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Xero is up 493% over the last year, is there more to come?

Dual-listed accounting software company Xero (ASX: XRO) has rocketed up in a spectacular fashion in the last year, gaining just under 500%, yet I feel compelled to ask if the best is yet to come.

Xero provides online accounting software, or Software as a Service (SaaS) software, to small businesses via the internet. Often people will describe this as being part of the “cloud computing” phenomenon – where a given service is accessible directly from the “internet cloud” through a standard browser. The company’s meteoric rise has been associated with a growing trend for businesses to move from traditional accounting software based on desktops or PCs, to the cloud.

The company has grown exponentially over the past six years with the most recent half yearly result of NZD$30.3 million in revenues representing an increase of 84%. This has translated to a net loss after tax for the half year of NZD$17.1 million, with the main reasons cited by the company being continued investment in product development, recruitment of senior leadership and accelerated expansion in the United Kingdom and United States. The market seems to have taken its losses in stride, with the share price rising 493% to AUD$36.90 in the last year, equating to a market capitalisation of AUD$4.7 billion.

Xero’s price to sales ratio stands at 88 times on a trailing 12-month basis, which seems to indicate a significantly more expensive proposition in comparison to its competitors such as Intuit (NASDAQ: INTU) at 5.3 times and Reckon (ASX: RKN) at 2.7 times.

Based on Xero’s current market capitalisation and an estimated 80% increase to revenues in 2014, this roughly equates to a forward price to sales ratio of 68 times, a number that still seems to be quite expensive, although it becomes more reasonable in the context of Xero’s customer acquisition and revenue numbers, with both increasing over 80%. In terms of market share, Xero estimates that it currently has 19% of the New Zealand small business market, 4% of the Australian market and less than 1% of the U.K. and U.S. markets respectively, indicating that there is room to grow their customer base further.

The company currently has just over 250,000 clients and aspires to take this to over 1 million in the next five years, no small feat given the stiff competition. In contrast, MYOB claims to have 1.2 million customers and Reckon states it has 600,000 registered businesses on its platform. Xero’s current focus is to use its NZD$230 million cash position to bolster its activity in the United States, a market that the company estimates has 29 million potential customers.

There are several risks here that I am wary of. There is a question mark over Xero’s current market capitalisation of nearly $5 billion, given it has not turned a profit and does not anticipate one in the near future due to the reasons mentioned above. Additionally, recent media articles indicate that competition in this space is heating up, with MYOB, Intuit and others ramping up staff numbers and marketing spend in addition to investing in the quality of their products.

Xero has responded with an aggressive tilt at client acquisitions planned for the US, and is currently in the midst of a roadshow across Australia to win over more accounting firms to its partnership channel, an important aspect of their growth strategy. The company is also investing heavily in its product which has won over some unlikely supporters.

Another positive for Xero is the incredible amount of experience in its management team and board, which has been originated from its competitors Intuit and MYOB, as well as large IT behemoths such as Google, Microsoft, IBM, Apple and HP.

Foolish takeaway

If Xero is able to continue to build its market share and revenues whilst managing its costs and product quality, it could be a juggernaut in the making. However, investors should exercise caution, given the company is not profitable and in fact, its losses have increased, with the company choosing investment in its product and staff over profit in the short term. This implies that the company is taking a long-term view towards profitability and has prioritised its growth agenda over hard returns, a risky strategy that is not for the faint-hearted.

Investors should consider the risk and return trade off inherent in a company like Xero (fast growth, heavy investment, year on year losses and huge potential). Although the accounting software landscape is shaping up for a competitive battle, Xero’s combination of innovative product, experienced management and capacity for expansion makes it the main contender from the land of the long white cloud.

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Motley Fool contributor Sid Narsey does not own shares in any of the companies mentioned in this article, but plans to take a position shortly.

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