Accounting software company XERO FPO NZX (ASX: XRO) has always been unprofitable, and management intends to continue running at a loss while they invest heavily in expansion in multiple overseas markets.
This makes the company difficult to value without running Discounted Cash Flow (DCF) calculations that the average reader might find difficult and time consuming. Management has asserted that Xero has enough cash to see it through to break-even, although prudent investors will also be aware that unforeseen events could render this forecast inaccurate.
Unlike many other cash-burning companies however, Xero could easily become profitable if it chose to be.
I want to briefly illustrate how a lay investor with 'xero' accounting knowledge (heh) might examine a hypothetical Xero that wanted to be profitable right now. We can then glance at how that stacks up against global and local peers like Intuit and Myob Group Ltd (ASX: MYO).
Trimming the fat
In order to make Xero profitable, there are three main expenses that management could cut – Cost of Revenue, Product Design and Development (aka Research and Development, or as I will call it, "R&D"), and Sales and Marketing. Xero already has a good stable of customers with long customer lifespans and low 'churn' (loss of customers to competitors). A manager looking to maximise the cash flow from existing customers would likely elect to cut R&D and Sales and Marketing expenses, which involve investing for future customers.
All figures below are from the company's most recent half-year report.
Now, Xero should see a lower 'Cost of Revenue' (cost of actually selling the product, including online hosting and customer service costs) this year due to the transition to the Amazon Web Services hosting platform. The cost of data hosting has also been duplicated while Xero migrates. For the purposes of this hypothetical example, let's assume that these savings are being reinvested into customer service, in order to keep as many customers as possible. Thus, the Cost of Revenue remains the same at $34 million.
In order to become profitable ASAP, Xero would have to cut its R&D and Sales and Marketing expenses. If we say the R&D budget gets cut by 75% to $11 million, and Sales and Marketing budget shrinks by 50% to $43 million, that would free up $33 million from R&D, and a further $43 million from Sales and Marketing, for a total of $76 million in savings.
Given that Xero is currently running a loss before tax of $43 million, the company would shift to showing a profit of $33 million before tax at the half year. We would then have to apply the company tax rate to that, which differs by jurisdiction. For simplicity's sake, as the report is in NZD, we will use New Zealand's 28% company tax rate. Xero would thus have had a hypothetical half-year profit of $24 million. Since we are trying to avoid complex forecasting, we will double that to $48 million to approximate the full-year, giving Xero a Price to Earnings (P/E) ratio of 48 times at its current market capitalisation of $2.3 billion.
Although we have slashed expenses heavily, this hypothetical Xero retains a reasonable marketing budget and some R&D expenditure, and may be able to continue to grow customers for some time based on the strength of its existing software.
So?
Xero's hypothetical P/E of 48 in this example is very high compared to peer Intuit which has a P/E of 34 full year earnings, according to NASDAQ, while Myob Group Ltd (ASX: MYO) has a P/E of 21 times, according to Thomson Reuters consensus estimates. What's more, this pricey, hypothetical version of Xero is stacked up against against real versions of Intuit and Myob which retain their full R&D and Sales and Marketing budget.
So even after slashing marketing and development by 50% to 75%, Xero is still some 30% more expensive than Intuit in P/E terms.
(We do need to remember the potential for things like cost cutting, growing margins, operating leverage and so on, none of which are accounted for in this example.)
Another way to compare the companies would simply be to look at their price to sales ratios. Myob is valued at 6 times its sales, Xero at 7 times, and Intuit at just under 6 times (according to Thompson Reuters). On this metric, Xero also looks more expensive than peers.
Yet to compete with Intuit, that $29-billion titan, Xero must invest heavily or risk being marketed into obscurity by Intuit's monstrous budget. This heavy investment relative to the size of Xero is the key reason the company is losing so much money, and still a chief contributor to the high hypothetical P/E above, because Xero's expenditure is so high (in relative terms) to begin with.
Investing for the future
As of the recent half year report (page 16), Xero spent 32% of revenue on product design and development, after accounting for capitalised costs and amortisation. Myob's was a little harder to track down, but appears to be about 20% of segment revenue, according to the segment data in the recent half-year report (page 11). In its latest annual report, Intuit reports it spent 19% of revenue (page 8) on product development.
Xero is also much smaller than Intuit, and has correspondingly greater growth potential if it can beat the market-leader at its own game. Thus Xero's current valuation may be appropriate, especially if there is some evidence of customers preferring it to competing software.
Foolish Takeaway
Obviously, Xero would be shooting itself in the foot by cutting its research and marketing budgets, as these are together the two factors that allow it to compete in new markets already dominated by the likes of Intuit. We can, however, see that the company could be profitable if it chose, and it carries no debt. Being profitable would allow it to add debt to continue growing, if it required additional capital and had difficulties sourcing it from investors.
So although investors need to make sure Xero's continuous expenditure generates good outcomes in terms of growth in customer numbers and so on, it appears as though unprofitable Xero's likelihood of entering financial peril is very low – lower than several profitable companies.
We can also see by the higher price set on it by the market, that investors are expecting Xero to continue to grow quickly and disrupt competitors like Intuit and Myob. A company that loses millions every year and is in no rush to become profitable is usually a company for investors to avoid. However with Xero, it's a strategy that appears to make good economic sense. It might also have the unintended side effect of helping to mask the company's valuation – or value.
