Xero (ASX:XRO) was supposed to be the death of MYOB (ASX:MYO) and Reckon (ASX:RKN). It might just be their making.
In November 2008, private equity firm Archer Capital led a successful takeover bid for accounting software company MYOB. The price, $1.25 per share, equated to approximately $500m for the whole company.
Seven years later, in 2015, MYOB was re-listed on the stockmarket for roughly $2bn, an outstanding fourfold return for Archer and its partners (even better given a good chunk of the purchase price was funded with debt).
To many, including me, the enduring success of the business came as something of a shock. In the interim period, new market entrant Xero had been growing like wildfire.
We were one of many businesses that shifted from MYOB’s desktop software to Xero’s cloud-based solution, and will never go back. Both companies provide small and medium businesses with software that enables them to maintain their financial accounts and to manage their tax and payroll. In the old days, one person had access to accounting software on the computer where it had been installed. With today’s cloud-based solutions, I can scan a receipt and upload it to the correct account from my mobile phone. All I need is an internet connection, and I have access to everything.
Both MYOB and smaller competitor Reckon now have a cloud-based solution, but by all accounts they are still a long way behind Xero in terms of functionality and usability. Xero’s NZ$100m ($A92.7 million) of annual development spend likely ensures it stays that way. From a standing start, Xero now has 312,000 paying subscribers in Australia, giving it roughly 30 per cent market share on our numbers (MYOB says it has 170,000 “online” customers but both it and Reckon still have a lot of customers using the desktop version of their software).
How can they all be worth more?
By now you are probably asking the same question as me. In the seven years MYOB was in private hands, a new competitor with a superior product has gone from a standing start to perhaps 30 per cent market share, yet MYOB is worth four times as much as it was. What gives?
The answer is that, rather than destroy it, Xero has made the whole industry vastly more profitable for everyone.
Firstly, it has grown the total number of customers significantly. Many small businesses that were previously using spreadsheets and shoeboxes to run their business are now using Xero’s user-friendly offering. As MYOB and Reckon get their acts together on their own cloud offering, it will likely grow the market further.
Secondly, and probably most importantly, Xero’s subscription-based business model is vastly superior to the old model of selling perpetual licences on a disk. Previously a small business would buy a disk for $500-$600 from Harvey Norman or JB Hi-Fi and install the software on their own computer. Many of them never bothered to update the software until they needed a new computer, if then. Not only does this leave the software provider managing dozens of historical versions of their software, it means they only get paid once every five years or so and have to pay a healthy chunk of their margin to the retailer.
Under a cloud model, the software is updated and improved without the user even noticing. The distribution cost is close to zero. And a customer typically pays $20-$30 per month, which adds up to significantly more revenue over the average life of a customer. More revenue times more customers equals an industry much larger than the old one.
Finally, it has become increasingly clear that, despite Xero’s technical advantages, the switching costs for customers are still high. Most businesses have many years of data stored in their existing systems, making them reluctant to shift across to something new. By offering free migration, Xero has been spending a lot of money trying to overcome this hurdle but many small businesses will still stick with what they know. If MYOB or Reckon can offer their existing desktop customers a half-decent cloud solution that minimises the hassle of migration, many are likely to take it.
This makes the established players’ databases a very valuable asset.
Despite Xero’s success, or perhaps because of it, MYOB looks like it is going to survive and even prosper. Reckon is late to the party but still has the advantage of a large established user base (and a market capitalisation a fraction of the other two). The entire industry is already more profitable than it was and, once the transition to cloud-based solutions is complete, I expect competition to reduce and profit margins to increase even further.
Xero will be in the thick of it, but there is plenty of room for the incumbents.
This post was first published in the Australian Financial Review as The Case for Investing in Accounting Software. Funds managed by Forager have interests in Reckon shares, we will explain the rationale in the June quarterly report.
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