Xero valuation – part 1

So went off to the Xero AGM the other day. For those who don’t know, Xero is a online accounting system, SaaS stuff, and generally most excellent. Its basically the most interesting company on the NZ stockmarket, given that it is operating in a global market, and with massive potential for growth.

Its an awesome example of … dreaming big from NZ. This is the kind of thinking that NZ needs. So I have super-high expectations for Xero.

But… what is Xero worth? Someone asked me whether Xero was a good buy and I went… hmm. I love the story, but do I love it at this price?

So I thought I would do an investigation and attempt a valuation on Xero, to answer this question and to practice. This is part 1, which is a super simple look at the business of Xero, and perform a basic sanity check valuation.

Summary of Xero: SaaS accounting business, revenue from user subscriptions per month.

Assumed numbers:

  1. 20,000 -number of current subscribers. The annual report says 17,000 but I vaguely remember the 20,000 figure from the AGM.
  2. $40 – average revenue per month per user (ARPU). Probably pretty generous, since I imagine a lot of users are on the lowest price point ($29/month).
  3. $1.59 – current share price
  4. 83,455,000 – Weighted average shares
  5. $130,000,000 -current market capitalisation, probably a little on the low side

So thats pretty basic. 20,000 subscribers, each paying $40 per month, so $800,000 per month revenue. This value is forward looking so, if we stop customer growth from now on, this is how much revenue would be received. So what does that mean?

To work this out, remember that $40 today is worth more than $40 in a month, because of inflation and opportunity cost. So to work out the present value of the monthly income from subscribers, we need a discount rate. This number is a bit arbitrary, and can be calculated a lot of different ways, but its meant to reflect the risk free rate, ie, if you stuck the money in the bank (and the bank didnt go bust!), plus a bit because stocks and companies are risky. So, I’m going for a risk free rate of 5.5% and a extra risk bit of 4.5%. Which all is obviously a complicated way of saying 10%!

🙂

I’m going to look at a subscriber staying with Xero for 5 years. Why five? Simply because 5 years is quite  a long time in internet world. I might look at a 10 year period too, just to see. So, lets work out how much those future cashflows are worth to us now:

Present value of 1 person paying us $40/month for 5 years: $1,898.30

which is obviously less than $40*12*5 ($2400) which reflects the discount rate.

So each current subscriber, assuming they stay with Xero for 5 years, is worth $1900 to Xero. Now, if we look at Xeros market capitalisation, $130 million, and divide that by the number of subscribers (20,000) we get a market cap per subscriber of : $6500

Therefore, if you bought the whole company now, you’d be paying $6500 in order to get $1900 back over 5 years.

Which is completely whacked out, padded-cell, rubber spoon, straight-jacketed, 2 eggs short of a dozen nuts. So, whats wrong here? Why is Xero priced so much higher? Answer: growth and estimated market, and… risk.

But this is a warning sign. When the current valuation per subscriber is so much off the revenue that subscriber will generate… theres potentially an issue here. Bear in mind valuing early stage companies is … hard.

Let me know if I got anything wrong, which is highly likely, and any questions/thoughts. In part 2 (and maybe 3-10!) I’ll go through a more detailed evaluation of Xero.

Appendix:

Present value calculation is : =PV(0.83% (ie, 10%/12),60 months,$40/mth, beginning)

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Xero valuation – part 1

11 thoughts on “Xero valuation – part 1

  1. John says:

    You’re right, the valuation IS nuts based on the customers they currently have and the revenue that would be generated from that.

    Basically, buying Xero shares is a bet that

    (a) They can quickly acquire several hundred thousand clients.

    (b) They can do this without raising more money, as raising more money (especially if it was done at a materially lower share price, which could happen in this economic environment) changes the equation.

    If they achieve (a) with the resources they have, then hindsight will show it to be a good bet.

    1. Hi John, thanks for the comment. You’re exactly right, Xero is a gamble based on those two things. I’ll be doing a more in-depth analysis over the next week or so, just to work out an approximate dollar value for Xero (mainly to go through the exercise of valuing a start-up stock). Hindsight is a great way to pick stocks, but hopefully we can get a bit more proactive!

  2. Kerry NZ says:

    The $1900 is also just revenue. Costs must come out of that too. Key assumptions around the valuation are how costs scale in relation to revenue, ie does the proportion of the $1900 that goes in costs decline with more customers and by what extent, and what growth is expected in customer numbers and conversion to higher price points.

    I suspect that conversion to higher price points will be negligible, so the key factors are costs per customer and growth in customers. I also suspect that growth in customers will mainly come through expansion into new markets (something NZ firms are notoriously poor at) and hence one would expect higher costs in the short-term – looks similar to an Amazon-type growth model of burn money until you’re established as THE player, the difference presumable being that they are not so much burning money as just not making much, ie like electricity companies buying customers but with more lock-in perhaps. Talking about lock-in, that is also a key factor in Xero’s potential – the ease with which customers can move their data into and out of Xero will help determine both customer growth and customer attrition (note that the turnover of small businesses is reputedly quite high so one would expect the bulk of Xero’s customer base to be quite volatile, thus potentially raising costs and lowering value per customer).

  3. yes, good comments. This is only a first, basic look at the valuation, and subsequent parts will (hopefully) deliver a fuller picture.

    Growth is key. So will be looking at that in the next parts. Customer growth, and revenue growth in particular.

    I suspect lock-in will be pretty good, since there really is no comparable offering on the market. And Xero is excellent software. My feeling is their target market are not the ‘volatile’ edge of the SME market, but more established players.

    The market is definitely there, and it is of sufficient size. The only question we’re looking at is…. how much should I pay for a share of Xero right now?

  4. MarkSF says:

    I’m no expert but what they taught me in Finance 101 was that the Value of anything is the Sum of the Present Values of its future cash flows(EPS).

    This applies to all stocks all the time and if you decode what Warren Buffet says, this is what he alludes to when he says ‘ I buy good companies that are temporarily undervalued’.

    In other words he is saying that he assesses the value of the company by estimating the current value of its future cash flows and if these add up to more than the current share price, he buys. Simple as that.

    The problem is of course estimating future cash flows and deciding on what the appropriate discount rate should be. Not too hard if its Coke or McDonalds, but highly speculative if its a start-up such as XERO. Which is why Warren Buffet doesn’t like companies like XERO. And why he didn’t buy Amazon or Google.

    I am in the accounting/small business advisory industry and I can tell you for sure that XERO’s model is the future. I have personally migrated some 20 business from MYOB to XERO and none the other way. SaaS accounting has and will transform the accounting world for small-medium sized businesses (my largest client turns over $10mill.)

    As of last week their customers numbered more than 22,000, 33% up from March 31 (17000). They are at break even in NZ now and will be at break-even overall sometime in 2011 with around something like 30-35000 customers. That’s only 50% more growth (down from 600% and 200%).

    So with 300,000 small-medium businesses in NZ, they only need 10-15% market share in just NZ, to break even. (MYOB has 700,000 customers in Australasia.)

    10% in NZ = 30000, 5% in Australia = 60,000, 1% in the UK = 86,000. Total = 176,000. And that’s pretty conservative. And doesn’t include the US. Or the rest of the world.

    So, breakeven is pretty much a done deal. The potential is astronomical. The only question is – are they good enough to do it.

    The two big things that will happen this year is Yodlee coming online – meaning bank feeds from 11,000 financial institutions. Bank Feeds are the magic bullet. I am a huge XERO fan because of the way it can transform the productivity of a business. I use XERO for 7 of my own entities but wonder if I would bother if there were no bank feeds.

    The other thing will be when they launch in the US market.

    I have done a discounted cash flow forecast with XERO and calculate that the shares are fair value now if they can maintain a consistent growth rate of 28%.

    The I am a glass half full guy. I would be interested to here from the glass-half-emptyers.

    PS. I disagree with the 5 year thing. I believe that once on board most people will be on for as log as they are in business.

    1. I think that MarkSF’s calculations of potential customer acquisition are pretty interesting. I agree, the calculation of 176,000 is pretty conservative because as he says it only includes 1% of the UK and doesn’t even include North America. Imagine what the calculation would be if they could win say 5% of the UK and the USA.

      A couple of years ago I read “The Dip” by Seth Godin, and one of the critical ideas I took from it was the idea of the importance of being number one. Of being the market leader. Whoever is the absolute best in any given field will take away the majority of the market share and margin from the industry.

      This isn’t a new concept. It is something that companies such as Procter and Gamble and Gilette have realised for a long time. It is the basis behind the idea of superbrands. The interesting thing I got from the book was a more general application of the concept. For companies that use the Internet for distribution, and especially for Saas companies, I think this concept is amplified. If Xero is able to be the market leader then it could well win the majority market share of Saas accounting. However if Xero is surpassed by something cooler and better, then it may only win a small fraction of the market.

      My guess is that there are only two likely outcomes. One is that Xero is a 100,000 customer company that struggles to make a profit. The other is that it is a 1,000,000+ customer company that leads the way.

      I’m a glass half-full guy too. I’m impressed with a lot of what Xero has achieved to date and consider that if they can maintain momentum, there is a say a 20% chance of the 1,000,000+ outcome. That is why I currently hold shares at the current market price.

      1. @Kelvin,
        mm, 20% chance of the home run? So… current market price/20% = your share valuation, $7.50?

        🙂

        man, that was a lot less work than what I did!

        The main thing that surprised me with this valuation is … well, there are basically no SaaS companies doing really well. There are some doing ok, there are others that are struggling, but … none really doing a mini-microsoft, or a mini-google.

        Which leads me to think that SaaS is just not as compelling as the pundits would have you believe, at least not now. Maybe the customers already have the infrastructure, and have spent the capital spend that SaaS would save? or theres still that ‘risk’ thing? I’m not sure. But the jury is still out on SaaS models, and whether they can successfully transistion into high revenue/high margin companies.

  5. Hi John, thanks for the comment. Starting at bottom first… 5 years is pretty arbitrary, but basically saying… 5 years is enough for something cooler to come along.

    But consider the 10 year case, $3500 per subscriber. Still miles below the current market cap per subscriber value.

    Bank feeds obviously are crucial. But easily replicated once the banks have it sorted. So no great moat there for Xero.

    Agree that Xeros business model is the future. The question I hope to provide some answer to is how much Xero is worth right now, based on what we know. Given a lack of growth in the SME accounting market as a whole, are people inclined to change their system? I don’t really know.

    Launching in the US is going to be a whole large, different, expensive kettle of fish. Am very interested to see how they approach this.

    The next stage will be to plug in some revenue growth numbers, and work out operating margins. All based on the tried and true ‘guesstimate’ technique!

  6. Vince says:

    Hi Greg

    Thanks for getting this process underway. You’re right that Xero’s curent valuation is based on speculation about huge growth.

    Is that speculation realistic? Only time will tell but as you will read below I remain sceptical but very interested in what develops for Xero.

    Xero itself has always spun a very positive story and they have to be congratulated on the consistency of their line. They’ve also managed to enrol quite a few people in that story which is something like the following:

    * Current accounting soloutions provides such as MYOB, Sage and Intuit are fat, slow, stuck in the past and don’t care about their customers

    * Online accounting is the way of the future – and the existing major providers of accounting solutions can’t do it properly

    * We’re the best online accounting provider and have very little competition

    * We’re an innovative Kiwi company taking on the world

    * We’re already a great success and nothing is going to stop us

    The reality of this market space is that it will be a much tougher battle than the standard Xero story suggests.

    * It is certainly true that the incumbents can’t move as quick as Xero. But they are moving. MYOB Live Accounts is about to be launched and will be a significant competitor in New Zealand and particularly in Australia. Intuit is already up and running with Quickbooks online and has a significant customer base. While Sage are undoubtedly going to try again after their first effort was unsuccessful. These companies have a huge amount of clout and are brands that customers are familiar with.

    * Xero is a very slick and well designed product but there is nothing particularly innovative about it. Their major point of difference from most accounting products is direct bank feeds. However, they took that idea off BankLink who have been around for more than 20 years and have a major share of the NZ small business accounting market. Xero’s reliance on Yodlee for future bank feeds is a concern. Yodlee’s screen scraping technology involves users passing over log on and password details for their internet banking. This process concerns many people and upsets many banks as it breaks their standard terms and conditions for internet banking.

    * There are many other online accounting products. Dennis Howlett of http://www.accmanpro.com has compiled a list of more than 50 online accounting products. There is no doubt that Xero is amongst the best designed of these products and that is an advantage. Coming from New Zealand is however, not an advantage in this case – the rest of the world couldn’t care less about Kiwi success stories and other products are developed in key markets and have greater opportunity to understand the market better and build the networks that lead to success (or take advantage of their existing networks). There is fierce competition and a lot of choice in online accounting.

    * This product space is going to face ongoing downward pricing pressure. Xero’s IPO forecast $75 per customer per month. That dropped to $49 per month at launch. They have since released a three level pricing plan which has helped pick up customers but also further decreased their average revenue per customer. There are already much cheaper online accounting products available including some which are free. The great thing about Saas is that as you grow the costs per customer drop away. That’s also the problem because it means all it takes is one serious competitor to drop their prices (because they can) and everyone else ends up following. This price pressure already seems to be occurring.

    * There is still plenty of doubt that pure online SaaS products are the best solution. May end users do not like the lack of control over Saas and have fears about data security and access. While these fears appear largely groundless they are very real to those people holding them. Recently there has been talk about Software plus Services being a better option. This involves software being hosted and updated locally but synchronising data with files hosted elsewhere. Whether this takes over from SaaS or whether it is a side alley is yet to be determined – but Xero’s business model is not as clear cut and confirmed as they way of the future as they would have us believe.

    * So far Xero has spent more than $20 million to pick up 22,000 customers. It will continue to pick up more. But in the meantime Xero continues to lose money and incur increasing costs as it enters new markets (notably the USA). Xero has promised breakeven in 2011. To me that appears to be a very challenging target and will involve a considerable increase in customer uptake at the same time as greater competition is entering the market.

    The challenges are far greater than Xero would have us believe. It will be very interesting to see how it all pans out. To me Xero isn’t worth its current share price – it is simply too risky. But obviously plenty of people disagree with may analysis and are prepared to take the punt.

    1. Excellent points Vince. I’m probably a little more of a believer, particularly that SaaS is the way forward. And also that slick and well-designed can be innovative (just ask Apple). However, the challenges as you point out are enormous, and their story is a particularly positive version of reality. Which is cool, since kiwis tend to be shy and retiring. The major concerns I have are around the downward pricing pressure you mention, and the cost/difficulty of acquiring customers. I’m busy putting together some numbers, which will really be a straw man that we can all critique. Check back soon (next day or 2)

  7. Yes, exactly. Since there are wildly different valuations based on how successful Xero is, I think a weighted-average of the valuations would be a good approach, weighted by the probability of the outcome eventuating. This is the crux of the guestimates we’re all making; what is the probability that Xero will win a significant share of the market?

    Greg, you make a good point about the comparable Saas companies. None of them have profitable growth trajectories similar to an early Microsoft or Google. So maybe I need to rethink my 20% probability a bit.

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