Xero Poised For Substantial Reinvestment

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Accounting software provider Xero passed several milestones in its FY19 results and brokers assess the substantial opportunities that lie ahead.

-Little clarity on specifics with no actual guidance provided
-Growth momentum slowed, but the US remains the largest opportunity
-Main issue for investors could be the cost of growth
 

By Eva Brocklehurst

Subscriber growth accelerated offshore and accounting software provider Xero ((XRO)) experienced its first full year of positive free cash flow and a maiden half-year of profitability.

Cash flow in FY19 of NZ$6.5m represented 1.2% of revenue and the company has guided to a similar proportion in FY20. Ord Minnett calculates this to mean that total R&D (research & development) expenditure in FY20 is likely to increase 45%, to NZ$247m.

As a result, the broker's forecasts for operating earnings (EBITDA) decline by -31% for FY20 and -23% for FY21. Despite the large step up in investment expenditure, Ord Minnett points out there was little clarity on the specifics. No actual guidance was provided.

Platform revenue was up 128%, which comprises revenue from adjacent products, and a lot of the company's commentary involved investment around the scalability of its platform. There were positive impacts from the introduction of Single Touch Payroll in Australia as well as the UK's Making Tax Digital. Brokers accept the timing of this regulation helped UK subscriber growth, although at 48.4% it was definitely a highlight.

Meanwhile, the core business is tracking well and North America remains the largest opportunity. However, Macquarie points out this is likely to be a slow path for growth because of a fragmented market. Xero is focusing on the partner channel and cultivating relationships.

Credit Suisse found North American results "pedestrian". US growth was less than 10% half on half and is typically more than 20%, although the company was pleased with the build up of capacity in the partner channel. Morgan Stanley liked the result, as underlying operating earnings were slightly stronger than expected, and flags the company's growing success offshore.

Ord Minnett takes a different view, downgrading to Lighten from Buy. Annualised monthly recurring revenue was little soft relative to expectations and there are concerns the strength in the UK could be a one-off.  While acknowledging cloud accounting adoption rates in the UK are still relatively low the broker suspects the tailwind from the April 1 revenue customs deadline for compliance legislation affected the result.

Reinvestment

Reinvestment is now to the forefront and Credit Suisse believes this will constrain free cash flow in FY20. The main concern is how quickly the company can leverage its investment and the issue for investors, the broker also asserts, is the cost of growth. Credit Suisse expects a focus on product development and subscriber acquisition in similar measure to past years.

While incorporating a bullish UK scenario and extending Australian subscriber growth, the broker offsets this with increases to product and subscriber acquisition expenditure. As a result there are downgrades to FY20 and FY21 estimates of -12% and -9% respectively, but meaningful upgrades from FY23.

While expecting Xero to continue to invest, Citi forecasts operating expenditure growth to slow to 24% in FY20 from 28% in FY19 and free cash flow as a percentage of revenue to rise to 3.2%.

Valuation

The lack of material near-term free cash flow is a drag on valuation and, to justify the current share price, UBS believes Xero needs to lift its share in the UK/US to 30/7% over the long-term and hold share in Australasia.

Drivers of FY20 growth are expected to be revenue per unit growth in Australasia, subscriber momentum in the UK, and subscriber growth taking priority over yield in the rest of the world. Citi expects UK revenue to grow at a 3-year compound rate of 35%, driven by subscriber growth of 29%. The UK already represents the second largest region in terms of revenue and the broker envisages upside risk to forecasts.

UBS acknowledges Xero has transitioned from a loss-making start-up to a self-funding business with structural growth opportunities and the outlook is less risky, yet downgrades to Sell from Neutral. While comfortable with the growth prospects and supportive of the strategy, the broker believes valuation has overshot the level at which there is a fair risk/reward trade-off for investors.

While positive about the strategy and execution, Macquarie believes it is too early to hail the company as a winner, and the valuation is difficult. The broker sticks with a Neutral rating, given the strong run up in the share price. Operating excellence can continue to translate to earnings, and the next leg of growth is likely to come from adjacent products such as payroll and inventory, in the broker's view.

FNArena's database shows one Buy (Morgan Stanley), two Hold and three Sell ratings. The consensus target is $52.75, signalling -13.5% downside to the last share price. This compares with $45 ahead of the results. Targets range from $41 (Credit Suisse) to $61.50 (Citi).

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