Transformative innovation is not just ‘new ways of doing things’, but that it significantly changes the nature of ‘doing things’ themselves.
There is no more profound example than the evolution of connectivity, most notably the rise of the internet and smartphones, and recent advances in digital infrastructure, such as cloud computing and distributed ledger technology. It has radically shifted business models to allow organisations to deliver products and services at demonstrably lower costs, and often in very different ways to traditional businesses.
Global scalability, accessibility, security, affordability and efficiency are now the prime movers in the marketplace. Google, Amazon, Netflix and Xero are stand-out examples.
The innovation transforming the structural shift of global businesses is also transforming local businesses by providing similar opportunities to adopt different models. Cloud-based communication (such as Google’s GSuite) and accounting (such as Xero) platforms allow small business to securely scale at much lower cost than was previously possible.
Scalability, and corresponding affordability, are indispensable for small business to compete in an increasingly competitive environment and are fast becoming embedded in the fabric of socioeconomic activity.
The global opportunity set for businesses embracing transformative innovation is now significantly changing the investment landscape. These business models have different parameters and opportunity horizons than traditional businesses, and the force of this change is increasingly being felt, and will, undoubtedly, continue to be felt in the future.
At 30 June 2017, the International Telecommunications Union (ITU) estimated there were 3.6 billion people, or approximately half of the global population, connected to the internet. The remaining population is expected to be connected in the years ahead as advances in network connectivity improves access and lowers cost (Figure 1). As of May 2019, 56.8% of the world’s population has internet access, and 81% of the developed world in line with ITU expectations.
Figure 1. Global connectivity.
In addition, and as a consequence of greater connectivity, the quantum of data generated is growing at an exponential rate (Figure 2) as highlighted by the International Data Corporation (IDC), Data Age 2025 study (sponsored by Seagate, April 2017).
Figure 2. Annual size of the Global Datasphere
The acceleration in global connectivity, particularly through smartphones (and web interfaces), and cloud computing services, are enabling businesses models to scale like never before. In June 2007, when the Founder of Apple, Steve Jobs, unveiled the first iPhone, he stated that:
“Every once in a while, a revolutionary product comes along that changes everything.”
Twelve years on, Job’s visionary announcement was not an overstatement of the ubiquitous impact the iPhone would have on business and society. Further advances in digital infrastructure, such as distributed ledger technology, will only accelerate the already exponential expansion of connectivity in the future.
The structural shift in global business models
Global digital technology platform models like Amazon, Netflix, Airbnb and Xero are transforming industries at an accelerated pace. Innovative digital infrastructure is allowing organisations to deliver products and services at demonstrably lower costs, disrupting the economics of prevailing business models. This transformation is comparative to the shift from analogue to digital photos which took place in the first decade of the twenty-first century (Figure 3), where digitisation left analogue in the dust.
Figure 3. Photos taken each year (billions).
In global businesses, the growth in cloud computing revenue and earnings of Amazon Web Services (AWS) provides evidence of the significant structural shift occurring as a result of transformative innovation driving business models with global and scalable opportunity sets (Figure 4).
Figure 4. Amazon Web Services revenue (LHS) & earnings before interest and tax (RHS).
Airbnb (March 2019 valuation of US$35bn) and Uber (May 2019 valuation of US$82bn) are further examples of businesses that have scaled (with private capital) predominantly through recent advances in mobile and cloud computing technologies (both utilising AWS). Netflix is another example of a business with global scale opportunities using AWS’s cloud platform (Figure 5).
Figure 5. Netflix Global Customers Numbers.
Netflix’s share price has responded to the substantial rise in subscription membership driven by its global scalability (Figure 6).
Figure 6. Netflix’s share price (NASDAQ:NFLX).
Given the size of the global opportunity set, and the innovation of Netflix’s streaming video on demand service, the probability of obtaining 400 million subscribers by 2023 is possible based on global broadband subscriptions alone (Figure 7).
Figure 7. Global Netflix subscribers in the future
Netflix’s announcement in January 2016 that they had expanded into 130 new international markets, while committing to substantial investments in original content (US$8bn in 2018) to accelerate their international expansion, reinforces the flywheel effect that underpinned their successful domestic growth strategy.
In 2017, global digital pay-TV household subscriptions (including cable, satellite and streaming video on demand) stood at approximately 1 billion users, with the market likely to expand due to innovation that sees 75-80% of the cost and a better service provided than traditional pay-TV.
As smartphone technology and connectivity improves, the market is likely to expand further. There is a possibility that Netflix could obtain 1 billion customers over time, thereby moving to be a US$100bn per annum business.
Given the fixed cost nature of content and the scale necessary to break away from the traditional media competition in getting to global scale, the strategy in building the business to capture a large portion of the global subscriber opportunity as quickly as it can, including borrowing in the capital markets at a reasonable rate, may be the right one.
Amazon has recently started to disclose more information about the potential for Amazon Prime thirteen years after launch. Like Netflix, Amazon is starting to expand into the global opportunity set. Prime members are valuable to Amazon, not just for the annual or monthly fee they pay, but because they spend more money on the platform than non-members (estimated to be at least two times) producing increased loyalty to the company.
While early in the international expansion, a subscription-based retail model importing global scale into localised markets will make it increasingly difficult for locally based players to compete against long term (Figure 8).
Figure 8. Global Amazon Prime subscribers in the future?
Amazon has started to disclose subscription like service revenue as well to bear out the change in the business model (Figure 9). In essence, the relentless customer focused, long term strategy of the CEO, Jeff Bezos, is providing a global platform for long-term growth on a scale never witnessed before.
Figure 9 – Amazon’s subscription like service revenue annualised sales.
The Xero example
Businesses employing a transformative innovation mindset understand the size of the global opportunity and the need for a long duration execution plan. Rod Drury, the Founder of Xero (ASX: XRO), a leading global Small to Medium Enterprise (SME) cloud-based accounting platform, understood this from the outset when he established XRO – that moving to cloud accounting would fundamentally change the economics of the SME accounting industry.
As the resourcing required was substantial, he decided to IPO the company from near inception (raised $2m pre-IPO and $15m at IPO) and proceeded to raise over NZ$537m (over 12 years) to develop a global product and service offering prior to the company establishing cash flow breakeven.
Today, the business has over 1.8 million customers and a stock market capitalisation of over AUD$8.5bn. While XRO resides within the S&P/ASX 100 Index, and is thereby classified as a large stock by Australian standards, on the global stage, the business is still in start-up mode with a substantial customer opportunity set.
Think Global, Act Global
Conventional funds typically do not invest in businesses like Xero due to the stock falling outside traditional evaluation parameters, such as price/earnings ratio and dividend yield. Nonetheless, the structural shift from transformative innovation means businesses such as Xero may continue to expand for many years. While the company today has 1.8 million customers, it is conceivable that this number may increase multiple times and its market capitalisation worth multiples of its existing value.
Although Xero’s platform is currently used in 180 (out of 195) countries globally, they have a direct presence (website, pricing and people) in 12 countries today that have a combined population of 936 million and nearly 100 million SMEs according to their respective government statistical bodies.
In Australia, according to the Australian Bureau of Statistics (ABS), for every 11 people in the population there is approximately one SME. In New Zealand, according to Stats NZ (the national statistical authority) the ratio is 1 in 9. Xero, due to its ubiquitous coverage in New Zealand, understands that the ratio is closer to 1 in 7 as they have the data to verify this through the interactions with nearly all the SMEs in the country.
Australian and New Zealand markets annualised revenue for the SME accounting market has more than tripled due to the cloud accounting innovation. Xero leapfrogged the competition (MYOB and Reckon) through attracting new-to-market customers who are valuing the benefits of moving from Desktop to Cloud to Code Free Accounting. Innovation (real-time usability) is spurring greater adoption rates amongst SMEs.
In Australia, prior to cloud accounting, desktop & support subscriptions were running at approximately 500,000 per annum out of a pool of about two million SMEs. Today, the subscription market (desktop and cloud) is 1.2 million and growing relative to an SME population of 2.2 million (based on ABS surveys).
All players are growing as the market expands from what was a $200m per annum market 5 years ago to $500m per annum market today. This may explain why local players, MYOB and Reckon, have not been significantly impacted by Xero’s ascent to leadership in Australian cloud accounting. However, the global game is emerging as a key issue for both the subscale competitors.
Accountants have also been a key driver of customers switching to cloud-based accounting solutions as the benefits to their own business model are significant, such as improving revenue quality (move to monthly fee for service) and productivity. This lowers expenses while enabling more customers per accountant/adviser/bookkeeper.
Longer term, the move to Code Free Accounting (led by Xero) is likely to commoditise the core accounting offering. Differentiation will be a function of a global networked ecosystem, and the gulf between global and local players may grow considerably.
Underestimating transformative innovation
The evidence suggests that Xero’s total addressable market is likely to be underestimated globally due to a combination of conservative statistical estimates used by authorities and the transformative innovation itself driving greater SME adoption. However, to keep the statistics simple and conservative, sticking to a 1 in 10 ratio suggests a total market of 100 million SMEs where Xero is focused today.
By 31 March 2024, Xero may have nearly 3 million customers and approximately NZ$1 billion in revenue in these three markets alone (approximately 35% market share across the three geographies) as the United Kingdom scales and the core Australian and New Zealand markets deepen and mature.
Typically, SME accounting providers (based on MYOB, Intuit and Sage’s historical results) have earned a 50% EBITDA margin. Simplistically, this suggests that Xero is likely to be earning NZ$500m per annum in its three core geographies.
Most of this profit will continue to be reinvested into the other nine geographies where they are established today. It is quite likely that Xero will have entered into more countries along the way, with total customer numbers potentially exceeding 5 million by 31 March 2024.
At 5 million customers, Xero would still have less than 5% of the global market it currently operates in today. If we consider the 180 countries where Xero’s product is currently used but does not have a physical presence (ie., people, office, etc.), the number of SMEs exceeds 400 million. With less than 2% global market share at this point, it would continue to make sense to reinvest just about all the NZ$1.5bn in revenue to capture the global network effect of a platform ecosystem.
This scaling process will take time (up to two decades) with the likelihood of accelerating rates of growth as the compounding effect of scaling across regions takes hold. Xero’s profit growth may lag the growth in the underlying value of the business as it seeks to achieve scale and capitalise on the global network. This means that, while traditional metrics such as price/earnings ratios appear high, the stock itself may be undervalued.
Even if Xero acquires 15 to 20 million customers globally in the next decade, it will still have less than 5% global market share. At 100 million customers globally (or 50 times the size of the business today) Xero is likely to have less than 20% of the global market.
Investment and transformative innovation
As Netflix, Amazon and Xero’s business models illustrate, the scale of their global opportunity may not be captured through a conventional lens. The trickle-down effects in scalability and corresponding affordability are becoming indispensable for small business to compete in an increasingly competitive environment.
The ‘Think Global, Act Global’ mantra is more embedded into the fabric of socioeconomic activity than ever before. These types of business models have different parameters and opportunity horizons than traditional businesses, and the force of this change is increasingly being felt, and will, undoubtedly, continue to be felt in the future.
From an investment perspective, a long duration view on the global opportunity set for these business models may take advantage of the multi-decade trends they represent as the global economy increasingly adopts transformative innovation.
Footnotes  https://www.itu.int/en/ITU-D/Statistics/Pages/facts/default.aspx  https://www.internetworldstats.com/stats.htm  https://www.seagate.com/www-content/our-story/trends/files/idc-seagate-dataage-whitepaper.pdf  https://technology.ihs.com/601159/global-digital-pay-tv-subscriptions-exceeded-one-billion-in-2017-ihs-markit-says