Start-up cloud accounting software company XERO FPO NZX (ASX: XRO) popularised the acronym SaaS (Software as a Service) and it's not hard to see why – $2 billion market capitalisation, no profits, entrepreneur Peter Thiel as a major investor. It's the stuff that tech company dreams are made of, although Xero is strictly small fry compared to some wannabe US companies in this sense – I'm looking at you, Snapchat.
What is there to like about Xero? The company looks expensive on most metrics. Here are the 3 main reasons I hold shares:
- It's a disruptor
While there will always be a need for accountants, much of the industry is paper-bound and in dire need of automation. Xero can handle that through a variety of plug-ins and innovations. One example is a partnership with cloud storage providers that let photos of receipts be uploaded into the software program as an expense (rather than manually inputting the data).
The theory is that by saving time all along the business chain (think tax expenses, payroll, business financing etc.), Xero will integrate deeply with its users' businesses. It generates value above and beyond the cost of the software, giving the company both highly sticky customers and the ability to raise prices over the long term.
I try not to place too much weight on anecdotal comments, but I have been told repeatedly by accountants that use all 3 platforms, that Xero's offering is head and shoulders above competitors Myob Group Ltd (ASX: MYO) and Reckon Limited (ASX: RKN) – although both are investing in improving their software.
- It could potentially become much larger
Xero is already a market leader in Australia and New Zealand, but is expanding into the USA, Singapore, and the UK. Taking a 10-15 year time frame, Xero only needs to capture a small fraction of these markets to become much larger, given that its ANZ home base is relatively small.
So far the company has been posting high rates of growth in its overseas markets, albeit off a low base.
- It could be profitable if it chose to be
Unlike many tech companies that have no choice but to raise capital repeatedly, Xero is both well-funded and could be profitable if it chose to be (e.g. by cutting research & development and marketing expenses).
Instead, Xero has elected to plough its sales revenue back into development and marketing to grow further. Even so, the company is expecting to break even in the next 18 months.
When it is profitable, Xero will still look expensive. In this case, I believe that with growing customer numbers and longer customer lives, improving technology (adding more value for customers), and rising profit margins, Xero has the footprint to become much bigger over the next decade, and generate attractive returns to shareholders along the way.
