Tuesday, April 12, 2016

Xero Valuation - How do you value a company without earnings? $XRO

Anyone who believes that exponential growth can go on forever in a finite world is either a madman or an economist - K Boulding



If users are growing like that, then why is share price doing this:




What is a SaaS company growing users at an exponential rate worth?


Over $1bn with 593,000 users  - find the moat talks about the value in more depth.   The current Enterprise Value for Xero is $1.6bn ($14.10 share price).

Estimates of when the company will turn a profit

First let's start with the analysts estimates of when the company will turn a profit

Analysts are expecting break-even to occur between 2019 and 2020.  The model I have created has break even at the same period, 2019; after it earns over $A 400m in revenue with over 1m users.


Why and how does a SaaS invest for future profits?


A positive development is that the last quarterly cashflow saw that the cash burn is slowing; which would alleviate concerns of another round of dilution in equity.


What is the Market Size

Whilst the total market for cloud services may total around 29m, the target for total users for XERO would be just over 2 million.

The development of cross platform cloud solutions are critical to the growth of XERO.  Most small businesses are still delaying the move to cloud based accounting - with a lot of users still using desktop software.  My own personal experience was MYOB forcing me into their cloud software and the process of bookkeeping actually took much longer than the desktop software; 30 seconds lags between saving entries was the biggest issue.  Xero dramatically reduces the time it takes to do the BAS reports compared to MYOB and the ability to add users to the software with cross platform capability is the feature that MYOB sorely needed.  XERO beats MYOB in all attributes of accounting software for small businesses except for the lack of keyboard shortcuts for frequent data entry tasks.


What are investor's expectations from last year?

There are various reasons why the ASX market participants will find it hard to value XERO higher than the current $1-2bn range; one is the anchored number of lifetime value of $1bn, makes it hard for investors to want to pay for growth.  The latest funding for the company was done from people who have previously invested into SaaS companies and more importantly have a different risk profile to the retail investors.
Retail investors want to see normal looking statements, with growing profit numbers.  When the net losses are increasing at an accelerating rate as your revenue grows, then it's easy to take the usual reasoning that if it costs too much to grow your business, it's not worth growing. Thus it could be a rational business decision to profit from local markets (AU and NZ) that have matured and slow down on the marketing spend for global markets.  However, the cloud space tends to be stable at only one or two dominant players; and clearly XERO is investing heavily for that position.  If this is the scenario that does reveal itself in the next 3 years (expect users to be over 1 million by 2018); then the valuation for XERO would be 5 to 10 times what it is now.  This is how you would reverse engineer the projections that the VC firms may be making when they make late round investments into the company at $20.00/share.  I'd say the target value for the VC rounds would be between 25%+ for 5 years+, looking for a minimum exit value of $6bn.  This is about $44.00 per share.


DCF Valuation

It is difficult to value a business with any degree of certainty, when it operates within a rapidly changing industry.  

Assumptions for growth in users:


2017201820192020202120222023
users900,0001,055,0001,146,8001,258,6181,370,4541,482,3091,556,532
y/y %33%17%9%10%9%8%5%
2024202520262027202820292030
users1,635,3541,719,0901,808,0761,902,6732,003,2692,110,2772,224,145
y/y %5%5%5%5%5%5%5%

The absolute total users at 2030 at glance seems high; however if we look at the table for regional breakdown by 2030, we can see that we are already factoring in slowing growth in AU/NZ markets and the remaining growth will come from the U.S and U.K markets at a moderate pace; as we assume intense competitive pricing pressures from Intuit and Sage.  Given Xero's head start in cloud, and it's captured service partners in the platform for services space, it's very likely XERO will get it's share in the U.S and U.K markets.  As a comparison Sage (U.K) have over 6m, MYOB (AU) have over 1m, Intuit(US) 7m customers.


Year2030
NZ203
AU564
UK717
US740
Total (000's)2224

The argument that the accounting business is a sticky business, with high switching costs is true. The time and energy it takes to learn a new accounting system and move the accounts are usually not worth the struggle, given the usage of the system is during a few weeks where the accounts are being prepared.  The opportunity for XERO occurs when the incumbents such as MYOB, Intuit and Sage customers force their own inferior cloud software to their clients that want to keep their desktop software.  The need to compete with XERO has rushed to market a vastly inferior product which can only compete by lowering price. In the case of MYOB, the cloud offering is a hybrid slower, clunkier and less flexible across multiple users and cross platform (pc/mac). The increasingly tech savvy business operators will make the move to try out other software.

My expectation of the upcoming earnings report is 640-720k users for 2H16, if I had to pick one number it would be 675,000.  Weighting the probability of different users reported, the valuation would be $20.45; 31% discount to today's closing price $14.00.


usersvalueprob %e(v)
60016.973%0.51
64018.3810%1.84
68019.7945%8.91
72021.1924%5.09
76022.615%3.39
80024.013%0.72
100%$20.45


Peter Lynch claimed to look around you when looking for investment potential; something that can grow at high rates for a long period of time, can compound into multiple baggers.  Phil Fisher and his scuttlebutt method of research was one reason why I realised this was a much superior product than others on the market that has a team dedicated to long term value creation.  If you can look beyond the short term losses, this first half year might be the last time the stock may be bought under $20.