Rod Drury, ceo of New Zealand-based cloud accounting software firm Xero (ASX: XRO), is frustrated with local investors. The reason? He believes they don’t understand software companies like Xero.
Although listed on the New Zealand Exchange (NZX: NZX) since 2007 and the ASX (ASX: ASX) since 2012, Xero has found it easier to raise expansion capital from foreign investors such as Peter Thiel, co-founder of PayPal (NASDAQ: PYPL) and also an early investor in Facebook (NASDAQ: FB).
I can’t speak for other local investors but it’s likely that a lot of them do understand software companies. Instead, I’d suggest Xero’s valuation – expensive based on normal metrics – is the real reason for their reluctance to invest.
Although the company’s revenue is rapidly growing – it’s forecast to reach NZ$200m in the current fiscal year, up from NZ$120m last year – losses are also growing rapidly as Xero spends money acquiring more customers. Normal metrics like price-to-earnings ratios and free cash flow yields are meaningless but even at 12 times next year’s revenue, Xero shares look expensive.
However, perhaps normal metrics aren’t relevant for a fast growing company like Xero? Its accounting losses appear worse than they really are because Xero expenses all of its customer acquisition costs in the year it gains the new customer, even though customers stay with it for an average of eight years.
More importantly, Xero’s accounting software is easy to use and customers rave about it. This is why it’s rapidly gaining more customers and has grabbed the lead in Australia’s cloud accounting software market over competitors such as MYOB (ASX: MYO).
The company has global aspirations and has recently entered the UK and US markets. With the cloud accounting software market potentially being a global natural monopoly, if Xero does come to dominate this market then today’s share price will look very cheap in ten years’ time.
Yet by investing now you’re assuming – even relying on – this occurring and Xero generating large profits in future. If this doesn’t occur, you could lose a large percentage of your investment, something that's no doubt at the forefront of local investors’ minds.
Still, with backers like Peter Thiel, Rod Drury’s comments may turn out to be correct after all.