Xero versus Ecoya – round 1!

Happy new year everyone!

To kick off the new year, I thought I would look at the 2 ‘glamour startup’ companies in the NZX, Ecoya and Xero. Xero as we know are a online financial software provider, while Ecoya sell ‘eco’ candles, body type stuff (obviously I’m a guy, but think smelly stuff for house).

Both companies are relatively new, with Xero (~2006) having a few years on its younger brother (2008). Ecoya obviously target a mass-consumer market (mainly cosmopolitan reading girls and the guys wanting to impress them), while Xero targets small/medium business (and accountants wanting to impress them!)

Neither has made any profit, with the March 2010 Annual reports showing revenue of 3.4 million for Xero, and 3.9 million for Ecoya. The Xero net loss for that period was $8.45 million, and Ecoyas was $2.35 million. So both companies are currently burning investors cash like a new years bonfire. In their latest (30 Sept ’10) interim reports, both indicate accelerating revenues (3.8million for Xero, 4.4million for Ecoya – note this is in 6 months), and increasing losses as expenses also ramp up, in Ecoyas case increased sales and marketing (no surprise) and admin (not sure why?) expenses. Xero are a bit less informative in their interim reports (which is funny for a financial software company! I find it funny. But my sense of humour is too ‘advanced’ for a lot of people).

So all up, both are looking… fairly startup-ish. Increasing revenues, increasing expenses etc.

Xero has dug a deeper hole in terms of current losses, but has a well-capitalised balance sheet. Ecoya has a bigger market (girls, and guys wanting to impress them!) but only 1.3million cash in the bank. Ecoya will definitely need some cash in the future, whereas Xero has enough to survive to their theoretical breakeven in 2011.

So thats the comparison in a nutshell. Xero, lots of cash on hand, high development expenses. Ecoya, pure consumer/brand play, huge market, not much cash.

On the face of it, the companies are pretty even. Xero is the more ‘glamourous’ stock at the moment, whereas Ecoya is flying very quiet. So its cash and celebrity that is the big difference between the companies.

So how much is Xero’s cash and celebrity valued at? In a startup, cash is worth much more than the face value. Cash in startup land = ability to survive another few months = not having to go back to market or raise debt = much less risk. If we do a quick market cap comparison, Xeros cash and celebrity are valued at approximately… $235 million! (thats the difference in market caps between Xero (270million) and Ecoya (33million).

Which… is quite a lot. Justified? Hmm. Ecoya will have to raise debt or go back to the market for more cash (unless Trilogy is an undisclosed cash machine). So there is a lot more ‘current’ risk associated with Ecoya. However, I would suggest that their model is easier, in that the high-end consumer products market is well proven, and the Ecoya board have a lot of experience (via 42below and the other board members) getting into that market.

So, although a much riskier current play, it looks like on pure revenue and model terms, Ecoya might be a reasonable bet. Oh yeah, if they can survive another year. Xero? At 10x Ecoyas valuation, the market sure does love Xero.

I love Xero too, but not so much at this valuation. I will be keeping a close eye on Ecoya, particularly with regards to cash flow over the next 6 months.

2011 is going to be an exciting/interesting year for both companies!

Xero – a great business?

The Xero share price has been rocketing up recently, making people a fair whack of paper money. Which is great, and why we invest in stocks right?

Right?

Well. Actually, not really. I know, the end goal is to make money. But I would submit that the “why” we invest is to actually own great companies at good valuations. Which end up making us lots of money, because they are great companies.

Why this definition? Well, many people in the stock market define winners as stocks where the price has gone up and up. As Xero has in recent months. Just like a rocketship after take off. So if you had bought at $0.75, and sold now at $2.68, you would have made a nice chunk of cash. But this is not how I invest (for better or worse!).

So Xero is a rocketship after take-off. My interest is whether Xero has enough gas to get out of orbit, and thats what is not clear to me now. I just can’t tell whether Xero is going to be a best-of-breed business, or a very successful company, or one of the also-rans in a highly competitive marketplace, or go bankrupt, or whether a big player will buy them out.

All of these scenarios are still on the table. My valuation of Xero portrays Xero as a ‘very successful’ company, with almost 2 million subscribers by 2018, and a ‘now’ shareprice around $3.75. Now, valuations can be wildly inaccurate, but they are a good ‘line-in-the-sand’ if you’re looking to work out whether a company will hit orbit. With the shareprice currently at $2.68… theres just not enough ‘up’ for me for all the risks still on the table.

So I’m watching Xero with interest. I suspect a buy-out might be the best outcome for Xero (and shareholders), but only time will tell.

Restaurant Brands, part 2…

Back to the beautiful world of deep fried chicken, with a serving of pizza, and a creamy coffee chocolate creme extravaganza!

So the first part of the story was just a simple look at how to identify a potentially undervalued company, in order to make yourself buckets of money which you can then use to buy buckets of deep fried chicken!

This second part goes more in-depth, and produces a snapshot image of the company, with a basic valuation. Heres the document, similar to the previous Michael Hill one, based on the Valueline reports produced by… well, Valueline, for US companies.

valueline-restaurantbrands

The big takeaways are that 1) the P/E is about ‘right’ for Restaurant Brands. 2) they have been increasing dividends fairly consistently after the Aussie Pizza Hut Debacle. and 3) margins are trending upwards, which is a sign that costs at Pizza Hut and Starbucks are under control.

An interesting aside is the treatment of leases. RBD obviously have some pretty big lease commitments, which are normally treated as an operating expense… But Damodaran argues that these should be treated as debt, because operating leases are much more like debt (in that if you don’t pay, really bad things happen to your company) than operating expenses. So I’ve broken these out and indicated that they are a form of debt.

So, my basic analysis indicates that Restaurant Brands is worth more. For people reasonably new to valuation, this is a pretty good example of a basic valuation. The “free cash flow” figure ($20,818,000) shows the money that the company gets every year. Assuming they keep making this forever, and pay off debt, how much is all those $20,000,000′s added up equal?

Obviously, a deep fried chicken coated in 11 different herbs and spices in the hand is worth 2 still clucking, so next years 20,000,000 is not worth as much as this years, and so on. The mechanics require a discount rate, which is makes next years (and the year after etc etc) 20,000,000 worth less. The discount rate chosen was 7.7% (PwC WACC), which includes 2% of growth (ie, rate of inflation, we assume that RBD can increase prices along with inflation). I suspect that the actual WACC should be a bit lower, which would increase the shareprice.

So finally, when all the mathmagic has been done, we get a share price of … $3.58! Current share price is $2.60, so RBD is sort of cheap according to me. The dividend is still around 4.8% which is pretty good for a stock with some potential upside. Rabobank are paying 5.3% for a 1yr term deposit, so at most you’re really risking 0.5%, and the KFC brand should see more boosting as the rest of the store upgrades start paying.

Let me know any comments, suggestions, corrections, blatant errors etc.

Disclosure: I sold out of RBD at $2.35, before I had done this valuation

xero half year earnings

Xero released half year earnings today, so I thought I should do an update. The numbers from the report:

- Near tripling of half year operating revenues from $1.3m to $3.7m.

- Net loss of $4.7m – an increase of 24%, is expected to be the maximum

loss incurred as the company drives toward break-even.

So that looks pretty good. It looks like they’re on track, although the increased loss, as expected, will make it interesting to hit breakeven, ie, EBIT = $0 by end of year 2011.

The previous model posted here looks good so far. The subscriber numbers are a bit lower than that forecast, but that suggests the revenue per subscriber is a bit below the $29 mark. Also, revenue numbers might be a little low, and expenses a little higher. But… not too bad for 6 months in the life of a rocketship!

Xero, spreading like a kiwifruit vine bacteria, taking over the world! (apologies to all kiwifruit farmers!).  So… what to do? Does this change anything? For me, no. These results are good, but not spectacular, more or less what was expected/hoped. The Xero rocketship has cleared the launch-pad, hasn’t blown up spreading chunks across the landscape, and is pointing the right direction. These are all good things for a rocketship! There is a long way to go however to justify its current price (remember that Xero has made NO profit for owners, and has banked about $15 million in losses). Obviously the shares are up 5% in trading now, since the NZ market is pretty boring, and people need something to do.

PS. Don’t compare these results to last years results. Doing that for a startup is like comparing the altitude of a rocket before and after liftoff.

So, what to do? I would still suggest a part position, and waiting for the very big data points, namely annual results 2011, and annual results 2012. 2012 will be… huge.

Sure, it sounds like I’m being a wimp. And if Xero hits the afterburners, people who are in now will say “I knew it was going to work”, and “Greg, you’re a big, girly, wimpity-wuss”. But its my money, and I’m happy to miss out on the early upside and lock in (still significant) gains later in the piece when the clouds have cleared, and we know if Xero is going to the moon, or will be orbiting as a low flying satellite, posing a significant risk to adventurous birds.

how much is $25,000,000 worth?

Since no-one complained about me posting so much stock stuff, heres another! But first, a question:

How much would you pay for something that made you $25,000,000 each year?

Its not a trick question, but it is a pretty straightforward way of getting a quick feel for how much a company is worth (a trick I learned from Buffettology). The company in question here is… Restaurant Brands! Purveyors of fine dining experience, like KFC and Pizza Hut. And Starbucks for that frothed, ‘I can’t believe they call that coffee’ fizzy coffee flavoured beverages.

So Restaurant Brands are going through a super share-price ride at the moment. The best performing share on the NZ exchange. From about 60c in Feb 2009 to $2.85 today. Thats… well, thats a lot. If you bought $1000 worth of shares then, you would have approx $4500 now. Plus some pretty nice dividends on the way. A bank account paying 4% would have got you… a bit under $1070. Yay.

So, $2.85. Is that the top for Restaurant Brands?

Back to my original question: How much would you pay for $25,000,000?

RBD are expecting to make $25,000,000 in net profit. Assuming that you could put some money in the bank, and get $25,000,000 in interest, how much would you be prepared to put in?

Kiwibank just came out with this 5.00% sort of but not really on-call account. So 5% of whatever you put in is paid to you each year. To make $25,000,000 you would need to put in $500,000,000.

The point is: If you had the cash, and were happy with a 5% return, you would be prepared to buy RBD for $500 million… But right now, RBD can be bought, lock, chickens and deep-frying vat, for about $277 million. Which suggests that RBD is not as expensive as it might look at first glance.

Obviously this is a major simplification, with lots of assumptions. But all I’m saying, is… maybe theres a few more chickens to be hatched (and then killed, plucked, chopped-up, seasoned and deep fried) in the ol’ Colonels pantry yet.

Disclaimer: I do have some RBD stock in the portfolio. Yay fried chicken!

Michael Hill. Jeweller.

Greg Day. Part-time stock analyst.

Hmm, doesn’t really work. No panache. I don’t even really know what panache is, but I’m pretty sure my supply is low. Disclaimer up front, I own some Michael Hill shares, which I bought because they had been hammered during the financial crisis, so looked pretty cheap. And I liked what I read in Michael Hills book, Toughen Up. And the Michael Hill financial reports are amongst the best I’ve seen, very focussed on shareholders.

So, heres the  analysis I have just done. Its pretty basic, summarises everything (based on what you get from ValueLine.com), and performs a simple (so simple I probably got it all wrong) discounted cash flow valuation.

Summary, Michael Hill is pretty cheap right now. According to me.

Let me know what you think, or if you’re sick of reading about stocks!

who wants to be an entrepreneur?

Being an entrepreneur is about accepting risk. Risk to succeed or fail, risk to make or lose money. That sort of thing. Its part of the territory. But theres other risks, that arent so obvious. Like risks to your sanity. My ongoing entrepreneurial activities regularly take me from quite high ‘highs’ to the opposite in a matter of minutes.

Like last week, had a good week visiting people and talking about Pronto, one of our new TXT messaging ventures. Really good response (its super cool), so was feeling pretty happy. A good couple of days, since enthusiasm begets enthusiasm!

And then, a brief interlude with our SMS gateway partner (they’re the people who give us access to the SMS txt network), where they basically told me that several intermittent problems were all because of my code. A few days later, they sort of admitted that their code is a bit dodgy. Does things like swallowing errors on  a regular basis. And then they told me that in order to help me out, they were resetting a whole lot of previous read (and processed) TXT messages and marking them as ‘unread’, so the system could process them again.

WTF?!?!?!?! Feeling my heart drop to the floor and then bounce up through my throat was an interesting, if somewhat unpleasant, and not recommended, experience. That would mean that every client of Pronto would be spammed, and worse, all their clients would also be spammed. But they wouldn’t know it was spam, so they would reply, generating even more spam, and everyone would get all confuses, and then pissed.  And then all the clients would have to apologise to all of their clients, and I would have to apologise to everyone. Thats a lot of apologising, and credibility falling like a rock with afterburners.

So from high to low, with not a lot of breathing time in between. When you’re doing your own thing in a business, often you’ll find theres a big fan, a big pile of shit and you, in that order. And sometimes the fan just turns on by itself.

Phew. Breath in, breath out. Relax. And don’t breath in when fan is on.

Xero, so… what?

I’ve had a few comments about my Xero valuation, a lot of which could be summed up by the words… “so what?”. In particular, people are asking if $3.55 means they should sell the family home, and load up on Xero stock (currently at $1.47). So understandably enough, theres a little bit of confusion around the value of Xero.

So what does $3.55 mean? It means that if everything I predicted comes to pass, then yes, you should load up on Xero. But hold on there Flash, you have to have some idea of the likelihood of predicting all that correctly. Which is 0%. Some bits are going to be wrong.

so we’re down to probabilities. Xero is worth ($3.55 x probability of sunny scenario + $X x prob of scenario X + $Y x prob of scenario Y + …) where all the probs sum to 1.

Lets look at a simple case, the sunny side versus the complete failure of the company.

($3.55 . 60% + $0.47 . 40% )

So, 60% chance of being valued at $3.55 versus a 40% chance of going broke, and selling assets at the net tangible asset value ($0.47).

equals…. $2.31!

Another scenario…

($3.55 * 33% + $1.77 * 33% + 0.47*33%)

33% chance of sunny side or a 33% chance of being worth half that (because of lower customers/revenue growth) or a 33% chance of going broke.

equals… $1.91.

In summary, depending on what you think the probabilities are will change your view of the current price. If you’re way bullish on Xero taking over the world, the current price is cheap. My take is that there is a lot of uncertainty around Xero, which will be reduced as each earnings release comes out. So for me, I would only have a small, speculative stake, waiting to add or reduce as those earnings releases come out.

Don’t sell your house in other words

Oops! Don’t do valuations with a cold…

Oops! A bucketful of apologies…

After getting over my cold, and having a break from all the numbers, I revisited the spreadsheet on Xero just to check it. Something didn’t add up. Once I looked, it was pretty easy to spot what I had messed up. The ol’ terminal value calculation, a beginners mistake. I blame the snot jamming up my keyboard.

The terminal value calculation basically adds the bulk of the value to the company, because it factors in all the cash flows after the company hits profitability. Its a big number, but I originally had it calculated as EBIT(1-t)(1-reinvestment)…

Doh! Which is actually just the free cash flow figure for the last year… oops. Sorry about that. Note to self: don’t do valuations with a cold.

So there were 2 steps missing. 1. Work out the terminal value from that cash flow figure, and 2. Discount that terminal value back to present value, and add it into the cash flows to get the firm value.

Which means, long story short, that there is a big number missing from the valuation.

Since I’m in revision mode, lets ‘improve’ some of the other figures. Firstly, lets cut down the Operating Margin to more realistic 15%, putting it in line with the best of the current SaaS firms. And lets boost the Sales/Capital ratio, maxing it out to around 4, hopefully reflecting that SaaS firms have lower capital requirements.

The end result of these changes is an addition of another $200,000,000 to the value of the firm, which gives a per-share value of $3.55. Sorry!

This is a very sunny-side valuation,so everything going pretty much perfectly for Xero. But whats in a couple of hundred million? The things to really focus on with Xero are: Growth rate in revenues (ie, customers and revenue-per-customer) and operating margins. If customer numbers don’t grow as predicted, for example if customers are only half of predicted, then the today stock price comes down to the $1.20 level. If operating margins drop (ie, expenses involved in moving to new markets are higher than estimated), value similarly drops accordingly. And alternately, if they go up, the stock price should increase. Roll on next earnings report!

In summary, note to self: be careful when doing these things! This is my first public valuation, so it was bound to go wrong. Learning from mistakes is always a plan… Apologies again! I will be tracking Xero on my spreadsheet as new news comes out, which I’m pretty excited about! heres the link to the spreadsheet.

Xero valuation – the final(ish) chapter

Lets just recap where we’re at. We’ve got a spreadsheet (see the last blog post) which projects revenue, customer numbers and EBIT. Sweet. So what more is there?

Well, the point of these posts is to do a discounted cash flow(DCF) valuation on Xero. And a DCF valuation needs cash flows, and EBIT is not cash flows. Net profit isn’t cash flow either, so theres a bit more digging to be done.

So what is cash flow? And why is it different to net profit? And who really cares, just tell me what I should pay for a Xero share!

Net profit is revenue – expenses – tax – depn – interest. So that all makes sense right? Money coming in, costs of doing business (including depreciation) and interest on any loans. And of course, the inevitable tax consequences.

Its an interesting number. Kind of. In a “mm, thats very interesting, whats on TV?” kind of way.

But as owners of a company, we’re much more interested in cash. Cold, hard, cash. Or, not cold, flappy paper cash. Any kind of cash. More = better. This cash is what we get in the bank at the end of the year, which lets us buy cool stuff. Like iPads. And food. Net profit is a more… airy definition, and you definitely can’t eat it.

So we turn to Cash Flow. Cash flow is intended to take the net profit, and work out how many iPads you can actually buy at the end of the year. The most interesting cash flow number is free-cash-flow-to-the-firm (FCFF). What this says is, sure, you’ve got some operating cash flows, but I want to know how many damn iPads I can actually buy at the end of the year! Dammit! FCFF in particular deals with capital expenditures.

And Xero has nearly 2 million per year of capital expenditure, mainly capitalised development costs. So it is pretty significant to them.

The idea with capital expenditure is it is what you are reinvesting in the firm in order to grow it in the future. So next years revenues depend on previous years capital expenditure. So how much will Xero have to reinvest in order to grow like the previous posts predictions?

Actually, thats a big question, so should be in bold:  how much will Xero have to reinvest in order to grow like the previous posts predictions? its big, because it is hard to tell. Theres not much data, so its very unclear.

So, another guess, the sales to capital ratio. How much do sales improve by reinvesting a dollar in capital expenditure? My guess looks like:

Xero	Terminal year (2018)	2017	2016	2015	2014	2013	2012	2011	2010	2009	2008
Revenue from operations	$684,768	$570,640	$475,533	$317,022	$158,511	$66,046	$25,402	$8,467	$2,851	$959	$134
EBIT	$171,191.92	$142,659.93	$118,883.28	$57,063.97	$23,776.66	$7,925.55	$1,016.10	$0	-8450	-6751	-4310
Change in revenue	$95,107	$158,511	$158,511	$92,465	$40,644	$16,935	$5,616	$1,892	$825
sales to capital ratio	1.60	1.80	2.00	2.50	2.00	1.75	1.50	1.08	0.59
Reinvestment (capitalised development costs)	$59,442	$88,062	$79,256	$36,986	$20,322	$9,677	$3,744	$1,749	$1,397
Reinvestment (as percentage of revenue – interest only)	10.42%	18.52%	25.00%	23.33%	30.77%	38.10%	44.22%	61.35%	145.67%

The important line is the Sales To Capital Ratio line. This reflects my thoughts that SaaS systems take a chunk of capital expenditure, particularly when moving into new markets (eg: US), and that this will continue for the next 8 years. Putting these values up, ie, for every dollar of capital reinvestment, you get X dollars back in revenue in the next year, will obviously make Xeros valuation higher.

I’ve also estimated a stable reinvestment rate as a percentage of revenue of 10%, which is more or less in line with other internet companies. If anything, I think this number will be higher.

Theres a couple of other numbers that are needed before the final valuation. Beta, or the measure of the firms risk. I have started at 2.5 to reflect the significant risk with Xero initially, and decreased to 1.4 in 2017. It sounds about right. Risk free rate of 5.5% and a equity risk premium of 5%. Sounds pretty reasonable to me, but more guesses!

Ok. Phew. Damn this is a lot of work. Cutting a long story short, finally, how much is a Xero share worth, right now?!?
$1.12

And, according to me, thats a reasonably sunny outlook. Not blow you away stunning, but reasonably optimistic. I’ll put the spreadsheet up on google apps now, so you can have a play.