Xero's North American gamble

Had you invested in employment classifieds site Seek when it first listed in 2005, you would have a sixbagger now. Investors in real estate classifieds site REA Group have done even better, with its price rising 45-fold since its listing in 1999.

Cloud accounting services provider Xero has already been a dream investment. Since listing on the ASX in 2012 at $4.50, the stock has more than tripled, but there have been some wild swings: in March 2014 its share price climbed above $40 making it nearly a tenbagger; since then it has halved. Could this be another opportunity?

Once dominated by MYOB and Quickbooks, small business accounting software used to be a frustrating affair. You paid for a CD and installed it on a local computer. It worked but the software was ugly, cumbersome and updates were infrequent. An improvement on the abacus, for sure, but a nuisance all the same.

Up in the cloud

Led by serial entrepreneur Rob Drury, some Kiwis decided they could do it better. First, instead of installing software on a user's computer, Xero put it in 'the cloud', allowing clients access from anywhere in the world, on any device.

Second, Xero encouraged a range of add-on services like payroll, inventory management, superannuation, expense claims and invoicing. These seamlessly plugged into Xero, enhancing its usefulness in the same way that the app store enhances an iPhone.

Third, Xero looks wonderful and is easy to use. In the era of Apple, Google and high-end design, this sounds somewhat lame but for accounting software it was a revolution.

Lastly, Xero adopted a software-as-a-service (SaaS) business model. Rather than a single upfront cost for the software, the customer is charged a smaller but ongoing monthly fee. Not only does this deliver high levels of recurring revenue, rather than a one-off cash sugar hit, it also increases overall yields.

It was a far better business model, as Table 1 suggests, but it does suffer from one weakness compared to the online classifieds. While the likes of Seek and REA enjoy network effects that keep new players out, MYOB, Xero and Quickbooks all have applications that automatically convert a competitor's file type to their own in a few hours. Switching costs are low and competition plentiful.

MYOB hit hard

This is part of the reason that Xero has been able to expand in just ten years from a small start-up to a global powerhouse, with 600,000 subscribers in over 180 different countries. In Australia and New Zealand, Xero has hit MYOB, the major player, hard. At the end of June 2015, it had 142,000 cloud customers and a total of 528,000 paid users. At the same point, Xero had 241,000 cloud customers.

Aside from its product strengths and the low switching costs, Xero's other main weapon has been to use bookkeepers and accounting firms including Deloitte and KPMG as a sales force. The low monthly fee and the extra added value of cloud accounting services have also increased the size of the overall market.

MYOB has belatedly established its own cloud product and is playing catch up. There remain potentially hundreds of thousands of MYOB customers ripe for Xero's picking in Australia and New Zealand alone.

Thus begins the intertwining of opportunity and concern. Xero claims it is doing a good job of taking on the local opportunity. The principal concern is that it has prematurely entered the UK and US markets which, at least in the case of the US, are far more challenging than the opportunities it still enjoys at home. That requires some explanation because it gets to the heart of the argument against investing now.

Xero's major expense is the cost of acquiring a new customer, a cost expensed upfront but recovered through the regular monthly fee. You can see the problem: the faster the company grows, the more cash it needs to fund growth. And the higher the cost of acquisition, the larger that amount becomes.

In Australia and New Zealand, customer acquisition costs are recovered after nine months of revenue. In Xero's international operations the figure is closer to two years. If you're looking for an explanation of why Xero burns through almost NZD$4 million a month in cash and announced a loss of NZD$44 million in the first half of 2016 even though revenue increased 71% year-on-year, there's your answer.

North America Gamble

REA Group and Seek expanded offshore through buying into local operations. By contrast, Xero is doing the heavy lifting itself. In the United Kingdom it is now the leader in the cloud accounting market but North America is proving more difficult.

This is a huge and attractive market. A 2012 report found 50% of all businesses could be considered small or medium-sized enterprises. With over a million subscribers worldwide, Intuit's Quickbooks product dominates and Xero is finding it hard to convert accountants and bookkeepers from Intuit. As this is the cheapest way to acquire new subscribers, Xero has to find another way and is spending four times its US revenues trying to do so.

If that weren't enough, Intuit is tackling the Xero threat head on, investing a substantial slice of its US$1.2bn in free cash flow in sales and marketing. Worse still, three years ago Intuit opened its first ever Australian office and now has about 33,000 customers. It is reportedly QuickBooks' fastest growing region.

So there's still a mountain to climb before the company is successful in the US, and it's barely out of base camp. Yet with an enterprise value of about NZ$2.8bn amounting to about 17 times its annual revenue of NZ$165m – even after recent falls – the market appears to be pricing the stock as though it's making a summit attempt.

Drury appears determined to give it his best shot, and that's probably the right approach for the time being. If success continues to prove elusive, the company may eventually have to cut its huge sales and marketing effort and settle for lower US growth rates, but this would give the competition the time they need to catch up on product functionality.

The final option would be to pull back from the US and concentrate on the UK and Australasia, which would improve the company's finances but probably wreck its share price. That might provide just the opportunity we need to get hold of Xero's best businesses at a reasonable price.

So, while we like the look of Xero's business and applaud its efforts thus far, we're happy to continue to watch this one from the sidelines. Further evidence of success in the US, a paring back of its attempts over there or a much lower share price might prompt a re-evaluation, but for the time being we're not going to commence official coverage and recommend you steer clear.