Xero: Accounting on long-term value creation

About the author:

Nick Harris
Author name:
By Nick Harris
Job title:
Senior Analyst
Date posted:
01 July 2022, 9:30 AM
Sectors Covered:
Telecommunications, Technology

  • Xero (ASX:XRO) is a challenger small to medium-sized business (SMB) accounting platform. Its vision is to " be the most insightful and trusted small business platform”.
  • All going to plan, there is plenty of upside on subscriber adds (increased penetration and geographic expansion) plus ARPU growth (product expansion). These should drive substantial barriers to entry/network effect and ultimately large free cash flow (FCF). We are conscious however that investors have switched away from growth stocks due to inflation/rising interest rates. XRO trades based on long-term value creation (LTV). With LTV at 7x customer acquisition cost (CAC), for the foreseeable future the company sensibly plans to invest surplus cash flow into growth.
  • We initiate coverage with an Add recommendation and (login to view) target price.

Xero (XRO) simplifies and automates accounting

XRO is a cloud-based accounting software platform that serves 3.3m small businesses and their accountants/advisors. It operates in ~180 countries.

Founded in New Zealand in 2006, XRO runs a single unified ledger that is accessible from any device. XRO has, for over a decade, run an open ecosystem that allows third-party data (eg banking feeds) and Over The Top apps from third-party software providers to add value to end customers and the ecosystem.

This ecosystem has grown to 1,000+ third-party apps and 300+ connections to banks and others. Actionability on real-time SMB data sets is a significant opportunity.

Today, platform revenue is ~11% of subscription revenue and substantial transactions go through XRO’s platform. Not all transactions are monetisable but we see substantial long-term potential for this likely high-margin revenue stream.

In addition to its easier-to-use accounting software, XRO layers in value add organically and via acquisitions. These have been done to add localised expertise, new customers, and new technology solutions, all of which should improve the value XRO offers customers and consequently their spend through XRO (ARPU uplift).

Analysis

XRO has a significant runway for customer growth with <10% penetration of a 45m+ SMB Total Addressable Market (TAM). We see additional earnings upside from platform / ancillary value-added services and margin expansion.

Execution risk and time value of money are the key operational considerations. What valuation framework investors are prepared to use is the greatest unknown. The subjectivity of this will create share price volatility along the way.

Forecasts

Our forecasts are broadly in line with consensus. We forecast an ~18% CAGR in subscribers and a ~35% EBITDA CAGR over the next 10 years.

Investment view

XRO boasts strong customer advocacy, significant barriers to entry, scalability and LTV at ~7x CAC. It should continue to grow earnings/FCF above economic trend and is profitable and liquid. We rate it highly and it appears others do as well.

A key risk is XRO trades on large short-term multiples. If we remove FY22F “investing for growth” CAC, XRO trades on a ~2.2% FCF yield.

Rising interest rates are a net negative for XRO’s share price and growth companies. However, XRO should be a top tech exposure due its high quality.

Price catalysts

In our view, 10-year bond yields stabilising at ~2.5% (indicating that currently high inflation is normalising) is a key share price catalyst. This could result in investors rotating back into high quality growth stocks including XRO.

Company-specific data points relating to CAC reduction and LTV expansion.

Risks

XRO is valued in the context of LTV and not priced on a short-term P/E multiple. Interest rate moves therefore create share price volatility and could impact investor willingness, in the short term, to invest in long-term growth.

XRO has large, well-funded competitors, that could in theory meet or beat XRO’s product offerings. Success in new geographies comes with execution risk.

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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