When most investors think of “value investing” they think of the standard quick-form valuation techniques such as low PE and cashflow multiples, solid dividend yields, low price/book values etc. Companies that don’t tick these boxes can sometimes mistakenly be classified as expensive. When we assess Xero ASX:XRO it meets none of these traditional valuation metrics, yet we see value at current share price levels. So why do we think there is value?
For the bulls…
In looking quantitatively at ASX:XRO we measure value in two parts. Firstly, we calculate the net present value (NPV) of its existing 1.6m subscribers factoring in its ~90% retention rate, 80%+ gross margin on existing customers, slight price rises, and gradual take up of its partnership offerings. Secondly, we assess the future cashflows of potential new clients. We consider this in the context of Intuit’s forecast of a Total Addressable Market across the US, UK, and Australia of 73m users. We think it unreasonable to assume Xero get anywhere near that number and instead forecast a doubling of its network over the next 5 years to 4% market share. Combining the two generates a value for ASX:XRO comfortably in excess of $55 per share.
What particularly excites us about Xero is the growing power of its platform/ecosystem and how increasingly mission critical it is to its clients, despite still being a very low-cost product in the context of its clients total cost of doing business. Xero is not simply an accounting software package rather is evolving into a complete SME business platform and we are only seeing the start of the potential this offers. For example, in addition to ongoing subscriber growth and price rises we believe it will continue to expand and distribute its partnership offerings, enhancing its value proposition and further entrenching itself with clients. The flywheel just keeps spinning!
While a completely separate business, we see Xero’s very low relative cost to clients but high value add in a similar light to where REA Group (ASX:REA) was around 15 years ago. Back then the world was only just coming to understand the strength of the realestate.com.au ecosystem and the absolute pricing power it had because of its importance to clients and its very low-cost relative to its value add. ASX:REA invested to grow an extremely sticky customer base, then once it cemented its market leadership continued growing revenue through new product development and pricing.
Some bear arguments…
One bear argument is the lack of free cashflow as the company reinvests for long term growth. Given the profitability of its existing client base Xero could easily slow its reinvestment (product costs and customer acquisition costs represented 75% of 1H19 revenue) to boost short term earnings. However, this would be to the detriment of its long-term opportunity set and we are more than happy to see Xero deploy the free cashflow from certain areas of its business into growing new future revenue streams.
There is also a query around the founder and former CEO Rod Drury stepping back into a Non-Executive Director role focussed on innovation and strategy. While such moves are often red flags, in this situation given the size and global reach of the company we think Rod’s move is the right one (admittedly for the bears Rod, the ex CFO and certain founding investors have been selling some stock over the journey).
With respect to North America, although this region has not been as successful to date relative to what was hoped for some years ago, Xero is currently building off a very low base and as at 1H19 had increased its subscribers 62% YOY with associated revenue up 34%. The US will be a tough grind but well worth the potential upside relative to the downside risk… and who knows if it starts gaining traction in this region will it become a takeover target for Intuit?
The upside potential for ASX:XRO appears to far outweigh the short-term risks. With years of strong top line growth ahead and a business model which entrenches itself into its clients’ operations we believe it is one of the strongest companies on the ASX. If managed correctly, it has the ability to continue reinvesting its cashflow at returns well above cost of capital, leaving shareholders to sit back and let the value creation continue.
Another point that is missed in the Xero/MYOB/etc analysis..... for the practicing accountant, the functionality to process through to final accounts within the client Xero ledger is a significant time saving benefit over a Myob client ledger. Myob has the legacy client base and is a cheaper option for large payrolls, but factor in the accountants processing time to the client's overall accounting cost and Myob is dead. Unless there's some major product improvements to catch up to Xero, more and more accountants will recommend Xero over MYOB simply because Xero clients are more profitable because the job can be done faster...clients will only pay so much for compliance tasks.
Thanks for the analysis Nick and I agree the upside potential outweighs the short term risks. Q: Do you think the payments accountants receive from Xero for each client they recommend is a potential problem? My concern is they have the flavor of a commission, and if banned, may reduce subscription growth rates.
Hey Daniel, accountants don't receive payments (commission) as such from Xero. Rather they get a lower subscription rate than the client pays if they go direct to Xero. It's then up to the accountant to recover the subscription fee from the client either directly or building into their fee structure. Myob on the other hand pays a commission to the referrer for 5 years. In a way Xero respects the relationship the accountant has with the client. Myob on the other hand, sees the client as theirs once the referral has been made. AndrewR