The story behind our investment in Xero starts back in 2001 when I first came across a small business accounting software company called MYOB. What caught my attention was the 80%+ share price fall as the dot com bubble had just burst. I knew the product well, as my parents were amongst the thousands of Australian small business owners who started using it following the introduction of the GST in 2000.

myob: kasa’s first high conviction investment

Some of you may remember, when the government introduced the GST, they offered a $200 rebate to all small and medium businesses (SMBs) to help with the implementation costs. Most businesses invested this money in buying an accounting software package for the first time, conveniently priced at $199. The impact on MYOB was significant with sales tripling in 2000. We were right in the midst of the dot com boom and the market became euphoric around the stock. In 2001 MYOB’s sales reverted back to their long term trend and the dot com bubble burst, sparking my interest

The final unusual aspect I saw was the reluctance of users to switch products. My parents were a great example, they were so busy running their business and the last thing they needed was to learn to use another one accounting software package. They had become captive MYOB customers with little choice to pay for an upgrade whenever the income tax tables changed.

In theory, these factors should have led to highly concentrated regional markets. And this was indeed the case, with MYOB having some 70% share in Australia and Sage and Quickbooks having similar shares in the UK and the US.

Besides the attractive share price and strong economics, MYOB also came with a great Founder/CEO, Craig Winkler. He stood out from other CEOs I had met, by embodying the company’s purpose and genuinely wanting to help small business owners. I was also impressed by his care and attention to the employees, when I visited their head office in Melbourne. Seeing the open and positive work culture gave me comfort that company’s most valuable assets, the staff, was being looked after.

Craig was also an astute businessman. US-based Teleware originally developed MYOB back in the 1980s. Craig co-founded Data-Tech software in 1991, localising and distributing MYOB for Teleware in Australia. Six years later, Craig acquired MYOBs IP from Teleware, renamed the business to MYOB and listed it on the ASX.

In short, what I saw was a strong business, run by a very capable manager, trading at an attractive price. And so MYOB became my first ‘high conviction’ investment, the second ever investment in KASA, and the fund’s largest holding for the first four years.

xero enters the market

In 1995, Rod Drury and Tony Stewart, both 29, left their safe Ernst & Young jobs and set up one of New Zealand’s first software companies with $10,000 capital, which they sold four years later for $7.5 ­million. Rod took the proceeds from the sale and built AfterMail in 2004, which sold two years later for US$45 million. In the space of a decade, he had created and sold two successful software companies.

In 2006, feeling traditional desktop accounting software had become outdated, Rod and his accountant Hamish Edwards, founded Xero, deciding to create a cloud-based product offered via a subscription model.

Since Kasa’s initial investment, MYOB had continue to widen it’s moat, not only by the sales growth funding product development and marketing, but also by its acquisition of Solution6, the lead software provider to accountants in 2004. Taking on MYOB was going to be a real challenge.

Replicating MYOB’s product features was going to be both expensive and take a long time and so Xero, instead, went to market offering a simple and beautiful product. This immediately struck a chord with a segment of business owners much as Intuit’s Quickbooks product did in the early 1990s, when it used a similar strategy in the US to disrupt the incumbents.

Besides the attractive user interface, Xero also offered a series of unique features only available through the cloud including: the ability to use the software any time on any device; eliminating the need to pay for and install upgrades; and removing the need to coordinate file sharing between accountants and their clients. Its decision to charge through a monthly subscription fee rather than a one off payment, lowered the upfront cost to customers while creating a more predictable earnings stream and a higher total lifetime value per customer.

There were three factors which reduced MYOBs competitive reaction to Xero’s entry. First, while users valued the new features, the vast majority didn’t want to learn a new product. Second, MYOB would need to re-write their software from the ground up, a long and expensive process, particularly if they wanted to match the existing features. And finally, in 2008 MYOB was the subject of a successful hostile takeover by a private equity, distracting management.

The takeover had the added benefit of Craig Winkler leaving MYOB and throwing his weight behind Xero. Craig became Xero’s second largest shareholder, providing much needed capital, and more importantly joined the Board, imparting all his learnings from building Australia’s dominant player over the preceding 18 years.

These factors combined to give Xero much needed 4 year head start in the cloud market before MYOB released its first cloud product.

winning the hearts and minds of accountants

Cloud significantly impacted distribution in two ways; First, retailers were removed from the value chain as there were no CDs to distribute. Second, accountants became natural advocates as the major pain point of coordinating file sharing with clients was removed. The result was the basis of competition for distribution firmly shifting to winning the hearts and minds of accountants.

These changes should have played right into MYOBs hand as it was the dominant provider of software to accountants. Whereas Xero had to build another suite of new software, this time for accountants, and then start developing relationships. 

MYOB was slow to react as accountants were slow to embrace the cloud; a major rebuild was required; and the distractions caused by the ownership changes.

Xero recognised this shift early and moved quickly. Its strategy to woo accountants had three main elements. First, build a cloud based software stack (workflow, tax, bank feeds, etc.) to run an accountancy, a process that took around 5 years. Second, it created a partnership program which essentially gave the software away, provided a directory for cloud based SMBs and accountants to find one-another, and created financial incentives for accountants to promote Xero to their clients. The final element of the strategy was to create a cult like fan base centred around the benefits of cloud accounting, epitomised by Xerocon.

Almost a decade after Xero released their full stack, MYOB is still re-freshing their accountant’s suite. It is difficult to find advocates of MYOB’s products among the accounting community and near impossible to find newly established firms choosing the MYOB stack over Xero’s.

from application to platform

From the outset Xero chose to use open-architecture and allow third parties to develop on its platform. This helped accelerate the development new ‘cloud enabled’ features.

Receipt Bank, for example, removes the need for data entry and receipt storage (a regulatory requirement). Users simply take a photo, email, or authorise direct fetching of an invoice and the software does the rest. This not only reduces labour cost (estimated to be 4 hours per month per client) but also increases the accuracy of the accounts by removing manual entry.

Each of these new apps incrementally expanded Xero’s appeal to subscribers in a way that was not easy for MYOB to replicate. At the same time, it raised the switching costs as subscribers as they are reluctant to move to a provider that doesn’t offer the apps they have become accustomed to using.

Once Xero got a head-start on this, it was difficult for MYOB to catch up, as developers like to build on the largest platforms to access the most number of subscribers. The more apps appear, the more subscribers are attracted, which then drives more app development.

winning the market

By the time MYOB re-listed on the ASX in 2014, it fully recognised the cloud threat and a transition was front and centre of its strategy. But it was too late, Xero’s had won the hearts and minds of many accountants, it was rapidly replicating MYOB’s product features as well as developing, along with third parties, new features unavailable in MYOB’s competing cloud product.

Today, after dominating the Australian SMB accounting software landscape for nearly three decades, MYOB is about to cede market leadership to Xero. Overcoming MYOB’s moat was far from easy, it took Xero 15 years, some $500m of capital, and many smart strategic decisions to win the market.

 

Xero is now in the early stages of replicating this in the UK. Applying the same playbook, it is the lead SMB cloud provider and is well on the way to winning over the hearts and minds of UK accountants. It is experiencing rapid subscription growth as it moves along the ‘s-curve’ of that market.

From all accounts, Sage, the dominant player in the UK, is a less capable player than MYOB. Sage, just like MYOB, placed transition to cloud at the centre of its strategy back in 2014, appointing a new CEO with this distinct mandate. The CEO’s failure to achieve this was reflected by a management overhaul last year.

The main reason why it has taken Xero longer to find success in the UK is that market has been slower in adopting cloud. Once Xero displaces Sage in the UK, it will be the first company to successfully carry its code-base (with some localisation) across multiple markets.

a beautiful business

Xero’s economic moat today is wider than MYOBs ever was. A new entrant not only has to overcome the scale economies of product development and marketing in the small business accounting software market, but needs to simultaneously compete in the accountant software market and attract third party developers to its platform. It needs to find a way to win over the hearts and minds of accountants and overcome the natural reluctance of both SMBs and accountants to switch products.

Having amassed 1.8m subscribers worldwide on its platform, Xero can spread its development costs and attract developers, in a way an Australian-only player would find hard to replicate. And so an entrant not only needs to compete in the SMB, accountant and developer markets but do so in multiple regions.

After three decades, it took a technological change in the form of cloud, over $500m of capital, 15 years of patience and a very talented team, for the first successful entrant in the space just to get to break even. Given the significantly wider moat, I expect it will be a very long time before the next successful entry.

Looking ahead, I believe we are in the early phases of the emergence of one or two global players dominating this space, with Xero being a lead candidate. Rod Drury and his team have created a truly beautiful business.


Important Information: the article (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this article is (or should be) considered to be financial, investment or other advice on which reliance should be placed. Nothing in the article constitutes a recommendation by Kasa Investments Partners.



Param Singh

very well written and detailed article. thank you.

Emanuel Datt

Thanks for the informative article Ali. I should point out that Receipt Bank are a solution that outsources the manual entry process to it's workforce in India; so definitely not a straight software despite what they portray. I've used the product for many years.

Alipasha Razzaghipour

Thanks Emanuel - appreciate the clarification. I'm not sure if I have this right, but it seems to me that a large part of Receipt Bank's success was their first mover advantage. Their technology is becoming outdated now. I'm curious to see if they end up losing the market to the next generation of players coming through like Veryfi. Thanks again for sharing.

Rob McGovern

great business, yes. been trying to find an entry point.. it's totally over priced at the moment.

Alipasha Razzaghipour

There are many different approaches to valuation. I come from the Benjamin Graham school of investing where I'm purchasing a fraction of a real business and my returns are the free cash generated by the operating activities of that business, relative to the price I paid. This takes me into the world of discounted cashflows. The discount rate I use in the DCF across all businesses I look at is the Strategy's target rate of return, which is 10%. Finally, instead of trying to value a business, I back solve the implied assumptions needed to generate the 10%, given the current share price. I then assess the likelihood of these cashflows coming to fruition. So I'm using an implied DCF valuation approach. The vast majority of my time is assessing the likelihood of these implied cashflows coming to fruition. I invest in those businesses where my conviction is highest. If the business does better than the implied assumptions, then the return will be more than 10%. This process is designed to minimise the chance of making a mistake (earning less than 10%) rather than maximising the return. When I back out Xero's implied cashflows, at the current share price, using a 10% discount rate, the numbers appear reasonable to me. Of course, I may end up being wrong through poor judgement or a tail event occuring. Anyway, sorry for the long response, but I thought it might help you better understand why I'm ok with the valuation side of things, even though Xero might look expensive using conventional valuation metrics.