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.

The recent successful Xero initial public offering (IPO) and the current BurgerFuel IPO have drawn comparisons to the 42 Below listing in 2003. The common characteristics of these 3 IPOs are that the companies involved all had minimal or negative earnings, valuations that implied significant growth and a global strategy. The products, markets and business models of the 3 companies are completely different. Commentators have cited the returns provided to investors in 42 Below, “Shareholders made a lot of money out of it” (at approximately 2 min 20 sec), as a guide to the potential returns available from growth companies. Valuecruncher has posted previously on both the Xero and BurgerFuel IPOs. Given the comparisons Valuecruncher has decided to review the return provided to investors in the 42 Below IPO.

42 Below undertook an IPO in September 2003 issuing 31 million shares at $0.50 raising $15.5 million (every 3 shares purchased in the IPO was accompanied by 1 warrant with an exercise price of $0.50 available for exercise during October 2005). The issue price of $0.50 implied a post-money valuation of $60.5 million. At the time of listing 42 Below had negative earnings.

Post the IPO 42 Below traded significantly below the IPO price of $0.50 and remained below $0.50 for the majority of the first year it was listed. In the year ending 31 March 2004 42 Below had operating revenues of $4.41 million and an operating deficit of $1.125 million. This is to be expected from a company such as 42 Below that is developing products, expanding into new markets and building a brand.

42 Below continued to grow sales and in the 2005 financial year had operating revenues of $12.58 million producing an operating deficit of $5.22 million. A key driver of revenue growth in the 2005 year was increased sales in the U.S.. During the 2005 calendar year 42 Below consistently traded above $0.50 and at times over $0.80. In 2005 42 Below engaged Macquarie to advise on strategic issues surrounding development of international opportunities, the Bacardi offer arose as a result of this process.

In the 2006 financial year 42 Below continued to exhibit strong revenue growth increasing operating revenue to $17.0 million and improving the operating deficit to $2.8 million. A key contributor to these improved results was a foreign exchange gain of approximately $1.2 million.

After being listed for 2 1/2 years and nearly 4 full years of financial reporting 42 Below had grown revenues to approximately $17 million, established a strong brand in the New Zealand market for premium spirits and had grown sales in the U.S. to over $6 million in 2006. Despite this 42 Below was still not profitable. Although 42 Below were growing revenues, these revenues were spread across geographical segments (primarily New Zealand and the United States). Based on management forecasts for the 2007 financial year 42 Below was expecting trading revenues to grow to $18.2 and EBIT of ($4.9) million [compared to ($3.7) million in 2006].

On 27 September 2006 Bacardi made a full takeover offer for 42 Below at a price of $0.77. The day prior to the offer 42 Below closed at $0.57 and had traded at a volume weighted average price of $0.55 in the 6 months prior to the offer. Valuecruncher has discussed the framework required to evaluate the Bacardi offer in a previous post.

The offer from Bacardi represents a 54% return for an investor in the IPO, this represents an annualised return of 15.5%. Based on the $0.57 price the day before the offer the gross return would have been 14% or 4.5% annualised. In Valuecruncher’s opinion the Bacardi offer represented an excellent opportunity for investors to realise value from a company that had done a great job building a brand and penetrating the tough U.S. market but was showing no signs of reaching profitability.

A professional early stage investor (i.e. a venture capitalist) targets a 10x return on investment over a period of 5-7 years. The 42 Below return for IPO investors (even with the sale to Bacardi) is well below this targeted level.

Although the 15.5% annualised return realised via the Bacardi offer was a significant improvement on the pre-offer price it can hardly be described as a “home run” return for investors in a startup IPO. Citing the 42 Below result as validation for investing in early stage growth companies on the NZX is misleading. Each investment should be considered on it’s merits. Companies such as Xero have the ability to develop into global players and have significant upside potential but investors should not be relying on a 42 Below style exit to realise their return. If these growth companies achieve a significant global presence investors should expect a return well in excess of 15% per annum (of course any return is a function of the price paid).

Note: This analysis focuses on the return to an investor in the 42 Below IPO who adopted a buy and hold strategy and does not incorporate potential returns from any warrants exercised. 

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.

Note:

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.

On Friday evening Wellington based company Xero released a prospectus and offer document with the intention of raising $15 million via a listing on the main board of the NZX. Xero is a startup company that is developing an online accounting software package for small and medium enterprises (SMEs). The company has an excellent team including founder and CEO Rod Drury and independent directors Sam Morgan and Guy Haddleton who each have outstanding track records with their own business. Valuecruncher has the utmost respect for these people and their achievements and believes that it is possibly the best team that could be assembled in New Zealand for this type of venture. Valuecruncher very much wants to see Xero succeed but feels there are some issues surrounding the IPO that need to be raised.

Valuation

The offer of 15 million shares at $1.00 per share implies a pre-money (prior to the IPO) value of $40 million and a post money value of $55 million. The valuation of a pre-revenue company such as Xero is a subjective exercise that often relies on the rule of thumb estimates of venture capital investors (see Valuecruncher’s April Newsletter). Valuecruncher recognizes the size of the global accounting software market but think its highly competitive nature and the projected time before Xero reaches profitably makes the pre-money valuation of $40 million expensive. Based on information contained in the prospectus it appears that the $1.3 million raised in March 2007 was raised at $0.25 per share, this is a quarter of the price that the public has been offered to invest less than two months later.
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Capital Markets v Venture Capital

Companies at Xero’s stage (i.e product development / testing stage) typically raise capital via private equity (venture capital [VC] funds). Generally companies’ wait until they have established revenues and a track record of financials before undertaking a public listing. There are three primary reasons for pre-revenue companies not undertaking public listings:

1. Risk
   

At the pre-revenue stage it is difficult to determine which startup will be successful and which will fail. VC funds address this issue by holding a portfolio of early stage companies recognizing that a significant portion of the portfolio will fail. Investors in the public markets often do not have the same ability to diversify their exposure to startups and consequently require a significant discount to invest and can only justify allocating a small portion of their portfolio to startup companies.
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2. Listing Costs
   

The Xero prospectus lists the costs related to the IPO at $1.02 million or 6.8% of the capital to be raised. For the majority of start-up companies the cost associated with a public listing cannot be justified for the amount of capital required
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3. Continuous Disclosure
   

The continuous disclosure and quarterly reporting requirements of being listed on the NZX main board can be a costly and time-consuming exercise for an early stage company where resources are often limited. While we at Valuecruncher understand that losses are fine as long as value is being created. This is a difficult concept for ordinary New Zealand investors to grasp. Explaining to the market how substantial losses over the next few years is the plan will be a challenge.
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Xero obviously believe the benefits of listing outweigh these issues but we at Valuecruncher believe that based on the skills and track record of the personnel Xero has assembled they could have raised the required capital in a private funding round and avoided these issues.  Having raised the capital privately the option of listing would still be available in the future. Given the projected cash burn and the anticipated time to reach profitability Xero may require a further injection of capital within two years.
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SME Accounting Packages and Software as a Service

Extract from Xero Prospectus and Offer Document�
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Competitive landscape The market for accounting systems for the SME market is large, but fragmented. Whilst there are established providers of traditional accounting software packages in Xero’s target markets, the Directors are not aware that any of the larger competitors to Xero have completely adopted a SaaS model. The Directors believe that the products offered by Xero’s most likely potential competitors are predominantly focused on traditional methods of software delivery encompassing an upfront licence fee, software upgrades and ongoing maintenance and services charges. SaaS is a fundamental shift from how software is traditionally delivered; it requires new technology architectures and the nature of customer relationships are different. The Directors believe that larger competitors are not as well placed to completely change their business models to the SaaS model which Xero offers. If so, this situation provides a good opportunity for Xero as a fast moving, unencumbered new entrant, operating from a low cost of sale environment to firmly establish
itself in the marketplace. The leading providers of accounting software packages tend to be large international companies, including MYOB (in Australia), Sage (in the UK) and Intuit (in the USA). These companies are listed on stock exchanges in their respective countries.
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The product being developed by Xero does not represent a disruptive innovation; it focuses on taking an existing product and delivering via an online interface. The core point of differentiation appears to be the SaaS model. Although none of the major players appear to have fully embraced the SaaS model, there are a number of examples of similar products being developed. If significant demand for SaaS were to emerge, we believe the major players would quickly embrace the transition from software in a box to an online solution. These participants have established products, distribution channels and customer bases in place and will compete vigorously to defend their market share.
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The initial feedback on the product suggests it is a high quality offering with a first-rate interface, the excellent team assembled and the size of the market suggests that there is definite potential for Xero. Realising this potential will be dependent on Xero’s ability to acquire customers in a market where the switching costs for customers are high. Valuecruncher finds it difficult to reconcile the current status of Xero with the pre-money valuation of $40 million but hope they will be successful.