During the Xero IPO process in May 2007 Valuecruncher estimated the number of customers Xero required in five years time to justify the $55 million post money valuation of the IPO. Based on a number of subjective assumptions Valuecruncher estimated that Xero would require approximately 25,000 customers. Xero has recently released their preliminary results for the six months ending 30 September. Although the company is still in its formative stages and there is limited available information Valuecruncher has decided to re-visit and extend our initial analysis.

Revised Analysis

A key assumption in the initial analysis was average monthly revenue per customer of $75 (based on information in the Xero prospectus). Xero has reduced the base monthly subscription price to $50 and in their preliminary results announced average monthly revenue per customer of $54. The lower average monthly revenue will increase the number of customers required.

A second key assumption was the future profitability of Xero. Valuecruncher’s initial analysis assumed that break-even including expansion into the UK was at 10,000 customers and that any revenue from additional customers would translate directly into EBITDA. Valuecruncher recognised this assumption oversimplified the business model and would over-estimate Xero’s future profitability. Over the last couple of months Valuecruncher has looked closer at the economics of the SaaS business model and the market for accounting software. The revised analysis incorporates a projected EBITDA margin.

Estimating an EBITDA margin for Xero

Projecting EBITDA margins for an early stage company is a subjective exercise that contains considerable uncertainty. A common approach is to consider established comparable companies. The issue with comparing Xero to established providers of accounting software is that these companies operate as traditional software businesses selling packaged software on a 2-3 year cycle as opposed to Xero’s subscription based SaaS offering. There are a number of listed SaaS operators that provide an insight into the potential profitability of Xero. Care is required when considering these companies as comparators. Although these companies utilise the SaaS delivery model they provide different services to different customers in terms of size and geographic location and via a range of pricing structures. When considering the potential EBITDA margins there are four key cost components:

Cost of Sales (CoS)

Development Expense

General and Administrative

Sales and Marketing

The CoS includes hosting, delivery and support expenses. Development expense relates to ongoing development and upgrading of the offering. General and administrative are the expenses associated with maintaining the business. These expenses can be estimated as a percentage of sales using SaaS companies operating in different segments.

The key unknown in Xero’s cost structure will be the sales and marketing component. Anecdotal evidence suggests that mature SaaS firms spend 30%-35% of revenues on sales and marketing. Leading customer relationship management provider Salesforce currently spends approximately 50% of recognised revenues on sales and marketing. As Valuecruncher has highlighted previously this metric will always be higher for SaaS companies during their growth phase due to the small portion of the revenue stream that is realised at the time of the sale. Based on some high-level analysis of Saleforce’s financial statements they appear to spend over 65% of the estimated annual subscription revenue to acquire each new subscription. This acquisition cost relies on Salesforce retaining the customer and implicitly selling ongoing upgrades via the subscription. This cost of customer acquisition reiterates the long-term thinking required when considering the SaaS business model and highlights the need to minimise churn. Salesforce primarily sells subscriptions directly via inside sales, telesales and field sales personnel. Salesforce customers range from a single subscription to 25,000 subscriptions so they will be expected to have a different framework to Xero. Xero’s offering targets the SME market and particularly 1-5 employee businesses. Salesforce’s primary method of engaging small businesses is telesales. Xero’s initial market focus has been on establishing relationships with accountants which is an important first step in building credibility but there has been limited information released on a wider marketing strategy.

Based on analysis of comparable companies and anecdotal evidence Valuecruncher has estimated a future EBITDA margin of 35%. This is a very subjective estimate and is very dependent on the unknown sales and marketing expense component.

Incorporating our revised assumptions of $54 per month revenue per customer, 35% EBITDA margins and the current share price ($0.84) Valuecruncher estimates that Xero would require 35,000 customers (in five years). As stated previously Valuecruncher does not know whether this is a big number or not. It is easy to say that 35,000 looks like a daunting target starting from 204 customers at 30 September 2007. It is important to put this number into perspective and consider that there are approximately 5.8 million SMEs in NZ, Australia and the UK. Based on U.S. estimates approximately 60% of SMEs are not using accounting software. The size of the market suggests that 35,000 is not a huge number especially when the potential to capture the large number of non-consumers. The one caveat when considering the size of the market is that the majority of these 5.8 million SMEs are in the UK and Xero is still to develop a UK product. Although Xero appears to be developing a quality product it is still to early to determine whether their offering will appeal to the estimated 60% of SMEs currently not using accounting software. There appears to be a huge opportunity here but successfully monetising it will depend on the ability to generate sales.

Valuecruncher’s estimate of 35,000 is a high-level estimate based on a number of subjective assumptions. We have created an Excel workbook that illustrates the calculation and allows users to vary the assumptions and draw their own conclusions. We encourage users to download the workbook and test our assumptions.

Valuecruncher Workbook – How many customers does Xero need?

This workbook contains Macros. If Excel’s macro security level is set to High the functionality will be limited. To utilise the full functionality of this workbook:

1. On the Tools menu, click options.

2. Click the Security tab.

3. Under Macro Security click, Macro Security.

4. Click the Security Level tab and then select the Medium secuirty level.

5. Excel must be restarted before these changes will take effect.

6. When opening the workbook select enable macros.

Note: We have noticed some issues with the workbook for Apple users – sorry.

Disclaimer: Valuecruncher Founder Mark Clare has a small shareholding in Xero and is considering becoming a Xero customer. Valuecruncher knows several material Xero Live shareholders and members of the executive management team. None of these parties have had any editorial input into this post.

Xero has released their preliminary results for the six months ending 30 September. Mainstream media have led with headlines highlighting the reported net loss of $1.75 million. Net profit (loss) is meaningless for companies in Xero’s position. Early stage companies are not expected to return a profit – losses are fine as long as value is being created. Financial analysis should focus on the cash used to fund the development and growth of the company (cash burn). Actual revenues have limited relevance for early stage companies; the focus will be on revenue growth which is a proxy for customer uptake. Early stage companies cannot be expected to support their operating and development costs from revenues as they are often do not have a fully commercial product or established customer base. Xero raised $15 million via an IPO in June to fund the development of the company over the next three years.

The runway for software as a service (SaaS) companies is typically longer than traditional shrink wrap solutions (e.g. software in a box like MYOB or Microsoft Office) because the subscription model collects revenues over a period of time as opposed to the one-off upfront payment. The subscription business model allows the SaaS providers to adopt an ongoing incremental upgrade approach as opposed to the shrink wrap method of a 1-2 year development cycle that aggregates improvements and delivers them in the form of a single paid upgrade. The SaaS model automatically “sells” users the upgrades via the ongoing subscription. Shrink-wrap solutions require an explicit transaction to take place. The new release will be required to cannibalise the earlier versions of software and typically involve an extensive marketing campaign on release. The SaaS offering is particularly appealing to consumers when the software is regularly required to go through a paid upgrade process. The appeal of the subscription model is lower where the shrink-wrap solution has an extended life. There are a number of proposed benefits of the “on-demand” SaaS delivery method but to achieve wide success in the small and medium enterprise (SME) market the offering should deliver cost efficiencies.

Adjusting for one-off expenses including loans to directors, IPO costs and purchases of property plant and equipment Xero burnt approximately $2.2 million over the last six months. This cash burn is consistent with estimates outlined in the prospectus. For growing technology companies a significant component of cash burn is staff expense. This cash burn can be expected to increase as the headcount increases, the existing staff cost is realised across a full six-month period and the company funds expansion into Australia and the UK (estimated at $1.2 million in the prospectus). Xero’s cash balance of $12.6 million will enable them to focus on executing their development and marketing plans in the short-term. When assessing the performance of early stage companies the focus should be on revenue growth (a proxy for customer adoption), cash burn and operating milestones. Since the IPO Xero has reached general release, established relationships with NZ banks, signed up over 200 customers, established partnerships with accountants and initiated activity in Australia and the UK.

The results to date are consistent with the information provided in the prospectus and with the advent of the general release the focus of observers will now shift to the customer uptake. The one material piece of information since the IPO is the reduction in price from $75 to $50. This decision is consistent with the focus on developing cost efficiencies to SMEs. The lower price point would be expected increase the addressable market and improve the customer uptake. This lower price point will increase the number of customers required to reach break-even. Depending on the demand elasticity this could extend the time taken to reach break-even. Although the SaaS business model should be considered as a long-term strategy the extended time taken to reach break-even may necessitate an additional capital raising.
Valuecruncher will be interested to observe release of additional products and price packages signaled in Xero’s interim report:

“In addition, the Company has identified a number of new opportunities that leverage its software development investment to date. These will allow it to offer additional products at varied price points designed to increase revenue over the remainder of the financial year and beyond.”

A key milestone in the short-term is Xero’s target of 1,300 NZ customers by May 2008. A key unknown to consider when assessing Xero is the customer acquisition costs. Xero have outlined a marketing strategy that involves partnering with accountants to reach potential customers. Accountants are one of the few professionals that have regular contact with SMEs. This accountant – client relationship is often quite strong and accountants are often consulted for advice beyond core accounting issues. Having a recommendation from a trusted advisor is important when introducing a new offering that involves a new delivery mechanism and pricing model. This model effectively outsources the marketing and relies on partners continuing to promote the offering. Aside from the improved ability for accountants to interact with clients and their information there appears to be no other motivation for partners to recommend the product (i.e. no commission payment). Xero have plans to implement additional marketing strategies.

There are numerous examples of established SaaS products in a range of sectors delivered by publicly listed companies providing considerable information on expected costs associated with the model. The consistent theme with these SaaS companies is the relatively high sales and marketing expense as a percentage of revenue. For example established SaaS provider Salesforce.com spends 40%+ of its approximately $500 million of revenue on sales and marketing. U.S. shrink-wrapped accounting software provider Intuit spends 28% of revenues on sales and marketing. Sales and marketing as a percentage of sales will typically be higher for companies in a growth phase. This metric is magnified for SaaS companies due to the pricing model that realizes a small portion of the revenue at the time of sale. While this could be seen as a weakness of the SaaS model it is important to remember the “automatic sale” of upgrades embedded in the subscription model. SaaS providers are not required to spend money on sales and marketing selling upgrades and new releases to existing customers.

Early stage technology companies should be considered long-term investments (venture capital funds typically have a five – ten year life). The SaaS model offers the potential for a stream of recurring revenues that removes the need for the traditional software 1 – 2 year development cycle, marketing expenses associated with new releases and the pressure to develop new products that can cannibalise earlier offerings. These benefits are best exploited where customers are required to regularly (every 1-3 years) upgrade software. Establishing a SaaS business will generally take longer than traditional software packages and require greater upfront capital expenditure to establish the required infrastructure. The longer runway and upfront costs make financing crucial to creating a successful SaaS business (note: financing is a crucial issue for all early stage companies but these issues are magnified for SaaS based businesses).
Over the next twelve months observers should focus on:

• Xero’s ability to grow customers, benchmarked against the IPO target of 1,300 NZ customers by May 2008.
• Revenue per customer.
• The costs are associated with the customer acquisition.
• Xero’s cash burn, benchmarked against IPO projections.

Measures such as net profit (loss) may make headlines in the mainstream media but have no relevance when assessing the progress of an early stage company.

Written by Sam Stewart

Disclaimer:
Valuecruncher founder Mark Clare has a small shareholding in Xero and is considering becoming a Xero customer. Valuecruncher knows several material Xero Live shareholders and members of the executive management team. None of these parties have had any editorial input into this post.