Xero: A Review

Introduction

XRO has generated plenty of headlines and opinions in recent times. The ever erudite and brilliant Mr John Hempton gave us a very good introduction here. 

It is not too difficult to find online reviews from users' perspective. Here is one. 

There are also plenty of articles on XRO posted on the Motley Fool Australia. Just Google the search term “Motley Fool Xero” to access all of them. To save you some reading, I can tell you folks that there are all unanimously bullish.* Herewith an example, and another example. 

The XRO expansion story

XRO's CEO Mr Rod Drury was recently reported in the press lamenting that the financial community in Australia does not understand the XRO story. In a nutshell, XRO's management call to arms is that this is a land grab, and they are spending money to tie down "real estate", which means massive cash outflow now, in return (presumably) of untold riches in the future.

Proponents of XRO's management vision points to Amazon as a leading shining example. They are also fond of pointing out valuation disparities between XRO and similar plays in the new fangled cloud/SAAS/software/technology area in the USA such as SalesForce. 

Any person who has experienced the dotcom boom in the 90s can instantly identify this familiar refrain. Don't look there (earnings, cashflow), look here (users, revenue, eyeballs, clicks, etc). Moreover, we are also blessed with generous people such as David Einhorn sharing their ideas publicly. In this presentation (which is an excellent read on its own), David warns us that such peer comparisons make an assumption that the valuation of peers are reasonable. And thus, we could again hark back to days of the dotcom boom where inflated/insane prices are used to justify even more insane prices. We are also reminded of the real estate story in Australia at present, but let's leave that aside for the moment.

The bull case proponents are also quick to point out the involvement of marque investors in XRO such as Peter Thiel. Yours truly one legged is then immediately reminded of the Sino Forest scandal. 

Dissecting the Bull Story and a comparison with Intuit

In his excellent book "Competition Demystified", Mr Greenwald presented us with compelling stories of why it is usually not a good idea to take on an incumbent in an established market. He cited the case of Kodak versus Polaroid in the area of instant photography. More importantly, Mr Greenwald explains that an incumbent, with its entrenched customer base and its size, usually has the advantage of scale in a price war. For example, marketing cost per unit of sale is lower when spread out over a larger base, or R & D costs per unit of revenue is lower.

So with that in mind, we now turn to XRO's assault on Intuit in the USA. We expect that, eventually and inevitably, this battle will be fought out globally.

The Salient Metrics

There are 5 salient metrics that are relevant to the battle, and the ultimate fate of XRO and Intuit.

The first is revenue. Revenue is self-explanatory. This is how much your customers are paying you.

The second metric is selling costs. Also known as marketing and advertising, it is useful to consider the framework espoused by Sanjay Bakshi in this excellent article in relation to GEICO's customer acquisition cost.  I can see the logic in applying a similar argument to XRO, namely that the marketing spend is a customer acquisition costs. If so, one can strip out marketing costs each year and capitalised it, and amortise it over 83 to 95 months, which is the length of stickiness of customers as presented in XRO’s presentation here.  Doing this allows us to see a clearer economic picture. As at 2015, XRO's marketing spend is a whopping 75% of revenue.

Unfortunately, at this stage, capitalising/amortising XRO's marketing spend is not much help, since the total of R & D, costs of revenue, and administration expenses are barely covered by revenue. 

The third metric is R & D. In a software business, this is an absolute necessity just to stay relevant and to stay in business. Accordingly, be wary of software companies that insist on capitalising their R & D spending.  As at 2015, XRO's R & D is 54% of revenue, bearing in mind that the relevant metric for MSFT and Google is about mid teens.

The fourth metric is costs of revenue. This is the same as costs of goods sold, which is a variable cost that is incurred every time XRO makes a sale.  The costs of revenue of XRO as at 2015 is about 30%.

The fifth and final metric is administration. These are the overheads required to do business, and as at 2015, XRO's admin expenses is 20% of revenue.

Intuit's metrics

These are Intuit's metrics for 2014:

Revenue is USD$4.5b versus NZD$143m for XRO.

Cost of revenue is 15% versus 30% for Xero.

Marketing is 28% of revenue versus 75% for Xero.

R & D is 17% of revenue versus 50% for Xero.

Admin is 10% of revenue versus 20% for Xero.

These figures paint out a stark picture in relief on the realities of fighting an entrenched incumbent on its own turf. The four major metrics totalled 70% of revenue for Intuit, and 175% for XRO. You can now see why Intuit is just spewing out cash, whereas XRO is just burning through its pile.

XRO's road ahead

To be fair, the market is big enough for both XRO and Intuit. It is unlikely that the online accounting software market will transition towards a winner takes all scenario. There will be a place for both, and especially if smart people could design a software that is capable of porting data from XRO to Intuit or vice versa. It is also reasonable to assume that XRO could achieve parity in terms of scale once it has achieved a critical mass of users and revenue, and that such critical mass may only need to be a small fraction of the total multibillion dollar market. 

Therein lies the opportunity, if XRO can achieve Intuit's scale.

If XRO can achieve a critical mass at one quarter of Intuit's revenue, say USD$1b revenue and achieve a scale similar to Intuit, then it should be rolling back $250m of EBIT per annum, which will easily justify a market cap of USD$3.5billion to USD$5billion. However, this would probably take a minimum of 5 years.

Daunting Task

The task for XRO is daunting. Current revenue of NZD$150m needs to grow to USD$1billion. Whilst XRO may have caught Intuit napping in terms of cloud solutions a few years back, Intuit is now clearly awake and fighting back, with all the luxury and advantages of an established incumbent in its home market.

If one looks through user reviews and forums, it appears that both product offerings are similar in terms of functionality, if not aesthetics. In other words, XRO is not offering a compelling new proposition. This is not a story of the iPhone/itunes sweeping the world, nor is it a story of Google. There is nothing "disruptive", to coin a tired old term, or at least it is no longer such since Intuit started its cloud offering.

At present, XRO is getting $1 of sales for every dollar of marketing spent. Intuit is spending 17% of revenue on marketing and is keeping pace with XRO in the cloud/online user growth numbers. The pricing for both products are similar, hence putting XRO at a disadvantage due to lack of scale. Due to its large user base, Intuit’s selling cost should be even lower if they can develop a feature allowing for easy portability of data from a desktop environment to the cloud. However, XRO is currently fortunate as Intuit did not appear, as yet, to have perfected this feature. But this is only a matter of time.

To get to USD$1billion of revenue, assuming optimistically that every dollar of revenue requires only 50 cents of marketing (as opposed to $1 currently), XRO will still need to spend close to USD$500m.

XRO only has NZD$210m in the bank.

The other problem is penetration of USA market. USA is not homogenous with a central taxing authority such as Australia or New Zealand. The USA market is characterised by state based laws and regulations. Penetrating each state requires software modification peculiar to each state. Intuit already has a massive head-start, and even if on equal footing, Intuit has massive scaling advantages to match XRO dollar for dollar on R & D. As far as user feedback is concerned, software features are currently head to head, however, we understand that XRO is not available in quite a number of states. This puts XRO at a disadvantage, as perhaps evidenced by increased of R & D to 54% of revenue versus 17% for Intuit.

For XRO to come good on its business model, perfect execution is required. For that to happen, we need to start seeing evidence of metrics trending towards Intuit's metrics, whilst keeping up revenue growth at the same time. This will at least indicate that XRO's disadvantage in scale is being narrowed towards complete elimination, allowing it to compete on parity. In its latest financial, XRO's costs of revenue started reducing from 35% to 30%, which is a good sign. However, this was counterbalanced by R & D increasing from 49% to 54%.

Conclusion

Despite a share price dropping from $40 to $15, it is still sobering to be reminded that XRO is still capitalised at over AUD$2 billion. It has a high hurdle to overcome, and not enough of an upside to justify the risks assumed. My assessment at this stage is that at current prices, this is a bet with a negative expected outcome.

*Edit: in the interest of accuracy, there is a rare dissenting opinion here.

Disclaimer: Not advice. Posts contain, where applicable, my opinions or my interpretation of facts. I am also not able to guarantee that the facts I rely on are accurate. Please seek independent financial advice. I do not hold any XRO shares, but this may change at any time.