There has been much discussion of late around the relative profitability of SaaS versus on-premises software companies. Most of the high-level analysis of SaaS companies is based on (relatively) mature companies – there being very few companies that are both young AND by necessity or choice report their number extensively.
SaaS accounting company Xero (disclosure – Xero has contracted me to produce some marketing videos with them) is a rare exception to this rule – being a relatively early stage company but also being publicly listed (albeit on a minor exchange). They’re also somewhat unusual in that they’ve managed to secure a second round of funding at a reasonable valuation (given the economic climate any funding is impressive, a round at close to listing price is a great result), and for the fact that much of this round was provided by the founder of one of the “big three” accounting software companies, Craig Winkler.
An excellent piece of analysis I stumbled upon the other day comes from Sam Stewart (co-founder of online analysis firm Valuecruncher) and discusses in much detail the financial numbers around Xero specifically but more generally around SaaS businesses. I’ve attempted to summarise Sam’s post where I can – but it’s still a length, but ultimately valuable, read.
- Xero has raised $45 million in equity
- Xero has so far burnt around $15 million in cash (development plus acquisition costs for approx 7500 customers)
- Second funding round caused an approximate 35% dilution for existing shareholders (around $25 million raised in second round)
- Not yet break even – current ARPU indicates that at current burn rate approx 30000 customers needed for break even
Sam has created a workbook that estimates the number required based on the purchase price, investment horizon, required rate of return, ARPU, EBITDA margin and EV/EBITDA multiple. Based on some high level subjective assumptions he estimates that Xero needs approximately 110,000 customers in 5 years to justify the $0.90 share price in the recent capital raising.
A key milestone for any startup is reaching break even. There is no problem with operating at a loss when creating value by investing in product development and building a presence in key markets. The key metric in Xero’s break even analysis is the ARPU. Based on the ARPU of $33 per month implied in the 2009 financial year results and estimated operating expenses of $11 million Xero would require ~28,000 customers to break even (at the EBITDA line). This figure is consistent with the 15,000 to 30,000 range suggested by CEO Rod Drury. Based on the average growth rate of 250 per week (based on the 6 weeks to 10 May 2009), an ARPU of $33 per month, $11million annual expenses Xero would reach breakeven (at the EBITDA line) by the end of November 2010. If Xero’s growth rate continues to increase this date will come forward. Any increase in expenses (over the $11 million assumption) or decline in APRU will push this date back.
It’s always tempting to assume customer growth rate will continue to rise or, at the least, stay even. But this assumption doesn’t take into account external factors. For example accounting software uptake is highly cyclical, peaking at fiscal year end and reducing throughout the rest of the year. Similarly Xero’s customer acquisition numbers are currently being bolstered by the run of good new they’ve had of late – a continuation or acceleration of these acquisition rates will require some good fortune.
Xero have often cited the potential to sell additional products to customers to increase the ARPU. Any additional product offerings will require an investment in development and ongoing support. As an example a $5 per month product adopted by 10% of Xero’s customers would add $0.50 to the ARPU. There would need to be significant investment in value added products and high adoption rates to lift the current ARPU to $50 before getting close to the $75 quoted in the prospectus.A key driver of Xero’s growth over the last 6 months has been expansion into the UK market (representing 2,000 of Xero’s 6,000 customers at 31 March 2009). This expansion into the UK has coincided with the decline in the ARPU from $54 per month to $33 per month. If the expansion into the UK has been at an ARPU below Xero’s average there is the potential for the ARPU to drop below $33 per month given the UK is currently Xero’s largest market. A lower ARPU would increase the number of customers required to break even and deliver the required return investors. At an ARPU of $30 per month the estimated break even point increases to approximately 30,500 customers.
ARPU is king but sometimes it’s not. As Sam points out the UK entry coincided with a drop in ARPU. What will a US market entry do? Personally I believe there is more price pressure in the UK than there is in the US. The US market is more segmented and there is less overall competition in the accounting software space. In the UK by comparison there are a number of SaaS players all duking it out for market share. As such I’d be picking a increase in ARPU to be a facet of a US market entry – this doesn’t take into account however any segmented offerings that Xero may come up with to increase it’s addressable market size. I’ve always said that utilising the core accounting engine to service customers who you wouldn’t otherwise be able to derive revenue from is a smart strategy. So potentially added products would actually lower ARPU but greatly increase customer numbers – SaaS changes everything and the traditional rules don’t necessarily hold.
Valuation and Customer Number Analysis
The $15 million IPO provided the capital required to start building a global offering, which has consistently been the stated aim. The $55 million post money valuation committed Xero to building a significant business to justify the valuation and produce the required rate of return for what was effectively a venture capital investment. Having raised $15 million at $55 million adopting a boot strapping approach based on re-investing retained earnings was not going to be sufficient. The recent capital raising could be interpreted as a double down by Xero (Xero and Craig Winkler clearly think they have a winning hand). Xero intend to increase investment in product development and to enter new and massive international markets.
How many customers do they need to acquire to justify their current valuation?
I have updated the workbook I created approximately 18 months ago. This updated analysis is my personal view. This analysis considers the purchase price, investment horizon, APRU, EBITDA margin, required rate of return and future valuation metrics when estimating the number of customers Xero require. These inputs are uncertain, subjective and will vary depending on the individual. Because of these factors I encourage readers to download the workbook and play with the assumptions.
Investment Horizon: 5 years
Despite the recent share price activity Xero should be viewed as a long-term investment.
No arguments from me here – early stage technology companies are long term plays. No one should be expecting a dividend any time soon. There is potentially an upside in terms of acquisition, as in the next year or two there are a few potential acquirers of the company – but given the situation of the major shareholders I’d be surprised if a trade sale ensued.
Based on the current ARPU and expected price pressure entering new markets with significant competition. This is slightly higher than the current ARPU reflecting the potential for additional revenue streams to be developed.
As stated previously I’m not confident that we can second guess the ARPU for such an early stage company. I see a couple of things happening here – US market entry for the core product will tend to raise ARPU (at east in comparison to the UK). At the same time however there is significant potential to leverage the core engine to drive sales to a formerly non-addressable market – as such there is the possibility that ARPU will drop but customer numbers will soar. It’s very much a case of watch this space and see how the strategy will play out.
EBITDA Margin: 35%
Based on my previous analysis of SaaS companies.
EV/EBITDA Multiple: 12
Purchase Price: $0.90 and $1.45
I have applied my analysis to both the $0.90 strategic placement/SPP price and the closing price on Friday 22 May of $1.45.
Required Rate of Return: 20% per annum and 5x return on investment (~38% per annum)
These are subjective assumptions and will vary depending on the individual. I have applied a 20% per annum required rate of return reflecting a high risk listed equity investment. Over a five year horizon 20% per annum return equates to a 2.5x return on investment. The 5x return on investment (38% per annum) reflects the minimum rate of return expected from a later stage venture capital fund investing in a company in Xero’s position.
Estimated number of customers required by Xero in five years time:
20% p.a. Return on Investment 5x Return on Investment Purchase Price: $0.90 110,000 225,000 Purchase Price: $1.45 180,000 360,000
The outputs highlight the wide range of potential outcomes and the sensitivity to key assumptions. This set of customer numbers are significantly higher than 36,000 figure estimated in late 2007. The key drivers of the increase is the lower ARPU and the shareholder ownership dilution resulting from the additional capital raised.
It is important to remember this analysis assumes a 5 year investment horizon and Xero would not need to hit these targets by Christmas.
Are these target customer numbers realistic/achievable?
To put these customer numbers into perspective they represent 1% to 3% of the addressable Australian, New Zealand, UK and US market (Intuit estimate that 60% of US SMEs don’t use accounting software). These required customer numbers illustrate why Xero is expanding into the larger UK and US markets.
Market Market Size Addressable Market New Zealand 322,000 128,800 Australia 1,200,000 480,000 United Kingdom 4,300,000 1,720,000 United States 26,000,000 10,400,000 Total 31,822,000 12,728,800
Again here I’d make the comment that the addressable market is a great unknown here – there’s plenty of potential to broaden the scope of the offering and I’d be interested to see what an even more mass-market play would do to the financials.
All in all a fascinating analysis and one that is valuable for other early stage companies out there – whether in the accounting space or not.