Xero: A Review

Introduction

XRO has generated plenty of headlines and opinions in recent times. The ever erudite and brilliant Mr John Hempton gave us a very good introduction here. 

It is not too difficult to find online reviews from users' perspective. Here is one. 

There are also plenty of articles on XRO posted on the Motley Fool Australia. Just Google the search term “Motley Fool Xero” to access all of them. To save you some reading, I can tell you folks that there are all unanimously bullish.* Herewith an example, and another example. 

The XRO expansion story

XRO's CEO Mr Rod Drury was recently reported in the press lamenting that the financial community in Australia does not understand the XRO story. In a nutshell, XRO's management call to arms is that this is a land grab, and they are spending money to tie down "real estate", which means massive cash outflow now, in return (presumably) of untold riches in the future.

Proponents of XRO's management vision points to Amazon as a leading shining example. They are also fond of pointing out valuation disparities between XRO and similar plays in the new fangled cloud/SAAS/software/technology area in the USA such as SalesForce. 

Any person who has experienced the dotcom boom in the 90s can instantly identify this familiar refrain. Don't look there (earnings, cashflow), look here (users, revenue, eyeballs, clicks, etc). Moreover, we are also blessed with generous people such as David Einhorn sharing their ideas publicly. In this presentation (which is an excellent read on its own), David warns us that such peer comparisons make an assumption that the valuation of peers are reasonable. And thus, we could again hark back to days of the dotcom boom where inflated/insane prices are used to justify even more insane prices. We are also reminded of the real estate story in Australia at present, but let's leave that aside for the moment.

The bull case proponents are also quick to point out the involvement of marque investors in XRO such as Peter Thiel. Yours truly one legged is then immediately reminded of the Sino Forest scandal. 

Dissecting the Bull Story and a comparison with Intuit

In his excellent book "Competition Demystified", Mr Greenwald presented us with compelling stories of why it is usually not a good idea to take on an incumbent in an established market. He cited the case of Kodak versus Polaroid in the area of instant photography. More importantly, Mr Greenwald explains that an incumbent, with its entrenched customer base and its size, usually has the advantage of scale in a price war. For example, marketing cost per unit of sale is lower when spread out over a larger base, or R & D costs per unit of revenue is lower.

So with that in mind, we now turn to XRO's assault on Intuit in the USA. We expect that, eventually and inevitably, this battle will be fought out globally.

The Salient Metrics

There are 5 salient metrics that are relevant to the battle, and the ultimate fate of XRO and Intuit.

The first is revenue. Revenue is self-explanatory. This is how much your customers are paying you.

The second metric is selling costs. Also known as marketing and advertising, it is useful to consider the framework espoused by Sanjay Bakshi in this excellent article in relation to GEICO's customer acquisition cost.  I can see the logic in applying a similar argument to XRO, namely that the marketing spend is a customer acquisition costs. If so, one can strip out marketing costs each year and capitalised it, and amortise it over 83 to 95 months, which is the length of stickiness of customers as presented in XRO’s presentation here.  Doing this allows us to see a clearer economic picture. As at 2015, XRO's marketing spend is a whopping 75% of revenue.

Unfortunately, at this stage, capitalising/amortising XRO's marketing spend is not much help, since the total of R & D, costs of revenue, and administration expenses are barely covered by revenue. 

The third metric is R & D. In a software business, this is an absolute necessity just to stay relevant and to stay in business. Accordingly, be wary of software companies that insist on capitalising their R & D spending.  As at 2015, XRO's R & D is 54% of revenue, bearing in mind that the relevant metric for MSFT and Google is about mid teens.

The fourth metric is costs of revenue. This is the same as costs of goods sold, which is a variable cost that is incurred every time XRO makes a sale.  The costs of revenue of XRO as at 2015 is about 30%.

The fifth and final metric is administration. These are the overheads required to do business, and as at 2015, XRO's admin expenses is 20% of revenue.

Intuit's metrics

These are Intuit's metrics for 2014:

Revenue is USD$4.5b versus NZD$143m for XRO.

Cost of revenue is 15% versus 30% for Xero.

Marketing is 28% of revenue versus 75% for Xero.

R & D is 17% of revenue versus 50% for Xero.

Admin is 10% of revenue versus 20% for Xero.

These figures paint out a stark picture in relief on the realities of fighting an entrenched incumbent on its own turf. The four major metrics totalled 70% of revenue for Intuit, and 175% for XRO. You can now see why Intuit is just spewing out cash, whereas XRO is just burning through its pile.

XRO's road ahead

To be fair, the market is big enough for both XRO and Intuit. It is unlikely that the online accounting software market will transition towards a winner takes all scenario. There will be a place for both, and especially if smart people could design a software that is capable of porting data from XRO to Intuit or vice versa. It is also reasonable to assume that XRO could achieve parity in terms of scale once it has achieved a critical mass of users and revenue, and that such critical mass may only need to be a small fraction of the total multibillion dollar market. 

Therein lies the opportunity, if XRO can achieve Intuit's scale.

If XRO can achieve a critical mass at one quarter of Intuit's revenue, say USD$1b revenue and achieve a scale similar to Intuit, then it should be rolling back $250m of EBIT per annum, which will easily justify a market cap of USD$3.5billion to USD$5billion. However, this would probably take a minimum of 5 years.

Daunting Task

The task for XRO is daunting. Current revenue of NZD$150m needs to grow to USD$1billion. Whilst XRO may have caught Intuit napping in terms of cloud solutions a few years back, Intuit is now clearly awake and fighting back, with all the luxury and advantages of an established incumbent in its home market.

If one looks through user reviews and forums, it appears that both product offerings are similar in terms of functionality, if not aesthetics. In other words, XRO is not offering a compelling new proposition. This is not a story of the iPhone/itunes sweeping the world, nor is it a story of Google. There is nothing "disruptive", to coin a tired old term, or at least it is no longer such since Intuit started its cloud offering.

At present, XRO is getting $1 of sales for every dollar of marketing spent. Intuit is spending 17% of revenue on marketing and is keeping pace with XRO in the cloud/online user growth numbers. The pricing for both products are similar, hence putting XRO at a disadvantage due to lack of scale. Due to its large user base, Intuit’s selling cost should be even lower if they can develop a feature allowing for easy portability of data from a desktop environment to the cloud. However, XRO is currently fortunate as Intuit did not appear, as yet, to have perfected this feature. But this is only a matter of time.

To get to USD$1billion of revenue, assuming optimistically that every dollar of revenue requires only 50 cents of marketing (as opposed to $1 currently), XRO will still need to spend close to USD$500m.

XRO only has NZD$210m in the bank.

The other problem is penetration of USA market. USA is not homogenous with a central taxing authority such as Australia or New Zealand. The USA market is characterised by state based laws and regulations. Penetrating each state requires software modification peculiar to each state. Intuit already has a massive head-start, and even if on equal footing, Intuit has massive scaling advantages to match XRO dollar for dollar on R & D. As far as user feedback is concerned, software features are currently head to head, however, we understand that XRO is not available in quite a number of states. This puts XRO at a disadvantage, as perhaps evidenced by increased of R & D to 54% of revenue versus 17% for Intuit.

For XRO to come good on its business model, perfect execution is required. For that to happen, we need to start seeing evidence of metrics trending towards Intuit's metrics, whilst keeping up revenue growth at the same time. This will at least indicate that XRO's disadvantage in scale is being narrowed towards complete elimination, allowing it to compete on parity. In its latest financial, XRO's costs of revenue started reducing from 35% to 30%, which is a good sign. However, this was counterbalanced by R & D increasing from 49% to 54%.

Conclusion

Despite a share price dropping from $40 to $15, it is still sobering to be reminded that XRO is still capitalised at over AUD$2 billion. It has a high hurdle to overcome, and not enough of an upside to justify the risks assumed. My assessment at this stage is that at current prices, this is a bet with a negative expected outcome.

*Edit: in the interest of accuracy, there is a rare dissenting opinion here.

Disclaimer: Not advice. Posts contain, where applicable, my opinions or my interpretation of facts. I am also not able to guarantee that the facts I rely on are accurate. Please seek independent financial advice. I do not hold any XRO shares, but this may change at any time.

Giverny Capital Annual Letter 2014

Another year, another letter from the good folks at Giverny.

To quote:

"Since 1996, our companies have increased their intrinsic value by 983%, or close to an eleven fold increase. Meanwhile, the value of their stocks has increased 1094% (including dividends but without currency effects). On an annualized basis, our companies increased their intrinsic value by 13.4% and our stock returned 13.9% per year. The similarity between those two numbers is not a coincidence (my emphasis)."

Giverny Capital Annual Letter 2014.

We are now on the final straight for the full year reporting season on the ASX for FY2015. May the odds be always on our side.

Yours One Legged

Patience= Investing Edge

About 2 years ago, I dealt briefly on the virtue of patience in investing.

A vast majority of participants in the sharemarket are overly-influenced by short term gains. A clear indicator of this phenomena can  be seen with the obsession with dividends and yield, to the exclusion of other important factors making up a good investment. To satisfy this demand for yield, we have experienced a proliferation of products and services, such as ETFs, financial products, and newsletters catering to yield hungry investors.

This appetite for yield came about via a confluence of various matters, a lollapalooza effect, comprising of:

1. Continual low interest rates;
2. Increasing SMSF growth;
3. The dividend imputation system;
4. Uncertainty generated in the aftermath of the GFC;
5. Low economic growth environment.

Apart from the above, I would humbly submit that the main driver of yield appetite is rooted in deep behavioural psychology, namely the propensity to seek a near-certain short term gain at the expense of larger long term gains perceived to be more uncertain. Various experiments and literature have repeatedly shown that a human subject prefers a gain of $100 today rather than a gain of $200 in 7 days. However, given a choice of $100 in a year or $200 in a year plus 7 days, rational decision making prevails.

So it is that a significant majority of investors also prefer buying shares in companies in expectations of price moving events occuring within a period of 12 months or less. In investing literature, these are loosely termed as catalysts. Developments expected to occur after a period of 12 months or more are severely discounted, or not even assigned any value.

Therefore, from the above, it is logical to deduce that an investor with a longer term outlook gains a significant edge. This  may be simple and obvious, but as good advice goes, simple does not equate easy. The vital ingredient necessary is behavioural in nature, namely temperament and patience. This is where the multitude of investors will fail, giving meaning to the phrase "the flesh is willing, but the spirit is weak."

Value investing is difficult precisely because it requires actions that run counter to ingrained behaviours. I have recently conducted a review of the various portfolios I have operated over the last 7 years, and some of my main findings are:

1. Over 70% of initial purchases are followed by price going lower within a period of 6 months;
2. About 20% of initial purchases experienced price reduction by nearly 50% within a period of 12 months;
3. Over 80% of successful positions experience positive price movements after 1 year, with the gains being experienced in year 2 and year 3 after initial purchase.
4. A significant portion of returns are contributed from positions added at lower prices after initial purchase.
5. Volatility decreases in direct proportion to the length of time of holdings.

What do we see here?  For every share that is purchased, you can expect the price to continue to drop for the next few months. The price drop may be as severe as 50% within 1 year. For the first year, price volatility will be very high, and the volatility starts decreasing only if the shares are held for a longer period. If more shares are purchased on the way down, the returns are increased, provided that the position is held for more than 1 year. A position usually takes 2 to 3 years on average to work out.

In short, my investing methodology virtually assures pain in the short term in the expectations of positive returns in the longer term. The process looks rational only in hindsight over periods of 2 years or more. The human brain is not wired for these sort of experiences. Loss aversion usually prevails, at the expense of long term gains.

Yours sincerely,
One Legged

Excerpts from Munger's Recent DJCO Meeting

This post is distilled from an excellent article of notes from the recent DJCO meeting.

The following are my main takeaways. Comments are welcomed as to whether there are further important lessons to be learned, and as to how these learnings could be applied in a real life investment setting.

Investment Philosophy- Find Your Own Way

I don’t think all you have to do is read Charlie Munger and you’ll get rich. If it were that easy, this place would be a football stadium.

Reduce Unforced Errors

Do not focus on being smart. Focus on being non-idiotic on a consistent basis. It is not easy at all.

If the incentives are wrong, the behavior will be wrong. I guarantee it. Not by everybody, but by enough of a percentage so that you won’t like the system.

Focus Your Efforts

I think people who multitask pay a huge price. They think they’re being extra productive, and I think when you multitask so much you don’t have time to think about anything deeply, you are giving the world an advantage you shouldn’t do, and practically everybody is drifting into that mistake.

Concentrating hard on something, that’s important, I can’t succeed at all without doing it. I did not succeed in life by intelligence. I succeeded because I have a long attention span.

Commoditization- In The End, Everything Becomes a Toaster

It is hard and dangerous to make money in commoditized business. Even businesses with huge advantages can become commoditized. In other words, everything eventually becomes a toaster and some will be toast.

Genius versus Tough Business

The auto business is very difficult, very competitive, and everybody is going to make wonderful cars. Everybody already has enormous size and wealth. So, I regarded it as a tough business. Elon Musk is a genius, and so if anybody has a chance to do it, he probably is the man.

But we have a saying at Berkshire that when a man with a reputation for genius takes on a business with a reputation for tough operating conditions, it’s the reputation of the business that’s likely to prevail. Without government help, getting electric cars off the ground is really hard. In China, it works a lot better than it does here, because their air is worse.

What Elon Musk really needs is for the whole country to have a disastrous smog attack that kills a lot of people. Short of something terrible like that, I think it’s going to be difficult. He’s a genius, but is going to have to be.

Assess the Downside First

If you’re unhappy with what you’ve had over the last 50 years, you have an unfortunate misappraisal of life. It’s as good as it gets, and it’s very likely to get worse. It’s always wise to be prepared for it getting worse. Favorable surprises are easy to handle. It’s the unfavorable surprises that cause the trouble.

In terms of monetary authorities, you can count on the purchasing power of money to go down over time. You can almost count on the fact that you’ll have way more trouble in the next 50 years than we had in the last. The technology is changing, so that a few nutcases could make the World Trade Center look like a picnic. We should all be prepared to adjust to a world that is harder.

Enjoy and Prosper

Yours One Legged

UOS putting in another solid year

I commented on UOS here in May 2013 and here again in April 2014.

Another year, another UOS annual report rolls along. A 10.6% increase in book value is plenty enough. Whilst waiting, we got paid a nice 2.5 cents dividend per share.

At current price of 54 cents, the market capitalisation is $630m market cap. This is the price that you pay.

This is the value that you get: UOS’ 70% holding of UOADB at current market capitalisation is about AUD$750m.  UOS’ 46% holding of UOA REIT at current market capitalisation is about AUD$110m. Cash at parent level is $80m. Total=$940m.

Would you like to swap 63 cents for 94 cents?

 Disclosure: I own shares in UOS.

Disclaimer: the content of this post is not to be relied on as financial advice.  It contains my personal opinion only, plus facts that I cannot verify to be accurate.  Do your own research and seek financial advice where appropriate. I have made many mistakes in the past, and will continue to do so in the future.

Reporting Season HY 2015- Part 2

Just a few glossary terms:

CAGR= Compound Annual Growth Rate
EPS= Earnings per share
EV= Enterprise value (derived by adding debt on top of MC)
FCF= Free Cash Flow
MC= Market Capitalisation
OCF= Operating Cashflow
HY= Half Yearly Report

23 February 2015

GNG results out. OCF $20m but $17m in unearned revenue. Dividends= 4.5 cents ff. Margins down. Cash hoard up to $51m.

24 February 2015

BYL HY out. Debt up again due to Rio contract. Margins low. Dividends maintained.

CMI selling TJM for $22m.

AMA HY out. NPAT $4.3m. Rev $43.5m, EBIT $6.4m, EBIT margins 14.7%. Presentation- evidence of start of operating leverage in panels business.

FLT HY out. Company cash near $400m. UK and US both on the growth path. TTV increased, margins decreased.

VRT HY out. Market in Australia contracting. Business affected by economic cycle, not defensive healthcare.

VEI HY out. Margin crimp appears to have stabilised.

25 February 2015

MRM- vessels valued on books at $1b, but MC is $370m with debt at $440m, giving EV of $800m. Poor outlook. High committed capex of nearly $300m in three years. A cyclical play cf Prabai’s Frontier. Check Baltic Dry Index, research vessel evolution to Cape Size.

SSM mopping up unmarketable parcels. Always a good sign.

RFL reach 52 weeks low.

CTE HY out. Revenue continues to increase. OCF is $1.1m. Still $1.5m locked up in working capital. $4.2m cash in bank. Ramp-up investments continue. ROE also healthy, nearly 20% annualised. Dividend of 0.5 cents unfranked. Biological services margin has jumped.

26 February 2015

RHT HY out. Maiden NPAT, scan volumes up. More details now provided, including commercialisation plans for HepaFat.

REF HY out. 1800 Reverse continues to improve. Net cash up to $6.3m.

UOS HY out. Net assets increased 10%.

ICS HY out. Revenue up, cash up. On the right track.

FID HY out. Profit increased despite $500k in restructuring costs. FUM up. Dividends increased. Strong balance sheet with $10m in cash plus extra $2m stuck in working capital, thus resulting in reduced OCF.

27 February 2015

TCN HY out. Cash $2.8m. Clean balance sheet, receivables exceed total current liabilities and no long term liabilities. NPAT $1.5m, and normalised $1.25m. Annualised over $2m of NPAT supporting $17m of MC, and $14m of EV after backing out cash.

3 March 2015

SXE director bought on market.

4 March 2015

BYL- $11m contract from Landcorp. Contracted work is $260m over 2 years.

5 March 2015

TCN director bought on market $20k worth of shares. Another director bought $12k worth. K Jakoby now owns 45m shares out of 223m.

CTE Andrew Kroger bought another 268k shares on market. Holdings crept up to 25% now.

6 March 2015

CTE director Christy Boyce bought 40000 shares on market.

GNG to be added to the All Ords. Will need to be purchased by the trackers and ETFs now.

SXE at MC $60m is equal to NCAV. SXE being dropped from indices. SP close to all time lows.

So all in all, not a bad reporting season for the watchlist and holdings.

Enjoy and Prosper

Yours One Legged

Reporting Season 1H15- Part 1

Okay folks. Reporting season is underway.

Just a few glossary terms:

CAGR= Compound Annual Growth Rate
EPS= Earnings per share
EV= Enterprise value (derived by adding debt on top of MC)
FCF= Free Cash Flow
MC= Market Capitalisation
OCF= Operating Cashflow
HY= Half Yearly Report

5 February 2015

REA HY out. Another great result, revenue up 25%, EPS up 34%. Flowing $128m OCF before tax, and $88m after tax. On track to hit $200m FCF per annum. MC over $6.6b implies CAGR of over 20% pa.

9 February 2015

COF HY. As expected, Geosciences still under pressure, but ID is doing fine. Mining services obviously still slow going, and government infrastructure spending has stalled.

IMF HY out. As expected, they spent $42m to get $35m net. The days of $1 for $3 are gone. Percentage of profit from claim value has gone done into single digits. The ROI profile for IMF is changing. Roughly $80m invested on which you would expect $160m to be returned, plus net cash and net receivables, yield value of just under $300m vs $370m market cap.

10 February 2015

COH HY. Back on track with sales growth in the teens. Nucleus 6 turns out to be successful despite initial misgivings. FCF roughly $160m to $200m pa, on $5b of market cap, implies CAGR of 15% to 20% per annum for 10 years. Pricey.

SGH- WIP is now $521m. Holders of SGH is well advised to read carefully on what is WIP and how SGH recognises revenue.

EAX update- sales up, NPAT static, declining margins.

BOL HY out. Operations squeezed out $12m in cash (boosted by $4m income tax refund), and sold $9m equipment versus $7m capex. Paid down debt by $14m. Squeezed working capital and reducing costs. Equity= $231m versus MC plus debt of $59 + $83= $162m.

11 February 2015

CSL HY out- 8% sales growth in constant currency. Gross and net margins maintained. Net FCF is US$1.3b, after deducting R & D of US$460m (annualised). So FCF pre R & D is nearly US$1.8b=AUD$2.3b. MC=AUD$39b, implying less than 10% CAGR for 10 years. SP dropped 8%, implying market expects double digit growth and was disappointed.

CPU HY out- Sales down, Costs up. Net debt of over $1.2b. FCF less than $300m annualised. MC=$6.3b.

BOL- Bewarder Stichting now up over 10% of the register.

TWD HY out- 73% increase in EPS pcp, interim dividend up. Qld still dominates. If NSW and VIC do only half as well as Qld, revenue will double, for very little capex spent.

12 February 2015

TLS results out- NAS division growing and revenue is $2b per annum.

13 February 2015

GBT- FCF HY is $10m. FCF run rate $20m with MC of $290m.

16 February 2015

SCD HY out. NPAT $300k, FCF $500k. Expenses all reduced. Total cash increased to $6.7m. Total revenue $6.2m, $3.1m for both product sales and service. Orders on hand=$3.6m, together with service revenues should ensure second half is not lower than first half, giving a NPAT and FCF runrate of $600k and $1m at a low point in the cycle. Margin of safety in initial thesis remains intact.

SEK HY- annualised $220m in FCF supporting $5.8b in MC, implying CAGR of just under 20% for 10 years. Not going to happen.

MGX HY out. $354m in cash but deduct $69m receivables and $44m provisions, balance is $240m which is roughly the MC. Extension Hill cash cost is roughly $50, realised average price was $61, so this mine is just barely cashflow positive. The only possible upside appears to the insurance claim.

FFI HY out. Flat results. OCF=$1.54m. Dividend reduced from 10c to 8 c ff.

18 February 2015

NEA HY out. Revenue is $11.4m, on target for runrate of $30m by Dec 2015. Expensed a big chunk of USA expansion, funded from strong cashflows. Cash is at near $22m, no debt. 36k named users up from 22k. Capture costs amortised over 5 years, very conservative because database has an indefinite perpetual value. NEA sold off on results- MC approaching $170m, meaning EV of $150m after backing out cash.

ISD HY out. FCF runrate of $28m to $30m supporting EV of $600m, implying FCF 10 year CAGR of 10%.

CRZ results out. FCF runrate $90m, supporting $2.4b in MC, implying FCF 10 year CAGR of 15%. Long term structural disruptive threat from self-driving cars.

SSM HY Out. Revenue up. NPAT $4m. Dividend declared 0.5 cents ff. Net debt $10m. Accrued revenue up from $71m to $80m. As expected, Fixed Comms and Mobile taking up where Energy & Water coming off. OCF disappointing due to $9m increase in working capital, showing up in accrued revenue. Looks like SSM throws off about $20m in cash per annum.

COO HY out. Revenue down slightly, with both divisions revenue down. Profit before tax remained steady due to cost control, and NPAT increased due to tax benefit. Cashflow is down. Cash at balance date is $12m, but would be less now after payment of dividend and employment termination payments to the CEO. OCF is $1.7m but payables have decreased by $1.8m, so normalised OCF is still well over $3m for the half.

ASW HY out. Steady despite soft conditions. Good yield, good management.

19 February 2015

SRV HY. Revenue up 10%, NPAT up 36%. OCF up to $29m. Normalised OCF is $27m. OCF per floor is $388k. Revenue per floor is just under $2m. ANZ section down, but Asia and EMEA up strongly. USA is slightly profitable but in red due to costs of new floors. Occupancy like for like is 80%. Cash up slightly to $103m. Dividend up 11 cents. ROE=14.7%, but if excess cash is backed out, we get ROE range in the high teens to twenties.

ONT HY. All metrics up. Rolling $6m cash pre-tax, annualised to $12m. MC $150m.

KKT HY out. The hard yakka continues.

IRI HY out. Massive headline results.

BOL Stichting Bewaarder up to 12% now.

20 February 2015

VOC HY out. OCF nearly $22m. Capex efficiency now 0.50. 14% utilisation on total network expanded by 33%. But dragged down by AMM's poor results.

AMM HY out. Poor, although telco division is still growing in low teens.

PME HY out. Revenue up, progress on track. $10m net cash left, but cashflow neutral before payment of dividends.

Yours One Legged