Cloud accounting software pioneer Xero has capitalised on its early-mover advantage over the last decade, but its rivals are fighting back.

Morningstar senior equity analyst Gareth James expects Xero's (ASX: XRO) contemporaries will fight tooth and nail over the next 10 years to win back market share, limiting its margin expansion and investment returns.

In a newly published special report 'Competition to Limit Xero's Margins and Investment Returns', James outlines why he believes Xero, which boasts strong underlying profit margins and investment returns, is increasingly vulnerable to competition from the likes of incumbent provider MYOB, and US accounting software giant Intuit.

"Although cloud software has enabled Xero to build a global business, it also means overseas large competitors can now compete in ANZ as well," he says.

"We expect Xero's market share to continue to grow and stabilise at around 44 per cent or 1.3 million subscribers over the next decade.

"However, the company faces much stronger competition in Australia than in New Zealand, where key competitors include incumbent provider MYOB, recently acquired by KKR, and Intuit."

Intuit, James says, is pursuing an aggressive price-led strategy in Australia and claims a subscriber base of around 160,000 as at July 2018, up 55 per cent in 2018, which is around double Xero's growth rate. Until 2014, Intuit distributed desktop software in Australia via ASX-listed Reckon, but now it sells its software directly via the cloud.

However, James notes that subscriber figures aren't necessarily comparable because "Xero subscriber figures include very low-cost versions of its software and Xero was growing at a similar rate when it had a similarly low base of subscribers".

James also expects the acquisition of MYOB by US private equity firm KKR to result in a more aggressive subscriber growth-based strategy for MYOB, which may include establishing operations in the UK.

"Considering that we estimate Xero's Australia and New Zealand division is generating earnings before interest and tax margins of around 30 per cent and gross margins are likely to be over 80 per cent for most providers, we expect aggressive price-led competition to continue in Australia in particular," he says.

For Xero, James expect future price-based competition to make significant average revenue per user growth "challenging".

"We consider small-business accounting software to be reasonably commoditised and believe the price elasticity of demand is greater than the market expects, namely that the software is price inelastic. We expect this to undermine Xero's efforts to increase ARPU," he says.

Although he acknowledges Xero's strong customer switching costs, due to the high operational risks and inconvenience of switching products and the low potential financial and operational benefits of switching, James still doesn't believe the company has a network effect, nor does he expect one to develop.

Xero was founded in a Wellington studio apartment in 2006 by Rod Drury and Hamish Edwards to exploit the disruptive potential of cloud-based software in the small and medium enterprise accounting software sector. It has since grown into a dominant player in accounting software market with offices in New Zealand, Australia the United Kingdom, and the United States, among others.

The company announced in December 2018 that they had surpassed one million subscribers in Australia and New Zealand. All up, Xero has around 1.7 million subscribers globally, with more than 463,000 in the UK and 175,000 in North America.

James explains that incumbent desktop software providers were slow to transition their products to the cloud, too complacent about the strength of their customers' switching costs, and too narrowly focused in a geographic sense, which enabled Xero to rapidly win market share.

Xero itself pursued a strategy of prioritising aggressive subscriber growth and long-term value creation over short-term reported profits.

"This strategy exploited the lethargy of incumbent providers but also acknowledged that competition would eventually intensify as desktop providers created cloud products and new cloud-based firms emerged," James says.

Deep in overvalued territory

James has materially increased his fair value estimate for the narrow moat rated company by 63 per cent to $45.50 per share following three key changes to his financial model.

  1. "We increased our subscriber compound annual growth rate over the next decade to 13 per cent (from 9 per cent), following stronger-than-expected U.K. growth.
  2. We increased our long-term earnings before interest and tax margin assumption to 30 per cent (from 26 per cent), following analysis of Xero's underlying margins and peer margins.
  3. We reduced our cost of equity to 7.5 per cent (from 9.0 per cent), as we now think Xero's earnings will be relatively insensitive to the economy, despite its exposure to business failures."

But the increase wasn't enough to change James' view on the company's investor appeal. At the current market price of $64.78, the stock is trading at a 42 per cent premium to its $45.50 fair value.

"We expect the market is extrapolating margin expansion to unrealistic levels and potentially incorporating more subscriber growth than we are," he says in the special report.

2019 marked the 11th consecutive year of losses for Xero, which is a member of the so-called Australian tech stock club, known as the WAAAX, which include WiseTech (ASX: WTC), Altium (ASX: ALU), Appen (ASX: APX), Afterpay Touch Group (ASX: APT) and Xero.

Strength in international markets

James believes Xero's international division will be the main driver of subscriber growth in the future. Xero's UK business is the largest business in its international division, which has 463,000 subscribers.

"We estimate Xero has a market share of around 10 per cent in the U.K. currently, and we forecast a long-term market share of around 40 per cent," he says.

Xero faces strong competition in the UK from incumbent provider Sage.

However, James notes that Xero has struggled to replicate its impressive Australia and New Zealand market share growth in the US, where it faces strong competition from Intuit.

"In ANZ, Xero faced much smaller incumbent competitors that were slow to develop cloud products, enabling it to capture significant market share," he says.

"Similarly, in the UK, Sage was slow to respond to Xero's emergence, which enabled Xero to build a strong foothold in the market.

"However, Xero's failure to make significant inroads into the US has enabled Intuit to rapidly expand its cloud business. If Xero continues to lose to Intuit in North America, Intuit will remain a massive threat to Xero in other regions such as ANZ and the UK."