March 27, 2013
In recent weeks the share price for listed cloud accounting vendor Xero has risen at an incredibly fast rate. The company, which has around 140000 paying customers globally and is yet to turn a profit, is now valued at close to $1.5B. This is a staggering achievement and something I wanted to dive into a little. But first a bit of a disclaimer, as a proud New Zealand, I’m happy for what Xero has achieved, it’s great for the investors but, more importantly, it’s great for New Zealand as a whole. With the market cap as it stands, CEO and founder Rod Drury looks likely to achieve his stated aims; to build a billion dollar business from the beach and to achieve an exit at a higher price tag than that which TradeMe achieved. Personal ambitions aside, it’s time to noodle on the share price a little.
The other day I was talking to a friend who told me that his retired father has suddenly discovered Xero on the bourse, and is considering investing. This is a reflection on the level of maturity of the New Zealand market and the investing public. It’s also, to be frank, a reflection on the fact that institutional investors and advisers have suddenly decided Xero is a sure bet, no doubt encouraged by the stellar share price growth. They’re buying the stock and advising their clients to do similarly. The day Xero entered the ranks as one of the top 50 market cap companies on the NZX they also suddenly gained visibility within the advisory community – the combination of a stock that isn’t heavily traded with this increased demand leads to an artificially high impact from low volume trades – this is great on the upside but painful on the downside. It’s actually very positive for the maturity of the company that they recently cross listed on the Australian exchange – it brings them a greater level of savvy investors that actually understand the dynamics of a potentially high-growth/high-risk investment. Drury has also signaled a possible future listing on the US exchange – this too would give both some stability and some liquidity to the share price – both positive things.
However this greater scrutiny will challenge the company to find analogues for its business. Drury has regularly pointed out the fact that Microsoft acquired enterprise social networking company Yammer for $1.2B as justification for the sort of valuation Xero is hitting. That might work for new Zealand investors who don’t quite understand the nuances, but Yammer was a very different deal for a couple of reasons:
- It had an exceptionally effective viral user growth pattern that Microsoft needed to learn about as they try and morph their business into the internet age
- It was an answer to the growing attention that social networking within enterprise was garnering – Salesforce’s Chatter product and Tibco’s Tibbr were increasingly making Microsoft look late to the party
For these reasons, and given the massive war chest of cash that Microsoft holds, the Yammer deal made sense. it may end up being a failure as a business division of Microsoft, but as a learning, marketing and corporate culture tool it makes sense.
Others rightly suggest that Intuit, the US’s biggest vendor of SMB financial products, is a potential suitor for Xero (some even going on to suggest that it is Intuit behind the buying that is sending the share price upwards – a theory I discounted). People point to the fact that Intuit acquired the personal financial management product Mint a few years ago and has an appetite for acquisitions that shoehorn itself into this new world. The Mint acquisition was, in my view, a very different deal, in a couple of important ways:
- Mint had delivered an interesting mix of behind the scenes business intelligence. It was mining aggregate data to deliver insights to customers and hence had some very useful technology that could be back doored into other Intuit products
- Mint, like Yammer, had worked out the viral uptake model and, at the time of acquisition, boasted over a million users
While Xero is doing very well from a user numbers perspective, for Intuit to acquire the company, it would have to be showing stellar growth in the only market that really matters – the US. Xero has really ramped up its US presence, the company has shifted into its own space and has ramped up the team significantly, but it’s coming from a relatively small customer base. While I recently reflected on the 100000 customer milestone and suggested that this indicated that Xero had reached escape velocity, this statement becomes far more nuanced when we look at the joint factors of massive market capitalization and global market share dynamics. I believe that Xero, at its current market capitalization, is yet to become a compelling proposition for a US acquisition. Rather, what a company like Intuit is likely to do is one of two scenarios:
- Wait until someone enjoys meaningful customer success in the US and acquire them for a lofty sum, secure in the knowledge that they’ve gained a path to continuing market domination
- Acquire a company for a far more modest sum that has potential to become the breakout product in the space
The cloud accounting space isn’t a zero sum game however and this creates another difficulty for Xero, it is unlikely that we’ll see a repeat of the emergence of a small number of companies that dominate in the three big geographies (Intuit in the US, Sage in the UK and MYOB in Australasia). Xero is helped by the fact that in the US there is no vendor that has really captured market share – Outright (recently acquired by GoDaddy) and Wave (an interesting company with a free model) are the two best known domestic providers, but potentially more compelling is FreeAgent, a UK based vendor that has recently entered the US market and is a savvy operator.
Xero is executing well and their potential is massive. However potential only explains part of a business’ valuation, does Xero’s potential justify a $1.5B valuation? Not in my analysis – surely it may go higher as market frothiness and low liquidity combine to drive the economics, but eventually an equilibrium needs to be found, one that is based on customer numbers, market growth and eventual profit – we’re yet to see Xero deliver on that.