Will Xero eat Inuit’s lunch?

Val Sabulis from Simply Wall St looks at Xero and its efforts at cutting into Inuit’s business.

Click to see our full report on Xero.

The once staid small business accounting systems market is undergoing a dramatic shift from sales of limited functionality standalone systems operated and maintained in-house to increasingly sophisticated cloud based business solutions offered as a “software as a service”.

A 2014 study by Emergent Research, sponsored by Intuit (INTU), indicated that 37% of US small/ medium businesses (SMBs) were “fully adapted to the cloud”, with that figure predicted to rise to 74% by 2020.

The global addressable market is estimated to be 30 million businesses in the US, 10 million in the UK and 2 million in Australasia. Assuming a subscription price of $25 / month, thats a potential global market of over $12 billion, excluding Asia and China.

Interestingly penetration rates by the major providers remain low, with leader Intuit having approx. 750,000 subscribers for its Quickbooks Online product, or 2%-3% of the US market, and less than 1% of the global market.

The players

The key markets have been dominated by Intuit (Nasdaq: INTU) in the US, Sage in the UK (LSE: SGE) and recently listed MYOB in Australasia (ASX: MYB).

Xero (ASX: XRO) is the new kid on the block, originally listed in New Zealand in 2007, and then listed in Australia in 2012.

Xero’s growth

Xero’s growth has been spectacular, with paying subscribers growing from 51,300 as at Sept 2011 to 475,000 as at March 2015. Revenues have followed growing from NZD 9.3m for the 2012 full year to NZD 70.1m for 2014. Currently annualised recurring revenue is in excess of NZD 127m.

To date Xero’s subscriber growth has primarily come from the Australian and New Zealand markets accounting for 341,000 subscribers (71%). Xero was able to effectively capture this growth through its innovative, user friendly and cloud based offering, coming at a time when local incumbents were slow (or even unwilling) to embrace the cloud or enhance user functionality.

The big game in town is of course the US market, and the UK market to a lesser degree.

Xero’s US progress so far

Xero started its foray into the US market in 2013, acquiring only 10,000 subscribers in its first year. Up to Sept 2014 US subscribers had grown to 35,000.

Clearly growth in US subscribers has not matched growth in the Australasian markets, so the question now facing potential investors is whether Xero’s takeup in other parts of the world can be matched in the US.

US roadbumps

Xero’s attempts to gain share in the US have not been entirely smooth;

  • US subscriber acquisition remains muted, with only 4,000 US subscribers added in the six months to March 2015 (versus 8,000 in the previous half). Things have improved with 17,000 added from 2014 to 31 March 2015. Intuit on the other hand reported 43% subscriber growth for Quickbooks online in the first quarter of fiscal 2015;
  • The former US CEO, Peter Karpas, hired in 2014, resigned after only 6 months — although the role was subsequently filled in February 2015;
  • The newly recruited Chief Marketing Officer, Andy Lark, appointed in November 2014, comes from a big company background, so his ability to drive growth in a disruptive startup business is unproven;
  • Xero itself has cited product gaps and execution as ongoing problem areas.
Lack of US traction takes a hit on share price (Src:RNZ)

Some positives

Its not all bad news though;

  • Xero introduced a “seamless” US payroll module to compete head on with Intuit in December 2013, although at the time it was only available in 6 states;
  • Xero is significantly cashed up, after a USD 100m investment by Accel Partners and a USD 10m top up investment by existing shareholder Matrix Capital. This brings cash reserves to in excess of USD 200m, giving them the firepower to compete with Intuit;
  • Xero has built a significant US team of over 100;
  • Anecdotally the Xero offering is attractive and simple to use, and is not burdened by the issues introduced from having a legacy desktop product.

Valuation and investment summary

Xero is currently trading at approx AUD 19.45 per share, giving it a market cap of AUD 2.47bn (USD 1.97bn).

Xero has yet to produce a profit — since listing in Australia losses have increased from 2012 AUD (6.5m) to 2014 AUD (32.9m). The company wildly missed their own forecast in the last few days and forecast an increased loss for FY 2015 of AUD (65m).

Future profit (or lack there) estimations for Xero

Clearly Xero is not yet a candidate for fundamental / value investors.

As a speculative investment, Xero is growing subscribers and revenues at an annualised rate of 80% which provides proof of concept to a degree. However penetration into the US market is unproven and the success or failure in that market will largely determine share price performance going forward.

At this stage the balance of risk and reward is skewed to the downside and the early gains are fully reflected in the share price. Our approach is to continue to monitor the success of subscriber acquisition in both the US and UK markets — strong traction will provide a potential investment opportunity to capitalise on the next phase of growth.

Optimistic analysts expect to see a profit in 2017

Note: Conversion rates and information used was calculated at COB 7/5/2015