MYOB versus Xero

Technology inflection points present incumbents with choices and insurgents with opportunities.

In the world of SME accounting today, software is undeniably shifting from the desktop to the cloud.

The primary protagonists in Australasia, MYOB (the incumbent) and Xero (the insurgent) are both listed on the ASX and currently they attract almost identical equity valuations (although MYOB has a higher enterprise valuation due to its debt).

What makes this sector case study particularly interesting is that despite competing in the same market space for the same customers, MYOB and Xero have adopted vastly different modus operandi.

Let us investigate first how MYOB and Xero are positioned today competitively.

Who is winning with respect to revenue?

If one were to simply look at the latest half year financials, MYOB generated AUD$178m of revenue (half year ended 30 June) while Xero generated NZD$137m of revenue (half year ended 30 Sept). So at first glance it would appear that MYOB is by the far larger company with respect to revenues.

However, there is more to consider.

Xero reported annualised committed monthly revenue of NZD$303m – indicating a c.NZD$25m monthly run-rate as at 30th September 2016. On the other hand, MYOB’s CY2016 revenue is expected to land at around AUD$350m indicating a c.AUD$29m monthly run-rate.

Consider that Xero is on a 50%+ revenue growth trajectory while MYOB is on a c.10% revenue growth trajectory. We can then reasonably deduce that Xero and MYOB should theoretically be neck-to-neck right now with respect to monthly run-rate revenue, with Xero set to overtake MYOB shortly.

Who is winning with respect to market share?

Here it is hard to debate who is winning market share in Australasia:

(note the above chart is exclusive of customers outside of ANZ as MYOB is Australasia only. In fact Xero added an additional 51k international subscribers on top of the ANZ subscribers added during the last half).

I won’t comment directly here on who has the better cloud product technology as this is not my area of domain expertise. However, you can obtain the answer to this question fairly easily by speaking with a few accountants or practitioners on the coal face.

Who is investing more?

We can see that Xero is currently investing twice as much money into its product development:

…and more than twice as much into sales and marketing:

So as the cashflow positive incumbent that is clearly losing market share and ceding product leadership, why is MYOB not investing more aggressively to at least maintain product parity or market share?

MYOB’s capital providers and structure

This is a classic example of how a company’s capital structure and shareholder composition can dramatically shape its market strategy and capital allocation decisions. MYOB was “sold“ in its IPO to institutional investors as a “2-in-1” financial product that “delivers both growth and yield”. Accordingly, MYOB now carries $435m of debt.

On MYOB’s register you’ll find predominantly large financial institutions. Its majority shareholder Bain Capital, is currently navigating towards a full selldown of its stake.

Given that MYOB is currently valued by the market on a multiple of earnings, it simply does not have the flexibility to increase the quantum of its investment expenditure (i.e. at c.23x P/E, every dollar of additional operational cost incurred has a direct negative multiplier effect on its valuation).

When you see MYOB, with the help of normalisations and acquisitions, consistently meeting its prospectus forecast earnings to within 1% to 2% accuracy, it is indicative of how important meeting short-term earnings expectations is to MYOB and its shareholders:

(I wrote about this in an earlier article – The science behind MYOB achieving its prospectus guidance).

In other words, there is a “pact” in place between MYOB and its capital providers to deliver an earnings number, pay out a quantum of dividends and to service its interest payments along the way. MYOB cannot simply change the terms of this pact without an immediate negative impact to its share price.

Xero’s capital providers and structure

Xero on the other hand has significantly more flexibility in investing its capital. Firstly, it’s debt free. In fact the NZD$138m of cash on Xero’s balance sheet should be sufficient for Xero to reach cashflow breakeven at current rate of cash burn.

On Xero’s shareholder register you’ll find the likes of Craig Winkler (ex-cofounder of MYOB!), Sam Morgan (founder of TradeMe), Peter Thiel (“Godfather” of the PayPal mafia), Matrix Capital (VC fund), Accel Partners (VC fund) and Rod Drury (CEO). These are either individuals who have built real businesses themselves or financial investors who place minimal importance on near-term earnings or dividends.

Xero therefore has a completely different “pact” with its equity holders (and no debt holders to worry about). Xero is not expected to provide explicit earnings guidances and it simply promises to the market that it will manage its business to cash-flow breakeven within its current cash balance.

Does Xero get a free pass because it’s a supposedly sexy “disruptor”? No, in fact it’s held to a different set of expectations that (in my view) are inherently more rigorous and challenging than meeting a set of accounting earning numbers.

Xero’s pact with its shareholders is that it will continue to grow its subscribers and improve its operational metrics. Accordingly, Xero discloses a comprehensive set of SaaS operational metrics reflective of the underlying economics of the business (MYOB on the contrary does not disclose any SaaS operational metrics to its shareholders):

If subscriber acquisition loses momentum or the above operational metrics deteriorate, Xero will certainly be punished harshly by its shareholder base.

The end game here is to continue to increase customer lifetime value – i.e. the accumulation of future cashflow:

(for how one may view customer lifetime value as a capital asset, refer to my previous article on Making sense of Xero’s valuation).

Xero is evidently not taking the shortest path possible towards profitability available but rather the path that maximises NPV of future cashflow.

Earnings today or NPV tomorrow?

As enterprising investors, we need to remind ourselves that the earnings multiple approach to valuation is simply a short-hand for a DCF valuation. It makes the imperfect assumption that future cashflow can be represented by a perpetual straight line.

In the context of retailing, Amazon recognised in its now famous 1997 shareholder letter that there were choices that needed to be made:

When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.

And, despite some bumps along the way, it has proven to be an extremely enriching choice for Amazon’s shareholders over a 2 decade horizon.

Note: The above article constitutes the author’s personal views only and is not to be construed as investment advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. 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 article. Disclosure – I hold a long position in XRO and a short position in MYO at the time of publishing this article (This is a disclosure and NOT A RECOMMENDATION).