SaaS vendor viability: Xero under the spotlight

by admin on June 2, 2009

in Cloud Computing/SaaS

I don’t usually talk about vendor viability in any depth on this blog because the information I have on vendors is often proprietary. However it is an important topic and one that has come up in discussions with professionals considering alternatives to Sage’s (near) monopoly. Enter Xero.

Ben Kepes has riffed on a technical investment analysis undertaken by Sam Stewart. The analysis centres upon Average Revenue Per User (ARPU) as a key metric for saas/on-demand/cloud (SOC) players. Although Stewart analysis is extensive, he caveats across a number of dimensions. That’s not unusual and is to be welcomed. However, I  believe there are alternative views to their combined analysis. For the purposes of this discussion, it is easier to home in on Ben’s analysis as he’s done the initial riff against the prime source.

Plans outlined in any prospectus are subject to all sorts of factors that may (or may not) materialize. Playing off the static nature of the plan without considering macro-economic conditions does not therefore provide any room for manouvre in arguing an investment case. Current conditions are such that the best anyone can say is that there is considerable uncertainty in the market. However, there is plenty of anecdotal evidence to assume that SOC will fare better than existing on-premise providers.

Even that has to be tempered with what we see elsewhere. Salesforce.com for instance missed on growth in its last quarter but was able to throttle back expenses to show a profit. You can make the apples and oranges argument for a comparision between SOC CRM and SOC accounting but as the SOC market leader, they are a beacon upon which to home in. On the other hand, proprietary analysis I have at hand that reviews Sage’s results indicates the SMB market is declining. This makes any prediction difficult.

Ben argues:

For example accounting software uptake is highly cyclical, peaking at fiscal year end and reducing throughout the rest of the year.

That’s not necessarily true. I know from on-ramping discussions I’ve had (along with past experience) with professional firms that clients can be brought on at any time of the year though year end certainly helps. It’s all about the marketing relationship and ability to assist the professional in kick starting the process. You only need to win one practice with say 1,000 clients to have an instant, captive market at which to tilt. There are plenty of those around the place. This is a good part of the motivation behind CODA2go and Salesforce.com’s 58,000 customers. Ben goes on:

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.

No explantion is offered for the drop in ARPU but this ignores the fact Xero rationalized its pricing, effectively introducing a reduction in price. That impacted ARPU directly. I don’t know where Ben gets the idea there is greater price pressure in the UK. All the evidence suggests there is NO price pressure at the moment. That may of course change although the discussions I have with vendors suggest there is plenty for everyone.

I have long considered that the real business model in SOC lies in the data, an issue I have suggested that SOC vendors build into their plans. This is an argument Zoli Erdos reprises to good effect. In this model, ARPU goes out the window.

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.

Again, I disagree. The US market has proven itself a graveyard for non-US operators. The best example I can think of is CODA-Baan which was very nearly destroyed in the late 1990s. If you look at Sage, it has had real problems, even with acquired brands and is currently retrenching itself across many of its product lines.

The market entry costs alone are horrific unless you have a very powerful word of mouth engine. Freshbooks for instance has spent 5 years building up good user numbers but was able to do so from a strong base in Canada. Xero (and any other entrant) would be coming from a long way behind.

The US market is dominated by Intuit. Its brand presence is as powerful as Sage in the UK but has done a lot more to recognize the changes occurring in the marketplace than Sage has managed. It’s also coming off a great Q3. Brand presence is difficult enough to overcome without the added pressure of competing against a company that is concentrating hard on value delivery with free offerings against which it can upsell. And then there is Intacct, but more of them later. All of that before we even think about localization.

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.

I completely disagree. If anything the reverse – if achievable. It is becoming increasingly clear that the question of penetrating addressable markets is as much a function of fit as it is winkling clients away from shoeboxes and spreadsheets. Here the key is vertical market attraction. Freshbooks for instance has captured a good lump of the contractor/freelancer market. This is an early adopter market and was a good choice. The good news is that there are very large addressable markets in all Xero’s territories. Australia for instance is pretty much virgin territory for Xero yet looks ripe for picking.

Xero has other fish it can fry but it has to choose those targets extremely carefully, developing offerings that resonate directly with need. This is often more luck than judgment so we;ll have to wait and see how Xero works out these issues.

I am not going to second guess what Xero will do next although I have had confidential discussions with management on certain of the topics raised in this post. However, the fact it has secured a solid second round demonstrates considerable confidence in a company that has – like many SOC companies before it – been on a fierce burn rate.

Rather than concentrate on break even, the central premise for Stewart initial argument, I’m more interested in cashflow. Here there are many ways to skin the SOC cat. Contract periods are falling but at Xero’s current price point, getting a year up front should not be beyond the realms of possibility if it so chooses to emphasize that option.

I’m not suggesting that Stewart or Ben are wrong. If anything our divergent views should be indicative of an emerging market where there is plenty to play for and where anyone can come out the other side looking good. However, I do believe we’re entering a new phase, impacted as much by macro-economics as local competition and technical advances. That’s why when discussing option with practitioners I have been careful to suggest they consider a basket of offerings.

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Sam Stewart June 2, 2009 at 4:47 pm

Hi Dennis,
Thanks for the link and your thoughts. A couple of quick points.

The name is Sam Stewart not Sam Schwartz – no offence taken?

The focus of my post was from an investment perspective and involved a high level fundamental (not technical) analysis of Xero’s performance to date and a framework to evaluate the current valuation. As with any early stage growing business this is a subjective exercise so I tried to make my assumptions as transparent as possible and included the workbook I used for others to consider their own views.

The reference to the prospectus was not intended to hold Xero accountable to their expectations over two years ago but to highlight the differences to the current situation to the assumptions in my analysis made at the time of the IPO.

Xero CEO offers an explanation for the drop in ARPU in the comments on my post.

The potential for benchmarking and other data aggregation services has value but these offerings require a level of scale to be meaningful. I don’t think the ARPU goes out the window in this model, the number of customers and revenue from these services would need to be significant to displace the return provided by the core offering.

I think you have misunderstood the breakeven analysis. I have used a simplified approach of estimating the number of customers required to breakeven at the EBITDA line. This analysis forms no premise for an argument of any nature it is merely a framework to highlight why Xero needed to raise additional capital and the likelihood of any further capital raisings being required. Analysis based on cash flow would have provided a more accurate estimate but would also have required additional assumptions.

As I stated in my post:

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.

Xero have raised over $45 million in capital and I would like to think my analysis has added some value to thinking about how this investment should be evaluated. Given your knowledge of the market and business model I would be interested in your view on the investment opportunity.

Cheers
Sam Stewart

Dennis Howlett June 2, 2009 at 5:40 pm

Another of my (in)famous typos…doh…fixed ;)

First up please understand I am not an investment person but an accountant who understands business models, has been invested in this market and has been following it for some years.

I disagree on benchmarking etc, especially where you have clearly defined verticals. The value such data holds is huge but agree monetizing is a ways down the track, especially for those vendors going after a land grab – as is the case here.

We can argue over assumptions etc but those are incidental details given that all of us engaged with this market are groping for decent data points at an early point in market development. On BE v cashflow, I would have thought it was fairly obvious last summer why Xero would need to raise funds but as I understand it, this was all part of a planned strategy. All we were really missing was the price. The market – however rationally or otherwise – has spoken.

You're asking a chicken and egg question. I have seen SOC co's very happy on modest numbers of customers but going for the slow burn. I've seen others do well with services that went viral at very low cost. Still others are looking at the Xero model and wondering if it can be mimicked in the SMB space. Each has its merits and attractions, depending on where you are in the investment circle.

In the past, I have been against taking external investment because of the VC pressure that can mean. In recent times my position has changed based on seeing some excellent deals. (for the founders that is.)

It has taken companies like NetSuite and Salesforce.com close on 10 years to realize profit although each has demonstrable share. This is still a young market and so the 5 year time horizon many not be appropriate. The key is getting under the skins of the professionals who often control the relationship plus having an offering that is end user drop dead easy. Those caveats aside, I see massive opportunity. Let's put it this way – I don't know anyone who isn't developing for SOC.

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