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.
9 thoughts on “New Rivers of Gold for Xero, Reckon and MYOB”
Hi Steve, I notice that Reckon’s management had their remuneration proposal voted down. Do you have any information or suggestions on how small holders should vote in the next proposal?
As relative newcomers to the register, I’m not privy to the goings on of the past few years but my impression is that there are some major shareholders very unhappy with the change of strategy. I don’t think it’s so much about the rem report as much as a protest vote.
Thanks for the reply – much appreciated
Hi Steve, have you had a look at the 9Spokes IPO (I know you guys generally don’t like IPOs but it is more about the concept). 9Spokes is trying to be the ‘hub’ of all of these Software as a Service (SaaS) applications that SMEs are using these days (of which Accounting software are just one) to allow them to integrate seamlessly. Kind of like what WordPress or Shopify does with websites or Apple does with the App Store, or closer to home a Wrap Account does for fund managers.
It is an interesting concept, and rather than betting on who will ‘win’ the wars of the Accounting software, perhaps a lower risk bet to punt on the company who doesn’t care who wins but just makes it easier for people to integrate their businesses and picks up a cut along the way (assuming they can grow market share themselves, and can beat their own opposition who will surely pop up).
Very interesting elusive-obvious analysis Steve. I’d put it on a par with your analysis on the length vs profitability analysis of toll roads from a few years back.
It’s surprising to rational vulcan-types like me, just how much extra people are willing to pay for the comfort of having access to their historical data.
An example: the family SMSF that I manage was paying over $20,000 per annum in brokerage fees to ETrade. I identified that switching to CMC would save us about $6,000 per annum in brokerage in addition to other benefits. My mother was extremely reluctant to make the switch because she feared that the historical trade data would be lost. This was despite the fact that keeping the ETrade account open wouldn’t cost a cent, and we’d still have all of that data. Despite this, it took me about three months of nagging (and over $1,500 in wasted brokerage) to overcome these utterly irrational fears and set up the new account.
Accordingly, it would seem that the lock that MYOB and Reckon would have on many of their legacy customers is much greater than logic would suggest.
I’m am one of those people using an old MYOB desktop version of the software and testament to the stickiness of the product. And I’ve not upgraded it either. A bargain for me. It’s good enough my SMSF and I probably won’t change unless as Steve suggests my Mac dies.
Great Article Steve.
I use & invest in XERO.
However have tested both MYOB & Reckon cloud offerings.
Reckon in particular are behind on stability & user experience but as you have suggested can draw on their existing clients as a conversion base. Is their cash position reasonable to further develop there offering?
Xero have just completely rebased their pricing model, do you expect they will experience a significant level of user attrition?
Will your June Quarterly report be publicly avaliable?
I follow Reckon and it’s worth watching so I’m interested to hear your rationale for taking on the Reckon stake and how you value it. From a headline metric view it is certainly cheaper than MYOB but it is a somewhat more complicated investment case. From a SOTP perspective I actually think the practice management segment is more valuable than the business accounting software – they’re sticky and the product has been iterative over time. I think this is what suitors were eyeing.
The customer base in the business accounting segment are on products which were built on a platform that wasn’t theirs (Intuit’s under licence in Aus) and operates as a hosted solution rather than cloud. They’re now trying to grow through a new cloud offering (Reckon One) which is fundamentally different and late to the party. The pricing structure seems to be the main differentiation. The existing customer base may migrate but these are very different products and a significant chunk of this is probably in what I’d call “run-off” due to inertia – some over an extended period of time but year by year as small businesses die; hence the 2015 revenue decline.
People like Christian above don’t matter – they’re non paying!