Is Xero worth a cool half billion?

Xero 12-month NZX performance (S&P Capital IQ; click to enlarge)

The below was first published on June 1, when Xero had a market value of $427 million.

Yesterday - Friday June 29 - the company closed at $5 for the first time, giving it a market cap of a cool half billion (or $520.5 million to be precise, according to S&P Capital IQ).

Xero gained extra momentum from its elevation to the NZX50 earlier this month (Rakon - once a tech darling, too - was deleted from the index).

In light of that milestone it's worth revisiting the debate: is Xero over-valued? (With a couple of figures updated for Friday's close.)

Xero full year result (12 months to March 31, 2012)

Profit: -$7.9  million (+5%)
Revenue: $19.3 million (+104%)
Customers: 78,000 (+116%)
Operating expenses: $28.4 millon (+58%)
Cash: $39 million
Cash burn/year: $12.7

Rod Drury is a smart guy.

And Xero is a clever company, with a great product.

But is it $520.5 million worth of great?

That’s the online accounting software company’s market value as of close of business yesterday (by S&P Capital IQ’s count, with Xero shares [NZX:XRO] closing at $5.00 on Friday).

I’m not sure why there’s only one brokerage following Xero (cue commentors feverishly hitting their keyboards), because it’s a fascinating company, with a lot of money at stake and lot interest from the public.

Still, that is the case: Forsyth Barr analysts Andrew Harvey-Green and Fraser Hunt appear to be on their lonesome (by Mr Harvey-Green’s estimate, a quick NBR survey of major analysts, and S&P’s coverage data.)

In February, the pair nudged their valuation of Xero from $2.60 to $2.63. They now calculate it’s worth $3.16 (or a market cap of $328 million).

ForBarr recommends people off-load shares.

The stock is rated high risk and on May 25 the broker re-iterated its warning to clients: “While we believe Xero has positioned itself well for success, it is still early days and we believe the market is already factoring in a high chance of success and overlooking the downside risks.”

ForBarr maintained its REDUCE rating on Xero following the company’s full-year result reported last week (which saw revenue more than double to $19.3 million for  12 months ended March 31, but losses increase 5% to $7.9 million; see table top of story.)

By any standard investing metric, you have to agree with Forsyth Barr.

However, at least one high-profile supporter (who didn’t want to go on record at this point) was keeping the faith, after carefully digesting  Xero’s annual report.

But was he comfortable keeping half a billion dollars’ worth of faith in a company with $19.23 million revenue, which now refuses to say when it will turn a profit?

How could he believe it’s worth more than $426 million?

“Easy,” he replied. “ This is a long term, global play. They have a good chance of hitting 10 times that.”

For me, it’s a great unknown: can Xero parlay its early entry into the cloud category into world domination? It does take off in the US and other markets, then it could spread like wildfire. And its cloud model means there’s very little incremental cost adding customers to its system.

The downside:  until it reaches that tipping point, it’s yakka hard spreading the word in Australia, the UK and the US (where customer numbers are growing fast, albeit off a low base).

Forbarr says expenses will grow as Xero expands in these regions as it pushes for growth. Last year alone, staff numbers swelled from 113 to 194 – a quarter of whom are now based off-shore.

And Xero itself has forecast a greater loss next year (last year, it formally abandoned its goal of breaking even by the end of 2011, saying it was better for investors’ long-term if it pushed for growth).

ForBarr estimates Xero’s cash-burn at $12.7 million a year.

Yet Xero’s coffers are bulging.

It raised $36.5 million last year from issuing new shares (Rod Drury sold $3 million shares around the same time) and you and I chipped $4 million through a government R&D grant.

Xero now has $39 million in the banks. Enough, Mr Harvey-Green estimates, to last it until it break-even.

What's Xero worth in a trade sale?
Another option, of course, is that Xero may never break-even because it is bought by a larger accounting software company (and Rod Drury has, in part, built his NBR Rich List fortune by selling two tech companies he co-founded - Glazier Systems and Aftermail.)

Last year we saw Bain Capital buy accounting software company MYOB for an estimated $US1.3 billion after a bidding war with UK-based Sage.

MYOB has says it has more than 1 million customers across its Australasian base (and with its nascent pushing into the cloud it is perhaps Xero’s closest rival, at least regionally).

With both companies privately held, no specific financials were released around the deal, but the Australian Financial Review (which judging by its reports anticipating other events around the deal had a reliable source) said Bain paid around 11.3 times earnings before interest, taxes, depreciation and amortization.

According to Reuters, KKR paid around 12.5 times ebitda for a majority stake in accountancy software vendor Visma in 2010, while HG Capital bought Italy's TeamSystem for 11.3x ebitda.

Xero, of course, has no earnings. But, once it does, the above sales do seem to indicate a benchmark (Rod Drury, I’m sure, would argue that his company is not bogged down by the legacy offline systems that most of MYOB’s customers, and others, still use).

And it’s a benchmark that Xero has a little way to reach. 

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32 Comments & Questions

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Good piece CK - you should come over to the other side of the house!

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If revenue is $19.3M with 78K subscribers, that's near enough to $23 per month per Xero subscriber. Putting aside timing issues with a growing monthly subscription base,and margin prices offered to accountants, there must be a lot of discounting somewhere when the most popular product sells for $49 per month. Or perhaps my back of enevlope anaylsis is flawed.

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Should that Profit be in brackets or even perhaps say "Loss". I know there is a minus sign but who can see that.

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I know this one is thorny - but here is a take.

Losses are fine - as long as value is being created. Xero is the poster-child for that statement here in NZ.

Think of it as a discounted cash flow (DCF) valuation calculation. If the profits down the track are suitably attractive - then losses (investment) in the short-term are the sensible call. That is the approach Rod and Xero are following - it isn't a crazy call.

From a valuation perspective - I would run three or four scenarios in a DCF. Recognise that there is a range of possible futures for Xero (illustrative only - all in 3-5+ years): 1 million+ customers (Xero investor presentation goal), 500K customers not breaking into US market, 250K customers in NZ/Australia/UK and 100K customers only in NZ/Australia.

Do a standalone valuation for each of those scenarios to give a picture of what the company is worth in each case (wide possible range). Then risk-weight the scenarios - based on what you think the likelihood of each occurring is. As the business moves forward (and there is more certainty around outcomes) - you adjust the assumptions and the risk-weighting.

That is what I would do...

Disclosure: very small XRO shareholding.

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There will be tears for Xero investors

It's just a matter of when!!!

This hype is not sustainable

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Nothing has changed

The spin goes on - the people doing all the spinning continue to sell shares despite the spin which should have the opposite result.

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Including Rod Drury selling shares recently

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Absoloute rubbish valuation. Drury selling down own shares isnt a good look and why are taxpayers funding his extravegent lifestyle. Drury is up their with hotchin & all those other scumbags. How does he sleep at night?

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Well actually Xero is going steady, you compare it with facebook stock and it's clearly doing well. Since 2007 it has had a steady increase, and the only reason Drury sold his shares was to raise more money for the company, you bought in a few 1,000 shares when they were selling for $2.75, now there worth $4.10 - they aren't increasing anymore because of the loss, the loss is for expanding in the states.

With backers like Peter Thiel and Sam Morgan, and run by Rod Drury who has made two companies before - it's looking relatively solid. Not hype, I personally use the service and MYOB honestly doesn't stand a chance. Xero really is beautiful accounting software.

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This is excellent analysis. More please!

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I hear Peter Thiel is going to inject another $100,000,000NZD into the company with his new venture fund "Mithril Capital" - it may just be a rumor and hype, but that would make my old work colleague a very rich man. Smirk.

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I'm sure Xero will do very well, but 500m well? I can't see it.

at it's maturity it would need to be bringing in $100+m EBITDA to make that sort of valuation make sense.
Chances of it getting there are extremely slim. One would have to be extremely optimistic to value it at 500m right now.

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This story is typical kiwi tall poppy I believe they will do it and have invested over the last year and can't wait for the next customer number count. They only need a very small percent of the markets they are in to hit a million customers. Word of mouth in Australia seems to have grown the business there bigger than here and I would expect the same in UK soon and then USA in about 2years.
We are lucky to have a COMPANY WITH SO MUCH UPSIDE TO INVEST IN LISTED HERE.

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Great article Chris, and Mark Clare your 'possible futures valuation' is good straight shooting.

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This is about growth rates. If analyst values are correct than its over valued by 9 months. Big deal. Xero bet big on picking the future of sme accounting, and they got it spot on. They aren't limited by geographical borders in same manner as desktop sunset businesses. The move to cloud is now accepted. Incumbents have royally botched their strategies. If xero growth rates improve as the doors get easier to push open then the forward multi yr view exponentially improves. Market dynamics are supporting an increase in growth trajectory. A 1m + user base is achievable. A multi million user base is just as achievable after that. The low case in the weighted av risk of 100 k is plain stupid. They're already there ! The entrepreneurs who understand this market have backed this company 100%.

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The latest spurt in the the share price is nothing to do with growth rates. Its been driven by speculation and rumours as suggested above by comment number 10. Have a look at this link for the sort of drivel that's being written about Xero in the USA:

http://www.hotstockmarket.com/t/234819/investment-tip-xero-nze-xro

For better summary of what Thiel is more likely actually up to look at:

http://techcrunch.com/2012/06/19/peter-thiel-mithril/

Xero has been prone to such unwarranted spurts in its share price before. A couple of years NZX wrote to Xero asking them what was going on. I think it might be time to ask again.

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Nobody seems to be asking the question "How hard is it for them to be copied/displaced by a major brand?" That is what I would be asking. And personally, I think they have very little, if any, unique IP. And that, I think, will limit their growth.

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No unique IP but they are years ahead in the R&D curve. Both MYOB and quickbooks have tried an online offering and it doesn't compare at all to Xero.

I have tried a couple of other online offers - Saasu and Wave and while both good, again are at least 2 years behind Xero in offering a competent product.

Teh big risk is that small companies will hold onto their outdated MYOB products long enough for MYOB to release a viable online version (and Quick books etc).

In fact if quickbooks stuffs theirs up again, it would be cheaper for them to buy out Xero for $1B rather than try a third time. MYOB probably doesn't have deep enough pockets for this.

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A very good question. Xero is at great risk of displacement.

In the very near future Xero will be facing major new competition in New Zealand and Australia from both MYOB and Acclipse. The Xero believers get very dismissive about MYOB but they have a strong user base amongst both SMEs and accountants and are in the midst of releasing a raft of new technology. Their current free website deal is a great strategy to retain their position in the minds of small business. Acclipse is shortly coming out with a new online product priced very cheaply.

Xero has already lost out to FreeAgent for the number 1 spot in the UK and seems unlikely to dominate in that market as it had originally hoped. In North America the fastest gowing online accounting product is the Canadian Wave Accounting - which provides its system for free - it uses a Google business model earning revenue from related advertising.

Wave raises the very real possibility that Xero's business model will be completely superseded. The disrupter may well get disrupted. And thats another major risk factor for Xero.

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If you have used Wave, you know it is not a competitor (yet) for anything other than very very small businesses.

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What annoys me if Drury paying himself MASSIVE salaries, flying private jets (leased) and driving expensive cars all at the Companies expense. He should pay for these luxuiries himself (not the company)

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I would not consider $420k (per annual report) excessive and in fact I wouldn't think he would do it for that amount if he wasn't a major shareholder and was passionate about the product.

Do you have proof for your other statements. And are you sure they are excessive or is this just tall poppie syndrome.

I would be interested to know if he considers his commute between Hawkes Bay and Wellington as a business expense as I know that flight can be expensive (based on tweets by Rod).

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Rods salary appears to be about average for a company of this size and profile doesn't appear to be excessive. I don't recall any private jets being leased. Can you show the source of this information?

What expensive cars has he purchased at the companies expense? Source?

Are you annoyed because you are a shareholder or just because you should have been?

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Are they unique? WaveAccounting, Kashoo, Ogogo, LiquidAccounts, FinancialForce, FinanceCentral, BillFaster, NolaPro, Saasu, Serenic .... Zero.

Is Cloud the way of the future? Who still uses GoogleDocs? Slow, cumbersome, questionable security. Is it the future or a fad?

Easy to scale, without doubt. But $500 million?

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Hi Harvey

While Wave may be more suitable for very small businesses at the moment, there is no reason its platform will not be developed so it is a direct and very disruptive competitor to Xero's full accounting product.

My point was that there is a new business model which is a serious threat to Xero's business model. Xero's model of charging a very high monthly fee is old style Saas. Wave's free model is new style Saas.

By the way you should be aware that a large proportion of Xero's user base is signed up using Xero's cashbook service - not the full accounting product. These are exactly the sorts of clients that Wave is targeting and suggests to me that Wave type products are more of a threat to Xero than you suspect.

Do an analysis on Xero's average return per customer in New Zealand (as suggested by the Forsyth Barr analysts) . You will find that the average return per customer is going down which suggests one of either two things is happening:

1 Xero is discounting to achieve sales
2 Customers are increasingly signing up to the cheaper versions of Xero - most likely the cashbook version

Either way - this is not good news for Xero that this is happening already, considering its still relatively low penetration in its core New Zealand market. That's unless you have a business model which chases apparent growth ahead of cashflow and profitability.

By the way I agree with you on the other comments on Drury's salary and alleged expenses. $420k is not at all unreasonable and I doubt the other suggestions have any truth to them.

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You raise Waves business model. Free ad supported. A great way to get customers but does it actually make money. If not, at some stage they will need to start charging. They may have a loyal custerom base by then but they may well lose 90% of the customers that they have acquired, solely because they are free.

"Free" is a great way to get new customers but if you have a real business, I would prefer to spend $600 a year on a quality product rather than get Wave for free [note: I do pay the $600 per year for one entity and am thinking of going cashbook for a number of smaller entities that Wave is just too annoying for].

And if free is the way to go, there is no reason Xero cant go there as well. Maybe put a very basic product as free and do the freemium model. I am happy with their current model though [ as a user and investor]

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$19.3 million turnover, 78,000 customers - this averages $20/month! Considering their cheapest plan is $29/month and most clients will actually be paying $49/month, something is fishy here. Plus on top of the end users you have accounting practitioners using it as well and bringing their clients over en masse. An accounting systems provider that can't add? Run for the hills!

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As pointed out by the previous Anon (NBR - you really need to number your anon people or make them pick an alias), Xero has a cash book option at about $10pm which is only avaliable through accountants.

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Harvey, have you actually used Xero? I'm a CA and I find it less than intuitive and frustratingly slow! I believe they still have a long way to go to match the functionality and usability of MYOB and other products that are available. They do have a fantastic colour scheme and great looking dashboard and I think that's what most people think is great about Xero - they don't really understand the back end bits.

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Nothing is fishy, it's basic revenue recognition. Its their monthly committed revenue at year end divided by their y/end user number.... Your not comparing apples with apples.. Accounting channel partners are the channel of growth and they have a discounted rate they take to end user.

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Think there is a mistake in the article.. "or $520.5 billion to be precise"

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Xero's cheapest public plan in NZ is $29 per month. However, accountants can sign their clients up to a simpler cashbook version for $10 per month. They also provide volume discounts for sales of all their products sold via accountants.

So, they are either signing up a lot on the cheap plans or discounting a lot on the expensive plans - or both.

Its not a case of Xero not being able to add. However, whatever way you add it up, its a long way from the $75 per month per customer that was forecast in Xero's IPO documents.

And I believe there will be continuing downward pressure on that monthly return per customer. There are more and more cheaper and even free products entering the market. Its not just about growth. As with any business it is ultimately about cashflow - something Xero clearly struggles with.

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