Why I think you should buy XERO FPO NZX shares today

In recent years, cloud computing technology has allowed software to be centrally hosted and delivered to customers on a subscription basis, a model known as software as a service (SaaS).

Recurring revenue streams can make the economics of a SaaS business very appealing relative to traditional software distribution models.

There are now several interesting SaaS companies trading on the ASX, including XERO FPO NZX (ASX: XRO), Aconex Ltd (ASX: ACX), Class Limited (ASX: CL1) and WiseTech Global Ltd (ASX: WTC).

I have previously outlined why I am an investor in Xero and why I think it is on track to reach $1 billion in annual revenues.

SaaS companies like Xero often delay profitability as they focus on investing to grow their customer numbers. There are various key metrics that are useful to determine whether the investment is money well spent. Broadly, investors should consider:

Annualised committed monthly revenue (ACMR) – this provides a 12-month forward view of revenue based on current subscriber numbers. It is a better indicator than operating revenue, which doesn't fully recognise the value of newly acquired subscribers. Xero's ACMR was $258 million at 31 March 2016, increasing 62% on the prior year.

Gross margin is another metric to keep track of. SaaS businesses typically have a gross margin of 60%-70%. Xero reported a gross margin of 76% at 31 March, increasing from 70% the year before.

Customer acquisition cost (CAC) reflects the number of months of revenue required to cover the sales and marketing expenses incurred in acquiring each new subscriber.

It is only worth outlaying cash to grow customers if the cost is recovered relatively quickly – preferably within 12 months or less. From that point on, if the business can keep the customer, everything is profit.

Xero reports show that it takes around 9 months to break even on a customer in Australia and New Zealand, but 23.5 months for an international customer, and 14.5 months on average overall, at a monthly average revenue per user (ARPU) of $30.

That brings us to churn. The churn rate shows the change in committed monthly revenue from customers who leave over the course of a month. Obviously, the lower the churn, the better. A good SaaS business is one with a product that is 'sticky', and may have a churn rate of around 1%.

Xero's churn rate has been decreasing and was most recently reported at 1.19%.

Knowing the churn rate lets us calculate the average customer lifetime metric. For Xero, this is currently around 7 years (1/1.19% = 84 months).

Multiplying the customer lifetime by the average monthly revenue per user ($30), and applying the gross margin, tells us that each Xero customer has a lifetime value (LTV) of $2,103.

A common benchmark for a SaaS business is to look for an LTV of at least 3 times the customer acquisition cost. Xero has a ratio of around 4.8 overall, however, the metric is far better for customers in Australia and New Zealand (9.1) than international customers (1.8).

International metrics should improve as Xero continues to gain traction in key markets such as the US and the UK.

The following chart shows the cumulative lifetime value of a customer on average, based on the above figures.

Data source: Xero reports

Multiplying the lifetime value per customer by Xero's 717,000 subscribers equates to $1.5 billion in total lifetime value.

The following table summarises all key metrics and shows how the total lifetime value has been amplified by growing customer numbers and improvements in ARPU, churn and gross margins.

Assuming these metrics remain stable or continue to improve, it appears that for Xero, investing to grow customers is money well spent.

Investors should keep their eyes on the trend in these numbers when Xero's half-year results are released on 3 November.