Making sense of Xero’s valuation
Xero polarises public equity investors. A company with only $17m of hard tangible assets generating hefty quarter-on-quarter losses does not often appear on the ASX/NZSE with a $2bn valuation.
However, no one disputes that Xero is an exceptional company with an exceptional product. The problem though is that this is not easy to quantify against Xero’s market valuation. A P/E multiple cannot be applied to a seemingly perpetual negative earnings number.
To make sense of Xero’s valuation, we have to first recognise that every great company with a wide moat begins with an investing phase where capital is first consumed to build productive capacity with the ultimate goal being the ability to generate sustainable supernormal profits later.
To use hundred year old examples, Henry Ford had to invest in factories and production lines first and John D. Rockefeller had to invest in refineries and pipelines first.
But you may argue – these guys built productive capacity in the form of hard tangible assets. Given Xero has very little hard tangible assets, how do we quantify Xero’s productive capacity let alone value it?
Xero’s most valuable asset is off Balance Sheet
We have to first ask the question – what is Xero’s productive capacity? In other words, what asset will be responsible for generating Xero’s future cashflow?
With out a doubt, it’s Xero’s SaaS customer base, quantified by the Customer Lifetime Value (CLTV) that Xero is aggressively accumulating.
Although easily quantifiable, CLTV is not capitalised on Xero’s balance sheet.
It’s obviously fraught with danger to allow companies to capitalise the value of its customer base (or even customer acquisition costs) on Balance Sheet. However, we do need to recognise that not all customer bases are qualitatively equal.
The specific nuances with Xero’s SME accounting software customers is that there are:
- Very high switching costs
- Low customer concentration
- Low % of customer’s overall cost base
- Predictable and quantifiable metrics
Example – As a small business owner generating say $500k a year in revenue, Xero is possibly the single most important system in my business yet a tiny portion of my overall cost base (c.$40 a month). So when times are bad this will be the last place I look to cut costs. It is also very difficult for me to move to a competitor product because to do so I have to migrate my data, change my internal processes, re-train my people, and possibly change my accountant. I’m not going to do all of this just to save $10 a month.
In other words, your SME accounting customer under the SaaS paradigm is very different to a widget buying customer or a mobile phone subscriber under contract.
Viewed in this context, Xero’s SaaS customer base actually take on the characteristics of a capital asset:
A capital asset is a type of asset that is not easily sold in the regular course of a business’s operations for cash and is generally owned for its role in contributing to the business’s ability to generate profit. Furthermore, it is expected that the benefits gained from the asset will extend beyond a time span of one year.
Now, we can actually ascertain and quantify the value of Xero’s customer base with reference to the SaaS metrics provided by the company:
Xero’s current estimate of future gross profits is $2,069 for each ANZ customers and $1,396 for each International customers. If we simply multiplied out these CLTVs against subscriber numbers then as at 30th Sep 2015 Xero had c.$1.1bn 0f gross profits “warehoused”. At current growth rates, Xero’s CLTV is increasing by c.$600m per year.
This is simply another way to view the compounding effects of SaaS recurring revenue. You acquire a customer once for what appears to be a low ARPU of c.$300 per year (and this is all you realise on your P&L), but you won’t need to acquire them again next year. Every new customer you acquire next year compounds on top of pre-existing customers from the years before.
We’ve seen from MYOB the resilience of its subscription based customer base. To put the MYOB price increases in context, each time MYOB increases its pricing, as long as subscriber churn does not increase proportionately, overall CLTV increases (i.e. the equation is 1 divided by subscriber churn multiplied by ARPU multiplied by the gross margin percentage).
It is also important to note that Xero’s CLTVs do not take into account potential future price increases.
Sales and Marketing as Capital Expenditure?
If we regard Xero’s CLTV as a capital asset, then sales and marketing costs spent to acquire its customers (by far the largest component of its expenses – without which Xero would actually be profitable) can actually practically be viewed as capital expenditure.
All else being equal, there is actually a significant advantage in being able to classify your investing capital as operational expenditure rather than capital expenditure. That is, despite a lower reported earnings – from a practical and cash perspective it actually increases your Return on Invested Capital significantly because you are able to reinvest 100% of your free cashflow and not incur a 30% upfront frictional cost from tax. When compounded year-on-year, this is very very significant.
Xero is an exceptional capital compounding machine
It simply does not make sense for Xero to stop investing aggressively back into the business at this point in time because it is an exceptional capital compounding machine.
Hold on, isn’t Xero’s ROIC negative given it’s running at a hefty NPAT loss?
Not if we take an intertemporal approach to assessing ROIC and recognising that CLTV is essentially gross profits “banked” for the future.
The key number to understand here is the Lifetime value/CAC ratio as defined below:
We know from SaaS metrics provided that Xero currently achieves a highly impressive Lifetime value/CAC ratio of 7.9x in ANZ, this means for every $1.00 of sales and marketing costs invested, you’re getting back $7.90 of gross profits in return over time (Lifetime/CAC ratio is much lower for International at 1.9x, but the hope here is that as each new regional market matures, their Lifetime/CAC ratio move towards ANZ levels).
Importantly, software is unique in that once scale is reached, incremental cost of delivery is negligible.
As long as these CLTV assumptions hold, you would continue to make this sales and marketing investment every single day of the week and twice on Sunday.
In fact we can take this line of thinking one step further and look at this from a “whole of company” perspective . Let’s look at Xero’s 3Q FY2016 cashflow statement for example:
Essentially, Xero consumed $20m of additional capital (net operating & investing cash outflow), but in return gained aggregate CLTV of c.$173m in future gross profits. With these type of returns, you want to continue to invest as much capital into this business as possible (until the economics begin to stretch).
Obviously the key risk and possible fallacy with this type of analysis is that it assumes that Xero’s CLTV holds true in the future. CLTV is hugely sensitive around changes in churn rate and ARPU and a key risk would be that Xero itself gets “disrupted” by another aggressive competitor before the entire CLTV is realised. To be fair though, every business you invest in today is in some way vulnerable to disruption. If you invest in a mining asset, its value is also highly sensitive to changes in commodity prices (of which you are a price taker). On the contrary, we’ve seen the resilience of this customer base (via MYOB) under disruption and how MYOB has actually been able to continue to manage its CLTV through price increases.
Ultimately though, Xero is still a money losing business trading at hefty multiples of revenue and understandably a lot of public equities investors would not be comfortable investing on this basis. However, under the prism of a fully-funded company currently investing into its productive capacity at an extremely high ROIC and accumulating quantifiable Gross Profits along the way, Xero’s current valuation makes much more sense.
I will end with a relevant quote from The Dao of Capital: Austrian Investing in a Distorted World
Make no mistake: Ford was a true-blue capitalist, who believed in making profits, but rather than consuming the capital produced today, saw the infinitely better wisdom of reinvesting intertemporally for a position of greater strategic advantage.
Note: The above blog post constitutes the author’s personal views only and is not to be construed as investment advice. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this blog post.