Xero FY 2016 - my unfettered opinion

Building a global business $30 at a time

I jumped off a plane last Thursday morning after an overnight flight back from Asia, turned on my phone and had throughout the day a flood of SMS; Emails; LinkedIn Inmails; Facebook Messenger messages; Tweets and voicemail messages all asking my opinion on Xero’s full year results.

At first it was – how awesome, some people want to know what I think – they’ve actually been reading my blog. 🙂

Then, wow, how awesome is the Xero brand?! People have so bought into the company and what they are doing that they care about stock market announcements – something most don’t concern themselves with in their day-to-day lives.

But then, ah shite, I actually have to deliver now. 🙁 I have been questioning where Xero are at (largely based on the absence of announcements and data, rather than much else) and now that the data is out there, put up or shut up Matt! This means I have to run the numbers. Sift through the spin. Find what’s missing. Look for concerns. Look for the genuine highlights. I probably need to take a little more care (and time) with forming and explaining my opinions. Some people are making strategic and investment decisions based on what I write (more fool them – all care no responsibility from me BTW, you’re probably better subscribing to the Motley Fool I reckon!). The pressure is on…but here goes:

Xero FY 2015/16 Results – the reaction

The NZX and ASX reaction is a nice place to start. After a flat announcement day Thursday, Xero was up on the NZX 13% Friday through Monday. The ASX is up 12% to Au$16.25 (NZ$17.44). Looking at the 6 month chart, obviously a nice jump, still a ways off the 12 month high, volume traded not huge, but certainly above average volumes:

So the markets have taken Thursday to assess the results and decided by Friday, that they were pleasing – above expectation.

As for me, on first reaction, pleasantly surprised. As many of you know, I’ve been raising concerns about where Xero were with their growth. It started with what I thought were some inconsistencies in the Q3 cash flow report and was exacerbated by the “missing” announcement over cracking 700,000 subscribers.

So was I right to be concerned? Maybe, but not overly. Given I threw out “The 7 things I’m looking for in Xero’s FY results” ahead of Thursday’s announcement, it makes sense that I delve into those 7 factors to assess:

1. Subscriber Numbers

Woohoo, they had cracked the 700k after all (which I was waiting for and in the end expecting) and must have done so around the first week of March. I wonder why no announcement? After Xerocon UK, just before FY results…? Too close to FY results perhaps? Though last year they announced 200k subscribers in Australia on March 31…?

On a straight-line basis, 700k came around March 5 or 158 days after they announced 593k as at September 30, 2015 – this represented 678 net new subscriptions/day. This is a slow-down in growth (500-593k took 119 days at 782/day), in numbers and percentage terms (500-593k @ 0.157%/day and 593-717k @ 0.071%/day).

So drilling in further, how’s it look by territory and what of my “early adopter saturation” hypothesis? Specifically Australia:

Looking at growth run-rate

There is certainly a dip, but vs the more mature cloud accounting market NZ over a longer period:

Whilst the direction in Australia isn’t great, there’s hardly significant evidence for panic to set it just yet, particularly when you compare with the longer term trend in NZ. If anything, probably hints to some seasonality in both markets with higher growth 1H – which *could* be an indication that uptake is higher at the start of financial years. Makes sense, though the UK seasonality is the opposite, despite the same financial year as NZ, with spikes in 2H:

And as there is always questions about the US & Canada. Still immature, but still growing with no end in sight to growth either:

I particularly liked this little chart on subscriber velocity in the presentation, which shows for all the doom and gloom commentary on the US the trajectory is in fact pretty good:

Conclusion

There has been some slow-down in growth, particularly in Australia, as I deduced from the Q3 Cash Flow report. The positive impact of currency fluctuations on the full year results, do help justify my questioning of the cash flow report and their excuse that this was the result of currency impacting results negatively. This seems reaffirmed by the run-rate slow-down.

But, growth hasn’t exactly “hit a wall”. 242,000 new customers in the year is still a good number, no, a great number.

Anyway, great numbers out of the UK not only dispel any thought of a “crossing the chasm” market slow-down over there, but are in fact largely offsetting any slow-down that seems to be showing in Australia.

Market penetration is a difficult thing to determine, particularly for cloud accounting tech. For one, not all players are transparent with their numbers. For two, cloud numbers that are described (like Xero subscribers), are by dataset/ABN, whereas desktop accounting tech is rarely licenced by dataset/ABN, with one licence often covering multiple active businesses.

I have been particularly keen to understand where Australian cloud (true, browser based) accounting adoption lies. I’m going to make a bold prediction, let’s call it an educated guess. 312k Xero subscriptions + MYOB Essentials + QBo + Saasu + ReckonOne + Wave + Freshbooks + SageOne + Netsuite + MYOB Advanced + Harmoniq + Gem Accounts etc – out of 2.1m actively trading businesses, surely we’ve cracked at least 380k (that’s Xero + just 68k from the rest) of them using true, browser-based, cloud accounting tech. My point, we have to be over 16-18% penetration (in fact I have to think we’re beyond 20% – at least 450k), which puts us firmly into “the early majority”, beyond the Geoffrey Moore chasm between early adopters and early majority.

What on earth is my point? Who is Geoffrey Moore and what is this chasm crap I keep going on about? Well, if you have a spare 2 minutes watch this – Simon Sinek is probably the best orator there is and here’s his explanation of what is Moore’s “diffusion of innovation curve” and the “tipping point” to the early majority.

What does this all mean? Well, I believe Australia is on the doorstep of significant en masse adoption of cloud accounting tech. This is great for Xero ($XRO), but also for MYOB ($MYO) as the two clear market leaders.

2. Churn

Now sitting at 1.19% Committed Monthly Revenue (CMR) churn, compared with 1.23% as at 12 months previous. A 3% improvement or within the realms of statistical variance..? I can’t really give this a thumbs up as I can’t really quantify this as a significant improvement.

3. What’s Missing

CAC (Customer Acquisition Cost) by market, moreover, the breakdown of SaaS metrics by region is missing.

Bundling CAC and other metrics for “ANZ” and “International” hides the reality of the UK tailwind “at what cost?”, or the true state of the US headwind for example. Note:

$148m sales and marketing spend! I’d love to know the breakdown across markets.

Beyond that..? I have to credit Xero with being pretty much transparent. I’ll keep digging, finding what’s missing can be difficult – further posts will come if I find anything…

4. Games

As above, one could claim games are being played around selectively aggregating markets (ANZ and International) where it suits, like CAC for instance.

Looking for more game play. Deep diving into the balance sheet, let’s look at Intangible Assets (a classic software developer P&L “management” tool). There has been a 50% increase in Net book value YoY (NZ$65m to NZ$98m). Amazingly, for a platform that is now 10 years old, $53m of a total at cost software development investment of $138m (38% – inclusive of acquisitions and net of disposals) came in FY 2016! Wow, talk about ramping up development! Anyway, back to games – do I think any are being played here? No, absolutely not. For comparison: Xero are carrying Au$91m in intangible assets vs MYOB who is carrying Au$1,219m vs Intuit with ~Au$1,800m.

How about Prepayments and Accrued Income…? Nothing exceptional:

One might state that when you aren’t anywhere near profit, you don’t really need the balance sheet to manage your P&L…in fact, the leaner you can keep it, the better for the future when you might need it…!

All-in-all, I can’t see too many games being played with the results. They probably don’t really need to…

5. SaaS Metrics

I can only give a double thumbs-up to the presence of detailed SaaS Metrics, once again. In reality, these are the metrics that sustain and will grow the shareholder value, NOT the current state of EBIT, so it makes sense for them to be so prominent in Xero’s results.

To me, the 7 metrics that really matter are the 5 in the chart below +:

the Gross Margin (which improved overall 70-76%); and
Annualised Committed Recurring Revenues (ACMR) @ $258m to start the 2016/17 financial year (NZ$99m added in the 2015/16 financial year);

Only concern here, is Customer Acquisition Cost (CAC) in terms of month’s revenue, moved in the wrong direction, I would say significantly, at nearly 10% in ANZ and 12.5% Internationally! Xero themselves would probably argue:

that CAC is in fact less important than Customer Lifetime Value(CLTV)/CAC ratio, which with the increase in CLTV (based on price increases, currency movement and marginally reduced churn) offset the higher CAC; and
CAC as % of revenues (as they highlight in the results presentation)

I’m personally more comfortable with argument 1 over 2. Whilst CLTV to CAC is improving, does CAC matter that much? As long as CLTV growth is maintainable, which I think it will most certainly be as alternate #Fintech revenue streams start to kick in.

Conclusion

Whilst I’m putting a “watch and see” notice on CAC, all-in-all its hard to be critical of the improving SaaS metrics coming through from Xero. This isn’t being inflated by break-even or loss making services revenue as we see with a few other listed SaaS players. Its about as pure as it gets and for me makes for an attractive long-term value generation engine.

6. Burn Rate

Looking at the numbers:

Total FY 15/16 operating and investing cash outflow slightly higher YoY to $88.6m c.f. 14/15 $88.4m.
Improved 2H ($39.1m) outflow compared to 1H ($49.5m)
Cash remaining: $184m

So, at current burn rate, there’s little more than 2 year’s cash left before further capital raising, or debt (in my view, with a clean balance sheet, more likely) would be required…BUT:

Conclusion

The numbers in isolation show cash burn 2015/16 was slightly worse than 2014/15. When you look at this chart below, its seems as if a mirror splits the 2 financial years with 2H 2015/16 mirroring 1H 2014/15 and 1H 2015/16 reflecting 2H 2014/15.

Looking closer, 2015/16 moved noticeably in the right direction (improvement of 21%) 2H vs 1H. The top (or bottom depending on which way you look at it) of the burn curve perhaps? Certainly the target/forecast of moving to cash flow positive with current cash balance suggests it most certainly is.

On YoY comparative result, it’s a thumbs down. On 2H trend and the bullish forecast, it’s a thumbs up. So I’m scoring this one a draw.

7. A forecast

Woohooo:

“Xero is managing the business to cash flow break-even within its current cash balance”

Now that’s a forecast many investors have been waiting for. Most likely this means no more capital raising, no more watering down of shareholder equity (aside possibly from generous employee share plans). Dare I hint that ultimately cash flow positive leads to the P word…at some point?!

Hey, they’ve hardly thrown out a flood of forecasts, but this one is pretty major and dare I say ambitious!

Summary

All-in-all it is difficult not to buy into what Rod Drury et al are creating with Xero. They continue to grow and grow, $30 at a time. With absolutely no end in sight. As they say in the report:

“Though we have reached several remarkable milestones to date, in a market of tens of millions of potential customers, we have only just begun”

ANZ continues to expand strongly (albeit at a slightly slower rate), despite effectively pricing themselves as a premium offering and increasing competitiveness from MYOB in particular. We are also seeing heavy price-driven competition from Reckon, Intuit and Sage, which emphasises the short-term “land-grab”, for the long-term financial services play. I stress again – subscription is not the only revenue source at stake. As the Chairman and Chief Executive Report alludes to: “loan approvals…competitive foreign exchange rates, and more payment options” are the future of this space and will all grow Customer LifeTime Value (CLTV)!

Note, the “other operating revenue” grew to over $5m (largely on “increased conference revenue”):

I will be eagerly watching this “other” bucket, as a serious growth engine into the future, through the expansion of their “financial web”.

UK looks exciting. Despite Sage seeming to be getting their act together under Stephen Kelly AND the significant number of other Cloud Accounting competitors in the market, accelerating growth and market leadership is impressive.

North America is still tough, but worth persevering with due to the sheer market size and growth potential, in which less than half of the 30m odd businesses, currently use retail accounting software (desktop or cloud)! Someone queried me on twitter the other day about Xero and the US market. My take is the US has never had the equivalent of the “artificial regulatory force” that came with the introduction of GST in Australia (and the $500 GST computerisation vouchers that came with it) to change the small business accounting culture. Instead, as is the liberal, “lean government” approach in the US, they are relying on market forces to drive efficiency gains in the accounting, small and banking business sectors. This is taking time.

Asia and Africa will be tough, but there is a tonne of growth left in the markets in which they have already taken market leader positions. For mine, Asia and Africa are nice potential cream, rather than required engines of growth. For now…

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For more commentary by the author on Accounting & Payroll tech: