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Morningstar | Xero Sensibly Cashes in Some Overvalued Scrip to Acquire Hubdoc

Narrow-moat-rated Xero’s NZD 100 million acquisition of data capture software provider Hubdoc is a sensible transaction that monetises its overvalued share price and adds real value to the company. However, the acquisition price represents only 2% of Xero’s market capitalisation, meaning the transaction isn’t sufficiently material to increase our AUD 24.00 fair value estimate. At the current market price of AUD 42.82, Xero shares trade on a fiscal 2019 enterprise value/revenue multiple of 12, and we still believe the stock is materially overvalued.

We’re not too concerned that Xero has decided to buy rather than build on this occasion, as the high share price gives management the opportunity to improve the platform quickly and cheaply. This is important because small and midsize enterprise, or SME, accounting software providers are currently immersed in a "land grab" for cloud customers, and any opportunity to differentiate in what is a relatively commoditised market should benefit sales. In this instance, the benefit is relatively small, as both Xero and its competitors already have various ways of importing invoice information into their software, but Hubdoc brings additional functionality nonetheless.

Our main concern with the acquisition is that it will reduce Xero’s fiscal 2019 EBITDA by around NZD 7 million, which we expect to reduce underlying net profit after tax from NZD 11 million to NZD 3 million. This follows the recent announcement that Xero’s United States business will incur a NZD 16 million impairment charge in fiscal 2019, which means we now expect Xero to report a statutory loss of NZD 12 million, representing its 12th consecutive annual loss since being founded in 2006. We’ve adjusted our forecasts to incorporate the minor earnings impact and associated costs and dilution from the acquisition.

Xero didn’t disclose Hubdoc’s revenue, earnings, or subscriber numbers, but we estimate the company is generating around USD 10 million in revenue per year, around 2% of Xero’s current revenue, and is loss-making. Hubdoc is already a partner software provider to the Xero platform, and Xero management knows the product and business well. Xero will fund the acquisition with 65% equity and 35% cash, with the cash component funded with a new debt facility. Even with the new debt, we expect Xero to maintain its net cash position for the foreseeable future, and we estimate the transaction will increase shares outstanding by just 1%.