Are we watching the wrong 800-pound Gorilla?

Xero is the classic disruptor. As the first cloud-based accounting platform for small business, it revolutionised the industry with real-time bank feeds, the single source of truth general ledger and an innovative subscription revenue model. Xero has been racing to scale its platform before the 800-pound gorilla, Intuit, matches its product offering.

Investors are fixated on competition between the two global accounting platforms, Intuit and Xero; but we wonder whether we should be looking wider? Currently, analysts are applying excessive scrutiny to subscription run rates, marketing budgets, pricing strategies and product functionality. Measured by any of these factors in context, the competitive dynamics in Xero’s core markets are unchanged — Xero is taking market share.

Our discussions with accountants validate Xero’s product lead both here and in the UK. However, emerging at the fringe of Xero’s ecosystem is a competitor with a very different revenue model — Square.

Square is a global financial services and mobile payments company that help small businesses grow their business by providing powerful payments and point-of-sale solutions. The company currently services an estimated 3 million small businesses; by comparison, Xero has 1.8 million.

Square creates highly innovative solutions, recently launching a mobile invoicing app. Interestingly, customers do not pay any monthly fees for these solutions and use them for free. This difference in the revenue model is what interests us, as Square only takes a clip of customer payments processed through the platform — perhaps a pricing advantage over time?

Will Xero and Square compete at all?

Looking at the Xero and Square product offerings it is not obvious that they will compete with each other at all. Currently, they are providing very different core services to small businesses. Square is a point-of-sale payments business and Xero is a core accounting platform. However direct competition becomes increasingly likely as the platforms race to expand their addressable market by leveraging the power of their data to offer higher-value services. Both platforms already offer payroll, invoicing and payment services.

In fact, a recent blog on Square’s developer site suggests a general ledger product may already be in the works. The company flagged it has recently updated its payments engine, building a new database called Square Books that is based on double entry accounting. While this is back-end infrastructure, it could be the precursor to building a general ledger product.

Importantly, Xero and Square’s target markets subtly differ. Xero services more sophisticated small businesses requiring a full-featured general ledger, payroll and accounts production. It is only at the very low end where a small business will be able to get away with some simple invoicing software and a few add-ons. This is where Square is focused.

Xero’s current business model limits the value it can extract from this “low end” segment of the market. Churn is prohibitive, reportedly as high as 45%. This is due to the transient nature of businesses that size — an abundance of “consultants” between jobs. Prices are low and customer acquisition is not cheap making the “customer lifetime value” equation hard to solve. Xero does offer a product for this customer but only through its accountant advised channel — it’s not for direct public purchase.

Business model risk or revenue model opportunity for Xero?

Whether they compete at all, the fact remains that Square is servicing small businesses with a novel revenue model, monetising through payments rather than monthly subscription rates. This approach reduces the barriers to adoption, masking the true cost of the service from the customer. Our back-of-envelope calculations indicate Square is extracting roughly 3x more gross profit per small business than Xero.

Xero’s business model of distributing through accounting partners and charging via subscription has been an important advantage and we are not suggesting this should change. But given it is just beginning to monetise it’s platform in new ways, Xero would at least be questioning whether it has the right model long term.

Square is coming, but Xero is no stranger to competing with giants.

Square is no minnow. It has a low cost of capital, US$26b market cap and US$2.3b in Revenue. Square is innovating and beginning to encroach on Xero’s market by offering Invoicing. Xero, however, is no stranger to fighting up a weight class. Intuit is a US$70b market cap behemoth generating US$6.8b in revenue. It is an 800-pound Gorilla that is interwoven into the fabric of silicon valley from before the birth of Google. Management alumni include the late Bill Campbell, Silicon Valley’s “head coach” who mentored luminaries Steve Jobs, Larry Page and Eric Schmidt.

Fortunately, we will be given a litmus test for competition between the payments and accounting platform models. Square will likely target the US market first with any direct competition, a market where Intuit is entrenched. Intuit is already battle hardened and cloud fit from fighting Xero, so it will take more than some free invoicing software to grab significant market share.

Intuit is also strong in the very low end with its product Quickbooks Self Employed where it has extremely low priced subscriptions and a monetisation path through payments. It may not be as easy as Square might think, but equally those investors expecting Intuit to pull the price lever may be disappointed.

Currently Square is playing nice, providing “friendly” APIs to integrate with Xero. We wonder whether this is a long term solution, or perhaps the integration needs to be more permanent. Both companies have a culture of fast innovative solutions for small business, little customer overlap and very complementary products.

Conclusion

“It’s accrual world” with high levels of competition, but Xero is a quality business with a strengthening Sustainable Competitive Advantage. Its strategy and business model have underpinned significant success to date, and the opportunity remains massive. That said, the current market valuation assumes a fair degree of future success, making it increasingly important to watch for unexpected competitive threats.

As far as disruptors go, Xero has executed to plan. Its innovation extends from its product to its distribution and brand positioning. Xerocon 2019, recently held in Brisbane, highlighted the growing importance of payments in Xero’s future — announcing new integrations with Stripe and Gocardless. It is unclear just how Square fits into the landscape just yet — is it friend or foe? Or is it simply a roadmap for us to gauge just how under-monetised Xero’s platform currently is?

The article has been prepared by ECP Asset Management Pty Ltd (ECP). ECP is a funds management firm based in Sydney, Australia. 

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial advice. ECP and the analyst own shares in Xero Ltd.

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