Xero's growth a success story

Online accountancy software provider Xero continues to deliver impressive subscriber growth, and its 2018 financial result partially exceeded expectations.

As a result, Australian research firm Morningstar has increased its fair value estimate by 9% to $A24 ($NZ26.10) a share to reflect a combination of a rolling forward of the financial model and higher subscriber growth forecasts for the United Kingdom business, analyst Gareth James says.

However, at the current market price of $A40, the company's shares were overvalued, in the view of Morningstar.

``Xero's subscriber growth is an incredible success story. Subscribers have grown from just 950 in New Zealand in 2008 to 1.4 million globally in fiscal 2018.''

The 351,000 subscribers Xero added in the 2018 financial year was greater than MYOB's entire cloud subscriber base, he said.

Although the 2018 subscriber growth rate of 34% was broadly in line with expectations, the UK growth outlook appeared to be strengthening. Xero was now the market leader and UK-based Sage Group appeared to be struggling in the small and medium-enterprise (SME) segment.

Morningstar now assumed Xero would achieve a market share of 21%, or 1.2 million subscribers, within a decade, up from 17%.

The UK Government's ``Making Tax Digital'' project was expected to act as a major catalyst, Mr James said.

Morningstar's assumptions included subscriber and revenue compound annual growth rates of 12% and 15% respectively over the next decade and an expansion of the group earnings before interest and tax margin to 27%.

But Xero was yet to report a profit and the valuation depended on strong profit growth being achieved.

``Although we consider this feasible, the current market price implies an enterprise/revenue multiple of 11, which is expensive considering likely revenue growth.''

Xero was making progress from a financial perspective. The scalable nature of the business model was highlighted by the increase in gross margin to a record 81% for the year - 82% achieved in the second half.

Morningstar expected further expansion to 84% by 2023, he said.

Management proudly highlighted a maiden full year of positive operating earnings and cash flow, but Morningstar was sceptical of those metrics.

The cash conversion rate implied the company burned more cash than the income statement indicated. And the discrepancy between the income statement and the cash flow statement was the highest in four years.

At the heart of the issue was the capitalisation of research and development cost, a subjective figure which could distort ``true'' earnings.

From a balance sheet perspective, Xero remained in good shape, Mr James said.

The company had no debt and $NZ80 million in cash at March 31, implying a 30% fall over the year.

As the company was now expected to be free cash flow positive, the $200 million debt facility continued to provide funding capacity but it was unlikely to be drawn.

Xero shares last traded on the ASX200 at $A45.04, which was up 2.48%.


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