EUR 850.00 For Business Accounts Only

Morningstar | Xero's Annual Customer Conference Dazzles, but So Does Its Share Price. See Updated Analyst Note from 10 Sep 2018

Xero’s annual southern-hemisphere customer conference, Xerocon, was held in Brisbane this year and was as spectacular as usual. It’s easy to see why investors are so excited about this world-leading software company, which continues to generate strong subscriber growth and has a relatively new and cool brand. The 3,500 accountant attendees were treated to a wide range of presentations and exhibitors in a setting themed around a Miami pool party. The event featured ping pong, basketball, mini-golf, and a DJ, and the excitement and positivity of all involved was tangible.

The company also provided investors with product demonstrations and executive presentations, but no material new announcements were made. Our key takeaway was that Xero’s strong momentum appears intact, with no indications of any material issues with the business. The most notable news was that Xero Expenses, which was launched at last year’s conference, appears to have missed management’s expectations, but Xero Projects, launched at the same time, appears to be progressing to plan. However, both software applications are complementary to the core Xero software, and we still assume that both contribute immaterial revenue for the foreseeable future.

Following the conference, we retain our investment thesis, namely that we expect Xero to continue to quickly increase subscribers and generate strong profit growth over the next decade, underpinned by its switching-cost-based narrow economic moat. However, Xero’s story is well known by the market, and we struggle to justify the current share price of around AUD 47.65. We have maintained our DCF-based fair value estimate at AUD 24.00, and we still believe the shares are materially overvalued. The fiscal 2020 price/earnings ratio of 190 means the share price is entirely based on future earnings, with no existing earnings to act as support should subscriber growth disappoint and the buzz around the stock decrease.

We’re not concerned about the likely large cost to hold Xerocon for two reasons. First, the cost to Xero is reduced by admission fees, and second, the conference is effectively a sales conference, which should support further revenue growth. Accountants are the main distribution channel for Xero’s software and typically leave the conference more motivated and knowledgeable about the product and therefore more likely to recommend it to their small and midsize enterprise, or SME, clients. Xero’s business model is also based on maintaining high recurring revenue growth by effectively reinvesting all its profits back into its business. This model is being rewarded by investors via a high stock market valuation in the current bullish environment, but also makes the share price highly vulnerable to a change in investor sentiment.

Our confidence in Xero’s subscriber growth is supported by the digitisation of the global financial services sector. For example, the Australian Taxation Office, or ATO, now requires all employers with over 20 employees to submit payroll information electronically and in real time, known as Single Touch Payroll. This requirement is likely to be extended to all companies within the next year, which will significantly increase the number of companies affected and increase demand for cloud-based software. Similarly, superannuation and tax lodgements must already be submitted to the ATO electronically, and similar rules are increasingly being adopted by governments around the world.

However, despite the positives, we’re still not entirely convinced by management’s description of Xero’s software as a "platform," or at least not based on our definition of the term, which assumes a network effect is present. Although Xero has many users around the world and is extracting valuable insights from the data they create, we don’t believe Xero users benefit directly from additional users of the software, nor do they interact with each other across the platform. These factors likely explain the difference between Xero’s share price and our fair value estimate. We also believe the supportive industry trends will benefit all providers, including MYOB, which we currently consider to be undervalued by the market.

As we’ve discussed previously, we remain intrigued by Xero’s North American business and suspect management is tempering its long-term growth expectations for this market. As was noted by CEO Steve Vamos, the U.S. used to be Xero’s main growth market, but management now talks about "ring-fencing" its U.S. investment and targeting a "healthy number-two" position in the U.S., behind massive incumbent provider Intuit. We’re thus not surprised to see Xero increasingly promoting the potential for its software in Asia, where a Hong Kong office was recently opened. There’s no question that Asia also offers huge potential, but it’s still early days for Xero in this region from a subscriber perspective, and it remains to be seen whether this is a broadening of the growth strategy or a pivot away from the U.S.