Xero Stock Analysis – Should you buy now?

If you like to invest in businesses with strong economic moats, then consider accounting software companies. In particular, let’s take a look at Xero stock analysis.

Once businesses start using a particular accounting tool, it will take effort and money to change to another service provider. Especially with today’s interconnectedness across multiple softwares. In other words, switching costs are high.

So, today we want to take a look at Xero, an accounting software company originated from New Zealand. It’s primarily listed on the Australian Securities Exchange (ASX).

Xero Stock Analysis: Business Overview

Xero Stock Analysis – Should you buy now?

Source: Xero / A unique platform that connects small businesses and their advisors

Xero is primarily a cloud-based accounting software platform for small businesses, using a Software-as-a-Service (SaaS) subscription model. As of the end of FY2021 that ended on 31 March 2021, the company registered 2.7 million subscribers globally.

It provides access to real-time financial data easily and conveniently across all types of devices. Not only that, the platform connects small businesses to their advisors sharing the common data.

The relationship between Xero’s accounting partners and bookkeeping communities are what makes the company unique. The platform allows these advisors to collaborate with their small business clients on a single, up-to-date general ledger. Other finance-related services include invoicing, payroll, tax compliance, cash flow management and much more.

Today, Xero has built a thriving ecosystem of over 1,000 connected apps. In addition, it has more than 300 connections to banks and financial service providers.

Xero Stock Analysis: Operating Segments

Xero Stock Analysis, Operating revenue by geographic location FY2021

Source: Xero Annual Report FY2021 / Operating revenue by geographic location

Xero categorizes their operations into two key operating segments. Australia and New Zealand (ANZ), and International. The latter consists of the U.K, North America and Rest of World.

As you can see from the table, the bulk of the revenue comes from the ANZ segment. Within which Australia contributed a giant share of NZD$384 million in FY2021. As for the International segment, its operations in the U.K contributed the majority of the revenue at NZD$224 million.

Again, here we want to highlight that Xero’s revenue comes mainly from the subscription revenue. It comprises of recurring monthly fees from subscribers to Xero’s cloud-based software products.

Its other operating revenue contributed only about 2.4% to the company’s topline in FY2021. They are revenue from related non-subscription services. These include financial services products, such as invoice payment services and Waddle’s invoice lending platform services.

Waddle is one of the recent acquisitions that Xero has made, along with Planday and Tickstar. These strategic investments expand the company’s capacity to create value-added services to its new and existing customers.

Just a quick overview. Waddle is a cloud-based lending platform. Planday provides a workforce management solution. And Tickstar is an e-invoicing infrastructure.

Xero Stock Analysis: Business Performance

Subscribers Growth

Xero Stock Analysis, Subscriber growth trend FY21

Source: Xero Investor Presentation FY21 / Subscriber growth trend

Observe that Xero continues to see strong momentum in its subscriber growth in FY2021. That’s despite the coronavirus outbreak that began in 2020, affecting most of its fiscal year 2021 performance.

In FY2021 itself, its subscriber base grew 20% to hit a record number of 2.74 million.

Xero Stock Analysis, Segment results

Source: Xero Investor Presentation FY21 / Drive cloud accounting

In fact, its subscribers registered double digit growth rates in FY2021 across all segments. The Rest of World category recorded the highest growth of 40%. Of course that’s partly due to the lower base figure in these countries outside its core locations currently.

Observe the noticeably smaller revenue growth of 2% in the North America segment, despite an 18% growth in new subscribers. This was due to the loss of revenue from bundling Hubdoc into Xero Business Edition subscriptions in late FY20. And also because of the absence of any Xerocon-related revenue  in FY21.

SaaS Metric

Xero Stock Analysis, SaaS metric FY21

Source: Xero Investor Presentation FY21 / SaaS Metric Summary

Let’s move on to the SaaS metrics to assess the company’s subscription business. We can observe improvement across most areas in FY21 compared to the previous year.

The average revenue per user (ARPU) in ANZ segment has improved from $29.83 in FY20 to $31.23 in FY21.

Similarly its customer acquisition cost (CAC) has reduced as well. The CAC months of 8.9 in FY21 tells us that it will take the company 8.9 months of ARPU to recover the cost of acquiring each new subscriber.

Both of these metrics signify improvements in its SaaS business.

On the other hand, the ARPU and CAC worsened for its International segment. This is understandable as Xero is expanding aggressively in these regions by providing promotional incentives and spending more on marketing. These activities will reduce ARPU and increase CAC.

Generally, its monthly recurring revenue (MRR) churn rates are lower year-on-year across both the ANZ and International segments as well. This means that lesser subscribers are leaving and abandoning Xero’s service.

Overall, they are hovering at around 1%. Given the double digit growth rates that the company is experiencing across the geographic locations it is operating, this 1% churn rate can be considered to be low.

Lifetime Value vs Cost of Acquisition

Xero Stock Analysis, Value of a Xero Subscriber

Source: Xero Investor Presentation FY21 / Value of a Xero Subscriber

Also, we saw that the lifetime value (LTV) of a subscriber has increased across the board.

Another important metric for a SaaS business will be to assess its LTV/CAC ratio. We saw that ANZ has improved from 10.6 in FY20 to 13.2 in FY21. On the other hand, the international segment has worsened from 2.9 in FY20 to 2.7 in FY21. Again, this is due to the company spending more to acquire more subscribers and grow its business in the International segment.

Overall, LTV/CAC has improved from 5.8 in FY20 to 6.4 in FY21. This means that Xero is earning 6.4 times more than what they spent to acquire a customer or subscriber.

This is an important metric to consider as it ensures the long term profitability of the company. Sometimes, softwares companies may be expanding very rapidly and incurring losses in the short term. But so long as the company can profit from whatever they spend on acquiring new customers, then it should be profitable eventually.

The chart above tells us that it takes about slightly more than a year to break even on the amount spent acquiring a new customer. Also, the average lifetime of a customer is about 8 years, hence it will be worth about NZD$2,789 per subscriber.

Xero Stock Analysis: Financial Performance

Revenue and Profit

Xero Stock Analysis, Financial Performance FY21

Source: Xero Investor Presentation FY21 / Financial Performance

Overall, Xero registered an 18% growth in revenue in FY2021 compared to the previous year. That’s despite the pandemic induced recession during the most part of the year.

Its net profit is substantially higher as well. However, at this point in time, it’s still not meaningful to measure the company’s profit for valuation purposes. Because the company is still spending aggressively to grow its business.

We will discuss more below.

Debt, Cash and Liquidity

Xero Stock Analysis, Net Cash Position FY21

Source: Xero Investor Presentation FY21 / Movement in net cash position

Observe the table above pertaining to the end of FY2021, that ended on 31 March 2021. Xero is in a net cash position of about NZD$257 million.

Meaning it has more cash than debt. Total cash and short-term deposits works out to be about NZD$1.1 billion. While the company’s debt works out to be about NZD$854 million.

Thus, we can say that Xero has a very healthy balance sheet. There is no need to worry about any liquidity risk at the moment.

Xero Stock Analysis: Growth and Valuation

Growth

Source: Mordor Intelligence / Accounting Software Market Growth Forecast

The accounting software market is expected to grow at a compounded annual growth rate (CAGR) of 8.5% from 2021 to 2026. Worth about US$12.01 billion in 2020, this market is expected to reach US$19.59 billion by 2026.

Xero is one of the leading players in the market. Hence, we can expect the company to grow at least with the pace of the industry growth of 8.5%.

Valuation

Xero Stock Analysis, Target Share Price

Source: Created by Carepital – Xero Target Share Price (AUD) / Data sourced from Xero Annual Report FY2021

Here we try to make some assumptions when trying to project a target price for Xero in 5 years time.

Per the income statement earlier, the company continues to spend hundreds of millions of dollars to grow its business.

Xero spent about NZD$308 million in sales and marketing in FY21. Most of it is associated with expansion business activities in acquiring new customers.

Same for its budget spent in product design and development. A portion of it would have been for refining and building more features for the future.

Therefore, all these spending for growth should be discounted off first. That will help us determine what is the sustainable earnings currently, if the company did not spend on growth.

Net Profit Margin Assumption

However, it’s difficult to segregate these items due to the limited data available. We will assume a net profit margin of 25% if the company did not engage in growing its business heavily.

This should be in line with the figures from more established accounting software companies like Intuit. Intuit is known for its QuickBooks products, which also provide accounting solutions to its customers.

Growth Rates Assumptions

With the aggressive marketing campaign that Xero conducts, the company will likely grow faster than the 8.5% industry growth rate. So, we lay out the various potential growth rates at 8.5%, 15% and 20%, to project the potential revenue of Xero in 5 years time.

Using the 25% net profit margin, we can derive the projected earnings or profit for Xero five years later.

Multiples P/E Assumptions

Now, I suspect that the cloud-based accounting software market may continue to grow even after 5 years. As such, valuation metrics like Price-to-Earnings (P/E) ratio may not equilibrate to a more stable figure of say 20 five years later.

Moreover, Xero is also increasingly adding new softwares and capabilities to create more value for its customers. It may even move the company away from just accounting software in the future.

Consider its recent acquisition of Planday, a platform that provides workforce management solutions. This is an example of such a shift taking place. Hence, the company may in fact continue to grow at double digits even after five years.

So, we use a few P/E ratios of 25, 40 and 50 to derive the target share price for Xero, based on the earnings we projected earlier from the different growth rates assumptions.

As such, the projected share prices for Xero five years later are listed in the table above. They are in AUD, based on the different growth rates and P/E scenarios.

Conclusion

Source: Yahoo Finance / Xero Limited Stock Summary

Consider Xero’s current share price of AUD126 with the target share prices based on the various scenarios we have discussed. I think the current valuation is a bit high.

Perhaps my assumptions for this Xero stock analysis may be a bit conservative. Xero’s share price may not come down to create an opportunity to invest. Especially if the market’s bullish sentiment continues to be elevated. 

But I prefer to invest with a margin of safety, and will be more comfortable working with these known figures.

Nonetheless, Xero is a great company with a strong moat around its core accounting software business. The network of advisors and bookkeepers handling the finances for Xero’s customers imply another layer of switching cost.

This is in addition to the already high switching cost in place once its business customers come on board. There’s a lot of training required for the employees to process their finances on Xero’s platform.

Not only that, Xero is actively expanding its capabilities to serve small businesses better. This can be observed from its recent acquisitions of Waddle, Planday and Tickstar as discussed earlier.

The interconnectedness of the ecosystem of applications will make it even harder for Xero’s customers to leave the platform moving forward.

Therefore, I’m definitely adding Xero to my watchlist.

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