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Morningstar | Xero Continues to Grow Quickly but in Line With Expectations, Remains Overvalued. See Updated Analyst Note from 08 Nov 2018

We have maintained our fair value estimate for narrow-moat rated Xero at AUD 25.50 following its first-half financial results that broadly met our expectations. We weren’t surprised that the company remains loss making, nor are we concerned that the reported loss per share increased by 50%. At this stage, Xero’s primary focus remains on reinvesting profits to maintain high subscriber growth rates, and profitability is a secondary concern. The first-half subscriber growth rate fell to 31.7% from 39.1% a year ago but was broadly in line with our full-year forecast of 31.2%, which we’ve maintained. We’ve also maintained our full-year revenue growth rate forecast at 36.0% following the 36.8% first-half result. At the current market price of AUD 43.30, we continue to believe Xero shares are significantly overvalued.

Despite continuing to report losses, Xero remains in reasonable shape from a balance sheet perspective as the company has been operating cash flow positive for over a year and is largely self-funding. The recent convertible bond issue also provides the company with a reasonably low-cost source of capital that can be used to either fund the existing business or for acquisitions. Importantly, Xero continues to scale, and profit margins expand, as expected. Short of providing its own guidance, management also said it remains comfortable with analyst consensus forecasts at the time of the bond issue in September, which were for fiscal 2019 revenue of between NZD 528 million to NZD 558 million, versus our NZD 555 million forecast, and EBITDA of NZD 66 million to NZD 94 million, versus our NZD 69 million forecast. Aside from the strong performance of its business, we continue to believe Xero remains susceptible to a takeover bid from Intuit that would create a globally dominant cloud accounting software business, should such an acquisition be allowed by competition regulators.

Although the result broadly met our expectations, we were initially a little concerned about a number of aspects. First, subscriber growth was boosted a little by the acquisition of Hubdoc, and Xero also changed the way it counts subscribers. However, the new approach to subscriber recognition is more conservative and the magnitude of Hubdoc not sufficiently material to warrant changing our forecasts. We were also initially somewhat concerned about the positive impact on EBITDA from the introduction of three new accounting policies. However, Xero has acted appropriately in this regard, benefits are reasonably small, and profits rather irrelevant at this stage anyway.

New Zealand and Australia continue to be Xero’s most mature markets but still generated subscriber growth rates of 20% and 27%, respectively, in the first half and collectively compose 62% of all subscribers. As these markets mature, Xero is increasingly dependent upon other markets to sustain high group subscriber growth rates as average revenue per user, or ARPU, growth has historically been low single digit at best. As subscriber growth eventually fades, we expect Xero to increasingly target add-on modules such as Payroll, Expenses, and Projects to boost revenue growth rates. The Australian Taxation Office’s Single Touch Payroll project should be a growth tailwind in this regard.

Xero’s United Kingdom and North American businesses continue to grow quickly, with growth rates of 42% and 62%, respectively, in the first half, although the North American growth rate was 45% on an organic basis excluding the recent Hubdoc acquisition. Combined, these markets compose 34% of total subscribers, but Xero is increasingly dependent upon them to sustain group growth rates. The North American subscriber growth is encouraging, particularly considering previous challenges in the region, but Xero’s decision to increasingly use accountant partners to distribute its software is impacting revenue growth. On a constant currency basis North American revenue growth was 34% or 26% without Hubdoc, which is rather uninspiring at this stage of the regional growth trajectory. However, in the United Kingdom, constant currency revenue growth of 46% outpaced subscriber growth thanks to upselling of add-ons and came without a price increase. The U.K.’s HMRC’s Making Tax Digital initiative and the relatively low penetration of cloud accounting software also means the growth outlook remains strong.

We expect the key difference between our fair value estimate and the share price relates to a different view on the long-term profitability of the business. Although Xero continues to grow subscribers quickly, we don’t yet see evidence of a network effect emerging, meaning the company remains dependent upon switching costs as a competitive advantage to defend profit margins. Although cloud-based accounting software is arguably increasing the addressable market, it also arguably reduces switching costs, and competition for customers appears to be intensifying. The decision by Intuit to create a simplified offering for the self-employed market enlarges its addressable market and may well be followed by Xero. However, this segment has a higher churn and lower customer lifetime value and is likely to be more difficult to monetise. The likely acquisition of MYOB by KKR could also see MYOB venture overseas, particularly to the United Kingdom, which could increase competition in one of Xero’s key markets.