Sam Stewart

Despite Xero’s relatively high profile and the recent media coverage of the capital raising and financial results there has been little or no analysis of the implications for investors of the capital raising and latest financial results. This post considers the implications of the recent capital raising, the number of customers Xero requires to reach break even and deliver the required rate of return to investors.

Summary of Analysis

Xero has now raised over $45 million in equity (a great effort for a NZ startup) and burned through approximately $15 million cash developing their product and securing 7,500 paying customers. Xero has not yet reached break even but the recent $29 million capital raising ensures that they can continue to grow and execute their strategy over the next 2-3 years. The $29 million capital raising has diluted ownership of non-participating shareholders by ~35%. This reduced ownership has been offset by the certainty provided by additional capital, the addition of strategic investor Craig Winkler to the board and the potential to enter the US market.

Xero have not yet reached break even. Based on the current average revenue per user (ARPU) and estimated annual expenses of $11 million Xero would need ~28,000 customers to break even. At the current growth rate (250 customers per week) Xero could reach break even by the end of November 2010.

Any estimate of the number of customers Xero require to justify their valuation is very subjective. I have 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 assumptions Xero need approximately 110,000 customers in 5 years to justify the $0.90 share price in the recent capital raising. This is a personal view and I recommend that you read through the assumptions I have made and try out some of your own.

Clearly the market opportunity exists but these numbers highlight that despite their achievements to date Xero are still in the early stages of their journey.

Background

Since listing in mid 2007 Xero have enjoyed considerable success. During this period they have grown to 7,500 cutomers (including 1,500 in the 6 weeks to 10 May 2009) across 25 countires. The company’s performance has been recognised by countless awards. Recently investors endorsed the performance to date and potential of Xero with a $29 million capital raising. This $29 million included an $18 million investment from MYOB founder and former majority shareholder Craig Winkler.The one area of potential concern for investors over the past two years is the decline in the ARPU. In their prospectus Xero estimated an ARPU of $75 per month. Shortly after listing Xero reduced the price of their NZ offering to $50 per month. Xero have further reduced their average price as they have entered new markets and announced an ARPU of $33 per month in their latest financial result. This reduced ARPU has facilitated Xero’s growth but has also significantly increased the number of customers required to break even and deliver the required rate of return to investors.

Xero’s $29 million Capital Raising

In April 2009 Xero announced a strategic placement that would raise over $23 million. This placement involved MYOB founder and former major shareholder Craig Winkler (and associates) subscribing to $18 million of new Xero shares. A capital raising of this size by an early stage NZ company is a great result in the best of times and is outstanding in the current environment. The announcement of Xero’s strategic placement was followed by the announcement of a share purchase plan (SPP) that allowed shareholders to purchase up to 5,000 shares at $0.90 each. Approximately 70% of shareholders participated in the SPP raising a further $5.8 million.

Why does Xero need to raise more money now?

Xero is a growing company that is investing in product development, marketing and sales and has yet to reach profitability.

Based on Xero’s cash position at 31 March 2009 ($3.81 million) and an operating deficit exceeding $600k per month (based on $7.2 million in the year ended 31 March) they would otherwise be running low on cash by late 2009.

What will Xero use the cash for?

As outlined in the Independent Adviser’s Report provided by Deloittes, plans include:

• Entering the US market
• Marketing partnerships in the UK and Australia
• Additional staff based in NZ and overseas - sales, marketing, customer service, development, support and training
• Setting up a physical presence in Australia
• Ongoing product development including market specific features/functionality
• Scaling of back office operations to accommodate growth

The largest individual component of Xero’s cash burn is employee expenses, totaling $4.6 million in the last financial year (during this time staff numbers have increased from 44 to 55). Following the placement Xero announced they hope to recruit an additional 36 staff, which would increase total staff numbers to 91.  At an estimated average cost of $90k per employee (based on $4.6 million in the last financial year and assuming constant staff growth) the 36 additional staff adds $3.25 million to Xero’s annual expenses taking employee expenses to an estimated $8.2 million per year.

What are the implications for existing shareholders?

The $29 million placement/SPP provides certainty for existing shareholders (and customers) that Xero will have sufficient cash to continue to execute their strategy for the next two to three years. The placement/SPP involves issuing 32 million new shares at $0.90, so will dilute the ownership stake of existing shareholders.

For example, a shareholder who purchased 10,000 shares in the 2007 IPO held 0.018% of the company after the IPO. This shareholder would now own 0.012% of the shares if they did not participate in the SPP and 0.017% if they purchased 5,000 shares in the SPP.  The ownership percentage of shareholders who did not participate in the SPP would have decreased by approximately 35%.

It’s important to note that the reduced ownership percentage does not translate directly into a dilution of value. Although less than the $1.00 IPO price the $0.90 placement price is consistent with the share price prior to the announcement of the placement. The view here should be that existing shareholders now own a smaller slice of a larger pie. This view is supported by the significant increase in the Xero share price following the announcement of the placement. Sources of this increased value include the certainty provided by the additional capital, the potential of the US market and the strategic input of MYOB founder and new board member Craig Winkler.

Breakeven Analysis

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.

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.

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. I am not criticizing the approach adopted, but simply highlighting that they have consistently pursued a higher risk and higher reward strategy. The higher risk relates to the amount of capital raised (now over $45 million) and the fact that they have burned nearly $15 million and have yet to break even. The higher potential reward is reflected by the size of the UK and US markets and earning potential of the subscription revenue model.

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.

Assumptions

Investment Horizon: 5 years
Despite the recent share price activity Xero should be viewed as a long-term investment.

ARPU: $35
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.

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:

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.

Small and medium sized business numbers

Source: New Zealand, Australian and UK figures from the Xero Prospectus. The US figure and 40% addressable market assumption are from the Intuit Annual Report 2006.

Xero’s ability to achieve these numbers won’t be constrained by the number of potential customers available. The challenge Xero face is managing the upfront investment and ongoing costs involved building  and maintaining the relationships/networks to acquire these customers. I think the 110,000 customers in 5 years is realistic and achievable. Growing at their current rate (250 customers per week) would result in 72,500 customers in 5 years. I don’t think I would invest at $1.45 if I required a 5x return on investment. I think the 360,000 target (70,000 customers per year) is unrealistic with Xero’s current sales and marketing infrastructure and they don’t have the capital required to fund this level growth.
Clearly the market opportunity exists but these numbers highlight that despite their achievements to date Xero are still in the early stages of their journey.
Please play with the assumptions in the interactive workbook.

Interactive Tool - How many customers does Xero need?

Disclosure: None