Xero Limited XRO.AX W
May 31, 2017 - 3:11pm EST by
Alpinist
2017 2018
Price: 22.99 EPS nm nm
Shares Out. (in M): 138 P/E nm nm
Market Cap (in $M): 3,363 P/FCF nm nm
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 3,249 TEV/EBIT nm nm

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  • Network effects
  • Cloud
  • High Switching Costs
  • Founder Operator
  • Application Software
  • Competitive Advantage
  • Operating Leverage
 

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:

 

 

  1. 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: