From Xero to hero

Xero (XRO) looks set to become one of New Zealand’s great success stories. And like Phar Lap, Lorde, and other great Kiwi exports, we Australians seem set on claiming it as our own. But regardless of its origin, it’s become increasingly difficult to ignore this high quality, high growth firm. Even the doubters seem unable to come up with any real criticisms of the business, instead focusing on the huge valuation multiples – it’s not every day that you see a $12 billion dollar company trading on more than 700 times forward earnings. For those that jumped in when it first listed in Australia in 2012, the returns have been life-changing, having appreciated by 18x since 2012.

Last year, Nick Maclean from Surrey Asset Management asked whether Xero was actually a value investment, despite the big sticker price, saying that the upside potential far outweighed the risks. Given Xero’s outstanding run last year, I got in touch and asked Nick for an update, whether his investment thesis still stands, and to share another out-of-the-box stock idea.

Hi Nick, thanks for chatting to us today. Last year you wrote a bullish wire about Xero. Could you summarize your view at the time? Has it played out as expected?

When we wrote about XRO ~12 months ago we were attracted to several factors. Some of these included:

• The company’s very large local and global existing customer base which totalled 2.1m in 1H20 – up 0.5m on the prior corresponding period and ahead of our expectation. We saw (and continue to see) this as very sticky and providing significant opportunity for XRO to cross sell its other platform offerings as well as pull harder on the price lever.
• Enormous future global market growth potential
• Acquisition opportunities
• The move to free cashflow breakeven which was achieved in 1H20
• Underappreciated by domestic institutions
• Significant share price upside to our assessed fair value. This value was based on our measurement of the LTV of its existing customers combined with a view on how much we would be prepared to pay for new customer growth.

With all our investments we outline a detailed road map as to how we see future value being created. We then track the company along all the defined future milestones we have set out. In the case of XRO they have achieved all our set objectives and are currently tracking ahead of our expectations. This reflects a world class product offering, solid management team which has executed very well, the stickiness of its client base and years of intense Research & Development which has created excellent value for shareholders.

Could you give us an update on your view on Xero?

We continue to own XRO (we have been buying more since our last Livewire report) as we still favour its future investment potential. The main reasons for this relate to:

• Growth in subscriber numbers
• An ongoing uplift in Average Revenue Per User (ARPU) via both growth in its platform offerings and prices rises
• Margin expansion
• Board alignment
• Continued successful execution

In terms of subscriber numbers, as growth in Australia begins to moderate, we believe its international operations will pick up the slack. We already saw signs of this at the company’s last set of results:

The global opportunity for subscriber growth is significant and is likely to take years to play out as businesses transition to a cloud-based offering. Given this fact, XROs network effect advantages and low churn we have forecast an ambitious but achievable increase in client numbers over the medium term:

Regarding these subscriber numbers, a contentious area of debate for investors has been XRO’s North American operations. We believe XRO has the infrastructure and strategy in place to make a success of this region however, given the dominance of the market leader Intuit we only model moderate growth in this area.

Meanwhile its existing customer base offers tremendous value through the roll out of its platform offerings and potential price increases. As we can see, platform revenue has increased from 4% of group in 1H19 to 6% in 1H20. While still a small part of XRO’s revenue mix it provides a solid tailwind for future growth.

Xero's Revenue Mix- 1H19 vs 1H20

If XRO’s group revenue growth opportunity plays out as we believe it will, there will come a point where the laws of diminishing returns will see R&D spend as a percentage of revenues decline materially. As this happens the profitability of the business should be significant. For example, we have forecast XRO to earn well in excess of $100m in free cashflow in 5 years despite still growing R&D spend.

In effect, while XRO is electing to reinvest for future shareholder value creation, we believe the amazing economics of its business will start to flow through to the bottom line in the medium term. 

As this happens the share price has the potential to comfortably exceed $100 per share.

Could you share another stock that doesn’t meet traditional valuation metrics, but which you think offers reasonable value upon deeper inspection?

Another company we like that does not meet traditional valuation style metrics is IMF Bentham (IMF). IMF funds litigation and arbitration claims for its clients. The company historically did this using its own balance sheet which led to very volatile returns and high capital intensity. It also made the business difficult to value as the earnings were so variable.

Led by CEO, Andrew Saker, IMF has evolved significantly whereby it has been unwinding its direct investments and moving toward a Funds Management business model. Under this strategy the company uses third party funds to deploy in litigation cases. It typically co-invests in these funds and collects fees for the management of them.

The Funds Management model dramatically increases IMF’s investment capacity while de-risking the business. Given the global Total Addressable Market (TAM) for IMF is in excess of $100bn we are excited by this increase in investment capacity:

It is interesting to note that to date IMF has had great success in securing new mandates into its various funds. Its distribution capability is proving first class and was recently enhanced with the acquisition of European based Omni Bridgeway. 

IMF’s products have the advantage of not being directly correlated to any traditional asset class such as equities or bonds. 

This is very attractive to many asset allocators looking for diversity in a low bond yield world where equity markets have performed well.

Given the growth in FUM they have already achieved - we would like to borrow their sales team for ourselves!

Also, of importance is the recent successful court decision in the Wivenhoe Dam case. This had the double benefit of significantly reducing on balance sheet risk while also being highly profitable to IMF. 

We are expecting the cash return from this case to be $100m - $130m to the company.

Contrary to certain other litigation funders, IMF books profits/losses on cases only when they are complete and ruled upon. It does not mark to market returns on an effective percentage complete basis. This is very important from an investment risk management perspective.

In summary, looking forward we have confidence in management’s ability to continue rolling out its Funds Management operation globally. As it achieves this, we believe the share price could track toward $7.

Thanks for chatting with us today Nick.

More on Xero

Xero was one of Livewire's 10 most tipped big-caps for 2020. Read more here.