The growth opportunities for technology companies stands out from most industry sectors in the current low growth environment. We keep a tab on technology players that are the real disruptions of their respective industry rather than frivolous silicon valley ideas.
When we first started out investing in shares, the lack of technology companies on the ASX was the primary reason that we shifted our focus from the Australia large cap (ASX 200) to US equities. US is the primary listing location for all mature silicon valley startups, hence you have to go where the opportunities are.
Australia recently become a hotbed of startup listing, primarily through reverse merger into small cap mining stocks that are past their time.
Xero (ASX XRO) is one of the only true exponential growth stories that we have seen in US listed technology players like Ebay, Google, Paypal and Apple for a time.
Xero is a accounting book keeping software with MYOB being the primary competitor. Rather than traditional software distribution model of user buying a license to use each software version i.e Windows (95, 2000, Vista, Home and 7).
XRO adapts a Software as a Service model (SaaS). The user purchase a subscription license with a monthly payment per user. The underlying software and functionality is upgraded and supported with limit front end major jumps in versions that require additional fees.
From the business perspective, the revenues can be considered an annuity as long as the churn rate or the rate which customer discontinue the subscription is low.
Xero Growth Trajectory
The growth story can be summed in the chart below. The chart shows annual number of subscribers since company inception. The chart shows that the product is gaining traction in the market and users and the business models is are actually working. As growth kicks in, it can be increasing economies of scale where the total number of sales increases over time and can be sustained at a higher percentage for a number of years.
Majority portion of the growth so far has been in Australia and New Zealand.
Source: XRO ASX
Xero’s growth is further broken down in the last 12 month by geographic segments. XRO has a decent market share in Australia and New Zealand that is essential supporting its international expansion. What is encouraging from the recent results is that while subscriber growth has been healthy, Xero’s Average Revenue Per User (ARPU) is steady and growing at 7% rather than going backwards.
This shows the growth is driven by market penetration instead of cost cutting. Long Term Value is defined as total expected revenue expected from users given historical subscription timeframe and ARPU. This is expected to increase as long as no dramatic falloff in subscription numbers.
It will be interesting to see if a higher LTV overtime means that XRO can be more aggressive in front end sales expenditure. We are sure the business would have a view of what LTV target will be and adjust sale force expenditure as % of that as budget. However if LTV continue to grow beyond what internal project shows then they can be more aggressive in the initial spend in acquiring customers. This could support growth longer than what the market is projecting.
Management provides a timeline on where they are in terms of market expansion relative to prior experiences. We are conscious that this can be subjective, however it shows the potential opportunities. So far Australia is the only major success outside New Zealand. Progress in UK and North America are actually slower than expected but the total pool of addressable market is a multiple of Australia. It will take time.
Xero is not an obscure idea and the growth story has been reflected in the company share price. XRO share price today have priced in a certain level of expectation that current pace of growth will continue. The company can be considered a high risk investment due the uncertain realization of its potential. This means the profile of the investors that would buy this stock would be different to those that buy Telstra shares ASX.
We currently do not hold a position but it is a space we are keenly watching. The key risk is the execution of global expansion is hindered by existing UK and North America competitors. Stronger than expected competition as well as loosing first mover advantage it had in Australia with a SaaS model poses the major headwinds.
Another area we are keeping an eye out is the ability to support the current rate of cash burn. The goal of management is to ensure that the ANZ cash flow will be able to provide internally generated capital to support its international expansion plans. Worst case is if the rate of cash burn requires an equity raise to support the growth.
If the share price pull back due to broader market, it is an idea that we are willing to add to the portfolio. Until then we will be watching from the sidelines.