Disclaimer
Leyland Private Asset Management is providing this article as an information service. All the information contained herein is for general reading only and should not be taken as a recommendation. This is not a recommendation to buy, sell or hold this or any other investment.
Before making any decision based on this document, you should assess your own circumstances or seek advice from a financial planner and seek tax advice from a registered tax agent. Information is current at the date of issue and may change.
We don’t know when the opportunity to purchase or sell investments at favourable prices may occur; for this reason, we encourage investors to investigate Leyland’s Discretionary Accounts.
Trusted, confidential advisor
Leyland Private Asset Management manages investment portfolios on behalf of family offices, high net worth individuals, professionals, business owners and self-managed super funds.
Share Price: $93.00
Market Cap: $13b
Business Overview
Business Overview
Xero Limited (ASX:XRO) is an accounting system provider founded 13 years ago that has been at the forefront in developing ‘Cloud Computing’ based accounting software solutions for small businesses and accountants. One of the key drivers behind the success of XRO is its pricing point; the software is easy to use and affordable, setting it apart from competitors, whose products can be complex and expensive.
XRO continues to develop its offering and has begun transitioning from an accounting software provider to a complete business management hub. Customers are now using XRO for a diverse range of business management solutions. Functions include connecting with financial institutions and fintech companies to become a central hub where they can access tools and information regarding their business. For example:
- Business performance dashboard, track business performance across different metrics.
- Automatically follow up on invoices for businesses and set reminders.
- Automated reconciliations of bank transactions and categorised incomes and expenses.
- ATO single touch payroll initiative – assisting businesses meet legislative requirements by producing payroll reports digitally.
- Automatic payroll management.
- Tools for accessing stimulus benefits digitally.
- Asset management, vehicle and fleet, hardware, and machinery management.
- Inventory management.
Migration to Amazon Web Services
XRO originally built its business on the Rackspace platform but migrated all its infrastructure and existing customer base across to Amazon Web Services (AWS) in 2016 making its operations hugely scalable. XRO managed to bring its cost of revenue as a proportion of operating revenue down by moving all 700,000 (at that time) customers and their data onto the public AWS platform. In total XRO moved 59 billion records, 3000 apps and 120 databases to the new cloud platform. The move improved XRO’s gross margin by 81% (with opportunities to improve this in the future) and gave the ability to automate customer experiences. AWS allowed XRO to develop machine learning capabilities and the ability to deploy advanced software updates in over a shorter timeframe.
FY20 Update
To the year ended 31st of March 2020, XRO was able to maintain financial and operating performance momentum. Xero delivered significant growth and posted a first ever full year net profit after tax and a positive cash flow result. However, the impact of COVID-19 on March trading did result in lower annualised monthly recurring revenue (AMRR) in that month. The full effects of COVID-19 will be represented in the FY21 results.
Xero finished FY20 with 2.3m subscribers globally and delivered top-line growth meaning the company has a strong financial position heading into the new financial year (all figures in NZD):
- Net profit (first time) of $3.3 million, growth of $30.5 million from -$27 million in FY19.
- 30% growth in operating revenue to $718 million.
- 29% growth in AMRR to $820.6 million (driven by strong customer growth and high retention rate).
- 26% subscriber growth to 2.3 million. One in four news subscribers from U.S or Europe (growing internationally).
- Total subscriber lifetime value grew by 27% to $5.5 billion.
- FCF WAS $27.1 million taking total liquid resources to $686m.
Future Growth
The immediate future for XRO is uncertain, with the negative effect of COVID-19 on SMEs around the globe (XRO’s key target market) the business is facing short-term headwinds. However, XRO’s ambition is to be a long-term orientated high growth business.
Management has estimated less than 20% of the English-speaking addressable cloud accounting market has adopted cloud platforms. This provides a runway for growth over the longer term. For example, in North America, XRO currently has only 241,000 subscribers, this compares to 914,000 subscribers in the far smaller AUS/NZD market. Speculatively, there is also the ability that XRO will enter into the non-English speaking market, and considerably larger addressable market than English speaking, which provides upside beyond current growth projections.
We feel Xero offers a unique product (with only two major cloud accounting software providers globally) that is not only easy to use and cheap but has expanded well beyond usefulness of traditional accounting software. With Xero becoming the centralised business hub of choice for small businesses, we think they are well positioned for future growth. When small businesses start up, XRO is normally one of the first purchases they make, and it is the last thing they axe when shutting down.
Financials
The benefits of scale are improving the financial performance of XRO at a rapid rate as can be seen by its revenue and EBITDA numbers (mentioned above). In FY20, although its revenue increased 30%, its EBITDA lifted 88% to NZD$137 million for the year. However, despite strong revenue and margin growth, the company trades on a high P/E multiple and does not pay a yield. This is largely due to the high growth nature of the business and the popularity surrounding high growth businesses in the current low interest rate environment. As value investors we feel that high growth businesses (ones trading large P/E multiples) are difficult to value, but we feel XRO is a good long-term growth story and one to accumulate on share price weakness.
| P/E | 320 | 160 | 80 |
| Revenue (NZD$m) | 850 | 1039 | 1257 |
| Revenue Growth | 17% | 22% | 20% |
| EBITDA (NZD$m) | 171 | 239 | 397 |
| EBITDA Growth | 23% | 40% | 67% |