Cloud accounting software company XERO FPO NZX (ASX: XRO) recently reported some impressive growth figures for the 12 months to 31 March 2016.
Total customers increased by over 50% to 717,000 and operating revenues were up by 67% to $207 million. Xero now has its sights set on becoming a $1 billion revenue business.
But if and when is it likely to achieve this?
In my view Xero has a good chance of hitting its $1 billion target within 5 years.
Xero is a “Super grower”
Research from McKinsey defines “Super growers” as software companies which are growing revenues at a rate of at least 60% at the time they reach $100 million.
Their analysis of 3,000 companies showed that although only 3% went on to reach $1 billion in revenues, the rate of revenue growth was the single best indicator of future success. Super growers were eight times more likely to reach $1 billion than businesses with growth rates of under 20% at the $100 million mark.
This make sense – a company with such fast growing revenues clearly has a product well suited to the demands of the market and a strong industry tailwind which is likely to continue.
Based on its current trajectory, Xero is among the fastest growing listed cloud software companies in the world. Of the 44 companies featured in the Bessemer Venture Partners BVP Cloud Index, Xero comes in at number two for growth based on the most recent data.
How much will Xero be worth in 5 years?
As is the case with Xero, cloud software companies typically delay profitability as they invest in building revenues as much as possible. For this reason, they are commonly valued by comparing their revenues to market capitalisation or enterprise value.
A faster growing company will generally trade at a higher multiple. This can be seen in the following chart showing the revenue multiples for the 44 companies in the BVP Cloud Index.
Data Source: Bessemer Venture Partners (Note: Figures are calculated based on Enterprise Value vs forecast 2016 calendar year revenues).
I agree with Tom Richardson that Xero has a good chance of at least 40% revenue growth for the next 3 years, taking it to $570 million in revenues, and over $1 billion if it can sustain this growth for 5 years.
Assuming Xero manages to hit its $1 billion target, its valuation will depend on its earnings, but also its growth prospects at that time, and general market sentiment.
If we assume the growth rate has slowed after 5 years, Xero is likely to trade on a more conservative revenue multiple. For example, at a multiple of 5x, Xero would be worth $5 billion, suggesting more than a 2x return from the current market value of around $2.2 billion.
This multiple would be consistent with several software companies from the BVP Cloud Index with growth rates of around 25%. However, I consider this is conservative and Xero is likely to maintain a higher growth rate and therefore a higher valuation. Starting from a low base of market penetration in a large addressable market means that its high growth rate is likely to persist if Xero can continue to offer a superior solution.
What’s the risk?
Xero’s current growth trajectory suggests it is on the right track. However, global competition in key markets is likely to be strong, with Sage in the UK, Intuit in the US, and MYOB Group Ltd (ASX: MYO) and Reckon Limited (ASX: RKN) looking for market share in Australia.
With this in mind, Xero still belongs in the speculative part of your portfolio, but may deserve a spot as a core holding at some point in the future.