Why the Xero Limited (ASX:XRO) share price is going gangbusters

One business I’ve written about a lot over the past few years as an investment opportunity on the local market is Wellington-based cloud-accounting startup Xero Limited (ASX: XRO).

Back in May 2016 I suggested it looked a blue-chip share of tomorrow after the group handed in its full year results that showed some accelerating subscriber growth in the large UK market, while also delivering strong subscriber growth in Australia, New Zealand and the U.S.

By 2016 Xero was already a market leader in ANZ, with the heavy investment in marketing and sales resources in the UK looking like it would pay off for the patient.

However, back then Xero had surprisingly little institutional analyst coverage and its big losses put off local institutional investors who probably missed the key driver underpinning the Xero investment case.

Put simply, Xero has always invested heavily in marketing to acquire customers at a strong rate in the knowledge that the cost of acquiring those customers should handsomely pay off over a three to five-year time horizon.

For example as at March 31 2016 Xero reported that it would take its Australia and New Zealand businesses 9.1 months of average revenue per user (ARPU) summed to recover the cost of acquiring a customer (CAC).

After that the revenue earned would start to generate Xero a profit at a high gross margin.

Overseas where it was investing much more heavily in sales staff and marketing it would take it 23.5 months to recover the cost it had invested in acquiring a customer.

Moreover, Xero expected to make $9.10 in profit from an ANZ subscriber (over the lifetime of the subscription) for every $1 invested in sales and marketing to sign up that subscriber. Internationally, where customer acquisition costs were far higher it expected to make $1.80 in profit for every $1 spent capturing a customer.

It came to these conclusions via its ratio of CAC / LTV (lifetime value), which translates as customer acquisition cost divided by the expected lifetime value of a customer (i.e. ARPU multiplied by average subscriber lifetime) to show how much it expects to profit over the lifetime of a new subscriber.

As at March 2018 it expects to get back $11.40 in profit from every $1 spent to sign a subscriber in ANZ and $2.60 internationally.

In other words, Xero has always been heading towards a profit, but the heavy upfront investment made in achieving that profit disguised this potential from many investors.

It’s important to note that pretty much all of Xero’s financial metrics such as costs as a percentage of revenue, ARPU and CAC are still moving in the right direction. As such it wouldn’t make sense for it to slow down on its heavy sales investments (or pay a dividend) as the upfront CAC in the form of marketing expenditures should pay off in the future.

Its software-as-a-servive (SaaS) business model is a recurring revenue model (subscribers pay monthly) and as such Xero could deliver strong compound returns for investors for a long time yet.

Furthermore, when you consider that the shift from desktop accounting (Excel spreadsheets, etc,) to online accounting (data stored online and potentially fed into small businesses’ banks online, etc) is still in its early days then you can see that even though Xero shares have tripled in two years they may have further to run.

Clearly though it faces competitive risks (such as Intuit’s Quickbooks, Sage, or Myob Group (ASX: MYO) and will need to put more runs on the board before the market is likely to bid it much higher than today’s fair looking valuation of $45.40. Still, given its track record and market position I expect Xero can deliver more success for investors in time.

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Motley Fool contributor Tom Richardson owns shares of Xero.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia owns shares of Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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