Has Xero reached its peak?

A Broker's View:

Company: Xero

Sector: Software

Overview: Xero is a riddle wrapped in a mystery inside an enigma. Its one-year price chart could easily be confused for a cross-section of the South Island, with the flat Canterbury Plains representing most of 2012, before a step up to the foothills in December last year when Xero announced it had raised $60 million from US investors, including PayPal's Peter Thiel.

There was then a swift ascent up the Alps to a peak of $18.90 on July 8 followed by an equally swift drop of 23 per cent in just over a week.

The question investors must now ponder is whether the recent peak represents Mt Cook and whether a descent to the West Coast is on the horizon or do we have further peaks to come?

Pros: It has swiftly gained market leading status in New Zealand and has shown exceptional gains of market share in Australia.

The reputation of the software is matched only by the reputation of the cornerstone investors, including Thiel, chief executive Rod Drury, Sam Morgan (Trade Me) and Craig Winkler (founder of MYOB - one of Xero's major competitors).

The software is part of the burgeoning "software as a service" sector, which is becoming the software delivery method of choice as it allows developers to charge monthly fees as opposed to the traditional one-off sale of a disc.

The company's recurring revenue and customer growth has been very strong (both in excess of 100 per cent for the 2013 financial year).

The company has set its sights on the lucrative American market, setting a preliminary target of 1 million customers.

Cons: Annualised committed monthly revenue for the year ended March 31 was $51.5m or $328 per customer (of which there were 157,000).

Back-of-the-envelope calculations lead us to a recurring revenue of $328m should it reach the 1 million customer mark.

This may not seem like much compared with traditional bricks and mortar companies but overheads and costs can be kept low (once the initial sales and development costs are cut back), meaning there is ample room for profitability.

The tightly held share register and reliance on fickle future revenue forecasts has resulted in a very volatile share price which may be a concern for some.

The risk of another company producing a better product is ever-present in the software industry.

Price performance: The share price appreciated 175 per cent last year and is up over 100 per cent so far this year to recently trade at $16.45 on Thursday.

Investment outlook: It all depends on penetration in the massive US market.

If the company's vision is realised then current share prices could look very cheap.

Suitable only for risk-tolerant investors prepared for volatility.

*A Broker's View is written by Grant Davies, NZX Associate Advisor, employed by Hamilton Hindin Greene Limited. This article represents general information provided by Hamilton Hindin Greene, who may hold an interest in the security. It does not constitute investment advice.