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Small-cap fund managers are scouring the market for high-potential “disruptors”: the next Seek, REA Group or Carsales.com that can shake up industries and deliver exponential profit growth. The great challenge, of course, is buying them at a realistic valuation.

Consider cloud-based accounting software provider Xero. One investment bank bullishly dubbed it the “Apple of Accounting” in 2013 and said it could become a $10 billion, NASDAQ-listed stock within five years. At one point, Xero’s valuation was 13 times greater than the well-established, profitable Reckon. Even by tech standards, it was heady stuff for a loss-making company that is hard to forecast.

Right on cue, Xero fell from a 52-week high of $42.96 to $14.96 as concerns about its prospects in the United States intensified, and as the market finally realised too much upside was factored into the share price. After slumping to $13.76 in September, the share price has formed a base.

Chart 1: Xero (in $A)

Source: ASX

That’s good news for prospective buyers. Xero has terrific potential and now a share price closer to reality. It’s an interesting idea for experienced investors who are comfortable with higher-risk stocks and able to hold Xero for at least 3-5 years as it realises its global potential.

Xero has long-term attractions. Its cloud-based accounting receives plenty of plaudits for its simplicity and useability. A friend of this author, and a hard judge to please, gave rave reviews about the Xero interface. Like many small enterprises, his is hooked on its software.

Another valuable trait is Xero’s potential to change the relationship between companies and their external accounting advisers by allowing online collaboration through the cloud. Potentially, Xero’s cloud-based software could help accountants spend more time on higher-value advisory work and less on manual accounting issues.

The size of the global SME market – and potential uptake for cloud-based accounting software – is another huge tailwind for Xero. It had 158,000 paying customers in Australia at September 2014, from 79,000 a year earlier. Subscription revenue for the six months to September 30 was $52 million, from $28.1 million for the same period in FY13.

Rapid customer and revenue growth is needed to justify the high valuation. But Xero has only scratched the surface in a giant global market for SME cloud-based accounting software. Its market share in Australia is about 8 per cent and less than 1 per cent worldwide.

Xero recently passed 400,000 paying customers and processed NZ$250 billion of transactions and 95 million invoices in 2014. It has already become a big business, despite having tiny market shares in Australia, the UK and US.

CEO Rod Drury wrote in late December: “… Our focus until now has been to establish Australia and the UK as our next growth engines. Having delivered that, our focus is now on the US. We are making good progress in getting our operating team in place. The small-business cloud market is still in its infancy: of the addressable market of hundreds of millions of small businesses, only a small percentage currently use cloud software.”

Like all good software providers, Xero benefits from recurring revenue, high margins and potentially has a capital-light business model. It’s pouring money into recruitment, product investment and, more recently, marketing – exactly as it should for a product in the early adopter phase in Australia.

Local industry dynamics could work in its favour. The likely multi-billion-dollar float of accounting software provider MYOB this year will provide a new yardstick for valuations. And greater industry competition could lead to mergers and acquisitions among smaller competitors.

Xero’s US strategy is gaining momentum, off a low base. An upgraded version of its payroll offering in the US, allowing customers to electronically pay tax and make tax filings, has been well received. The plan is a nationwide rollout by the end of 2015, from three states now.

Some brokers blamed Xero’s initial weak payroll software for its lower-than-expected customer-acquisition rates in the US. Xero’s payroll features have high uptake in Australia it believes they will gain similar traction in the US.  

The astute acquisition in November of Monchilla, a Seattle-based company that stgeloped online payroll software, has boosted its prospects in the vital US market. Xero said Monchilla had solved the complexity of electronic state-based payroll filings and that it would strengthen its offering as the US SME sector begins to embrace cloud-based accounting software.

It’s too soon to tell if Xero will lift customer-acquisition rates in the US, based on the upgraded payroll software and national rollouts strategy. But brokers such as Macquarie Equities Research view the changes favourably; it lifted its Xero recommendation this month from underperform to neutral. Its 12-month price target for Xero is NZ$19.

Macquarie wrote: “At NZ$16, we think the risks around Xero’s share price are more evenly balanced.  … As a result, we think clients that have a zero weight should consider starting to build a position and reduce their underweight position around these levels.”

Or put another way, it is time to build a position, cautiously, in one of the market’s more interesting “disruptors” after it has fallen sharply from its peak, and is starting to build a base on its chart, before the next, slower move higher.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at January 28, 2015.