Monday, August 13, 2018

Dear Bayer shareholders, what are you thinking?

Bayer is a life-sciences company. It sell drugs with litigation risks (especially Xarelto), it genetically modifies seeds (which I guess has litigation risks). It sells herbicides and pesticides all of which have litigation risks.

If you do "life sciences" you muck around with living things and that has litigation risks.

On twitter recently I sought out discussion on risks of Bayer stock and litigation was the key one.

Today Bayer stock is down 12 percent on a California court case where a dying plaintiff claimed that roundup caused his cancer and a jury agreed.

The damages were set at $289 million.

Having watched lots of legal stuff in American stocks I would be surprised if this were not rounded down at least 90 percent on appeal, and if the agglomeration of future cases didn't cost a lot of money.

But whatever. Here is a list of the biggest class actions in US history. None break $10 billion except the global tobacco settlement.

The biggest aggregate claim I can remember is fen-phen which wound up costing about $13 billion.

All of these are spread over many years. And are tax deductible to boot.

Today Bayer's market cap dropped $14 billion, bigger than the biggest set of (non-tobacco) legal losses in history.

This seems disproportionate to me - but then I own Bayer stock. And I am puzzled.

So I am asking the people trading it in Germany - why are you so pessimistic about this?

I genuinely want to know.


John


Thursday, August 2, 2018

A quick comment on the Herbalife results

Herbalife reported after market.

There was a lot of noise. Margins in various markets fell. There is the usual Herbalife currency noise. 


But lets cut through all of that.

I don't particularly care in this case whether you believe that Herbalife is a scheme that rips people off on their sales or whether you believe (as I do) that Herbalife is a network whereby weight loss products are sold via community support.

At the end of the day profits will eventually follow the volumes of product they sell.

If they are crooked profits will follow volumes.


If Herbalife is (as I argue) a true social support network profits will still eventually follow volumes.

Herbalife has for as long as I know used a consistent measure of volume - the volume point. This is not an arbitrary measure of volume. It is the mechanism by which distributors are paid and which real cash moves. 

With a single exception this quarter and only in a trial way in Brazil and Mexico a volume point has an unchanged meaning for the last decade.  For example a small tin of Formula 1, their main product and the largest selling diet shake in the world, is 23.95 volume points. It has been 23.95 volume points unchanged for decades.


The price of the product changes, but the number of volume points does not change. Changes in volume points are real changes. When volume points fell as the company implemented the changes demanded by the Federal Trade Commission those were real falls in volume.

And when volumes rose this quarter they were also real changes in volume. If they increase price revenue will grow even faster. 


Here is the volume points by sector this quarter versus the previous corresponding quarter.



 
Three Months Ended


Six Months Ended



June 30,
2018


June 30,
2017


% Change


June 30,
2018


June 30,
2017


% Change



(Volume Points in millions)

North America


336.4



284.1



18.4
%


639.6



586.7



9.0
%
Mexico(1)


237.1



228.9



3.6
%


458.9



454.4



1.0
%
South & Central America(2)


136.3



137.5



(0.9
)%


284.8



290.7



(2.0
)%
EMEA


319.5



283.6



12.7
%


614.2



557.8



10.1
%
Asia Pacific


302.8



275.9



9.7
%


589.4



536.7



9.8
%
China


196.1



153.9



27.4
%


337.2



335.9



0.4
%
Worldwide(3)


1,528.2



1,363.9



12.0
%


2,924.1



2,762.2



5.9
%



You see the highlighted things right. Volume points rose 12.7 percent this month in Europe, Middle East and Africa, 18.4 percent in North America and 27.4 percent in China.

This is an acceleration in growth. 

Now there are a couple of anomalies here. Firstly the United States (by far the bulk of the the North America segment) is lapping the particularly bad quarter when the company implemented the reforms the Federal Trade Commission demanded. China is lapping a strange quarter. Herbalife raised prices in March 2017 and volume points were particularly high in the first quarter of 2017 and low in the second quarter as customers bought purchases forward to beat the price rise.

But even without these anomalies Herbalife volume growth accelerated. A lot.

Now I say this because even if you believe Bill Ackman's thesis it is not a good stock to be short. Earnings growth is coming. And regulatory problems have passed.

--

But for a true Herbalife bull these results are even sweeter. 

Herbalife was made to change its operating rules in North America by the Federal Trade Commission. These rule changes ensure that Herbalife distributors can identify ultimate and real consumers for their product. Mostly the product is UPS direct from Herbalife to the identified ultimate distributor. Alternatively you go into a club and your name is taken. 

If the Bill Ackman case were correct (even in any substantial part) this would mean that Herbalife sales would collapse because Mr Ackman argued there were no ultimate customers and inability to identify them would make sales go away.

There was comment after comment from short-sellers arguing this and noting this quarter was going to be even harder as certain changes had to be fully implemented this quarter.

18.4 percent growth and record volumes in North America confirm what I knew - the vast bulk of Herbalife's sales are legitimate sales of diet products sold with community support networks to help people stick to their diet.

Herbalife remains an ethical company selling a product for which there is a real need.

And now it is a growth stock to boot - with very high incremental returns and a PE way below the market average.

All aboard. 




John

PS. My long post - the detailed background to the Herbalife story - is standing the test of time.

Wednesday, August 1, 2018

Xero

I was quoted in the Australian Financial Review on Monday stating that Xero is the only Australian company with the potential to be a $100 billion global tech behemoth.

As the market cap is less than USD5 billion now I am saying a 20 bagger is possible.

The $100 billion number was a matter of some dispute in the office - and a discussion is in the appendix. However suffice to say there is huge upside provided it all works.

Xero however have a few hoops to jump through on that path. This post is to explain my view and also what I hope management improve. I do not think they have done a great job of it so far (even though the stock and business have been a success).

But for the uninitiated I am going to explain what Xero does and why it has such potential.

Xero is an open architecture cloud-based small business accounting software package. It provides a proper double-entry accounting system for small businesses available from any reasonable device, and backed up automatically. It has permissions to allow various people different levels of access (to facilitate proper accounting controls) and in some jurisdictions it connects straight to banking systems to allow payments to be made directly from Xero.

We use it to run our business. It works. It is wonderful.

This is not an isolated view. Check out the @xero twitter feed. People unironically use the word "love" about accounting software. It makes their life easier - and is way better than alternatives out there. [Observation: as I wrote this I saw the first complaint I have ever seen about the Xero system having issues.]

A stylised history of accounting software and Xero's place in it


Small business accounting software tends to be localised by country such as Quickbooks (USA), MYOB (Australia) or bits of Sage (notably in the UK).

The reason for country-specific software was that this stuff arose during the 1980s (which was a big period of tax reform globally) and the localisation was important for compliance. Moreover, that was a different world - there was no reason to expect that (say) Intuit would have the local knowledge to succeed in Australia let alone France. [Question: could you imagine programming French tax law into an accounting package written in California now? Could you imagine doing it pre-internet?]

Small business software is a much more important business outside the United States than inside. Penetration in Australia for instance is over 70 percent (these are for businesses with say 5-10 staff). In the US it is likely around 20-30 percent. The Australian penetration rate is probably around the non-US OECD average.

I am pretty sure the reason for the high-non-US penetration is tax compliance. The US (almost alone) does not have a value-added tax. VATs are beautifully simple taxes, relatively easy to comply with and that raise revenue very efficiently. But they turn almost every small business into a tax collector. Even an architect or a small consulting firm collects value added tax - and it does so on behalf of other people.

Tax authorities get moderately upset if you do not pay tax you yourself owe to them. They become vehemently angry if you withhold tax on behalf of other people and you don't pay it to them. When you become a tax collector your relationship with the tax authority changes. Being compliant and being seen to be compliant becomes a business necessity.

Small business accounting software helps that - indeed it makes it automatic. And that is why in countries with value added taxes small business accounting software is pervasive.

And because small business accounting software was - from inception - about tax compliance it was necessarily highly localised. When these programs arose in the 1980s computer space was limited (you really wouldn't want a global system for your small business) and cross-border compliance was an unrealistic programming goal.

Xero and the rise of open-architecture, cloud based small business accounting software


Into this world of localised (and dare I say in antiquated) small business accounting software comes a truly disruptive company from New Zealand called Xero.

Xero offer a cloud-based accounting package to small business. There are plenty of reasons why cloud-based is superior. But the initial top-of-the-list is the ability to run your business without a dedicated server and on any device.

But there are some big advantages with cloud based software. For instance, if our business had to pay workers compensation insurance to some insurance company we may set up a direct debit (through our accounting software) and make the payment to what is - at least to us - just a bank account number. If we accidentally type the wrong number in that could of course be a disaster. However, Xero have almost certainly had the correct number typed in twenty times before and they can - using a little artificial intelligence - warn us that the number is wrong and get us to type it in again. That is the direction this is heading.

Xero is a minor miracle - a powerful small business accounting software package with an intuitive and elegant interface. Nobody ever said doing their accounts was fun - but following the Xero hashtag on Twitter almost makes small business accounting seem cool. Pushed on that, customers note it saved them the drudgery of the shrink-wrapped solution it replaced.

Anyway -  Xero from inception had a problem. It was based in New Zealand. New Zealand is not exactly the centre of the universe. And trying to run a global software company from New Zealand was a challenge. Besides, when Xero started it was diabolically short of money for expansion.

So they made a decision which seems obvious in retrospect, but was innovative at the time. They made the system open-architecture. They allowed people to put their own apps over Xero to meet specific functions.

For example there is an app for doctors’ practices in Australia. There are lots of small business management practices that are specific to a doctors practice in Australia - for example the classification of and collection processes for government reimbursement of medical procedures. Xero wouldn't know enough about how a doctors practice works in Australia to write that software - but someone else does - and they just plug it into Xero. Slogan: "there is an app for that".

And there is an app (often given away) for ordering building materials for a small construction firm. This app builds into the billing and bidding software and also to the ordering software. It is given away because it locks in customers.

And of course there is an app for payroll too. That app will (necessarily) be country-specific because tax laws and court orders and all the other things that you need to withhold from payroll are country specific. In countries where Xero is pervasive Xero might build or acquire a payroll app and will wind up owning a good part of the system. In countries which are a long way from New Zealand it is likely that there will be a third-party payroll system.

Payroll is particularly difficult. You might have an employee in California who is resident in Oregon and has a court-ordered salary withhold in Texas. No small business can comply with that and so they send their payroll to a payroll processor (such as Automatic Data Processing or Paychex) and the payroll processor complies with that. But there is no reason why this can't be done with cloud-based software. Indeed that is what Ultimate Software does. Ultimate Software (NASDAQ: ULTI) is a rocket-ship stock and is the bear case for (say) Automatic Data Processing.

Bronte (our business) does its payroll on Xero and functionality is more than sufficient. Xero have a payroll program with limited functionality in the USA - but you can have payroll apps on Xero with much broader functionality - see this list. Note in this list ADP is a plug-in for Xero but the one with the worst reviews.

The end-game for an open-architecture accounting system is that there is an app for every function that is hard to comply with. If for example private schools have to separate their building accounts from their general accounts and other things there will be an app for that. If a doctors practice needs to invoice simply 70 different insurance companies there will be an app for that.

And owning the open-architecture backbone will be a stunningly powerful (and ultimately stunningly profitable) position. Profits will - as per most of silicon valley - follow relevance.

The real reason a small business uses software


At the end of the day the reason the small business uses software is that it makes their life easier - and most of that "easier" is broadly compliance: compliance with governments, compliance with insurance companies, compliance with customers needs etc. Having payroll software allows you to comply with tax withholding and other payroll laws. Having accounting software allows you to comply with tax laws (especially valued added taxes).

The state of play in accounting software


Accounting software packages were nice regional monopolies or oligopolies. Compliance differences meant that they did not compete much across borders. There was one or two in most markets. In some markets these were segmented so there were very simple packages for one or two person businesses, then packages which became more complex as the business became larger.

The quasi-monopolies were pretty good businesses, high incremental cash flows but not much growth. In other words they were targets for private equity.

Many got bought and levered up. In Europe many more got hoovered up by Sage (a London based roll-up of accounting and payroll packages). For instance SolvAxis - which was the leader in Switzerland - was bought into the Sage juggernaut.

The exception was the US where the leader (Intuit) was too big and too valuable to be taken private or levered up.

So around the world you have lots of indebted (and hence weakened) competitors and one super-solvent, super strong competitor in the US (Intuit). Sage is only modestly levered, but a roll-up. It is a strong competitor but nowhere near as powerful as Intuit.

Enter the cloud


Cloud accounting is so much superior to the previous shrink-wrapped alternative it is a joke. Nobody would ever go back to the (very limited) box. Moreover the cloud programs get better and better and the improvements are baked in every day. They don't fail to work (notwithstanding Xero’s minor technical problems yesterday).

The customer drag will be one-way forever. Shrink wrapped loses share and eventually shrinks away.

When I first saw Xero I thought that Intuit was ultimately doomed. Relative to Xero, and especially relative to where Xero would be, their product sucked.

I don't think that any more. Every accounting package has come out with a cloud option. Intuit's has turned on a dime. Their investor relations presentations and indeed much of the company is now is a clone of Xero.

No I am not joking. Intuit (a USD55 billion company) copied Xero (a USD4 billion company) and they did it to survive.

Intuit however did more than that. They came to Australia with a cloud-based product (Quick Books Online) and gave it away for $1 a month. This is an unambiguously loss making enterprise. When I asked them why they did it they straight out said "to learn to fight Xero on their home territory".

This is a stunning admission. Intuit is using its huge cash flow (well over a billion per annum) to give away product so they can fight a tiny company from New Zealand.

But it is the right thing to do too. Intuit has learnt how to survive, deserves to survive and will survive.

Ultimately I am not so sure about everybody else. Most of the competitors are weakened and the cloud apps simply steal customers from their non-cloud businesses. At best they can "do an Adobe" and convert much but not all of their customer base to a monthly subscription model. But I suspect that is optimistic. You see artificial intelligence (AI) is going to make a huge gift to the big players.

And that is easy to see by example. Suppose I make a $2000 payment to Dell. You are smart, you know what it is. It is a computer or a server or some other piece of capital equipment. And being a computer it is (for Australian tax purposes) depreciable over three years. I had to look that up.

So I enter it into my accounting package as depreciable over three years.

And go on.

But when 20 people have done that with an AI system the accounting software should recognise this and automatically categorise it correctly. And that just saved you looking up the depreciation schedule.

Xero's stated goal is to get to 99 percent automatic classification of receipts. I don't see any reason why this shouldn't be 99.9 percent. The pain of much of this business - and the whole profession of low-level bookkeeping - should disappear.

And those with the biggest  data should win. They should win big. And it will be near-impossible to compete with them. I am sorry MYOB and Sage. You are destined for the scrapbooks of history.

Xero and AI


I am hardly privy to the software design decisions of Xero but they clearly have their eye on this. They originally wrote Xero so that it ran in Microsoft server hosted on Rackspace. They re-wrote it so its backbone is Amazon Cloud Services. This was a non-trivial task - and I think they did it because Amazon has a much better artificial intelligence as a service offering (either direct or third party). They did it for the AI.

The trick here is to get really big fast. If you get big fast. When you do you will have more data and you will win the AI race.

At the moment Xero is the world leader in cloud based accounting software and records more than a trillion dollars in transactions per year. This is a race that Xero can win.

Xero's management issues

Rod Drury who founded Xero and was CEO until recently was a talismanic software genius whose heart and lifestyle was in Hawkes Bay New Zealand.

Now Hawkes Bay may be one of the nicest places in the world to live - but it is not the centre of anything that matters. He was both the inspirational genius and the limiting factor to growth.

The company was listed in New Zealand, hardly the world's most tech-driven market. And when they moved the listing it was to Australia and not to the NASDAQ.

This stock has always been cheap relative to the US SAAS companies. Take Ulimate for instance - a well run company with a vision far less expansive than Xero. The market cap is about double. This is typical.

Xero run the business to be cash flow break even. They are proudly (just) EBITDA positive. The mantra here is to grow as fast as possible subject to the constraint that they do not run out of cash. Which seems a sensible enough mantra - but given the prize is so big why not grow faster?

A Silicon Valley CFO (say a former tech investment banker at Goldman Sachs) would have hyped the stock, listed it on the NASDAQ, raised a bucket-load of cash with the minimum possible dilution and used the cash to grow even faster. Not doing this is the first thing that the company has done wrong.

The second thing they did wrong was target the USA before they targeted Europe. The USA alone amongst OECD countries does not have a value added tax. It has much less software penetration and the usual selling channel (sell to the accountants who then sell to their clients) was not as easily open.

Moreover going to the USA wakened the only credible long-term competitor.

Instead they should have gone to Europe first. Europe has compliance problems coming out of its ears. It is a natural market for a software product that solves them. And it has a weaker competitor in Sage.

They should have produced Xero in multiple languages. They went to the US without a Spanish language version which seems stupid if not insensitive.

And Quickbooks Online is opening in France - a completely natural market for this product.

There is no reason why Xero should cede the natural markets of Western Europe to the Americans. Hop to it I say.

Hope in the management change

Rod Drury has recently resigned as CEO of Xero.

It is not normally great news for a tech company when the talismanic founding genius leaves. But in this case he might have done the right thing.

You see Xero has appointed a genuine internationalist, Steve Vamos, formerly a senior executive at Microsoft.*

Steve will do certain things much better than Rod.

- he will run the administrative side of the firm a lot better - he is a MUCH better people manager and will hire stronger direct reports
- he will be much better at running the US subsidiary
- he will run a global organization much better
- sales and marketing will strengthen

And he will do somethings much worse

- he has not demonstrated product vision in this area
- he is not a life time accounting expert
- he will understand customer need a lot less well

If Rod can stick around as the product visionary this will work very well as a transition. Steve can cover all of Rod's (considerable) weaknesses and not lose Rod's (also considerable) strengths.

The CFO is also changing and this is unambiguously good news. The old CFO was way too parochial. The biggest weakness of Xero was its financial clout to go with the global potential of the company. The company really needs a first-tier Silicon Valley CFO. I think they are going to get it.

Are they going to get this done? I think so - but they will probably wind up being a nice second player to Intuit because they have not gone fast enough. You can own either stock but the upside is far more considerable at Xero.

I bought my stock at under half the current price. It is not that cheap anymore - trading at 16 times trailing revenue and 11 times forward revenue. If the stock quadruples its revenue you will probably win quite nicely owning it - but I am not looking for a quadruple. I am looking at a path to global significance.

I think they might yet do it. It is far from written in stone - but it is as far as growth tech stocks go - a pretty good bet.




John


*Many of the observations here come from one of my regular tech correspondents. I have not sought his permission to quote them so I just borrowed them and presented them as mine.

The $100 billion number


The biggest debate in the office came about because of my $100 billion number as an end-game market cap. In some sense that is the big-hairy-audacious-goal (BHAG) for any putative tech giant.

But in this case thinking about how you get there explains it pretty well and also explains to some degree what the company needs to do.

Xero currently has about a million customers paying on average about $400 per year each. We pay a bit more mostly because we transact some of our business in foreign currencies and as we add optional features we would expect to pay more still. We would expect revenue per customer to grow over time and think $600 is not unrealistic. At least some of the customers become bigger over time. We know one 200 person business who runs the entire thing on Xero. Their next transition would typically be to Oracle accounts - but they do not feel this is necessary.

To get to $100 billion in market cap you probably need $15 billion in revenue at some point. Even that is fairly expensive at 7x revenue - but most of the tech giants trade at about 7x revenue.

At $600 per customer that means you need 25 million customers. To get to my BHAG Xero needs 25 million customers. It needs to be 25 times bigger.

My first cut was simple. Xero has the bulk of the market in New Zealand - its home market - and about a third of the market in Australia. It has a small market share in the UK and a tiny market share in the US. Australia is about 2 percent of the world - and so Xero could - if it got to this market share globally - be 50x bigger.

It is a superior product, mission critical and sticky. This seemed plausible to me.

Then one of my staff members pointed out that there are less than 6 million incorporated businesses in the US. And sure this doesn’t count sole-traders but it does make my 25 million customer target seem hard.

This of course led to a debate. How is it possible to have a million customers mainly in Australia and New Zealand (very small countries economically) and there only be a target market of about 6 million customers in the US.

The first answer was the one alluded to above which is that Australia and New Zealand both have value added taxes which means that everyone with any private business has to file regular tax statements and the vast bulk of them use software to comply. This will apply in Europe too. Xero should have gone to Europe before going to America.

The second answer (which I would love to confirm) is about the structure of the US economy versus countries without large pools of low-income labour. In the US there is a vast pool of labour at approximately $10 an hour which is lightly skilled. Many businesses work out how to leverage an entrepreneur’s talent through using dozens of these people. The average restaurant in America is much larger than the average restaurant in Sydney - and leverages one executive chef over many staff. By contrast this low-income labour pool barely exists in Australia - and of consequence I suspect the average small business is smaller and there are many more of them. Australia, not America is a land of thriving small businesses (at least by number).

I suspect the same is true in Europe. Indeed in Europe in many jurisdictions there are penalties for businesses getting too big. France for instance has different labour laws for companies that employ more than 50 people rather than less than 50 people and many businesses deliberately stop growing under that threshold.  My guess is that the market is again relatively bigger in Europe than America. Just because there are more potential customers.

In all cases it leads me to the conclusion that Xero has focussed its energy wrongly (on trying to grow in America) rather than going to countries where it is a natural fit.

Done well though I think there are 25 million customers out there to win. Whether they can do it - that is yet to be seen.



John



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