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Is Xero (ASX:XRO) the best ASX tech share?

Could cloud accounting software business Xero (ASX: XRO) be the best ASX tech share to own?

What is Xero?

Xero has become the dominating player in the business and accounting software market in Australia, New Zealand and the UK, since being founded in New Zealand in 2006. Employing more than 2,300 people, today Xero helps more than 1.8 million subscribers manage their accounting and tax obligations.

Why it could be the best ASX tech share

There are several reasons why it could be called the best ASX tech share:

Software as a service (SaaS)

The SaaS model is great if a business genuinely fits that description. SaaS business generate pleasing monthly or annual recurring revenue. All businesses need to file tax returns and prepare financial statements. You really need software to do that efficiently. I think Xero is the best player in this field. Subscribers pay Xero a monthly fee for their accounting and payroll needs.

The fact that Xero provides software which it designed itself means Xero has high gross profit margins. Software can be distributed to another subscriber for almost no cost. Imagine how much it costs to make and ship a new car or table. Even something like a phone takes a lot of cost to get into the customer’s hands.

In the FY20 result the gross margin percentage increased by another 1.6% to 85.2%, up from 83.6% in FY19.

International growth

I think the best ASX shares are the ones that are also exposed to international growth.

In FY20 total subscribers rose by 26% to 2.285 million. Australian subscribers increased by 26% to 914,000. UK subscribers rose by 32% to 613,000. New Zealand subscribers increased by 12% to 392,000. North American subscribers increased by 24% to 241,000. Rest of the world subscribers increased by 51% to 125,000.

Ecosystem

Xero has built a really good ecosystem. Not only does it offer a great core product for subscribers, but there are a large number of applications that can be linked into Xero’s software.

It’s this type of network effect that makes the offering of Android and Apple phones so strong, and a big reason that caused phones made by Blackberry and Microsoft to eventually fail.

The better the offering that Xero can give subscribers, the less likely they are to leave.

Cashflow positive

A key step for any ASX tech share is becoming cashflow positive. Once a business is making cash then it is much more sustainable. Xero could have been cashflow positive earlier if it wanted, but it was investing heavily for growth.

In FY20 Xero’s net profit went from a loss of $27.1 million last year to a profit of $3.3 million this year. Free cash flow climbed 320% to $27.1 million.

Time to buy shares?

The Xero share price has risen by 56% since the March 2020 low during the COVID-19 selloff. It has had a strong run. I’m not sure if it represents good value now considering that Xero warned of impacts in FY21.

Many big businesses may be performing well but small businesses don’t have the same access to capital or the same balance sheet strength. Xero may see some subscribers not able to pay or perhaps subscriber growth will slow. It’s a great ASX share, but it looks expensive to me. I’d rather buy something a bit smaller like Bubs (ASX: BUB).

Disclosure: At the time of writing, Jaz doesn’t own shares in any of the businesses mentioned. 

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