When I wrote about XERO FPO NZ (ASX: XRO) last year I thought the stock was a sell. I concluded that for Xero to justify its more than $2 billion market capitalisation, the loss-making company would have to generate profits equal to double its revenue at the time which I felt was unlikely.
I failed to consider the lifetime value of Xero's rapidly growing customer base which is realised over many years or to appreciate that each dollar of marketing spend is repaid multiple times over.
Fast forward 12 months and Xero's subscriber base has increased by 33% to 717,000. As my colleague Tom Richardson points out in this piece, a few years of similar growth and the current share price will look like a steal.
The Competitive Landscape
Xero has three main competitors, US-based Intuit Inc. with its Quickbooks product suite, UK-based The Sage Group plc and the Australian incumbent, Myob Group Ltd (ASX: MYO). When converted into Australian dollars, these three listed entities have market capitalisations of $39.4 billion, $11.8 billion and $2.1 billion respectively. Therefore, roughly speaking, the accounting software industry is currently valued at in excess of $50 billion and in this context Xero's market capitalisation of $2.3 billion starts to look reasonable.
Historically, a single company tended to dominate each national market but the advent of cloud computing has eliminated geographical boundaries. Therefore, it is possible that one of Xero, Intuit, Sage and MYOB will end up with a global monopoly and if so it would be hard to look past Intuit given its size.
If more than one company can thrive then Xero is well placed to become the runner up to Intuit as it has the best online subscribers outside of the US, where Intuit dominates. I suspect this is more likely than the first scenario given there are high switching costs for customers, although network effects increase the likelihood of a monopoly.
Xero has been successful in selling its software through accountants and bookkeepers who are the main users of the software rather than small business owners who ultimately foot the bill. Except where the business owner does the books themselves, it is usually the accountant or bookkeeper that makes the decision of which software to use and for them ease of use is more important than cost.
Having used the Xero product myself and spoken with other accountants, I believe that it is at least as good as Quickbooks and well ahead of its other two rivals. Whilst competitor products are improving all the time, Xero isn't standing still either and is constantly striving to introduce new features which add value to customers.
For example, in partnership with Hubdoc, Xero has developed automatic invoice posting which has the potential to save bookkeepers and business owners huge amounts of time and money. It is also looking to harness the power of machine learning to automate the accounting process further.
Final Thoughts
If it transpires that multiple software providers can coexist and Xero establishes itself in second place behind Intuit, then the stock looks like a bargain in the context of a $50 billion industry.
It could be argued that the industry will become even more valuable as the transition to a SaaS model raises prices across the board. This is certainly likely in the event of a monopoly and perhaps even an oligopoly structure, but recently both Intuit and Xero have been cutting prices to win new customers. If that continues then the industry may not turn out to be as profitable as it first appears.
