#10 Investing Ideas – Xero Limited (ASX: XRO)

This week, we chat with Brian Halim, a key financial blogger in Singapore. Brian shares his thoughts on his blog, 3 forever financial freedom, including his personal portfolio and how he analyses stocks, mainly within the Singapore stock market. However, Brian decided to go out of his comfort zone for us and talk about a fast-growing technology stock that he like from the Australia Stock Exchange, Xero Limited.

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*Disclaimer: The show is for entertainment purposes only, and should not be taken as investment advice. Please seek professional advice or do your own research when making any investment decision.Disclosure: Brian do not own Xero Limited at the point of the recording. Stanley owns Xero Limited and Microsoft Corp at the point of recording.

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Full Transcript:

Stanley:                                 Welcome to season 2 of our investing ideas, I am Stanley. This week, we chat with Brian Halim, a Singapore based investment blogger; Brian has been an active investment blogger in the Singapore market for the past decade, and has really become a key opinion leader for retail investors interested in investing in Singapore. Interestingly, Brian has decided to move out of his comfort zone this time around, for our interview and talk about a fast-growing tech company listed on the Australian Stock Exchange. So, this is our discussion with Brian on Xero limited. Here we go!

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Interlude:                              From valueinvestasia.com, this is investing ideas; where we talk to investors from all walks of life, learn from them and find out some of their favorite investment ideas.

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Stanley:                                 So, welcome Brian. How are you?

Brian:                                     Fine! Hi Stanley! Thanks for having me on the show. I’m very excited today.

Stanley:                                 [Laughs] Thank you, I’m very excited also. Before – Normally, before we jump straight into the investing ideas that you want to share with our audience today, we want to have a small chat with you first, why don’t you share with us, what was your background, and why do you end up choosing to become a financial blogger?

Brian:                                     Hmm! Yeah! So, I actually came from an accounting and financial background, so throughout my professional career, I’ve been in the accounting line, I started from a big four accounting firm, and then I moved to an MNC, and then now I’m actually for – this year, I actually moved to a startup firm, which basically is a kind of a new challenge for me, and gives me a whole new perspective of how to look at companies. So, I think I’ll be interesting to talk about this company that I will be talking today.

Stanley:                                 Right! Okay! So, from – you actually moved to a few industries before, like a different type of companies, and in your work right now, in start-up, what are you focusing on, what’s your role inside the startup?

Brian:                                     Yeah! So, I mainly – Basically, I’m the head of the finance in this startup firm. So, my role is a typical; maintaining the book, making sure that our numbers are looking good, budgeting, and raising funds to investors. So, of course while talking to our investors, then I kind of also have had a clear look exactly at what investors are very much looking into, the typical key matrix of a startup firm, which is what I’m going to talk about later.

Stanley:                                 Okay! That’s interesting, and why did you end up starting your own financial blog, what’s the motivation behind it?

Brian:                                     Yeah! I actually started writing it about maybe more than ten years ago. So, I think the key back then was to just – you know the whole idea about financial freedom, and of course financial freedom can be more than just personal savings alone. So, I started writing about personal finance, but also analyzing companies, which I am basically interested in, and I wanted to put my money where I talked about in a blog. So, that’s why I started to kind of analyze companies, meet people, and yeah…

Stanley:                                 Right! Okay, and also you have a very interesting feature on your blog, which is that you actually present out your own portfolio within your blog, it is a very sizable portfolio, congratulations on that, but I can’t help but to notice when I’m checking out on the update, you are actually holding onto a lot of cash right now.

Brian:                                     Yeah! I am.

Stanley:                                 Why is that, are you are you quite pessimistic about the market?

Brian:                                     Generally, I just feel like I cannot find a really compelling idea, especially because most of my investment in the past few years has been in the Singapore market, I haven’t really got a chance to look and venture out of the Singapore, but of course, these days I’ve been looking more into the Hong Kong, China, and also the US market, but generally, I think overall the price has been – valuation have been on the upscale, when we compare against the future earnings. So, I guess it’s a better time to wait in my opinion until there’s a little bit more blood on the street, where there are no hanging fruit to pick up from.

Stanley:                                 I see! Okay! That’s fair enough, why don’t we jump straight into the idea that you have today, it’s a very interesting company, one that I have only in the past, for my family portfolio as well, but why don’t you introduce this company to our audience?

Brian:                                     Sure! So, the company I’ll be talking about today is called Xero. So, Xero is a – the reason why I first chose this company is because it’s also outside my circle of competence, I don’t usually analyze the tech companies especially in the US, but since I started out working in this current startup firm, I thought you know, why not give it a shot, something more challenging, something more interesting. Right! So, the reason I chose this company was mainly because the financials are not looking great, if we take a look from an overall traditional P&L point of view, and of course then in this discussion, I wanted to give the bounded myth that a company that is a making lost right now does not mean that it’s not a good company to look at, and of course that Xero, and of course a few other tech companies comes into play. So, this is the reason why I wanted to choose Xero to talk about.

Stanley:                                 Right! Okay! of course, Xero is listed actually on ASX on Australian Stock Exchange, is an accounting software services, I would say right, do you agree, and now, why do you like this company?

Brian:                                     Sure! So, let me give a brief introduction about this company. So, this company is basically, like you mentioned is a cloud-based accounting software platform, it started off in New Zealand, but listed in Australian Stock Exchange, it’s an accounting software which is mainly used buy a lot of a startup, Small or even Medium Sized Enterprises. So, I guess if you are an Accountant, and you’re working in Small or Medium Sized Companies. I think you must have heard of Xero, because of course, there will be other competitors which I can talk about later, but the biggest advantage of Xero at the moment; currently as software, is its ability to integrate with a lot of other external applications into the software. So, if you’re trying to do a certain report, you are [Unclear 07:32] which most other company software, which I’ve used in the past have not be able to do that.

Stanley:                                 Right! So, you can actually link it with some external software that you’re using, can you give an example in your own experience, so how do you like combine Xero with other software that you’re using?

Brian:                                     Yeah! So, if you are to – for instance, if you’re trying to pull a report, and try to link it with your – even with some of the in-house operational system, or for example let’s say an MX card right, that you use for your company’s expenses, you are actually able to link the card together into your system such that you incur any cost on your business cards, yet expenses will actually go automatically inside your Xero system, instead of you know having you to key in manually how much you spend this today, and tomorrow, and following after that.

Stanley:                                 Okay. So, it like saves a lot of time on the bookkeeping side of things

Brian:                                     Yep, that’s right.

Stanley:                                 I remember, because when I’m starting up my own company also, I’m using the bank UOB, they also provide a service where you can link my UOB bank account with Xero directly if I want to as well.

Brian:                                     Yes! That’s right.

Stanley:                                 So, they just work with a lot of other partners to help you automate some of the bookkeeping systems, would you say that?

Brian:                                     Yes, correct.

Stanley:                                 Okay, but how is that different from say any other player, there’s quite a lot more I guess cloud-based accounting systems out there, even locally, so what makes it  Xero special?

Brian:                                     For me, when I try to look at, especially just in Singapore, not use worldwide, I guess cloud-based accounting software is not very much common in Singapore yet, there’s a lot of a much more desktop kind of a software. So, if you look at the APAC, MYOB in the past, even the very basic QuickBooks etc all they did was really a very simple accounting software which then allows you to key in your typical bookkeeping and manual journals, but then it doesn’t allow you to first integrate the other platform, and second all your information is then not stored on a cloud basically. So, if you want to retrieve after that, it would be kind of difficult.

Stanley:                                 Right! Okay, and for cloud base ones, are they already the biggest, may be globally, or maybe in Asia-Pacific, although why don’t you share a little bit about some of their…

Brian:                                     Sure, I think some of the competitors, if you’re just looking at the Asia-Pacific, I think Xero is one which is a lot more dominant, especially if we especially include Australia and New Zealand, inside the bigger Asian packing away, in Southeast Asia alone, a lot of almost I would say seventy to eighty percent of the Small and Medium Enterprise still uses Xero; there are others in play you know, such as Financial force, NetSuite, Oracle which I have a little bit of experience into it, but I guess the overall structure of the software is still very much into Xero.

Stanley:                                 Okay, and then you talked just now a little bit about how do you look at a start-up firm, some of the matrix that you look at, when you analyze such a company, you want to share that with us, how do you analyze such a company compared to a traditional type of company?

Brian:                                     Sure! So, if you look at the basically the very traditional P&L of this company right, if you’re someone who comes from a traditional background, and you look one glance at this P&L, you’d be disappointed right, because the rate basically right now, apart from the top line which obviously is growing, because they are in the growth phase, but apart from it, everything else is in the red. So, I have friends whom I showed his spreadsheet, and they inform me, this is not a company I wanted to own right, because why would you want to own a company that’s making net losses year after year even after like 12, 13 years of operations. So, even from a cash flow, free cash flow point of view is still also all in the red, but again I think this is not the way typically on how you measure, and read, and analyze a tech company. So, if you wanted to look more in the detail, you can actually look at one of their notes in their annual report, which actually show some of the key metrics for a SAS type of companies. So, what they did here was basically, they the kind of track the main a few things, and then the first is that the number of subscribers they have obviously, this is going to impact their top-line numbers, but more than just a number of subscribers alone, they actually go into the details of how they break down specifically into their CaC, which is then stands for cost of customer acquisitions. So, of course, the customer of cost of acquisitions, typically made up of more than just your typical selling and marketing, but also includes a typical operational cost, where it basically tells you how much the company is willing to spend in order to convert from a potential to an actual customers. So, look at the numbers all the way from the early days until now, the numbers have actually been quite constant, it is a cost of acquisitions, if I look at the numbers he is about like 377 dollars per subscriber, about 400 dollars per subscriber.

Stanley:                                 Right! So, those are the marketing costs to get one customer.

Brian:                                     That’s correct, and I think that one of the important key of Xero is that actually once a company start using Xero, it’s actually quite sticky, you don’t actually change accounting software here after year after year, because you want you want to keep one, where it is stable, and be there for us to look. So, what we do here is that, then the company, typically tends to compute what they call as the lifetime value of the customers the LTV subscriber. So, once the customer acquire this new potential subscriber into their company, it then compute how many years will then this subscriber stay in a company in their lifetime, so if we look at this matrix the numbers has actually has grown from 1700 five years ago to 2400 in 2019. So, if we look at the ratio which is then the LTV over the tech cost is actually around 5 to 6x now, which means for every single customers that they bring, they’re actually able to make six times throughout their lifetime.

Stanley:                                 Wow! Okay. So, that’s definitely quite impressive, given that you know, in 2015, I’m just looking at your table here, in 2015, the Lifetime Value (LTV) to the cost of acquisition is only around 4 plus times right, so they have also improved that, and also while maintaining the cost of acquisition is pretty impressive, but let me be the devil’s advocate here, because when you say that accounting software is the key, which I agree, because we start out on our accounting software, and I find it really hard, if you want to migrate to another one, but wouldn’t that also mean that it’s very hard for them to penetrate to say existing companies, who already have some software, it’s hard for them to penetrate that market and ask people to switch to Xero?

Brian:                                     Yeah! I think that actually one of the main risks, especially if the company is trying to break into a different political statement, they are trying to do go not only in pocketing the small and medium enterprise, but let’s say one day, they wanted to grow bigger, and they have a product, which is real, and try to break the higher I mean the larger type of companies, I’ve worked with companies that are bigger companies in the past, and typically they use SAP or Oracle Hyperion, that one has a totally different scale, therefore a large space of module’s able not only to integrate your typical accounting, but also things like, payroll, other expenses, budgeting, forecasting, operational. So, I think the larger place is definitely harder to break into, I would think they will further go geographically and try to penetrate the more stand-up kind of firm globally.

Stanley:                                 Right! Okay, but do you have any data, or say what is the biggest, their customers Range, like from startup to how big of a company that they can serve, because you talk about a lot of enterprises, they would just use some of the bigger guys, like Oracle, SAP; would they have a risk like, today I’m a startup, I might start with Xero, but as my company grow and grow and become much bigger, sooner or later, I have to migrate to accounting software by the big guys, like SAP or Oracle, is there such a risk?

Brian:                                     I think they there is, but then I think the reason why Xero is so attractive at the moment, is because their pricing package today is very competitive in my opinion, so if you look at their what they offer today, their pricing range starts from 20 bucks per subscriber, based on the starter, and then 30 bucks based on a standard, and then 40 bucks base on the premium. Which is still very affordable for a start-up or medium enterprise, of course, Xero is also trying to do a lot of enhancement to their product, so for example last year, they actually bought Hubdoc, which is then a software application in order to integrate a lot of the main administrative tasks that you can integrate together in at Xero, and they are actually only increasing the pricing package by two dollars from next year onwards, from 2020 onwards. I think there’s a lot of enhancement that’s being done to the product as the software tries to grow even to the SAP type of scale, but then I guess the prices then would be a main factor for any startup or medium enterprise.

Stanley:                                 Right! Okay. Yeah, I think if we look interestingly, even though they have not been very profitable, but if you look at the trend, and if you if you look at just now the key matrix which is measuring the LTV over the tech, it is actually very promising indeed.

Brian:                                     So, they started off with a lot of costs even back five years ago, the operational costs are up until 156%, which means they are typically making a net loss margin of 56%, but if we move all the way to 2018, 2019. we can look at it slowly, turning down the loss, so in the 2019 their net loss is actually only 4.9%, which is actually very small, and I think there is a there’s a good chance, that in 2020 or 2021, that they might even go back into the black finally, after like first 12 or 13 years of operations. At the Hubdoc acquisition, and the increase in the pricing premium from March 2020 onwards next year, if we pick a very conservative value of $2 increase in the package multiplied by the number of subscribers that they currently have in their boat, that alone would give them about like how much is that, around 30 over millions in year. So, I guess that alone, that enhancement alone would likely bring them back in the black assuming all numbers are constant. [Crosstalk 21:25]

Stanley:                                 Oh! That’s pretty good sign as well right? Okay, and so looking at it, so what could be the risks for this company, what do you think?

Brian:                                     Yep, I think the risk is, basically; just now we already touched briefly on it. So, I guess a lot of the risk is because they currently focus a lot on their small and the medium enterprises, so like you said, so the first is that probably their inability to penetrate into the larger companies, which of course, larger companies means they have a larger budget, which means then they typically wants much comprehensive modules to have in their software end,  and I think secondly, we have to really look at the economics as a whole, I think companies like Xero which obviously target small and medium enterprises, they kind of thrive in an environment where basically the economy is looking great, and there are more startup firms coming up, it is easy to get and of course startup means easy to get funding, and so on and so forth. So, in a scenario where let’s say we have a recession right, and a lot of companies are asked to cut their budget, or even getting difficulty in trying to raise funds to investors, so all these things will then of course that impact Xero, because their number of subscribers not only will they have to be you know a little bit stagnant, but also there is a potential where number of subscribers will actually go down because of all these risks, we have not seen really in the past ten years, and I think the other risk is; of course, regarding the cash flow right, I mean they are technically already public listed. So, in a way you know they cannot… [Crosstalk 24:09] they must eventually you know go into a positive or free cash flow, because if they don’t, obviously a few years down the road, that will mean a lot of burning on the cash, and then they will one day have to then raise funds to investors, which is typically not very nice. So, their Balance is okay, it’s nothing much special, because they are also trying to grow, and also a lot of the acquisitions like the Hubdoc for example, they actually capitalized on because a lot of their cost goes into the depreciation especially [Crosstalk 24:53]

Stanley:                                 I think a lot of investors will be stuck at this point. Which is valuation, how do you value such a company?

Brian:                                     Yeah! Okay, so for such a company that is basically not yet profit-making, so we typically a traditional company, we will do as a very simple multiple valuation on the price to earnings, but then because this one has no earnings, in a way so it doesn’t make sense to do price to earnings, which we then have to go up into how much does the company grow their top line ad, and if we take a backward method of valuing in this company, so the market cap today of the Xero is worth about 11.4 billion, which and today it’s share price, I think it’s about $80 per share, so if we do a quick mathematical computation, this will imply the sales turnover of  twenty times the top line numbers, and twenty times top line numbers is actually pretty high, because if we just typically take a very simplistic 20 percent margin on the earnings, so let’s say the company goes into the black next year, and the company makes a twenty percent net margin [Crosstalk 26:49] so I think it’s a very, very high and to be such a higher valuation in my opinion, you need to justify the kind of a potential growth that you know that the company is still growing. I think typically within eight to ten times would be would be pretty fair, actually the start of this year before the company rose to, today’s price is actually quite fair, and it is only like today, twelve months down the road, where we see the company grows their top line by 31%, but the share price has even gone to be much higher, that I do feel from the valuation perspective, is a little on the high side, of course [Crosstalk 27:49] in the next one or two years and then the market will be probably valuing much higher, but I guess we always want to do have like a margin of safety where we don’t want to overpay. Yeah! I think typically, I have a quick data list here a graph, where a typical SAS type of companies publicly listed, so if you are around 10 times your turnover multiples, throughout typically it should grow to about 30 – 40% which is exactly what Xero is calling currently growth, for you to justify [Crosstalk 28:41]

Stanley:                                 …They are still considered like almost like a one product type of company right, so if you compare it with other SAS company like your Dropbox, or Slack; which is one product, but doing it very well, do you think they will also struggle alongside with company like Dropbox or Slack, when the big guys start to realize that this is a profitable market, and we want to attack it. So, like Google with Google Drive and also Microsoft now with Microsoft team, would you see Xero facing such a big problem, and do you think they will still come out alright if such thing happens?

Brian:                                     Yeah, good question I think for me the key is really then to know at the companies economic modes right, now I think if we compare it against a Slack for example, they started off very strong in the chat applications software, but then if we try to take a holistic view at it right, there is a lot more competitors in this space, first is what, in the accounting software type of where a Xero has a mode at, so I don’t know for me, for example in my company, like we also use Microsoft teams, and we also have for Microsoft package bundles, where we typically have Access, PowerPoint, Excel and all these things right. So, the way Microsoft penetrate the market is more of like they are trying to sell overall as a bundle, which then of course includes Microsoft teams, while Slack is in the space whereby it’s a very traditional type of very one area, where it sells you know your chat box kind of a platform, and to me, I personally don’t see the need for a company to have that, we always have all those kind of things that we can use right, even within the company itself. So, Microsoft team, Google Hangouts, or you know Skype, and things like that, which is a lot free, so for me, as a finance personnel;  if let’s say one day, I have to really cut budget, and I have to pinpoint out where I think the company could cut my budget on, I think Slack will be one of them because I don’t feel that it is – you know it doesn’t have that importance number one space on my list, I think other big players might come in…

Stanley:                                 Let me challenge you on their part, because last time I [Crosstalk 32:05] but when my Microsoft Office 2010 expired, or then I tried to renew a new one, so I end up signing up for Microsoft 360, and within the 360, they provide everything including Microsoft OneNote, and they have a one click export from Evernote, because that they know Evernote is their biggest competitor for the note section, and it’s almost similar right, it’s just one click I put in my Evernote account, and then they put everything into my OneNote directly, and it’s like I never left, and from then on, I stopped using Evernote ever again, because with my 360 subscription, my OneNote is you know, I have a much larger space, would it also happen to Xero at the point where you know maybe Oracle or SAP find out how to export their data completely, and seamlessly, and SAP will say to the guys say, hey you know, we can have a one click export for your account from Xero, and then everything will be pumped into SAP as the company grow, because they might need SAP ERP system or other systems, wouldn’t that also happen as well?

Brian:                                     Yeah! Actually, SAP has also, if a company has already been using SAP or Oracle actually, a lot of the modules which Xero currently has, they also have it. So, it’s actually not a fair comparison, because obviously they’re a much larger scale, and basically has everything Xero has today, I think except – yeah, I think pretty much like even from integration from a UI, UX perspective, everything else is better, but I think that the key is then SAP actually price subscription a lot more expensive, I could actually call it of the top of my head, how much, but I think it’s about 150 per subscriber basis, if you want to have access, that is how much they charge, as I said very costly for them, it’s unlikely for SAP to penetrate into the small amount at the moment, because obviously from a budget wise, they cannot, but I agree like you said, if let’s say one day, they’re able to price it affordably, and they are able to have a one-click system where you know, typically an accountant all their interest is just having it cost right, you care what software to use, to do that, for sure they are, but I think one of the board members of Xero is actually a guy from MYOB, so MYOB is also some very good accounting software used, [Crosstalk 35:38] a new Texas company can actually break through to become the next big player.

Stanley:                                 Okay! Well, thank you so much for your time, Brian. once again, this is Brian Halim from https://www.3foreverfinancialfreedom.com/ if you want to check out some of his writing, and his blog, I’ll put a link down on the show notes, he recently I’ve been reading your report on on Straco Corp, what do you think of the company, so if you want to know more about that, do check it out, thank you once again Brian, thank you for your time.

Brian:                                     Yeah! Thank you Stanley

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