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.
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)
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.
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.