Why Xero is a strong buy

Xero provides affordable accounting software for small and medium-sized enterprises (SMEs) that is entirely cloud-based, outmanoeuvring slower incumbents that retain server-based solutions. It operates in an industry with structural growth driven by regulation and a broader shift to the cloud.

It has invested heavily in software development, enabling its intellectual property to drive consistent revenue growth of 30-40%. We forecast market-share gains and monetisation of its accounting platform ecosystem.

The business is highly cash-generative in its incumbent markets and scalable and we expect it to continue enjoying operating leverage. The management team is disciplined in capital allocation and has more than NZ$100 million in cash, which it can allocate as opportunity arises. This business is really set up for the next level of growth.

We maintain a ‘strong buy’ rating on Xero, whereas the broker community has a cross-section of recommendations evenly split among buy, hold and sell.

Our analysis suggests Xero is well placed to create value and deliver compounding returns over time. It might face near-term challenges to growth in subscribers and average revenue per user due to Covid-19. But over the medium to long term we are confident in Xero’s products, management, strategy and execution.

It has been able to build a dominant position in New Zealand and Australia from scratch and taken market share from desktop players. It is now deploying this playbook in offshore markets and has successfully built a position in the UK market. Hence we are attracted to its strong market position and potential for expansion domestically and globally, alongside a structural shift to the cloud.

We see valuations really growing from here. We use near-term revenue multiples and long-term discounted cash values to assess its value.

Price Chart: WiseTech, Altium, Appen, and Xero (WAAX).

Source: Bloomberg, 31 March 2020.

The chart above shows how Xero’s share price has outperformed both peers and the market over the past two years. We put this down to the quality of this business. It sold off 20% in the week of March 23 against a 12% decline in the broader market as Covid-19 fears escalated, falling to NZ$58 dollars a share. But it has performed well since the start of the year and at the time of writing was trading at NZ$76.

We still don’t think its share price fully factors in platform monetisation and potential subscriber growth in the rest of the world. We would look to capitalise on any price weakness to add to our position, having topped up on Xero in March.

In summary

Xero provides transformative cloud solutions for SMEs looking for a better way to manage their business. Covid-19 is a near-term risk to Xero’s revenue growth, but its medium to long-term outlook remains robust.

We expect its growth to come from increasing and leveraging its total addressable market and monetising its platform ecosystem – factors which are not fully appreciated by the market in our view.

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