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Morningstar | Xero FVE Increased to AUD 28 Following Solid Full-Year Result. See Updated Analyst Note from 16 May 2019

Narrow-moat-rated Xero’s fiscal 2019 result represented its 11th consecutive year of losses but the company continues to create value via strong subscriber growth and, importantly, unit costs continue to fall. Subscriber and revenue growth remain a top priority for two reasons. First, scale creates market dominance which should strengthen the brand and may eventually help create a network effect. Second, increasing scale will lower unit costs and potentially create a cost advantage by fractionalising marketing, product development, and head office costs.

The fiscal 2019 result was broadly in line with our expectations, with both the 31% increase in subscribers to 1.8 million and 36% increase in revenue to NZD 555 million revenue, in line with our forecasts. The NZD 27 million aftertax loss exceeded our NZD 16 million forecast, although a change in accounting standards, the degree of capitalisation of research and development costs, and currency movements all helped muddy the bottom line.

Although the result was largely in line with expectations, and management guidance lacked anything new of significance, we’ve increased our earnings forecasts slightly which has driven a 10% fair value increase to AUD 28 due to the high sensitivity of the model to forecast changes. However, we still struggle to justify the market price of AUD 60.15 per share which implies an enterprise value to revenue multiple of around 11 times. Although we expect fiscal 2020 to be the first profitable year for the company, significant profit growth is still required to justify the AUD 8 billion market capitalisation.

From a competitive standpoint, Xero continues to leverage its early mover advantage in cloud accounting software to grow market share. However, the reasonably commoditised nature of the industry means Xero’s pricing power still doesn’t appear to be particularly strong, despite the relative price inelasticity of the product. We therefore expect the company to become increasingly dependent on upselling software, rather than price rises, to drive average revenue per user, or ARPU, growth in future.

Xero’s ability to maintain high subscriber growth rates and lower its unit costs are helping drive gross profit margin and EBITDA margin expansion, respectively. Although the company reported a loss after tax of NZD 27 million, the underlying loss narrowed to just NZD 2 million from NZD 28 million in the prior year. Importantly, the underlying full-year loss implied a small maiden profit after tax in the second half of the fiscal year. We expect margin expansion to continue but also to be restricted to some degree by the prioritisation of revenue growth.

In the relatively mature Australia and New Zealand, or ANZ, region, revenue growth continued to slow in fiscal 2019 but was still a respectable 30%. In New Zealand, subscriber growth fell to 17% from 22% in the prior year although 24% revenue growth implies price rises and upselling are an increasingly important factor, which we expect to continue. In Australia, subscriber growth fell to 25% from 31%, but like New Zealand, constant currency revenue growth of 33% represented price rises and upselling, which is likely to continue.

As subscriber growth matures in the ANZ region, Xero will become increasingly dependent upon growth from its International business. However, international metrics are less attractive than in ANZ where both customer churn and customer acquisition costs, or CAC, are relatively low. This may simply reflect the maturity of the customer base and local awareness of the business, however, we suspect competition is also relatively high outside of ANZ, and it is in many other industries. This is likely to create pressure on the group’s SaaS metrics considering the lifetime value of a customer which the firm calculates at NZD 1,413 overseas, versus NZD 3,075 in ANZ.

The United Kingdom continues to perform well and slightly better than we expected but the United States is underperforming expectations. Although North American revenue grew by 39%, constant currency growth was 33% but the 48% growth in subscribers was significantly offset by a 15% fall in revenue per user reflecting increased commissions to accounting firm partners. North America is undoubtedly Xero’s toughest market with incumbent accounting software giant Intuit a formidable competitor. However, we continue to believe Xero can win market share.

In addition to margin expansion, Xero claimed free cash flow turned positive in fiscal 2019, excluding acquisitions. It could be argued that acquisitions are a form of maintenance capital expenditure which should be included in the free cash flow calculation, but we’re not overly concerned about this minor point. Importantly, the company is now effectively self-funding and unlikely to raise new capital or leverage its balance sheet, aside for a particularly large acquisition which we don’t expect.

From a balance sheet perspective, Xero remains in good shape and had a net cash position of NZD 100 million as at year-end. The NZD 450 million convertible bond issue late last year has provided plenty of capacity for acquisitions, although we expect acquisitions to be relatively small bolt-ons which add functionality to the platform.