There is a battle underway to capture the transition of accounting and bookkeeping software to the new world of cloud computing.
In Australia and New Zealand, 25% of small businesses are now using cloud accounting software. XERO FPO NZ (ASX: XRO) and MYOB Group Ltd (ASX: MYO) are the major providers, with 425,000 and 170,000 customers respectively at their most recent data points.
Reckon Limited (ASX: RKN), another smaller player with a history of desktop software, has also turned its focus to the cloud, and looks like a potential takeover target.
Cloud-based software companies typically bill monthly, meaning they receive recurring revenue streams, and large profits, once the cost of acquiring a customer is recovered. Fully aware of the long-term value of every subscriber they can get, Xero and its competitors are currently ploughing money into innovation and customer acquisition.
Accounting is not something that has traditionally made people excited, but Xero's software seems to do just that. Xero was named "World's Most Innovative Growth Company" by Forbes in 2014 and 2015. In a Canstar Blue customer survey last year it received five-star ratings across all six criteria.
Xero's goal is to create a complete financial operating system for small business at the centre of an ecosystem with links to banks, insurers, and other companies. Its "big data for small business" concept offers powerful analytics tools previously only available to larger companies.
MYOB was caught off guard and is now playing catch up by investing heavily in innovation and working to transition its desktop application customers to its cloud-based services. It too has been winning awards for innovation, being named "Most Innovative Large Company" by Business Review Weekly in 2015.
Around 12 months ago, Motley Fool analyst Matt Joass showed that Xero had already pulled ahead in popularity based on Google search engine data.
Social media metrics are also interesting to consider. Xero wins here again, with 44,000 followers on Twitter, 44,000 on LinkedIn and 78,000 'likes' on Facebook. MYOB has 10,000, 14,500 and 42,000 on these platforms.
The US & UK
Xero expanded to the US in 2012 where Intuit has a long history with accounting software and currently around 1.1 million global subscribers to its QuickBooks Online service.
Xero faces an uphill battle to grow market share, but has done well to quickly become known as the "QuickBooks alternative" and win around 50,000 US customers. With a potential market of nearly 30 million businesses, the US market represents a massive opportunity.
Xero has another 100,000 subscribers in the UK, where Sage is the major competitor, also with 100,000 customers on its cloud service, and a long history of selling software in that market.
Source: Xero reports.
Is Xero Worth Buying Now?
After listing at $4.65 in 2012, Xero rocketed up to over $41, and has now pulled back below $14.
A company that is burning cash and strategically delaying profitability is difficult to value with traditional metrics. For this reason, cloud software companies are often valued based on comparing their committed subscriber revenue to their enterprise value.
With 600,000 subscribers paying an average of around $30 per month as at September last year, Xero has annual committed revenue of approximately $220 million. At an enterprise value of $1.9 billion, this gives a ratio of 8.71.
This is cheap relative to its history, but not cheap relative to many other cloud software companies listed in the US.
However, this may be justified given Xero's level of growth and huge potential. Xero has a strong chance of hitting 1 million customers in the near future, which would be likely to boost annual revenues to over $350 million.
In the days of desktop accounting software there was more than one winner, and that is likely to be the case with cloud accounting. The market is huge, and companies which succeed in growing a large number of users will benefit from recurring revenue streams in addition to further profit opportunities arising from having access to a huge ecosystem of valuable business data.
I think that Xero is currently well placed to be one of those companies.
