Yesterday Valuecruncher received a tour and presentation from Rod Drury at the Xero offices. It was our first chance to see the product up close and it is impressive. Rod has built an “A” team to execute on the business plan.
Valuecruncher believes that if Xero is successful then one of the large players in the industry will likely acquire the company to implement a Software as a Service (SaaS) offering. Xero is a pure-play SaaS model and if Xero is successful and there is a significant market demand for a SaaS product then other players will need to reconfigure their offerings to incorporate this. Valuecruncher does not believe that Xero’s competitors (MYOB, Sage and Intuit) will standby and watch a start-up using a business model they can copy dominate the industry. Why could they copy the business model? These competitors want the customers that Xero are targeting and the profit margins Xero are able to obtain will be attractive as well. These competitors would have the motivation and financial resources to go after the SaaS market if it proves to be attractive. The acquisition of 42 Below by Baracrdi is a reasonable model for what we would expect the outcome to be for a successful Xero.
What does a successful Xero look like?
In our view there is one key metric – the number of customers that Xero obtains. Xero has a recurring revenue model (monthly payments from customers – NZ$75 per month is the assumption in the Prospectus [page 48]). Once you sign up a customer they will produce a monthly revenue stream for as long as they are happy and need an accounting product. There will be some churn but this is a good model if Xero can get it to work.
The Xero Prospectus states that “New Zealand revenue will begin to exceed its New Zealand cost base at around 8,000 customers” [page 34]. With the SaaS business model we would expect a reasonably fixed cost base for the company – i.e. once Xero covers its costs the resulting revenues will represent mostly profit.
Based on the 8,000 customers at NZ$75 per month Xero outlines in the Prospectus this cost base is approximately NZ$600,000 per month or NZ$7.2 million per annum. This is New Zealand only and Xero is looking at Australia and the UK as well so we will push that out to 10,000 customers at NZ$75 per month for an annual fixed cost base of NZ$9.0 million. Based on this analysis – when Xero gets over 10,000 customers it starts to become profitable fast.
If you are investing in the IPO with a valuation of NZ$55 million – what does this mean as a breakeven customer number?
The following are very high-level numbers. Assuming everything above 10,000 customers or NZ$9.0 million of revenues is 100% profit (we think it will actually be less than 100% but this is indicative analysis only). We have seen analysis estimating company value at 10x EBITDA which is probably reasonable. MYOB trades at 7.3x EBITDA, Sage at 14.0x EBITDA and Intuit at 13.3x EBITDA. To risk adjust this to factor in the time to achieving this position we have worked backwards at a 20% discount rate for five years. This means that to be equal to the NZ$55 million valuation today Xero would need to be worth NZ$137 million in five years. For Xero this represents NZ$22.7 million of revenues (less the NZ$9.0 million of fixed cost base) or approximately 25,000 customers in five years. To put this in context MYOB generates approximately NZ$30 million of revenues in New Zealand alone.
If you are going to invest you will need to believe that Xero will get to these 25,000 customers in five years without any additional capital. You will think it is a good buy if you believe they can sign up a lot more customers than 25,000 in five years with the funds from the IPO.
The Xero Prospectus projects customer numbers at 1,300 at the end of year 1 (10 May 2008) [page 48]. Under key Milestones [page 34] the Prospectus states Xero’s Directors do not believe that the company will make a profit in the first three years and uses 8,000 customers as the breakeven number. We will assume 8,000 customers at the end of year 3 (10 May 2010). This means that Xero would have two years to grow the customer base to 25,000 from 8,000. It should be noted that lawyers insist that companies are conservative in making any projections in a Prospectus. By going down an IPO route we believe that the company is probably looking at far more aggressive growth in the initial years.
Again from the Prospectus [page 23] – SMEs by country Xero are focusing on: UK 4.3 million, Australia 1.2 million and New Zealand 322,000. But as a qualifier – Intuit in the US estimate that 60% of the 26 million SMEs in the US don’t use any accounting software (page 2 of 2006 Intuit Annual Report). Xero are targeting this segment– but there will always be a component that doesn’t consume.
Do we think that Xero will get to 25,000 customers in five years? We honestly do not know. But we believe that is the key to assessing the Xero IPO – what is the customer uptake is going to be?
With early stage companies – losses are fine as long as value is being created. Investors in Xero should basically ignore the losses the company will make over the first few years after the IPO (as long as they don’t burn all the cash too quickly). The key metric to understanding the business will be the customer uptake. Investors should watch that customer uptake closely and have an opinion about where it is going to understand the value of Xero.
We would be very interested in opinions about what the uptake will be.
This analysis is very high-level and relies upon some key assumptions that are certainly open to debate. Namely: a 20% discount rate, that Xero would be valued at 10x EBITDA, the fixed cost base of NZ$9.0 million, and 100% of revenues above the fixed cost base equal EBITDA. We would expect a variable cost component to each sale made but it is impossible to determine exactly what this would be.