capital One, Wells Fargo, and Silicon Valley Bank.  Xero is building execution team across the U.S, and now has offices in San Francisco, New York, Denver, Los Angeles, and Seattle.

Xero is also expanding to Southeast Asia (fast growing markets with approximately two million subscriber TAM; Singapore and Hong Kong opened in the last year; broadening strategic bank collaborations: DBS launching soon, CIMB Malaysia launched April 2017, HSBC Hong Kong and Singapore launched March 2017, UOB Singapore launched July 2016), and South Africa (almost 1,000 South African accountants attended two roadshow events in Feb 2017; first bank feed partnerships now underway).

Valuation

• Xero has raised more than NZ$470 million in funding, including $2m pre-IPO, $15m at its IPO, and subsequent investments from MYOB co-founder Craig Winkler, Peter Thiel (via Valar Ventures), Matrix Capital Management, and Accel Partners.  

• In April 2017, Technology Crossover Ventures invested roughly NZD$28.6 million / US$20 million at NZD$20 per share.

• Xero’s valuation had gotten ahead of itself in late 2013 (as high as NZ$41.49 per share) after investors including Matrix Capital Management and Peter Thiel backed Valar Ventures invested NZ$180 million at NZ$18.15 per share.

• In February 2015 Accel Partners invested US$100 million at NZ$20 per share, and Xero’s largest existing institutional investor Matrix Capital Management invested an additional US$10.8m at the same price.

SaaS companies with better unit economics (e.g., higher CLTV/CAC, lower / negative churn rates, shorter CAC payback, etc.) justify higher multiples than companies with inferior unit economics because of better free cash flow economics over time.  However, despite its attractive unit economics, Xero trades at multiples below the median of comparable companies selling to SMBs globally with a free trial offering and a self-service, “product-driven” purchase:

Xero’s revenue multiple is also well below the regression line in Credit Suisse’s report for EV / 2017 Revenue Multiple vs. CLTV/CAC for CLTV/CAC of 5.7x, not to mention the CLTV/CAC in Australia/New Zealand of 10.8:

However, my valuation assessment of Xero is not primarily based on its valuation relative to its comps, but based on a variety of DCF scenarios with consideration for the economics of Xero’s key metrics.  Xero’s current investments (which depress near-term earnings and cash flow given the timing misalignment of revenue and expense recognition) are being made at an attractive ROI that will result in sustainable and attractive free cash flow generation over time.  In combination with its large—and largely untapped—total addressable market and competitive advantages through network effects and switching costs, Xero has a long runway of attractive future growth.

Australia/New Zealand produced a 46% contribution margin (excluding R&D and G&A) in FY2017, while other geographies still in investment mode produced a -39% contribution margin in FY2017.  When these geographies are more mature, they will also produce a positive contribution margin:

Xero’s Recurring Revenue Margin (as defined by Tien Zhuo here and here) reached 46.7% in the second half of FY2017.  Gross Margin was 77.5% in the second half of FY2017, which included some double platform costs during the transition to AWS, so Gross Margin will be higher in FY2018.

At 3/31/17, Xero’s total group CLTV (gross profits expected to be realized in the future from existing customers) was NZ$2.2 billion, an increase of NZ$688 million (46%) y/y:

Note that Xero’s group CLTVs do not assume any future price increases, which are a potential lever Xero could pull in the future (as MYOB has done following its acquisition by Bain Capital, discussed above).  My DCF scenarios also do not assume future price increases.

With Xero’s CLTV/CAC of 5.7x overall and 10.8x in Australia/New Zealand, S&M investments to acquire these customers have a highly attractive return: each $1 invested in customer acquisition in ANZ is returning $10.80 in future gross profits.  In addition, Xero’s CLTV/CAC metrics have been improving steadily over time, not decreasing with scale.  As Xero continues to increase its group customer lifetime value, it continues to accumulate future cash flow (and its NPV) from existing customers.  With these metrics, Xero represents a solid capital compounding engine, and it makes sense to continue investing aggressively back into the business.

In addition, as Xero’s additional front office applications lead to steady revenue expansion in its accounts, I expect continued improvements in net churn due to expansion revenue over time from both growth in existing customer accounts and additional apps, and that Xero’s net churn will eventually turn negative (i.e., net expansion).  Negative net churn will lead to a meaningful drop in S&M as a percent of revenue.

Xero’s Gross Margin reached 77.5% in 2H FY2017, and that includes some duplicated platform costs incurred migrating to AWS (two hosting platforms ran in parallel for a large part of the year) and increased investment in hosting tools and software.  So Xero’s Gross Margin will continue to increase in FY 2018 now that the migration to AWS is complete.  I expect Gross Margins to reach the mid 80s% level in coming years.  Xero has already been benefitting from operating leverage, but the operating leverage will be magnified if and when its churn turns net negative.  

The following looks at potential return multiples over the next few years in scenarios where 1) monthly net churn = 0% in 2019 and beyond (i.e., churned revenue = expansion revenue), and 2) monthly net churn = 0% in 2019, and modestly negative 2020 and beyond (i.e., expansion revenue is slightly larger than churned revenue). Note that in FY2017, monthly net churn in Australia/New Zealand was already down to 0.865%, and total monthly net churn was down to 1.13%.  So it will not take much expansion revenue from additional applications in 2019 and beyond for monthly expansion revenue to exceed monthly churned revenue. Both scenarios assume net churn in FY2018.

Competition

Key vendors in the global business accounting software market are Acclivity, FreshBooks, Intacct, Intuit QuickBooks, Microsoft, Oracle, Red Wing Software, Sage Group, SAP, Xero, and Zoho.  In SMB cloud accounting, the key vendors are Intuit, Xero, GoDaddy (via its Outright acquisition), FreshBooks, Wave Accounting, Kashoo, and Simple Accounting.  

A “magic quadrant” for accounting software can be found here:

A Google Trends comparison of interest in Xero vs. QuickBooks Online vs. Sage One vs. MYOB is below (FreshBooks and Wave Accounting are below Sage One):

• Intuit leads the US market for small business accounting software, with a customer base of 5 million businesses.  In May 2017, Intuit announced that QuickBooks Online subscribers grew 59% to 2.22 million subscribers (including 360,000 QuickBooks Self-Employed subscribers), and the majority of its growth has been from non-QuickBooks desktop users: >90% of QuickBooks Online users are new Intuit customers.  On the conference call 5/22/17, Intuit mentioned that in the US, they introduced a SKU at retail last year that gave Quickbooks Desktop customers a QuickBooks license and the right to access QuickBooks Online service for one year at no additional charge.  I assume these subs are being counted in the QuickBooks Online total subs, so the number may be inflated if the conversion rate to paid QuickBooks Online subscribers is low.  But QuickBooks Online is the incumbent to beat in N. America.  QuickBooks also integrates with third party apps listed in its App Center.

• Xero is the package most comparable to QuickBooks in functionality, and has 1.035 million paying subscribers at March 31, 2017, with 44% growth in the fiscal year.  Xero’s strategy is that it wants to become the main portal for small businesses accessing web services, where it becomes the key hub for financial web services.  After building a horizontal global accounting engine, they are now adding additional software for small businesses integrated with their platform.  Professional CPAs and other public accountants who offer services to small businesses play a key role in SMB adoption, and Xero has a channel of >100,000 of them.   A comparison of Xero and QuickBooks Online is here.

• Sage One (Sage’s cloud accounting offering for small businesses has 382,000 subscribers (37% of Xero’s subscribers).  Sage is a legacy U.K.-based enterprise software vendor (ERP, CRM, and accounting) that has added a cloud accounting offering.  Software subscription (desktop and cloud) growth of 30.5% y/y in the First Half FY17 announced May 2017.  Sage now has >1.2 million subscription contracts, including 382,000 Sage One and >110,000 with Sage 50 and Sage 200 cloud-enabled products.  Combined with the “accountant suite,” Sage has >500,000 cloud subscriptions total.  Sage One ARR increased by 88% to £22 million, but Xero now has almost 9x Sage One’s ARR.

• MYOB is a competitor in Australia which Xero has surpassed in subscribers (MYOB announced 249,000 cloud subscribers (up 47% y/y) and 585,000 paying subscribers (up 7% y/y) as of 12/31/16.  But despite the gain of 79,000 cloud subscribers, total subscribers only grew 40,000 y/y, so there were 39,000 desktop subscriber losses.  Bain Capital acquired MYOB in 2011, and it went public in Australia in April 2015.

• Kashoo (a private, venture-backed company) most recently announced >150,000 registered users in more than 180 countries.

• Wave Accounting (a private, venture-backed company) has claimed that it supports 2.5 million users total, but its cloud accounting software is free, and they charge for payroll and online payments of invoices via credit card, and will likely add other business-focused applications.  They do not disclose what percentage of their users are paid users versus free or dormant accounts.

• FreshBooks (a private, venture-backed company).  More of a cash-basis (i.e., not accrual) invoicing and expense management package than a full-blown accounting package.   Claims >10 million people have used FreshBooks, and >$60 billion invoices have been paid through FreshBooks (compared to Xero’s >20 million unique recipients of an online invoice).  They also do not disclose what percentage of their users are paid users versus free or dormant accounts.  Target market is service oriented small businesses.

Key Risks

• Competition: there are many solutions in the market.  Xero’s growth demonstrates that it is competing effectively, but competition will be an ongoing issue.  In particular, I expect Intuit QuickBooks Online to be a formidable competitor, particularly in N. America, given the QuickBooks installed base, Intuit’s marketing budget and balance sheet, etc.  However, the market is not a zero sum market, and marketing by Intuit to connect small businesses online can also help Xero’s marketing efforts, as potential customers want to evaluate more than one possible solution.  

• A re-rating of SaaS multiples like the one that bottomed in Feb 2016 could cause temporary quotational loss.

Links of Interest

• Xero Financial Information

• Two relevant articles by Tien Zhuo, CEO of Zuora and former early executive at Salesforce, and a presentation by Zuora’s CFO:

• Wall Street Loves Workday, but Doesn’t Understand Subscription Businesses

“Zuora often discusses the three metrics that matter when valuing any SaaS business. We believe that Annual Recurring Revenue (ARR) drives everything. A company’s Growth Efficiency Index (GEI – the sales and marketing expense needed to acquire new dollars of ARR), retention rate, and recurring profit margin (how much non-sales and marketing dollars are spent on servicing existing ARR) tell you far more than profits. But not a single one of these metrics is disclosed in GAAP financials. That’s a disservice to the companies, to analysts and to individual investors.”

• These Numbers Show That Box CEO Aaron Levie Is A Genius

• The Only Three SaaS Metrics That Matter

• Andreessen Horowitz on SaaS valuations: Understanding SaaS: Why the Pundits Have It Wrong

• David Skok’s (GP Matrix Partners) SaaS Metrics 2.0

• Brian Arthur’s Increasing Returns and Two Worlds of Business, and a summary on its 20th anniversary: A Short History Of The Most Important Economic Theory In Tech

• Michael Mauboussin’s Competitive Advantage Period “CAP” The Neglected Value Driver

• Bessemer Venture Partners’ State of the Cloud report 2017 and 2016 (comparable metrics)

• Credit Suisse 2017 Software Outlook (includes CLTV/CAC comparison)

• Three articles about targeting a small market initially before expanding to dominate a big market:

• Andy Rachleff (Benchmark Capital co-Founder)

• Peter Thiel

• Paul Graham (Founder of Y Combinator)

• The Investor’s Guide to the New Zealand Technology Sector

Catalyst

Potential Catalysts

• Continuing improvements in net churn, eventually crossing into negative net churn.

The company has steadily reduced its monthly net churn, which in March 2017 was roughly 1.13% overall, and 0.865% in Australia/New Zealand.  

Xero currently has three pricing tiers—starter, standard, and premium—and increases in usage and connected employees drives moves to higher pricing tiers.  Now that Xero has built a horizontal global accounting engine, they plan to continue to add additional front office applications to further support its small business customers.  These additional applications should lead to steady revenue expansion in its accounts, with a meaningful impact on revenue over time.  I expect continued improvements in net churn due to expansion revenue over time from both growth in existing customer accounts and additional apps, and that Xero’s net churn will eventually turn negative (i.e., net expansion).  

The power of negative churn is described in detail here, and is underappreciated by the market:

• Increasing presence in the US, which will raise visibility from US-based investors as the company continues to grow.  Xero has expanded to the U.S. and now has offices in San Francisco, New York, Denver, Los Angeles, and Seattle.