Today, we will look at why we like Xero Limited (ASX XRO) shares.
Xero offers a cloud-based accounting software platform for small and medium-sized businesses.
Cloud computing is the delivery of on-demand computing services.
This includes servers, storage, databases, networking, software and analytics over the Internet (“the cloud”) to offer innovation, flexibility, and economies of scale.
Cloud computing is the next big thing as it allows mobility, a distinct advantage during the COVID-19 pandemic.
Given the volatility surrounding the coronavirus, the Xero share price along with almost every other stock was sold off during the early phase of COVID-19.
However, it has bounced back and regained nearly all its share price losses since then.
Additionally, Xero delivered strong financial results for the FY 2020 financial year.
The company invested heavily in software development, enabling its software business to achieve consistent revenue growth of 30-40%.
Over the past five years, the company has significantly overperformed the ASX index by about 490%.
(source: Google Finance)
In FY20, the company posted its first full year of profit with $3.3 million.
The impact of COVID-19 on Xero’s operating and financial performance for the period has been modest, given the recent performance.
This strong growth was driven by a combination of increased subscriber numbers, low churn levels, and higher average revenue per user.
About Xero (ASX XRO)
Xero is a New Zealand headquartered public technology company listed on the ASX.
It provides affordable accounting software for small and medium-sized enterprises (SMEs).
The main objective of the company is to evolve the accuracy and speed with which small businesses can generate data and then use AI (artificial intelligence) and ML (Machine Learning) to create insights.
Xero’s products are based on the software as a service (SaaS) model and sold by subscription.
It is entirely cloud-focused. The software is known for offering strong accounting, ample features, reports and 3rd party integrations along with unlimited users in each plan.
With a global presence in around 180 countries, Xero’s core markets are in Australia, New Zealand, UK, and North America.
Employing over 3,000 people, Xero helps more than 2.2 million subscribers manage their accounting and tax obligations.
Xero is the perfect example of a product that embeds itself into its customers’ daily operations – these customers being small and medium-sized businesses.
Accounting is an integral part of running a business and Xero’s software makes this process simple, more efficient, and cost-effective.
This all leads to a highly scalable product with great economies of scale, minimal churn, a great proportion of recurring revenue (98%), and high switching costs.
In addition, the company aims to provide a wide range of enterprise connections in the future.
With its heavy investment in software development, it is moving past incumbents offering server-based solutions.
In addition, Xero is focused on expanding its offering into a broader financial services platform.
Even though it has built a foundation operating platform for small businesses, there is an opportunity to build new apps on top of this platform.
Xero is moving beyond accounting and seeing the potential of creating a platform that connects small business to banks and to suppliers and to their customers, which is essentially an expansion into financial services.
Xero’s market capitalisation as of this writing is around A$13 billion.
Even Stronger Growth in Cloud Computing During COVID-19
The growing coronavirus crisis has been a major transformative force for companies to securely scale operations online – a feature possible only because of cloud computing and their companion technologies.
With social distancing and work from home orders in effect, there has been a massive surge in users of collaboration and digital solutions around the world.
There has been a major shift to public cloud services like video conferencing, project collaboration, and e-commerce in a huge way.
In such a time, public cloud companies have seen a boost in demand owing to its ability to meet the challenges brought by a global pandemic.
A large number of companies have been able to adapt quickly thanks to the cloud.
Businesses and consumers appreciate the resiliency that has been demonstrated in recent weeks by front-end applications like Zoom, Skype, but it’s the back-end infrastructure of Cloud that is keeping those now-vital services running smoothly.
Cloud services are an unsung hero in enabling this massive, sudden shift to a remote-first workforce.
There have been indications cloud adoption will continue rising considerably.
This presents a massive opportunity for Software-as-a-Service providers and enterprises like Xero to quickly scale operations.
Additionally, the Australian industry is increasingly shifting to cloud computing.
The number of Australian businesses using commercial cloud computing services has risen from 19 per cent to almost one-third in just one-year, Australian Bureau of Statistics data has reported.
Australian spending on public cloud services is expected to grow by 18.3% year on year in 2020, outperforming the increase in global spending which is at 17%.
By the end of 2019, Australian organisations had spent $6.6 billion on public cloud services, and the forecast increase of 18.3 per cent would see this figure increase to $8.1 billion in 2020.
Furthermore, cloud application services are expected to see the most spending, with a predicted $5.2 billion in 2020.
Cloud system infrastructure services are expected to see the biggest year-on-year growth globally at 24 per cent due to demands of modern application and workloads.
This growth has been helped by business digitisation thanks to the pandemic.
Xero is Well Positioned to Grow in the Current Environment
Xero was well-positioned prior to the crisis, with a strong growth model, good capital discipline and a strong balance sheet.
It has established a dominant market position in Australia and New Zealand, a growing presence in the US and UK and is expanding to provide a platform solution.
Prior to Covid-19, it was also enjoying a good subscriber growth rate.
While we might expect these growth rates to slow down in the coming months due to the pandemic, the structural growth drivers of Xero are persistent and meant to stay including the government regulation to accelerate the transition to the cloud.
The increase in digitisation of tax and compliance for small businesses will be a key driver of demand for Xero’s cloud accounting solutions.
Xero runs as a SaaS model, which means it generates recurring revenue.
Since all businesses need to file tax returns and prepare financial statements, good software is required to do it efficiently.
Once businesses convert to new accounting software, it is practically very hard to change or go back to traditional methods.
Due to this, Xero has an advantage in the form of high customer retention.
Additionally, Xero is arguably the most powerful software for accountants to use in the cloud because it was built in a cloud-first environment.
Competing products like QuickBooks, Intuit, and Reckon also offer a cloud-based alternative, but they weren’t born this way.
Xero has a significant first-mover advantage when it comes to cloud accounting compared to its competitors.
Xero is on track for Global Expansion
Xero has experienced phenomenal growth in Australia, New Zealand and the UK.
Along with other geographies, it has surpassed 2.2 million global subscribers.
Xero’s subscribers in Australia grew by 26% in the year to reach 914,000.
Xero’s Australian market share is expected to double to 65% by 2025.
In the UK, subscribers grew by 32% to 613,000 and revenue grew by 54%.
In particular, the growth of UK subscribers was a standout, especially given cloud accounting in the UK is still underpenetrated at 28% market share.
Xero is quickly gaining market share in the UK. This is due to its core competitor Sage struggling with difficulties transitioning to the cloud thanks to platform outages and management changes.
Xero is expected to triple its UK share to around 25% by 2025 largely at Sage’s expense.
With evolving trends like single touch payroll in Australia, payday filing in New Zealand, and filing digital tax in the UK, there is a significant opportunity for Xero to expand market share.
In North America, Xero has already gained a foothold with 392,000 subscribers.
With less than 10% of small businesses have opted for cloud accounting services, Xero has a huge opportunity for growth in North America.
In North America, Xero’s main competitor is Intuit with a market capitalisation of US $44 billion.
XRO is also on track to expand to other regions including Asia and South Africa.
Xero shows no sign of slowing down with 432,000 subscribers added in the past 12 months.
COVID-19 Still a Key Risk for Xero
Xero is a company that investors are pricing for a high growth future.
The potential lies in the fact that governments around the world are pushing for businesses to switch to digital platforms, which is a great tailwind for the company.
However, there are some concerns during this disruptive period.
There are some significant risks that Xero faces in the near term since Xero’s customer base is dominated by SMEs. Companies which have been heavily impacted by COVID-19.
Three main risks that will be of concern:
- Nearly every country in the world will enter a recession this year and with mandatory shutdowns of businesses, there is a risk in subscriber growth.
- There is a risk to the existing subscriber base, with a high probability of SME turnover and liquidity crisis.
- There lies a potential risk with customers to cancel or downgrade their subscription as they look to cut costs.
However, governments in the markets that Xero operates in have announced huge stimulus packages for supporting the small business during this pandemic. This can soften the blow for SMEs and help them survive the pandemic.
Additionally, working from home is more likely to increase business transition to the cloud.
In fact, there lies the potential for growth of cloud platforms considering the shift to digital solutions which Xero offers.
Irrespective of Covid-19, businesses will continue to have tax obligations to tend to in Xero’s core markets of Australia, New Zealand, UK and the USA. This provides a degree of resilience for Xero.
Strong Financial Performance
Xero achieved an important milestone in the first half of FY20, surpassing 2 million subscribers globally with 467,000 net subscribers added during the period.
This brings total subscribers to 2.28 million in FY20.
Xero also experienced exceptional revenue growth, from 552 million in FY19 to 718 million in FY20.
(source: Annual report)
Even though revenue growth has slowly tapered off from over 40% in FY17 to 30% in FY20, this is to be expected as Xero becomes a leader and saturates the Australian and New Zealand markets.
If Xero can replicate its success in the UK and North America, we can expect revenue growth to accelerate.
In addition, Xero reported its first net profit. In FY20 Xero’s net profit went from a loss of $27.1 million last year to a profit of $3.3 million this year.
Free cash flow climbed 320% to $27.1 million. This was driven by an increase in operating revenue growth, subscriber growth, increased uptake of Xero add-ons, and growth in other operating revenue.
This was also driven by Subscriber numbers at 31 March 2020 increased by 26%, compared to 31 March 2019.
EBITDA improved by 88% in FY20 and has been growing on a year on year basis, due to increased revenue growth and operational efficiency.
(source: Annual report)
Xero is currently trading at around A$89 per share.
With its last reported earnings, this would indicate a PE ratio of about 3,970x.
However, the PE ratio at this time is misleading. This is due to the fact that Xero just got over the line this year with a profit.
If Xero continues to grow at its current pace, we should see the PE ratio come down significantly.
For a better metric such as the Price to Sales ratio, this comes in at a more comfortable 18.6x.
The main competitors of Xero are MYOB and Reckon (ASX RKN). Both of these competitors have been around for a very long time, but have both been completely overtaken by Xero.
Reckon has been expanding its cloud offering, focusing on a niche market comprised of microbusiness and small traders.
Its product is the cheapest and the most flexible on the market, with basic accounting starting at just A$5 a month.
Currently trading at a share price of A$0.68, Reckon has a market cap of A $75 million.
MYOB, on the other hand, is software that provides tax, accounting and other business services software to small and medium businesses.
MYOB was delisted and taken over by private equity in April 2019.
Xero is a leader among its incumbent competitors which were relatively slow to adapt to cloud-based computing.
The company has been called the Apple of accounting thanks to its ease of use compared to its competitors.
|Metrics||Xero (ASX: XRO)||Reckon (ASX: RKN)|
|Debt to Equity||115%||209%|
|Total Revenue Growth (YoY)||29.92%||-7.95%|
|Price to Book Ratio||33.1||3.95|
Source – investing.com
We will use the price-to-book ratio to compare valuations, total debt-to-equity to compare leverage, and total revenue growth to compare the growth of the two companies.
With a debt to equity of just 115%, Xero is only half as leveraged as Reckon at 209%. A strong balance sheet, especially with the COVID-19 challenges we have ahead, will definitely be an attractive advantage for Xero.
Xero has also experienced strong revenue growth of close to 30% year on year, with Reckon ceding market share to Xero as revenue fell 7.95%. This is a very positive sign for Xero.
In terms of valuation, Xero has a P/B ratio of 33.1, 8 times higher than Reckon. However, this is justified by Xero’s high revenue growth compared to Reckon’s diminishing Revenue.
With strong growth prospects, stellar financial performance and continued momentum, we believe that Xero is well-positioned to continue to grow.
The company is on track for global expansion with large untapped markets in the UK, North America and Asia.
Despite the pandemic, Xero does not anticipate significant changes to its long term strategy. In fact, the pandemic could provide a strong tailwind which may be able to offset the economic downturn that is coming.
Although there might be short term challenges to growth in subscribers and revenues, Xero has a great product and has shown they have what it takes to dominate a market.
We believe that Xero has significant upside potential. However, the stock right now is relatively pricey due to its high growth prospects.
Considering the current environment, it may be prudent to wait for a downturn in the market and a correction in the stock before considering taking a position in XRO.
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