Bronte Capital’s John Hempton, one of the country’s most vocal and aggressive short sellers, owns just one ASX-listed company in his fund: Xero. And he says the accounting software group, which has a $5.4 billion market capitalisation, has a shot at being a $100 billion company.
“If any Australian company has the potential to be a $100 billion tech giant, it’s Xero,” Mr Hempton told The Australian Financial Review. “In order to pull that stunt, they need to succeed in what the global ambition of Xero should be – we are the backbone accounting system all round the world and everyone plugs into us.”
Xero, bought at much lower levels, is now one of Bronte’s largest positions, driven by its share price rise, which is up around 60 per cent this calendar year.
Mr Hempton’s ambitions for the group, which earlier this year made the ASX its sole listing after controversially leaving the New Zealand Exchange, are enormous. He said the company was far ahead of many of its competitors by putting accounting software in the cloud but hasn’t perhaps been as ambitious as it might have been.
But now Xero is at an inflection point of sorts. In March, founder Rod Drury announced he would step back as chief executive, though would remain as a non-executive director and shareholder. Former Microsoft Australia chief executive Steve Vamos was appointed to the job.
It was a move that surprised the market, with questions being asked about what had triggered Mr Drury’s decision. Any number of theories are still being tossed about. The prevailing one is a combination of some investors pushing for a more ambitious global outlook, coupled with Mr Drury reorganising his own priorities.
Mr Hempton said the transition has risks but also great potential. He compares it to when Microsoft founder Bill Gates retired.
“The pros and cons are complex and reflective of the Gates-Ballmer transition. It all depends on the relationship between Vamos and Drury,” he said.
“If Drury can remain the guru and Vamos runs it, then it will do great. If Drury gets pushed out of the day-to-day, then it could enter the same product stagnation as Steve-era Microsoft.”
Mr Hempton isn’t the only bullish voice on the stock. Morgan Stanley analysts published a report in June, titled “It’s the fast that eat the slow, not the big that eat the small”. It argued that while Xero might be on a high enterprise value to sales multiple of 11 times, it had a $31 billion market opportunity to exploit.
The analysts are forecasting international accounts will grow from about 32 per cent of revenues to more than 50 per cent by 2025, based on the company knocking competitor Sage from the number one spot in the UK, and the US to improve 36 per cent.
Morgan Stanley says Xero has a major advantage on its competitors – like global giant Intuit and the UK’s Sage – because Xero started as a cloud product in 2007 and, unlike the others, doesn’t have any legacy desktop products to protect.
Its detractors, while recognising the company is a great software company with a strong position in its core Australian and New Zealand markets, view the outlook differently.
They point out Xero hasn’t succeeded with its US expansion, bringing into question the whole global roll-out play beyond New Zealand, Australia and the UK. The risk, ultimately, is whether it will struggle to grow offshore.
They also say the market’s ability to shrug off Mr Drury’s decision to pare back his day-to-day involvement is startling, particularly when coupled with other moves.
“There are a few red flags that makes me feel uncomfortable with the nosebleed multiples which have been like water off a duck’s back: CEO selling and quitting, CFO selling and quitting, founding director selling, large write-downs of capitalised software, ongoing changes to reporting metrics definition,” said one investor who has held the stock in the past but no longer owns it.
Earlier this month, chief operating and financial officer Sankar Narayan said he would leave at the end of December.
Director Craig Winkler, who first invested in Xero in 2009, has sold $120 million worth of shares since May last year, with his most recent sale on June 18. That’s been explained as selling to fund his philanthropic interests.
As for the US? Supporters say it’s a different market. Unlike Australia and New Zealand, small businesses aren’t so reliant on accountants, which are the main sellers of the Xero product. One suggestion is this might be because the US doesn’t have a value-added tax, like the GST, which requires small businesses to file regular tax statements.
Chasing other markets
It’s also a tough market because Intuit will do whatever it takes not to cede share in its home market. It showed how closely it is watching Xero when it aggressively entered the Australian market with its Quickbooks product.
Xero is actively chasing other markets, and many of them do use accountants and bookkeepers more than the US. But is that enough?
“I see no reason Xero will have any more success in Canada, South Africa, Asia, Germany and every other country they’re targeting, because they are spread thin spending less money in each market and have Intuit and Sage throwing rocks from the sidelines wherever they go,” said the sceptical fund manager, adding competitors have caught up and rolling out similar offerings.
Others say that misses the point. Xero is constantly improving technology: consider its decision to switch from the Microsoft cloud to Amazon cloud aimed at using more artificial intelligence which would catapult it into another league again.
Xero’s track record ensures the market will give it time to deliver on its global ambitions. Though with so many competitors breathing down their necks, taking their time isn’t the best strategy.
Bronte Capital’s Mr Hempton said Xero, backed by the market, is being too conservative. “Their ambition is to grow as fast as they can subject to not running out of cash. Why is it subject to not running out of cash?
“A Silicon Valley company with a global ambition would hype and raise.”
NOW LISTEN: Bronte Capital hedge fund manager John Hempton on what makes a good business, and the perils of shorting stocks
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