04 July 2018

    Xero: wearing out the shoe leather

    Sam Dickie treads across the world to visit portfolio company Xero

    Sam Dickie (CFA)

    Head of International Equities, Property & Infrastructure

    Email Sam
    Sam Dickie (CFA)

    Head of International Equities, Property & Infrastructure

    Email Sam

    There are two pieces of art on the wall next to my desk at work — both are quotes by Peter Lynch, the former manager of the rockstar Magellan Fund. The first is "There is absolutely no better investment technique than wearing out shoe leather and visiting companies". The second is "Know what you own and know why you own it".

    There are two potential reactions to those pieces of art — either we need to inject some flair into our taste in art or, given that as the manager of the Magellan Fund between 1977 and 1990, Lynch averaged a 29.2% annual return, consistently more than doubling the S&P 500 market index and making it the best performing mutual fund in the world, perhaps we should heed his advice.

    While the former may be true, we decisively follow the latter and agree whole-heartedly with Lynch's advice. There is no substitute for looking in the eye of the managers at a business — it accelerates the knowledge process and gives us confidence that there are layers of quality management below the "C" suite. Given more than 50% of the revenue from the NZ Growth Fund is derived from offshore, we recently visited several of the offshore operations of the portfolio companies in the NZ Growth Fund as well as global competitors of these companies.

    One of the highlights of the trip was an opportunity to spend some time with the head of Xero's UK operation, Gary Turner.

    Xero is the market leading provider of cloud-based accounting software for small-to-medium businesses and their accountants in NZ, Australia and the UK, with growing presences in the USA and other markets such as SE Asia and EMEA. We assume Xero will continue to be the innovators of the industry, allowing it to retain its market leading positioning in Australia/NZ and the UK, grow its foothold in the US market, as well as overtime, grow its rest-of-world business. Combined with the huge market opportunity (global penetration less than 3%) and the wide MOAT Xero is building around its small business customers, we think Xero has material future earnings growth and the UK will be a key driver of that growth.

    The UK: a lucrative opportunity

    Gary is one of the longest standing executives at Xero and has presided over the UK operations of Xero since inception almost 10 years ago.

    Not only has the UK gone from less than 25,000 subscribers and less than 15% of group revenue 5 years ago to more than 325,000 subscribers and more than 20% of group revenue today, importantly we see the UK as the strongest revenue growth driver for the next 5 years.

    Xero has around 1.4m customers globally today and we agree with Gary that there is no reason Xero cannot reach over 1m customers in the UK alone and we forecast them reaching that milestone within the next 5 years.

    A powerful tailwind for the business is the UK government's mandate requiring firms to lodge consumption tax (VAT) returns digitally from April next year. Given approximately only 1 in 7 of the 1.4m VAT registered companies in the UK currently use accounting or tax software, this will help ensure the impressive growth rates we have been witnessing continue.

    The secret to Xero's success in the still relatively nascent cloud accounting software market in the UK will continue to be great product, great people, strong relationships with the accountant channel as a key route to market and the courage to continue to be the innovator of the industry.

    It is face to face meetings like this that are invaluable in building our further understanding of portfolio companies like Xero.