Is Xero worth a cool half billion?

The below was first published on June 1, when Xero had a market value of $427 million.

Yesterday - Friday June 29 - the company closed at $5 for the first time, giving it a market cap of a cool half billion (or $520.5 million to be precise, according to S&P Capital IQ).

Xero gained extra momentum from its elevation to the NZX50 earlier this month (Rakon - once a tech darling, too - was deleted from the index).

In light of that milestone it's worth revisiting the debate: is Xero over-valued? (With a couple of figures updated for Friday's close.)

Xero full year result (12 months to March 31, 2012)

Profit: -$7.9  million (+5%)
Revenue: $19.3 million (+104%)
Customers: 78,000 (+116%)
Operating expenses: $28.4 millon (+58%)
Cash: $39 million
Cash burn/year: $12.7

Rod Drury is a smart guy.

And Xero is a clever company, with a great product.

But is it $520.5 million worth of great?

That’s the online accounting software company’s market value as of close of business yesterday (by S&P Capital IQ’s count, with Xero shares [NZX:XRO] closing at $5.00 on Friday).

I’m not sure why there’s only one brokerage following Xero (cue commentors feverishly hitting their keyboards), because it’s a fascinating company, with a lot of money at stake and lot interest from the public.

Still, that is the case: Forsyth Barr analysts Andrew Harvey-Green and Fraser Hunt appear to be on their lonesome (by Mr Harvey-Green’s estimate, a quick NBR survey of major analysts, and S&P’s coverage data.)

In February, the pair nudged their valuation of Xero from $2.60 to $2.63. They now calculate it’s worth $3.16 (or a market cap of $328 million).

ForBarr recommends people off-load shares.

The stock is rated high risk and on May 25 the broker re-iterated its warning to clients: “While we believe Xero has positioned itself well for success, it is still early days and we believe the market is already factoring in a high chance of success and overlooking the downside risks.”

ForBarr maintained its REDUCE rating on Xero following the company’s full-year result reported last week (which saw revenue more than double to $19.3 million for  12 months ended March 31, but losses increase 5% to $7.9 million; see table top of story.)

By any standard investing metric, you have to agree with Forsyth Barr.

However, at least one high-profile supporter (who didn’t want to go on record at this point) was keeping the faith, after carefully digesting  Xero’s annual report.

But was he comfortable keeping half a billion dollars’ worth of faith in a company with $19.23 million revenue, which now refuses to say when it will turn a profit?

How could he believe it’s worth more than $426 million?

“Easy,” he replied. “ This is a long term, global play. They have a good chance of hitting 10 times that.”

For me, it’s a great unknown: can Xero parlay its early entry into the cloud category into world domination? It does take off in the US and other markets, then it could spread like wildfire. And its cloud model means there’s very little incremental cost adding customers to its system.

The downside:  until it reaches that tipping point, it’s yakka hard spreading the word in Australia, the UK and the US (where customer numbers are growing fast, albeit off a low base).

Forbarr says expenses will grow as Xero expands in these regions as it pushes for growth. Last year alone, staff numbers swelled from 113 to 194 – a quarter of whom are now based off-shore.

And Xero itself has forecast a greater loss next year (last year, it formally abandoned its goal of breaking even by the end of 2011, saying it was better for investors’ long-term if it pushed for growth).

ForBarr estimates Xero’s cash-burn at $12.7 million a year.

Yet Xero’s coffers are bulging.

It raised $36.5 million last year from issuing new shares (Rod Drury sold $3 million shares around the same time) and you and I chipped $4 million through a government R&D grant.

Xero now has $39 million in the banks. Enough, Mr Harvey-Green estimates, to last it until it break-even.

What's Xero worth in a trade sale?
Another option, of course, is that Xero may never break-even because it is bought by a larger accounting software company (and Rod Drury has, in part, built his NBR Rich List fortune by selling two tech companies he co-founded - Glazier Systems and Aftermail.)

Last year we saw Bain Capital buy accounting software company MYOB for an estimated $US1.3 billion after a bidding war with UK-based Sage.

MYOB has says it has more than 1 million customers across its Australasian base (and with its nascent pushing into the cloud it is perhaps Xero’s closest rival, at least regionally).

With both companies privately held, no specific financials were released around the deal, but the Australian Financial Review (which judging by its reports anticipating other events around the deal had a reliable source) said Bain paid around 11.3 times earnings before interest, taxes, depreciation and amortization.

According to Reuters, KKR paid around 12.5 times ebitda for a majority stake in accountancy software vendor Visma in 2010, while HG Capital bought Italy's TeamSystem for 11.3x ebitda.

Xero, of course, has no earnings. But, once it does, the above sales do seem to indicate a benchmark (Rod Drury, I’m sure, would argue that his company is not bogged down by the legacy offline systems that most of MYOB’s customers, and others, still use).

And it’s a benchmark that Xero has a little way to reach.