17 July 2019

    Xero’s North American business

    A giant in the making?

    Sam Dickie (CFA)

    Head of International Equities, Property & Infrastructure

    Email Sam
    Sam Dickie (CFA)

    Head of International Equities, Property & Infrastructure

    Email Sam

    We spend a lot of time thinking about what our point of difference is.  

    We have concluded that it is not reading tonnes of research, regularly meeting management teams, rapidly analysing the most recent quarterly or semi-annual earnings releases.  It is not building excel models that can analyse our earnings projections six ways from Sunday and it is not scouring the internet for the terabytes of information on that particular company or industry. 

    We do all of those things but so does everyone else (or at least they should do) so we don’t expend excessive energy on them. 

    We pride ourselves on deep dive, proprietary research. Meeting multiple layers of management and team members within a company, meeting that company’s competitors, meeting that company’s customers.  Meeting industry experts. Really understanding what makes the industry and company tick so that we can further our goal of thinking about our companies like a business owner, not like a financial analyst. 

    That is what we think our point of difference is.  That helps us see what is not well understood by the market or what the market may be missing. It better prepares us for curve balls the company or the industry may throw at us in the future. It means we can take advantage of situations when a company is punished for the wrong reasons and buy when others are fearful. 

    Our recent trip to the US was all that and more. We met separately with almost ten different Xero executives and we met with Xero’s accountant partners/customers.  We met with Xero’s largest global competitor Intuit and we met with Xero suppliers in the form of data centre providers. 

    North America has been a small business for Xero, accounting for less than 10% of revenues and has been growing inline with group revenues for the past two years. However, given the partner strategy in the US (selling via accountants vs selling direct previously) is now well entrenched and, coupled with strong growth in the Canadian business, we believe North America can grow in excess of group revenues in the future.

    The US cloud accounting software market is huge and is very under penetrated. We think cloud accounting penetration in that market is less than 15% which compares to around 50% penetration in NZ. 

    Intuit are the giant in that market with around 3.2m cloud accounting subscribers. That is around 15x the size of Xero in the US. But, this is a market that Intuit thinks could be as large as 25m subscribers.  Intuit themselves think that there is room in the market for another large but second placed player. 

    We agree. Even if Xero just gets to a 15% market share (leaving Intuit with 85%), Xero can grow 20x in the US market before the market is saturated!

    We attended Xerocon San Diego where over 1,000 accountants, customers and ecosystem partners of Xero gather to share their enthusiasm and learn about Xero in more detail. 

    The excitement at Xerocon around Xero’s Canadian business was palpable. Xero only entered the market in the past year or two but the Canadian cocktail party was the best attended cocktail party at Xerocon! There was standing room only in Will Buckley’s address (head of Canada). Xero does not split out Canada in its earnings releases but we think it is growing significantly faster than any other country off a low base. The total addressable market in Canada is larger than the Australian and New Zealand markets combined.  While Sage and Intuit have a presence in Canada, Intuit only has 250,000 customers in a market that could be as large as 2-3m customers - so it is still wide open.

    While we were there, Xero announced a strategic tie up and revenue sharing arrangement with Stripe for payments. Payments is potentially a very lucrative opportunity for Xero and could be a $100m revenue opportunity in years to come (from near zero today).

    This type of non-core accounting revenue stream is very exciting. The existing non-core accounting revenue stream is only 5% of total revenue but it is growing at ~85% vs ~33% growth for the core accounting revenue stream. This ability to grow outside its core by “bolting on” or organically creating new businesses that leverage off the core makes Xero a platform business. A platform business is rare and in many ways is the most exciting investment opportunity. These non-core revenue streams are typically harvested at very high incremental returns on invested capital.

    Couple our excitement around the North American business with the substantial uplift above expectations in UK subscriber additions in the most recent result and you can understand why Xero is one of the most exciting positions in the portfolio. Antagonists of Xero lament the fact that the NZ business where it all began is nearing maturity and saturation point. This supposedly mature NZ market continued to grow well in excess of 20% in the most recent result. Given NZ has a head start of 5+ years on underpenetrated markets like the US and the UK, it may may provide a quasi-blueprint of the growth rates the US and the UK can achieve in 5+ years time. 

    We also came away from our US trip more convinced that the market is not properly appreciating the opportunity Xero has in North America.  It is a giant in the making. We came away more convinced the market is still not properly appreciating the explosive growth opportunities in non-core cloud accounting revenue. And we remain convinced that the combination of the extremely profitable core markets of Australia and NZ are in the powerful position to be able to fund the exciting growth in the U.K., North America and Asia. And eventually Europe and South America. 

    With 85% of Xero’s revenue coming from outside NZ, we think these deep dive, proprietary research trips are critical to our goal of thinking like a business owner.