How XERO FPO NZX could be profitable in 2017

How would it look if XERO FPO NZX (ASX:XRO) changed its business model to focus on immediate profitability?

| More on:
a woman

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Accounting software company XERO FPO NZX (ASX: XRO) has always been unprofitable, and management intends to continue running at a loss while they invest heavily in expansion in multiple overseas markets.

This makes the company difficult to value without running Discounted Cash Flow (DCF) calculations that the average reader might find difficult and time consuming. Management has asserted that Xero has enough cash to see it through to break-even, although prudent investors will also be aware that unforeseen events could render this forecast inaccurate.

Unlike many other cash-burning companies however, Xero could easily become profitable if it chose to be.

I want to briefly illustrate how a lay investor with 'xero' accounting knowledge (heh) might examine a hypothetical Xero that wanted to be profitable right now. We can then glance at how that stacks up against global and local peers like Intuit and Myob Group Ltd (ASX: MYO).

Trimming the fat

In order to make Xero profitable, there are three main expenses that management could cut – Cost of Revenue, Product Design and Development (aka Research and Development, or as I will call it, "R&D"), and Sales and Marketing. Xero already has a good stable of customers with long customer lifespans and low 'churn' (loss of customers to competitors). A manager looking to maximise the cash flow from existing customers would likely elect to cut R&D and Sales and Marketing expenses, which involve investing for future customers.

All figures below are from the company's most recent half-year report.

Source: Company reports
Source: Company reports

Now, Xero should see a lower 'Cost of Revenue' (cost of actually selling the product, including online hosting and customer service costs) this year due to the transition to the Amazon Web Services hosting platform. The cost of data hosting has also been duplicated while Xero migrates. For the purposes of this hypothetical example, let's assume that these savings are being reinvested into customer service, in order to keep as many customers as possible. Thus, the Cost of Revenue remains the same at $34 million.

In order to become profitable ASAP, Xero would have to cut its R&D and Sales and Marketing expenses. If we say the R&D budget gets cut by 75% to $11 million, and Sales and Marketing budget shrinks by 50% to $43 million, that would free up $33 million from R&D, and a further $43 million from Sales and Marketing, for a total of $76 million in savings.

Given that Xero is currently running a loss before tax of $43 million, the company would shift to showing a profit of $33 million before tax at the half year. We would then have to apply the company tax rate to that, which differs by jurisdiction. For simplicity's sake, as the report is in NZD, we will use New Zealand's 28% company tax rate. Xero would thus have had a hypothetical half-year profit of $24 million. Since we are trying to avoid complex forecasting, we will double that to $48 million to approximate the full-year, giving Xero a Price to Earnings (P/E) ratio of 48 times at its current market capitalisation of $2.3 billion.

Although we have slashed expenses heavily, this hypothetical Xero retains a reasonable marketing budget and some R&D expenditure, and may be able to continue to grow customers for some time based on the strength of its existing software.

So? 

Xero's hypothetical P/E of 48 in this example is very high compared to peer Intuit which has a P/E of 34 full year earnings, according to NASDAQ, while Myob Group Ltd (ASX: MYO) has a P/E of 21 times, according to Thomson Reuters consensus estimates. What's more, this pricey, hypothetical version of Xero is stacked up against against real versions of Intuit and Myob which retain their full R&D and Sales and Marketing budget.

So even after slashing marketing and development by 50% to 75%, Xero is still some 30% more expensive than Intuit in P/E terms.

(We do need to remember the potential for things like cost cutting, growing margins, operating leverage and so on, none of which are accounted for in this example.)

Another way to compare the companies would simply be to look at their price to sales ratios. Myob is valued at 6 times its sales, Xero at 7 times, and Intuit at just under 6 times (according to Thompson Reuters). On this metric, Xero also looks more expensive than peers.

Yet to compete with Intuit, that $29-billion titan, Xero must invest heavily or risk being marketed into obscurity by Intuit's monstrous budget. This heavy investment relative to the size of Xero is the key reason the company is losing so much money, and still a chief contributor to the high hypothetical P/E above, because Xero's expenditure is so high (in relative terms) to begin with.

Investing for the future

As of the recent half year report (page 16), Xero spent 32% of revenue on product design and development, after accounting for capitalised costs and amortisation. Myob's was a little harder to track down, but appears to be about 20% of segment revenue, according to the segment data in the recent half-year report (page 11). In its latest annual report, Intuit reports it spent 19% of revenue (page 8) on product development.

Xero is also much smaller than Intuit, and has correspondingly greater growth potential if it can beat the market-leader at its own game. Thus Xero's current valuation may be appropriate, especially if there is some evidence of customers preferring it to competing software.

Foolish Takeaway

Obviously, Xero would be shooting itself in the foot by cutting its research and marketing budgets, as these are together the two factors that allow it to compete in new markets already dominated by the likes of Intuit. We can, however, see that the company could be profitable if it chose, and it carries no debt. Being profitable would allow it to add debt to continue growing, if it required additional capital and had difficulties sourcing it from investors.

So although investors need to make sure Xero's continuous expenditure generates good outcomes in terms of growth in customer numbers and so on, it appears as though unprofitable Xero's likelihood of entering financial peril is very low – lower than several profitable companies.

We can also see by the higher price set on it by the market, that investors are expecting Xero to continue to grow quickly and disrupt competitors like Intuit and Myob. A company that loses millions every year and is in no rush to become profitable is usually a company for investors to avoid. However with Xero, it's a strategy that appears to make good economic sense. It might also have the unintended side effect of helping to mask the company's valuation – or value.

Motley Fool contributor Sean O'Neill owns shares of Xero. The Motley Fool Australia owns shares of Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

More on ⏸️ Investing

Close up of baby looking puzzled
Retail Shares

What has happened to the Baby Bunting (ASX:BBN) share price this year?

It's been a volatile year so far for the Aussie nursery retailer. We take a closer look

Read more »

woman holds sign saying 'we need change' at climate change protest
ETFs

3 ASX ETFs that invest in companies fighting climate change

If you want to shift some of your investments into more ethical companies, exchange-traded funds can offer a good option

Read more »

a jewellery store attendant stands at a cabinet displaying opulent necklaces and earrings featuring diamonds and precious stones.
⏸️ Investing

The Michael Hill (ASX: MHJ) share price poised for growth

Investors will be keeping an eye on the Michael Hill International Limited (ASX: MHJ) share price today. The keen interest…

Read more »

ASX shares buy unstoppable asx share price represented by man in superman cape pointing skyward
⏸️ Investing

The Atomos (ASX:AMS) share price is up 15% in a week

The Atomos (ASX: AMS) share price has surged 15% this week. Let's look at what's ahead as the company build…

Read more »

Two people in suits arm wrestle on a black and white chess board.
Retail Shares

How does the Temple & Webster (ASX:TPW) share price stack up against Nick Scali (ASX:NCK)?

How does the Temple & Webster (ASX: TPW) share price stack up against rival furniture retailer Nick Scali Limited (ASX:…

Read more »

A medical researcher works on a bichip, indicating share price movement in ASX tech companies
Healthcare Shares

The Aroa (ASX:ARX) share price has surged 60% since its IPO

The Aroa (ASX:ARX) share price has surged 60% since the Polynovo (ASX: PNV) competitor listed on the ASX in July.…

Read more »

asx investor daydreaming about US shares
⏸️ How to Invest

How to buy US shares from Australia right now

If you have been wondering how to buy US shares from Australia to gain exposure from the highly topical market,…

Read more »

⏸️ Investing

Why Fox (NASDAQ:FOX) might hurt News Corp (ASX:NWS) shareholders

News Corporation (ASX: NWS) might be facing some existential threats from its American cousins over the riots on 6 January

Read more »