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Date : 26/11/2020

Xero Limited

ASX :

XRO

Market Cap : $19.36 Billion

Watch

52 Week Range : $54.69 - $136.94

Share Price : $133.52

A very well run company with strong unit economics. We recommend to "watch" at these high prices.

Company Analysis

Xero Limited (ASX: XRO) has been a top performer on the ASX for a few years now. In the past year, the share price has returned over 62% to investors. It has had a 30% return in the past 3 months, and if you hold Xero in your portfolio, there has been little opportunity to buy the stock during a dip, because there has hardly been one for sometime now. If you have not invested in Xero yet because the price may be too high, the biggest question is how big is your opportunity cost?


Source: Tradingview.com

Tech stocks have high P/E ratios, especially in their early stages because of the growth potential they come with. In order to meet their growth forecasts and fulfill investor expectations, they have to invest a lot of money in product development and sales & marketing. Hence, the earnings are reduced during the growth phase. This is the hallmark of a SaaS business model. Quality SaaS businesses in the long-term, however, will see a gradual increase in earnings margins as their brand grows and their costs for acquiring customers reduces. If you plot the costs and earnings of the top SaaS businesses in the world on a graph, the picture in front of you will show a huge cost in the beginning and a gradual smoothing out. The earnings graph is the exact opposite – you will notice very low earnings initially, followed by a smooth and sustainable growth. Pricing ratio hence tends to result in misinterpretation of high growth technology stocks.

Xero has been regarded as one of the easiest and clutter free accounting software in the world. Their brand is growing globally – resulting in an increase in lifetime value of a customer (LTC), reduction in churn rates, and reduction in customer acquisition costs (CAC). These are 3 of the most important metrics to track when looking at SaaS businesses.

Xero’s target market are small businesses and high growth start-ups from around the world. These firms cannot afford in-house accounting teams for the high costs associated. A full-time accountant costs you an average of $60,000 a year, and this is just the salary cost. Xero’s technology enables these firms to take care of their accounting needs on the go by uploading their invoices and transaction, all for $30-$40 a month. This is the biggest tailwind for their business, and it is evident in their monthly revenue churn of just 1.1%. What this means is that Xero loses just 1% in revenues from customers who stop using the service. This low churn rate is even better than the churn rate of Netflix & Amazon (which are the kings of as-a-service businesses).

Total Addressable Market (TAM)

Xero has been a disruptor that has leveraged the power of the cloud. There are over 2 million small businesses in Australia, over 30 million in North America, and about 6 million in the UK. These are the 3 regions where most of the activity of Xero has been. Research suggests that approximately 25% of these businesses have shifted to cloud services, but they will do so or be forced to do so in the future. The total addressable market for the firm is thus huge, and it has been showing a very sustainable and disciplined growth in subscribers. During a turbulent pandemic year, Xero has managed to grow its subscriber base in all of the regions it operates in.


Source: Xero Limited

Xero has over a million subscribers in Australia – approximately 50% market penetration. With cloud adoption set to grow, we expect growth for Xero in Australia. The biggest markets, however, that will drive growth in the future growth will be North America and Asia. The gig economy is forecasted to grow into a $500 billion industry by the end of 2023 and it has bolstered growth for cloud services, with Xero being one of the biggest benefactors. The TAM is thus huge, and its Xero has been very strong in expanding its brand value and capturing new subscribers.

The latest half year results of FY2021 showed a 19% growth in total subscribers compared to the previous period, even during the challenges Covid19 threw at everybody. The total subscribers now stand at just shy of 2.5 million.

Customer Lifetime Value (LTV)

LTV measures how much value a customer brings to Xero during the course of their subscription. Again, with the increase in brand value and product enhancements, the LTV increases. Why is this important? Because it tells us how long a customer will stay with Xero and continue to pay them for their services, and it also tells the firm how much they can spend on marketing and sales to acquire these customers. Over the last 2 years, the LTV of Xero has grown by 1.6x. Currently, the H1 FY2021 report shows that the LTV for each subscriber is $2516. It is rather a conservative figure, because the average cost of Xero’s service is $30 a month. For a customer to spend $2516 by paying $30 a month, it means to say that they will be a customer of Xero for only 83 months, or approximately 7 years.
Source: Xero Limited

The total LTV of all the subscribers of Xero is $6.2 billion, adding close to a billion from the previous corresponding period.

Customer Acquisition Cost (CAC)

The CAC months metric that Xero reports indicates how many months of subscription fees it takes for the cost of acquisition to be covered. Marketing & Sales expenses are the biggest driver of these costs. While CAC for Australia and NZ will decrease due to the market penetration already achieved, the overall group CAC will increase due to the aggressive growth strategies that Xero follows in markets such as North America, Asia, and the UK. The H1 FY2021 reports shows that it takes just 14 months for Xero to break even on its cost per subscriber. With a retention of 83 months for a subscriber, that gives Xero an average of 69 months to profit from each subscriber.


Source: Xero Limited

Sales & Marketing costs have decreased by 10% during the half year due to the firm reducing costs during the pandemic. This did not, however, hamper its growth. Revenues were increased and the CAC as a % its revenues decreased to 31.9%. During the year, Xero has increased their capital expenditure as investments are being made to improve their product. These efficiencies have resulted in the gross margins of the firm going up an all-time high of 85.7%.

Performance & Outlook

With a 21% increase in operating revenues compared to H1 of FY2020, Xero has earned $409 million in 6 months. A similar second half performance means that revenues for the firm for FY2021 will be over $800 million. We estimate the growth in subscribers to be an average of 20% over the next 5 years, and then continue to grow at an average of 8% for the next 5 years following.

A trend for the reduction in operating costs relative to revenues and thus a growth in gross margins is already in place for the past 2 years. EBITDA margins increased to 29.5% during the half year from 19% in the 1H of FY2020. We estimate this trend to continue and EBITDA margins to be around 35% for the next few years given the marketing expenses will increase in new markets such as North America.

Xero’s free cash flow chart is remarkable. After starting to generate positive free cash flows in FY2019, the firm generated $27 million the following year. In the first half of FY2021, Xero’s free cash flow has already seen a growth of 100% compared to the full-year cash flow of FY2020. Compared to the previous corresponding period, free cash flows have gone up by $49.4 million. The financial management at Xero during a challenging operating climate in 2020 has been very disciplined, without sacrificing on growth expectations.

The outlook for further market penetration in Australia, NZ, UK, Asia is high. However, the lucrative North American market is tricky. Xero will grow in the North American markets; however, the growth will be capped due to the sizable penetration that its competitor QuickBooks has in the continent. This means that the growth in earnings might not be able to catch up to the high P/E that we mentioned earlier in the report.

Earlier this week, Xero priced zero coupon convertible notes worth US$700 million. These notes are set to mature in Dec 2025 if they are not converted. The funds are set to be used for partial buy back of existing convertible notes that are due in 2023, funding the premiums for call option contracts, and potential mergers & acquisitions. The partial buyback will mean that there will be a difference in the fair value and amortized cost and will thus incur a loss of US$40 million in FY2021. However, this should not be much of a concern as these financial management techniques are usually used to reduce income tax. As a result of this deal, Xero will reportedly have more than a billion dollars in cash on its balance sheet, giving us reason to believe an acquisition is on the cards. An acquisition that will support the penetration in the North American markets would be the best possible scenario at this stage.

Recommendation

Xero is a very well structured and run business with strong unit economics that has driven growth. The free cash flow has turned a corner and profits will only increase. However, it is still priced high given the headwinds in the very crucial North American market. We recommend members without exposure to “Watch” for now and wait for a buying opportunity in the price range of $110 – $118.

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