Forum Topics Xero Ltd General Discussion
ShareCat
2 weeks ago

I'm very new to learning all about the stock market and investing. (I did some accounting modules at uni over 20 years ago, but my financial accounting knowledge is very rusty.)

I originally bought Xero in my Strawman portfolio because as a user and as someone with software development experience  I really like their product.  I use Xero myself (having also tried several other pre cloud systems years ago) as do several of my clients. 

However now that I having been learning more about the financial aspects of investing, the Debt to Equity ratio seems high at 117.7.  This seems much higher than other companies I have looked at. How much importance do you place on D/E ratios when you decide to invest in one company compared to another?

6
0
Reply

Chalky1610
2 weeks ago

Goldman Sachs currently has a buy rating and $153.00 price target on its shares, they don't seem to be to concerned about the Debt to equity ratio.   However and generally speaking, higher debt-to-equity ratio indicates that a company has higher debt, while a lower debt-to-equity ratio signals fewer debts. Generally, a good debt-to-equity ratio is less than 1.0, while a risky debt-to-equity ratio is greater than 2.0.

But don't just look at debt to equity ratio alone, all metrics and all available information needs to be collectively reviewed as a package. Personally I also would have no significant issues or concerns about their debt to equity level based on an assessment of combined and collective information readily available to an investor

8
0

Bear77
2 weeks ago

Acceptable debt levels really depend on the type and size of the business and the industry that it is in.  A company like Transurban or Sydney Airport can (and both do) carry lots of debt and it doesn't worry most investors because the debt is locked in at low rates over long periods and is underpinned by income-producing infrastructure assets that will keep producing reliable income for decades.  On the other hand, a capital-light and asset-light business like a software services provider (like Xero) should not generally have high debt levels, and any debt to equity ratio or gearing ratio over 60% would generally be regarded as high for such companies, and if they had a ratio of 117.7% as you suggest @ShareCat, then I'd be very worried actually.

Commsec list XRO's gearing as being 92.1% at 31-March-2020, after having net cash in every other year.  XRO's FY finishes on March 31 each year, not the usual June 30.  They are due to report shortly (in May) for the FY ended 31-March-2021. However, I've had a look and the Commsec number is wrong.  Slide/Page 17 of XRO's FY2020 Annual Results Investor Presentation shows that they actually not only had net cash (NO net debt) but they also managed to increase their net cash from NZ$100.6 million to NZ$111.5 million in FY2020.  

It also pays to remember that for years Xero just kept plowing all of their profits back into growing the business and grabbing more market share.  They were cashflow positive in FY2019, but FY2020 was the first year that they actually reported a net profit, despite being a A$9.6 billion company (at 31-Mar-2020; they're now a A$21 billion company).  It's the Amazon model.  Amazon also lost money for several years after becoming a public company in May 1997.

Anyway, Slide 20 of their H1 FY2021 Results Investor Presentation (for the half ended September 30th, 2020), released on 12-Nov-2020 showed that by 30-Sep-2020 they had increased their net cash balance to NZ$177.6 million.  Still no net debt. 

Since then they have announced two acquisitions, being a small one (Tickstar) and a large one (Planday), and they have also announced on 03-Dec-2020 the settlement of their US$700 million zero coupon convertible notes due 2025 and the concurrent repurchase of US$297m of the Guaranteed Convertible Notes due 2023 ("Existing Notes") for a total consideration of US$666.4m. As part of the buyback consideration in respect of the Existing Notes, Xero has issued 3,750,005 ordinary shares amounting to US$374.2m based on the Reference Share Price of A$135.86/share.  

They also said that pursuant to the terms and conditions of the Existing Notes, Xero (through its wholly owned subsidiary, Xero Investments Limited) intends to commence redemption of the remaining Existing Notes which were not repurchased already (representing an aggregate principal face value of US$3m).

Basically now that they are highly profitable - finally - and have cash rolling in, they are quickly paying off all of their long term debt, even though they do not need to yet.  Yes, they DID have debt - NZ$394.9m of it at 30-Sep-2020, but they also had NZ$572.5m of cash and short-term cash deposits, so they had NZ$177.6m of net cash (no net debt).  

When a company is in a net cash position (as XRO is), their ND/E ratio or Gearing Ratio is actually negative, so a negative Net Debt to Equity ratio means they have net cash and no net debt.

Even though by my quick back of the envelope calculations the cash components of the up-front payments and potential earn-out payments for the Planday and Tickstar acquisitions adds up to around NZ$180m, both were completed - and settled - on April 1st, the first day of XRO's FY2022 financial year, and so will not affect XRO's FY2021 numbers, which should once again show that they are still in a net cash position.  The earn-out payments aren't payable anyway until certain product development, performance and revenue milestones are met.  I do not think XRO would be paying off their 2025 term debt in advance - as they have - if it was going to leave them in a net debt position now.  I am confident that they will still be in a very healthy financial position.

And the data provider that Commsec and NABtrade use has just got it wrong.  Xero have no net debt.

27
0

ShareCat
2 weeks ago

Thank you Bear for your very detailed reply.  It looks like the ANZ (via CMC Markets) figures that I looked at are also incorrect.

I thought that from a business point of view, having debt levels that high did not seem to make sense.  If a business did have that level of debt I'd be very worried about their sustainability as a organisation.

The learning I will take from this is to dive deeper into the actual financial reports before investing in any stocks (I do not have Shares in Xero, just Strawman shares), rather than relying on the published ratios as fact.   

Kind Regards,

ShareCat

7
0

Bear77
2 weeks ago

You are right @ShareCat to be concerned if a cloud-based SaaS business like Xero had a net debt to equity ratio (gearing) of over 100%.  Luckily, as we have established, Xero does not.  They have net cash.  That's a good place to be for a company that does not have much in the way of tangible assets (an asset-light business).

However, as I said at the top of my previous post above (in this thread), some companies CAN sustain those sort of debt levels.  Transurban (TCL) had gearing of 212.8% at 30-Jun-2020 and Sydney Airport (SYD) had gearing of 782.9% at 31-Dec-2020.  APA Group (APA), who own and operate a network of gas pipelines and other associated assets, had gearing of 304.5% at 30-Jun-2020.  These companies all own a huge amount of infrastucture (toll roads, an airport, gas transmission pipelines, etc.) that all produce a lot of income and will continue to do so for many years to come, and those income-producing assets underpin the long-term debt, and the debt is locked in over long periods at low rates of interest.  The debt was used to purchase the assets which provides the income to pay off the debt over time.  It's similar to an investment property that has tennants in it paying rent which pays off the mortgage on the property.  If John Smith owned 10 or 20 investment properties instead of 1, it doesn't mean that he is at a much higher risk of going broke due to the massive amount of money he owes on all of those properties, because the tennants are providing the income to John to enable him to meet all of those debt repayments, with some change.  The market is happy to overlook high debt levels with such companies, for those reasons. 

Those figures come from Commsec, and we have already established that Commsec's data provider is not entirely infallible - seeing as they got XRO's gearing number for FY2020 so wrong.  However, these numbers for SYD, TCL & APA all seem to be in the ballpark, as the following website shows - for SYD:  https://au.investing.com/equities/sydney-airport-holdings-ratios

If you click on that link and then scroll down, you'll see the Total Debt to Equity Ratio given first for SYD (768.55%) and then for their industry (388.85%).  From that, we can see that the average total debt to equity for companies in the Transport sector is 388.85% according to investing.com.  And by using this webpage we can see APA has a Total Debt to Equity Ratio of 307.17% according to investing.com and the average Total Debt to Equity Ratio of companies in their sector, the Natural Gas Utilities Sector, is 220.25%.

Other sites I've checked have similar numbers.  Even Telstra (TLS) has high debt levels, with Net Gearing of 123% according to Commsec and a Total Debt to Equity Ratio of 127.32% according to investing.com.

If the company is big enough and has enough income-producing assets, the market is actually quite comfortable generally with high debt levels.  In fact, such companies are often said to have a "lazy balance sheet" if they have NOT geared up and bought assets with borrowed money.  The argument is that if they CAN borrow the money, and if they can use it to buy assets that will generate reliable and consistent profits well in excess of the interest payable on the debt, then it makes sense to do it.  Again, the same argument is often used to justify individuals buying additional investment properties.  The asset produces income that covers the debt repayments, including the interest, and you end up with assets that pay for themselves over time.

So, it's horses for courses.  Xero is not such a company.  They do NOT own billions of dollars of tangible assets, like SYD, TCL, APA and TLS do, and the market would understandably be far less tolerant of high debt levels with a cloud-based software services provider like Xero.  

So all that is to say that it is best not to just set a number (X%) and say that any company with an ND/E ratio greater than X% is a bad risk and should be avoided, because it really does depend on the company and the sector in which they operate, and most importantly what they have used that debt to purchase, and whether those assets are going to produce reliable and dependable income for them for decades, or not.

14
0