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Xero's key US rival piles on cloud customers - but strategy boss sees a key weakness

Xero's [NZX: XRO] key rival in the US market, Intuit, is piling on cloud customers.

In its second quarter result (for the three months to January 21), Intuit says paid subscribers to its QuickBooks Online product increased by 45,000 to 591,000 - a 30% increase on the year-ago quarter. An overwhelming majority of these cloud customers are in Intuit's home market of the US, with most of the international subscribers over the border in Canada.

Overall, Intuit lost $US46 million during the quarter against a year-ago profit of $US140 million. Quarterly revenue dipped 12% against the year-ago quarter to $US782 million.

The company completed the buyback of $US1.4 billion of its own shares. It finished the quarter with $US625 million cash against the year-ago $1.01 billion.

The quarter was marked by an aggressive marketing spend, notably a Super Bowl campaign and daily TV ads. The cost of the Super Bowl campaign alone has been pegged at $US10 million-plus.

In worldwide terms, Xero is well within coo-ee of Intuit, at least in the cloud space.

In a February 20 ASX/NZX update, Xero said it now had 250,000 paying customers - a net gain of 115,000 over the past year, and 50,000 since August.

But in its home market, Intuit seems well ahead.

Xero offered no geographic breakdown on February 20, and the company says it won't be until its full-year result - although it did offer that Australian customers are now close to 100,000.

In an October 2013 update, when it had 211,300 paying customers, Xero gave the following geographic breakdown:  NZ: 85,500; Australia: 79,100; UK: 30,100; US/rest-of-world: 16,600.

Intuit says most of its cloud growth this quarter was overseas but last quarter it said just 42,000 of its QuickBooks Online customers were outside the US; its cloud product seems to be still very heavily concentrated in the US.

Most pundits think Xero must do well in the key US over the next few years to justify its sky-high $US5 billion market cap and lay the way for a Nasdaq listing but so far almost all of Xero's growth has been outside of North America. The company says, until December last year, it was effectively fighting with one hand tied behind its back, given its lack of direct payroll support. Payroll modules have now been rolled out for several states, though it's still very much a work in progress (see Xero's latest update here).

Talking to NBR before a "fireside chat" with reporters at last week's Xerocon event in Auckland, chief revenue officer Stuart McLean said he was charged with doubling revenue each year. Obviously it gets harder and holder to fold the same piece of paper but he says he's aiming to do jus that over the next couple of years at least.

With its current revenue (an annualised $80 million), Xero has 250,000 customers. Doubling revenue, then doubling it again, implies a leap in customers to 500,000 next year then one million the next - remembering Xero now says it wants to hit one million customers before gunning for profit. McLean says it's not quite that simple; part of his strategy is to gain more average monthly revenue from existing customers (which had very mixed results when Xero suffered a backlash after raising rates - for the first time ever - in an experiment in Australia late last year).

Still, that million customer goal has to involve making big strides in the US, where Intuit stands in the way. How to crack it?

Intuit's weak points
Xero global strategy head Chris Teeling says he's unimpressed by Intuit's latest result. He says the 30% growth in cloud subs is flat over the previous year, and notes that while online subs have increased, overall revenue has remain flat - and in fact fallen. 

Like MYOB in Australia, Intuit is torn, Teeling says. It has to defend its revenue from an installed base of five million or so offline/desktop users, while making the transition to the cloud (it's estimated the US has around 19 million small businesses but most use Excel for their accounts or nothing, simply shoving paper work in their accountant's direction).

As Teeling puts it, "Intuit can't afford to have the arse fall out of their revenue in other any other areas while they pursue online growth."
 
(It's worth noting that despite his Kiwi vernacular, Teeling has spent a lot of time working in the US, both in New York as a senior manager for JP Morgan, and with San Francisco startup Green Button, which forged alliances with Microsoft, Amazon and Dell, among others. He's also worked in a global strategy role with Fonterra.)

But where Xero perceives privately-held MYOB's key weakness (beyond its offline legacy) being its towering debt, for Nasdaq-listed Intuit, it's a promise to keep growing revenue.

Teeling says that on conference call after conference call with investors and analysts, Intuit CEO Brad Smith has promised an annual revenue growth rate of 9%.

So Intuit can't suck up loses or a big revenue hit as it repositions for the cloud, Teeling says (though it's latest quarterly result seems to be leaning in that direction, NBR notes; see also this commentary from Ben Kepes for Forbes, which says while Intuit's cloud product has been "substandard" in the past, the company has finally got serious about external theats. "In essence, they’re disrupting themselves before Xero does it for them," Kepes writes).

Xero investors, by contrast, have been well-trained to accept losses on the march to the magic million customer mark.

Teeling also says a 45,000 quarterly gain in Quick Books Online users isn't that impressive for QuickBooks, given it was "switch season" in the US.

At the XeroCon fireside chat, CEO Rod Drury said there was a chance to peel away Intuit customers with the move to the cloud, and more, because the US company had cut accountants out of the picture, selling directly to customers.

Teeling picked up on this theme in his comments to NBR this morning. He said while Australia and New Zealand were unique in that most people bought whatever software their accountant recommended (leading to a fierce battle between Xero and MYOB for the hearts and minds of bookkeepers), the fact that accountants have been marginalised in the US made them open to Xero's advances. It hopes to sell them on the opportunity for services revenue.

In Australia, Xero started experimenting with its first traditional advertising late last year, involving millions spent on bus ads, fly posters and radio ads. McLean says it was very successful. The most blunt measure of success will be whether Xero replicates the test-bed strategy in other markets. So far, it's not. McLean says it won't until it gauges the effect of a second-phase campaign in Australia that will involve a "call to action." (The creative for phase one involved customer tweets being quoted on posters, or read out  on radio).

Traditional advertising in the giant US market is not on the agenda however, Drury said at the fireside chat, whatever its success across the Tasman.

Instead, the company will continue to sign on accountants as partners, and schmooze them at its XeroCon events, and push social media and search ads, and similar online tactics.

High-powered US recruits
Teeling also notes that today is the first day on the job for Xero's new US CEO Peter Karpas - whose previous roles include chief marketing officer at Intuit. Karpas' inside knowledge of its rival has to help, Xero figures.

Karpas' appointment coincided with two additions to Xero' board: New York-based Chris Liddell, who has become chairman, and the US-based Bill Veghte, whose day job is running HP's enterprise group. And Xero says the recent appointment of Telecom/Chorus veteran Victoria Crone as Xero' NZ GM will allow Rod Drury to spend more time in the US.

Increasingly for Xero, it's all about America, and that means it's all about Intuit.

For a contrarian take on Xero's US prospects, read Xero may not fully appreciate what it's up against in the US market - analyst, slapping on a sell.

ckeall@nbr.co.nz


RATING XERO

Woodward Partners Securities:  Reduce; 12-month target: $27.00 
Forsyth Barr: Underperform; 12-month target: $24.75
First NZ Capital: Outperform; 12-month target: $45.70
(Xero [NZX: XRO] was  flat at $40.00 in midday trading)

XERO HALF-YEAR RESULT (reported Oct 3, 2013)

Loss: 17.1 million
Revenue: $30.3 million
Cash: $230 million
Customers: 250,000 as of February 2014. No geographic breakdown given. (In October 2013, with customers at 211,300, Xero gave the following geographic breakdown - NZ: 85,500; Australia :79,100; UK 30,100; US/rest-of-world: 16,600)
See also NBR's report on Xero's Jan 31 NZX update: Xero customer receipts rise 14% in 4Q as cash burn creeps higher

More by Chris Keall

Comments and questions
3

I agree moving from a licence and M&S model to SaaS is a hard pill to swallow, however, intuit have the cash reserves, and if it is pitched well to the market (no doubt part of the buy-back strategy...) then they could switch pretty quickly.

It's pretty hard to see the the difference between Xero starting out cloudbased with no customers and lots of cash, and an established company with more cash, existing customers, running (what appears to be a successful strategy based on 50k customers this quarter) to re-invent its self. Yet Xero has a capex vastly different.

If you split out the Cloud/Service revenue component from Intuit which I think is about 1Billion/annum and run similar metrics to Xero for ARPU, acquisition, etc it either says Intuit is massively undervalued, or Xero is massively over-valued.

Having been involved with a company that successfully made the transition from licence/M&S to SaaS, if you have a big client base, there is enormous upside and lower cost retaining/retraining than acquiring. Once you have the revenue-expenses back in balance for profitability, it looks unassailable from a continuity perspective, but revenue growth at a lower ARPU is a slog. Hence the focus on a "metric" which tells a good story, ie "number of users".

Inevitably there will be room for Xero, will it justify the current valuation...? I say it's Intuit's to lose.

I agree with all of the comments above. It seems obvious now that Intuit will make the transition to the cloud.

that said, it is also great that the conversation is Xero vs Intuit, if this is the conversation in the US then Xero will easily reach its million target, even as a 2nd place holder in the category. A move to the Nasdaq will help their US profile a lot.

Their eco system model, partner program and cloud nativeness all create advantages that will allow them to take a good share of the market in innovative ways that are forcing intuit to react.

It's inspiring to see a kiwi company competing at this level in the hottest show on Earth - all power to Xero.

Xero are revolutionising the Accounting Industry. Having an accounting and IT background for the last 25 years, and installed and trained on all different types of softwares over the years, Xero makes so much sense for so many reasons. I have always battled to understand why accountants and clients have different ledgers. So much time in wasted in accountants offices on client files. Xero are definitely leaders in this market. Intuit are along way behind.