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Morningstar | Xero Gears Up with Convertible Note Issuance. FVE Increased to AUD 25.50.

Narrow-moat-rated Xero has demonstrated its commitment to maintaining high revenue growth rates via the issuance of nearly half a billion New Zealand dollars’ worth of debt. The use of the new funds is yet to be determined but we expect the company will undertake further acquisitions, like the recent Hubdoc acquisition, which add functionality to its cloud-based accounting software platform. Although acquisitions may prolong losses from an income statement perspective, they are also likely maintain or accelerate already high revenue growth rates.

We have increased our fair value estimate by 6% to AUD 25.50 following the issuance of USD 300 million, or NZD 450 million, worth of convertible notes which mature in 2023. The convertible notes earn an interest rate of just 2.375% per year which lowers Xero’s cost of capital and drives the fair value increase. We have incorporated the additional interest costs into our earnings forecasts but not any potential benefit from further acquisitions at this stage. Xero provided some fiscal 2019 revenue and EBITDA guidance by indicating their comfort with consensus estimates, which are in line with our forecasts. At the current share price of AUD 48.15, we continue to believe Xero shares are materially overvalued.

The relatively low interest rate payable on the notes reflects their convertible nature which gives note holders the option to request repayment of the debt in Xero shares instead of cash at maturity, based on a Xero share price of around AUD 65.00 per share in five years’ time. This provides note holders with a combination of equity and debt exposure but also creates an additional liability for Xero, over and above the face value of the debt, if the Xero share price moves above AUD 65.00.

To offset the liability of the call option embedded in the convertible notes, Xero has bought call options with the same exercise price from Goldman Sachs and Morgan Stanley, partly funded via similar call options with a higher exercise price, of around AUD 85.00, an investment structure known as a call spread. The net effect of the convertible note issuance and the call spread is that Xero may need to effectively repay the NZD 450 million debt by issuing shares to note holders at a price of around AUD 85.00, some 76% above the current share price but potentially dilutive to shareholders if the share price trades above the exercise price.

On balance, we’re reasonably comfortable with the convertible note and call spread transactions but we would have preferred a pro rata equity issue, open to all shareholders. This would have been more equitable and would have exploited, what we believe to be, an overvalued share price. In contrast, the issuance of debt leverages earnings growth but also creates less room for error. If Xero’s business model stumbles, note holders will likely want repayment of the debt in cash, and Xero may find refinancing difficult, a situation which could force the company to issue new equity at a beaten down share price and potentially materially dilute shareholders.

We consider the complicated structure of the capital raise and involvement of investment banks to be a red flag to a certain degree. Investment banks like Goldman Sachs don’t come cheap and corporate executives don’t always fully appreciate the potential consequences of complicated derivative based financial structures. Considering Xero is borrowing NZD 450 million it’s also a little disappointing that the company will only have NZD 361 million to invest after fees and other debt repayment. Admittedly, around NZD 46 million of the NZD 89 million difference probably relates to Hubdoc acquisition funding but our back-of-the envelope calculations imply the investment banks may have pocketed most of the remainder in fees for the call spread. However, this isn’t a huge issue considering the upfront cost of the call spread effectively helps lower the annual interest cost of the notes. We are comfortable with the U.S. dollar foreign exposure created by the note issuance considering Xero’s existing exposure to global markets including the United States and that acquisitions are likely to be U.S.-based.