Is Xero worth a cool billion?

Xero co-founder and CEO Rod Dury

KeallHauled

Chris Keall

 UPDATE: Xero shares [NZX:XRO] slid 9.09% to $7.00 Tuesday, pushing the company's market cap back to $820 million.

Rod Drury is a smart guy.

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

But is it $ 1billion worth of great?

On June 1 this year, I asked those questions in a blog called "Is Xero worth a cool half-billion?"

Now, I need to rephrase.

Since then, the company's worth has almost doubled. Yesterday, the company's shares closed up 11.92% to $7.70 

In the two trading days since companies controlled by Facebook and Paypal billionaire Peter Thiel injected $60 million, Xero's market cap has risen 18% to a cool $902 million.

Is that a little over-heated?

We're looking at a company that is growing fast.

Revenue in the six months to September was $17.3 million, vs $7.9 million in the year-ago half-year. 

And customers more than doubled to 111,800.

But its half-year loss also doubled, to $7 million, and the company says it will lose even more over the next half year.

By any conventional value measure, Xero is not worth $902 million.

Xero's September half-year quick summary. Click to zoom.

Three years' breathing space
But of course we're not looking at traditional value measures; we're looking at a high-growth company that created a new field (online accounting software). Will it push aside traditional accounting software companies, which are only just starting to push online products? 

Can Rod sweet talk influencers in the key US market?

Will the likes of MYOB, Sage and Intuit smack Xero down; get trampled by its success; or try to buy it? 

Can it hit a million customers, and turn a modest profit? That was the level MYOB was at when it was sold to private equity company Bain Capital for $US1.3 billion ($NZ1.6 billion), or an estimated 11.3 ebitda.

I don't know. 

What I do know is that Xero now has a lot more breathing space, thanks to the issue of 10 million new shares at $6 each (the trading price at the time).

Forsyth Barr says Xero now has enough cash to last three years' at its current burn rate.

Of course, nothing stays current for long at Xero. On Friday, Mr Drury told NBR the company would hire around 200 more staff over the next 18 months for a total of 500 as it continued to focus strongly on growth over profit. Against this, more money money should be coming in through the door.

Xero 12-month NZX performance. Click to zoom. Source: S&P Capital IQ.

From reduce to hold
In June, Forsyth Barr had a reduce rating on Xero and a valuation of $2.63 - with a sensible proviso "“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.”

Oh to have bet on yesterday's horse race.

ForBarr's latest note - issued after yesterday's big run up to $7.70 - has a hold rating on Xero and a 12-month target price of $6.32.

Too much cash
ForBar raises a curious problem: $85 million is too much cash.

The $30 million the company had in the bank ahead of the Thiel deal was sufficient for immediate needs.

According to ForBar's sums, $85 million is around $40 million more than needed to get to cashflow breakeven, "unless Xero significantly ramps up costs."

Said ramping up is a clear and present possibility.

As noted above, Drury has already told NBR he plans to hire 200 more staff. And while Xero has so far favoured the guerilla tactics that worked so well in NZ, Australia and the UK (winning over accountings, working industry events, and exploiting social media), you could spend what you like on an attempt to crack the US market.

And there is a lot of room to grow in the US. Although Xero continues to expand overseas at pace, most of its customers were NZ-based as of its September half year report, which listed

  • NZ customers: 57,300 (last year: 36,600)
  • Australia customers: 32,500 (10,400)
  • UK: 15,100 (7300)
  • US/rest of world:  6900 (3,000)

"Having a large pile of cash increases the challenge that Xero's board faces to ensure spending is focussed such that investors receive an adequate return on
capital," ForBar analyst Andrew Harvey-Green writes.

"The size of the capital raising raises questions about Xero's investment plans in the US and the UK. We had assumed a significant ramp up in expenditure (in line with the customer growth), but not to the extent implied by the capital raising." (Dury told NBR the cash would be used to fund growth across the board.)

Harvey-Green mentioned to NBR another possibility (not covered in his note): that Xero might be planning more acquisitions. That would help explain why Xero raised more cash than it needed, he said.

While ForBar's forecasts are unchanged, the analyst noted the "downside risks associated with poor spending." (I'm going to take it as read that Rod reckons they'll be smart spending.)

"I'm not saying that will happen, at all, but when the money's in the bank there's always the temptation to spend it," Harvey-Green told NBR.

There are worse problems to have.

Current share price assumes growth to 1.1m customers
Using fancypants financial modelling, ForBar says Xero's current share price assumes around 1.1 customers in about five years a "not unreachable target."

Compared to the slagging ForBar gave Xero in June, it's positive stuff. However, it's nothing analysts or journalists have said that's caused Xero's 18% run up in to trading days; it's that sophisticated investor Thiel has put his money where his mouth is. 

At the same time Thiel upped his stake, Drury sold $5 million worth of shares, co-founder Hamish Edwards $2 million and director Craig Winkler $15 million. The sale was guaranteed to provoke cynical comments. Personally, I don't have a problem with it. Drury has to pay the grocer. And he's not lying around the beach spending his fortune on cocaine, he's been an active backer of other NZ startups.

ckeall@nbr.co.nz


POSTSCRIPT:

Rod Drury has always said he's in it for the long-haul with Xero.

But NBR does note he has (very successfully) sold two previous companies.

And we did spy his tweet the other day about another SaaS (software-as-a-service) company - selling for $US1.2 billion.

No doubt Drury was looking to highlight the inherent hotness of SaaS companies, rather than hint at the kind of money Xero could go for in a trade sale ...

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30 Comments & Questions

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It is hard to believe Xero is worth as much as the share price says. If traditional investment metrics are being dispensed with by investors in favour of momentum, then someone may end up with burnt fingers if they are relying on euphoria to value XRO.

All that cash makes for a very tempting takeover target, though.

Good on Rod Drury, his success is deserved.

[Edited]

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You don't take over a $900m company for $80m cash. I think this shows they plan to go it alone rather than hope to be bought out by MYOB, etc.

With 200 extra staff, will be interesting to see what their cash burn goes to.

In the meantime, I am a very happy Xero user and expect the product to get better and better over time.

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What a crazy comment. Who would takeover the company at that valuation just to get a little bit (relatively speaking) of cash?

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They would use the cash to pay for the bid, getting an immediate discount on Xero by using cash to help fund or pay off their debt. Do you not understand how takeovers work and why some companies are attractive as takeover targets when they are either under valued, under geared or over cashed up?

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I think it's you who doesn't understand. The price you have to pay reflects the cash on the balance sheet as well as the future prospects of the business. And even when you eventually get access to the cash big deal you get $80m back after you have spent ONE BILLION DOLLARS. Duh

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And the cash isn't surplus cash (say distributable after a purchase), it is required to fund the ongoing operations of the business (and hopes and dreams of thousands of mum and pops). You could say, well, lets slash and burn - cut operations and then distribute all the cash, which would be an awful idea because you just paid a billion for $80m. Besides, say you only paid $50m and thought you were really clever, the number of redundancy costs, lease termination costs, etc, would eat that amount up. That $80m has no value.

The only thing that has value are future profits. Not revenue growth, non-customer numbers, not fancy business model, not twitter accounts and gossping/bad mouthing competitors - but profits. The end.

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Bit slow on the commenting today. The Doctor should be along shortly, I imagine.

I would just like to take the time to say I think it is good that the share price is going up for whatever reason and that I don't wish doom on investors who are backing this company.

I am sure people who do wish doom upon you will be along soon.

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It will be interesting to see where it goes today. Yesterday looked just a bit too exuberant for my liking.

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I pity anybody paying money to Forsyth Barr for investment advice. Less than six months ago they valued the shares at $2.63 and a SELL, and now they're saying $6.32 and HOLD? And the best analysis they can come up with is they might have too much money?

Xero are a global play but NZ media are not awake to this. It seems, though, that the investors in Australia and NZ are. When Xero arrives in the US, and on the NASDAQ, they are going to be compared with other internet businesses ... and guess what? They are going to look like gold.

Unlike many online businesses, Xero has:

1) Huge barrier to entry
2) Locked in revenue
3) Endless expansion possibilities
4) Data that is worth its weight in gold
5) Real ways to monetise

and guess what? No banner ads involved.

Those investors who have pumped Xero to near a $1b can see the path that Xero is heading down. The media, on the other hand, especially in NZ, continue to look like a deer in the headlights. "Hey ... what? ... surely not ... this is just not normal... "

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To be fair, they do a fair bit of advertising online. Plenty of banner ads :-)

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This comment was in reference to display advertising being a revenue generator like Facebook.

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Anyone who relies on Forsyth Barr gets what they deserve.

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I am a Forsyth Barr client and after their earlier email sold enough of my Xero shares to recover my initial investment, believing that Xero was overpriced. I still believe it is overpriced, but the price keeps going up, so I will retain my current holding as I have nothing to lose and potentially a lot to gain. IMHO based on the information I have, this is more of a speculation than prudent conservative investment. Peter Thiel et al being closer to Rod Drury than I would no doubt have a bit more information than I do.

As a side note, it is well worth reading Richard Koch's The Star Principle. Because of this book I bought shares in Xero and continue to hold them.

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One of the theories in growing an early stage/high growth business is take all of the funds that are offered regardless of whether or not it is required. The world changes (GFC, etc) rapidly so better to have the cash, so good move by Xero. It also creates options for them which obviously adds value to the business.

I think it also signals to the likes of MYOB and others that the threat from Xero is more than real – maybe it will provoke an offer from one of them.

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Star Wars sold for $4 billion, Xero valued at $1 billion.

Just goes to show how much softwear companies are overvalued.

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When will it make the NZX15? Surely that will cause more passive fund purchases?

While I don't agree with the price, and it looks high, they are playing the regulatory and operating environment very well.

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I honestly thought the NZX would issue a "please explain" to Xero today.

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No trade player will acquire Xero because it will be massively (EPS) dilutive to the acquirer's shareholders. They would buy it for the product, but the price has gotten away from reality. Second, Xero isn't growing that fast. Sure it's doubling, but from a low base, which is easy to do. Try doubling when revenues are $300m, then you will have my attention, but only if it reaches scale profitability in the next year. Third, cloud accounting software isn't hard to do. It's harder to build global distribution networks to generate sales, which Xero is finding out. Fourth, how dare Rod take money off the table when he has put thousands of mum and pop investors hopes and savings into a high-risk asset and talked up share prices. He is the only one who will do well.

[Edited]

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Mum and dad investors should be investing in companies with a better strategy than hope and with savings they can ill-afford to lose. Rod never said people should invest in the company, he actually said if you don't like the model don't invest.

Perhaps he should bag the company and tell people to be ready for inevitable failure. God forbid a CEO or founder stand behind or support his company. The horror!

Why shouldn't Rod take some money off the table? He has certainly made enough for his investors so far.

Cloud accounting S/W isn't hard to do... How is your cloud company going?

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I dont have a problem with the Xero's model. I have a problem with Xero's over-hyped valuation, which has no fundamental or economic basis. The model and the product are fine. TELL me what financial metric justifies the valuation.

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I don't believe there is a standard company metric that really justifies this valuation but it's the investors who are pushing the share price. There seems to be a lot of support for the Xero world view.

Nothing wrong with that as long as you understand that this is a hugely speculative play and you are using money you can afford to potentially lose.

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How much of this valuation is dependent on Rod Drury? How is Rod's health? Not that one would wish this, but what would the impact be if he was to fall unwell? Is the leadership team - of which we know little, presumably deliberately - able to carry on? One could argue that with Rod being the embodiment of Xero in the marketplace, Xero = Rod = potential risk?

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Please...be serious. Rod Drury is a clever guy but he is not Steve Jobs. Forget about his health and what affect that might have on the company.

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Rod's looking pretty smart in that business suit.

He reminds me of Graeme Hart now ... jumped a few levels up on the pegging order and liking the view :)

Go Roddo!

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Tulip bulbs, anyone?

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The general public are valuing this company and nobody else. That's what public companies are. However, I won't be buying at the current level.

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Zero: A mania in the making.

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People thinking share prices have anything to with EPS or "intrinsic value" need to be doing more research.
The value is simple - people are buying shares because they believe that this company is going places in the future, and not selling them.
Same logic as why Apple is so "over" priced.

What I love about Xero even more than the product is it's shaking up NZ investors to realise growth from overseas can be phenomenal after so many years of NZ companies doing the Aust expansion thing and failing.

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Um, Apple overpriced? Apple's EPS $44.16, PE 12.96, income $42b, seems fairly priced to me. To get Xero to similar earnings P/E, earnings PS need to be 59c on current $7.70 share price. Xero has something like 108 million shares, net profit needs to be some $64m. Seems (if calulations are right) a hell of a long wait and risk to get a adequate market return based on cashflow, rather than current market speculation.

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A man with a mission, and a really good bloke as well. Glad we bought in on day #1.
Go go go, Rod. I love successful people. Wish we had more of you in NZ.

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