Why you need some XERO FPO NZ in your portfolio

I have previously written about my reasons for investing in XERO FPO NZX (ASX: XRO); how to understand its key software as a service (SaaS) company metrics; and why I think it has a good chance of hitting its $1 billion revenue target within 5 years.

After attending a Xero roadshow event recently, and being impressed with the latest developments, I decided to revisit the current outlook for investors.

Making great progress

Xero has been developing a complete cloud-based operating system for small businesses which connects them to a global network integrating all parts of the financial ecosystem. Obviously, this requires lots of innovation and investment and comes with substantial execution risk. However, the potential payoff is massive.

Xero has made good progress, most recently reporting 862,000 customers as at 30 September last year. Results for the year ending 31 March 2017 are due out in May, and I will be surprised if it has not reached the milestone of 1 million customers, with a total lifetime value of somewhere in the vicinity of $2 billion.

If Xero does reach these targets for 31 March, it will represent several years of impressive growth, with over $1 billion in total customer lifetime value created in the last two years alone.

A huge market – but plenty of competition

Xero is competing against Sage in the UK, Intuit in the US, and Myob Group Ltd (ASX: MYO) and Reckon Limited (ASX: RKN) in Australia. However, product ratings suggest that Xero has one of, if not the best solution, meaning it should continue to win market share as accounting moves from the desktop to the cloud.

The potential global cloud accounting market is also much larger than the desktop software market it is replacing. This is because the power, simplicity, and low cost of cloud software make it a compelling solution for the many small businesses that previously shied away from using accounting software products.

This is reflected in Xero's customer data – many of its current customers were not won from competitors, but are new to accounting software.

Demand for Xero will only grow as its capabilities continue to improve and its network becomes more integrated. In my view, any small business not using cloud accounting software is already at a competitive disadvantage – research suggests those that do are more profitable.

Much more innovation to come

Xero CEO, Rod Drury, expects that there will be more innovation in the next two years than the last 10, as machine learning and artificial intelligence transform the industry.

This technology has the power to automate most of the accounting process, from coding transactions straight from the bank statement, right through to preparing financial reports. This will help to unlock the tremendous value that comes from having current and accurate data, such as real-time insights into business performance that were previously impossible.

Granted, the future value of these technologies is hard to quantify for Xero investors today.

An income stock of the future?

Shares are currently trading around $17.30; a level they first reached back in 2013, not long after Xero listed on the ASX. In my view, this represents good value given there is a reasonable chance of Xero surprising on the upside in relation to its customer growth in the next few years. However, weaker than expected progress out of key markets such as the US has the potential to weigh on the share price in the short term.

Xero is yet to make a profit as it has been investing heavily to win market share. The next challenge will be to transition to profitability while continuing to manage growth.

Xero's growth rate, attractive margins, and recurring revenue model could mean that it becomes an attractive dividend paying stock in the future.