Xero Finds Going Tough In US Market

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-Slow US growth pressures valuation
-Medium-term estimates reduced
-Acquisitions may fill product gap
-US sales model needs to change
 

By Eva Brocklehurst

Xero ((XRO)), the New Zealand-based cloud accounting software company, is having a tough time in the US. First half operating statistics revealed 22,000 US customers. The company has spent the money but is yet to gain a material foothold in the US market. In contrast, Australian customers have reached 158,000, with the company recording its fastest growth yet in an individual market.

There have been some teething problems with take up in the US, but Xero has a number of accountancy partners and further deals are expected. Still, Credit Suisse believes time is running out to fix early issues before the incumbent competition, Intuit, extends its lead. Intuit is well resourced and the broker fears Xero could become insignificant in the US market. Despite the company confirming 80% revenue growth guidance for FY15, Credit Suisse has decided to cut away the "blue sky" in valuing the stock. Substantial downward revisions are made to medium term estimates and probability weightings for the US scenario.

Valuation falls sharply, hence the broker's target is lowered to NZ$27.00 from NZ$43.00. The broker has downgraded FY16 customer expectations for the US as well. The US is now a top priority for management, with the potential for growth expected to emerge in FY17 once new leadership and strategic direction are established. That said, the broker acknowledges that Xero has, eventually, executed well in other markets and the US exposure is still at an early stage. An Outperform rating is maintained.

Goldman Sachs is also disappointed at the slow growth in US subscribers and believes structural factors will lead to slower growth, at a time when Intuit is having renewed success with QuickBooks Online. Diminished US growth prospects could put further pressure on Xero's trading multiple and the broker downgrades Xero to Sell, believing that medium term consensus sales estimates need to be reduced. Target is lowered to NZ$18.00 from NZ$35.00. Goldman has also pulled back its assessment of the US payroll opportunity with the emergence of cheaper "do-it-yourself" products such as Zen payroll, which deliver a similar service at a lower price than legacy providers. One positive counterpoint to the disappointing customer numbers was average revenue per subscription increased to NZ$309 per annum from NZ$304, driven by the strong growth in the higher-priced Australian market.

Expectations need to be modified, in Deutsche Bank's opinion. To justify its lofty 18 times FY15 revenue multiple Xero needs good momentum in the US market. The broker does not envisage the US foray will be easy going, with the company still needing to develop a full product suite that is customised to that market, as well as build a management team. This is a much larger market compared with the two relatively small markets in which the company has had much success, namely Australia and NZ. Growth has been exceptionally strong in Australia and firm in NZ. The UK business also grew in the first half and the broker expects that market growth will be weighted more to the second half.

Xero had 371,000 customers at the end of September, up 31% from March. Deutsche Bank has reduced its overall FY15 customer year-end forecast to 487,000 and pushed out expectations for the US growth ramp-up . Reductions in in earnings forecasts, by 10% for FY15, are partly cushioned by the recent fall in the New Zealand dollar. Xero has made small acquisitions in the past but now, as it is better funded, a larger acquisition that fills a gap in product capability, such as payments or tax in the US, could lead Deutsche Bank to take a more positive view on growth prospects. In the meantime, a Sell rating is retained with a target of NZ$18.50.

Xero has typically addressed its market via a sales network of accounting partners, but Goldman notes the US market is unique in terms of distribution. Some estimates indicate as few as 30% of small-medium businesses have an established relationship with an accountant. In contrast, in Australasia and the UK almost all small businesses file tax returns through an accountant. The broker believes this may be a cultural factor or, possibly, Intuit has disintermediated successfully to the accounting channel over time. Irrespective of the mix of these two factors, the broker believes Xero's sales technique is likely to be less successful in the US as a result. The broker acknowledges the company has recognised this situation and is changing its strategy to incorporate more direct marketing, and targeting of niche markets where it can gain a competitive advantage.
 

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