About
Xero is a New Zealand domiciled public technology company, listed on the Australian Stock Exchange, that offers a cloud-based accounting software platform for small and medium-sized businesses. The company has three offices in New Zealand Wellington, Auckland and Napier), six offices in Australia Melbourne, Sydney, Canberra, Adelaide, Brisbane and Perth), two offices in the United Kingdom London and Milton Keynes), three offices in the United States Denver, San Francisco and New York), as well as offices in Canada, Singapore, Hong Kong and South Africa.
Xero's products are based on the software as a service SaaS model and sold by subscription, based on the type and number of company entities managed by the subscriber. Its products are used in over 180 different countries
Strategic Focus
At its core Xero is an easy-to-use but powerful online accounting system that was born in the cloud. Xero provides a growing family of connected solutions:
client accounting for small business available anywhere, anytime, and on mobile devices
accountant tools for management reporting and final accounts production
Xero’s software-as-a-service business model, where software is hosted securely on the internet, allows Xero to address the large and fragmented small business market. Xero releases new features monthly. Additions and extensions to functionality are developed in response to the needs of new customers and new industries.
The size of the small business market is second only to that of individual consumers. Typically the consumer internet has reverted to non-direct, usually advertising-based, revenue models. In contrast, we believe the small business market provides the greatest opportunity for monetisation on the internet and Xero is proving itself to be a leading innovator in this market.
Small Business Opportunity
Xero states in their most recent report:
"To provide some context around this opportunity, we estimate that less than 20 percent of small businesses currently use cloud accounting technologies, across the English-speaking countries in which we operate. In Xero’s home markets of New Zealand and Australia ANZ, our small business customers and partners are leading the world in the adoption of cloud accounting technologies. We estimate that over 50 percent of small businesses in the region use cloud accounting, which is more than double the uptake within other markets such as North America and the UK."
It's clear that the domestic market is quick on the uptake and may reach it's maturity in several years, more on potential catalysts later. Hence i would expect Xero to take a proactive approach in gaining subscribers overseas while developing their moat in the domestic markets to hold their lead.
Group KPI’s
Xero is experiencing significant growth as a result of the perceived opportunity that has arisen from the migration to cloud accounting software. I have seen firsthand how efficient and user-friendly Xero is in comparison to other software. Without a doubt, Xero is the best small business accounting software available right now in my humble opinion. If they can maintain this level of quality going forward with regular updates, i believe their userbase will be parabolic in the coming years.
Xero’s Value Chain
An organisation's competitive advantage comes from the way an organisations activities affects it's value chain. A value chain defined is a network of interrelated activities that provides value to customers and other stakeholders. So, to have a sustainable advantage, Xero must consist of a number of value-adding activities.
Product Life Cycle Analysis
Product life cycle analysis holds that each stage of a product’s life cycle has different cash flow and profit implications. Products in the early stages of their life cycle, introduction and growth, require high levels of cash investments in design, and for new manufacturing plant and marketing. In the maturity stage of the product life cycle, little investment is required and cash inflows increase dramatically. In the decline stage, revenues are reduced while service obligations must be met.
Xero pulls most of its revenue from its subscription-based software-as-aservice cloud accounting. In addition, there is several acquisitions to improve the system and third-party software 700 that is offered as plugins to work simultaneously with xero.
It is clear that Xero is nearing maturity with growth rates declining consistently in every market; however, growth rates are still very high, and Xero still has a huge opportunity to maintain high growth in subscribers overseas as is evident from their near 50% growth this year.
The same cannot be said of Australia and New Zealand, as it is much further along in its product life cycle. The recent advent of Single touch payroll may bring a helpful boost in its subscriber figures evident in the following financial year. To explain, Single touch payroll essentially has made payroll lodgement on every pay-period a legislative requirement, furthering the need for fast and convenient payroll preparation and lodgement.
In summary, Xero is still in the growth stage of it’s life cycle with large growth rates in consumer base with strong revenue growth. However, it is nearing maturity in the domestic market. Once top line margins stabilise, I would expect Xero to relax its aggressive growth structure and emphasisie returns on investment on the bottom half of it’s financial universe. Think a switch from emphasis on top line revenues to net margins and cash flows Evidenced by their recent cash flow positive FY19 result).
Porter’s Five Forces
Porter's Five Forces is a model that identifies and analyzes five competitive forces that shape every industry, and helps determine an industry's weaknesses and strengths.
Competition in the Industry
Xero's key competitors include MYOB and Intuit Quickbooks. Other noteworthy names are Reckon Ltd, Sage Group, Saasu and Wave, although pale in comparison for market share.
In Australia, Xero is strongly contesting with MYOB with subsciber numbers of 726,000 for Xero As at 31 March 2019 and 628,000 for MYOB As at 31 December 2018. Intuit lags in the domestic market with only 160,000 subscribers As at 30 June 2018.
However in the Global space, things change drastically. Xero has a total Subscriber base of 1.82 Million, while Intuit is over double that at 4.2m for it's Quickbooks online product. Sage is strong in the UK, however Xero has still beat it out there.
Threat of New Entrants into the industry
There is a number of free accounting software programs out there such as Wave Accounting, however they just do not have the quality behind them due to availability of financial resources. This makes it very difficult to match the level of quality of products such as Xero and Intuit. Brand reputation is high for the main players, reflected by Xero's $289 Million in intangible assets. In essence this reflects the premium xero has paid in developing it's brand via acquisitions and investments.
Due to this high degree of quality and brand value, a degree of anticompetitiveness exists between the major software providers in terms of price-setting. For instance, in Australia Xero charges $75 a month for the equivalent to Quickbooks top plan that is only $40 a month. Despite this, Xero has a significantly larger market share in Australia. MYOB is $60/Month with less features, however offers unlimited employees in comparison to 10 on the $75 Xero subscription.
Customers
When it comes to accounting software, the most significant thing when it comes to the cost of switching providers is whether the software has the ability to import from another provider (i.e. Import quickbooks file to Xero). The breakdown of Australia's major software in this area is broken down below:
Quickbooks - Choose Essentials $30 or Plus $40, and it's free to transfer up to 2-years of data from an existing Xero, Reckon or MYOB account.
MYOB - Using Convert2MYOB it is free for up to 10 employees and $49 for up to 25 employees from exisiting MYOB Products, Xero or quickbooks No Reckon listed).
Xero - Their conversion service works with MYOB, Reckon & Quickbooks.
As a free software, Wave Accounting does not offer a conversion service, and most other free software isn't likely to either. This provides a strategic advantage to the major accounting software that does, allowing them to retain customers once received.
Alternatives
As covered above, the main viable alternatives to Xero are those with a strong brand name and a quality product, capable of conversion. This narrows down the list significantly with the main competitors in Australia being MYOB, Reckon & Quickbooks, while international competition includes Quickbooks & Sage to name a few. With Xero's high quality product, i believe retention is very achievable for them and a focus on lifetime value figures is appropriate.
To achieve onboarding, Xero is aggressively investing into it's business via acquisitions such as the recent Hubdocs. In the 2019 Investor Presentation this focus was front and center in regards to their outlook, with much growth expected to continue.
To be specific, MYOB has too many different packages available, often making it confusing for customers to know which one is suitable for them. Quickbooks while cheap, pales in comparison to Xero in the quality of product that is provided due to it's reliance on third-party software and limited functionality
Suppliers
The closest thing to supplier's xero has are the partners that use the software Accountants). In order to bring on a bulk amount of customers, their partner program is key to maintain a strong strategic growth. The key features of Xero's partner program include:
Xero has a brilliant tier based partner system with incentives to retain Key partner talent.
Exclusive events for Partners across the world.
Financial-web between financial service providers - i.e. Super payments, invoice payment requests etc.
Developer partnerships
Education via Xero Learn partnership with universities etc. 700 third-party apps make the Xero platform modular and scalable in some degree
Workflowmax - Job management software that integrates with Xero
Quickbooks partner program, while impressive does not compare to the completeness of the Xero partner program and relies on more third-party integrations due to it's inferior product.
MYOB Partner program is better than Quickbooks, yet still lacks the complete and attractive nature of Xero's partner program.
So how much should I pay for a great business like Xero?
Most value investors would instantly write off Xero due to metrics such as their 25x book value and 16x revenues which i would tend to agree with. Despite their parabolic subscriber growth, Xero has remained a loss-making company and does not represent a great investment at the current price on traditional valuation metrics.
To try to gain an appropriate approximation of value for this company, i will use the Enterprise Value-To-Revenue Multiple and compare to it's competitors.
The enterprise value-to-revenue multiple EV/R is a measure of the value of a stock that compares a company's enterprise value to its revenue. EV/R is one of several fundamental indicators that investors use to determine whether a stock is priced fairly. It can be used for companies that do not generate income or profits. A lower multiple indicates a cheaper price.
The results show that Xero and Intuit are the most expensive of the bunch, while Reckon is significantly cheaper than the rest. This makes sense given that Xero and Intuit are the market leaders in the industry.
A point of note is that even though Intuit has significantly more subscribers and market share, it is cheaper than Xero on this metric. This could mean that Xero is significantly overvalued OR priced to take Intuit's market share. I am leaning toward the latter. However this is still much to high of a multiple to pay.
A reasonable multiple to looks to be around 7-8 EV/Revenue, given that it is slightly above MYOB and Sage in Market share.
This would mean that all else remaining constant, a market Capital of around 4.5B is a fair price for Xero, which implies a stock price of $32 is a fair value. On top of this, i would want a margin of safety of 20% given it's growth and my confidence of the business. Therefore my buy price is $25 a share for Xero.