Liam Dann: Why Xero's different from the billion dollar unicorns

The recent Twitter result was a reminder that those who base their profitability on ad revenue alone face an even less stable internet landscape. Photo / AP

Xero’s graduated approach to profitability after its strong growth path is reassuring.

There are those who say you can never have too many unicorns. But others fear that increasing numbers may be a bad omen.

No, this is isn't the start of a bad fantasy novel. It's a tech column.

Ironic hipster humour seems to have infiltrated the jargon of the US venture capitalist community.

Unicorn is the new buzz word for start-up companies with a valuation in excess of US$1 billion dollars.

In recent weeks, on the back of some lacklustre IPOs and disappointing financial results from the likes of Twitter, commentators have started worrying about a tech bubble again.

So we've got headlines declaring that too many unicorns is a sign the end is near. Eventually someone has to make a profit, right?

Shares in New Zealand's most unicorn-like company, Xero, have been soaring in the past two weeks.

The company is hardly a start-up but like many of those attracting close scrutiny in the US, it doesn't make a profit - it is not yet trying to.

But the question of when it will and how much it will make remains central to its valuation.

Xero shares closed on Friday at $19.55 having ended October at $15.99 - a 22 per cent rise in less than a fortnight.

That's still a long way off the heady heights of more than $40 per share that it hit in February 2014, but those valuations were built on US market hype and never seemed realistic - at least in the short term.

Xero is largely valued on its success in gaining customers and growing revenue.

As long as these things continue to grow at a breakneck pace, investors won't worry about profit.

But if and when growth slows and flattens, then the time will come to start converting the revenue to profit.

Last week's half-year result was a good one on that measure and suggests Xero has a lot more growing to do.

The company's losses actually grew too - from $24.5 million to $44.3 million.

But set against a current market capitalisation of $2.64 billion that looks a lot less frightening.

The good news was that revenue grew by 71 per cent, it added 222,000 customers and also grew revenue per customer.

That's still an impressive track. And it can afford to stay on it.

The company raised $147 million in March and says it is increasingly funding its growth with revenue. It currently has cash reserves of about $224 million.

The wild ride isn't about to stop anytime soon, although chief executive Rod Drury has prudently indicated that the company will look to keep its cash burn capped at around $90 million a year.

Converting to profit won't be an easy process. It will inevitably involve a look at cost structures and require some big management calls.

It is reassuring to see that Xero is taking early steps towards a process which is smooth and graduated rather than requiring a radical restructure when the growth and funding honeymoon ends.

There is always a high degree of risk in the transition from being a pure growth stock to a mature, profitable one. Failure can be catastrophic for investors.

And having listed early means Xero is doing its growing up in public.

But that risk is built into the price and should be apparent to any serious investor.

Xero faces tough competition both from incumbent rivals like Inuit and the shifting tech landscape which will constantly throw up new start-ups with new models to shake up the market.

That's the nature of the tech sector.

But Xero is in better shape than many other high-profile tech companies. It has a paid model for starters.

Even if growth tails off faster than expected, the company should, from this point, find its way to some kind of profitable future.

The recent Twitter result was a reminder that those who base their profitability on ad revenue alone face an even less stable internet landscape.

Twitter is so embedded into the media fabric now that it is hard to imagine a world without it.

But last month the social media giant's fourth-quarter forecasts missed expectations and user growth disappointed.

Twitter expects to generate total revenue of between US$695 million ($1.06 billion) and US$710 million in the fourth quarter. Analysts hoped for US$740 million.

It predicts ebitda of between US$155 million and US$175 million - below estimates of US$198 million.

Those numbers don't sound too bad but Twitter shares dropped 12 per cent immediately after the announcement. The fear is that Twitter's growth is stalling.

In the United States its user base has been stuck at 66 million all year.

If everyone who is going to use Twitter is already using it then the company needs to start converting those users into dollars.

But Twitter is also reporting slower ad revenue growth.

A great platform for political debate it may be, but it is a difficult one to monetise.

There are high hopes that new chief executive Jack Dorsey will make changes which appeal to more users and integrate advertising in a way that doesn't scare old users off.

So far the most visible move - changing the favourite button to a heart shaped "like" - has hardly been inspiring.

But Twitter users should expect to see more change on their feeds in coming months as the company begins what will be a difficult and closely watched reinvention.

Meanwhile, watch out for those unicorns ... and rainbows and imaginary pots of gold.