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Treasure Chest: Xero Defensive

Treasure Chest | Apr 06 2020

This story features XERO LIMITED. For more info SHARE ANALYSIS: XRO

Accounting software is core to a business and Xero is considered a defensive stock in a difficult environment.

-Main impact is likely to be on subscription growth rates
-SME numbers could be reduced but the business climate should gradually improve
-Cloud accounting transition and/or regulatory changes should benefit Xero


By Eva Brocklehurst

While the coronavirus crisis has spread its influence widely, hitting all types of businesses very hard, accounting software provider Xero ((XRO)) is considered one of the more resilient.

The main impact, if any, Macquarie suggests, will be on subscription growth rates. Most customers pay for their subscription as part of a bundled service, with around 90% using the accountant/bookkeeper channel. Xero has recently re-financed a $150m bank facility and has no drawn debt.

Hence, Morgan Stanley considers this a defensive stock, as accounting software is core to a business. The company has is a strong balance sheet and a valuation below historical levels. The broker describes this as a rare opportunity for long-term investors.

There are also likely to be some offsets from government assistance programs and subsidies to small-medium enterprises (SMEs) that could reduce cash burn and mitigate the impact of the crisis on their operations.

Free cash flow is positive and Macquarie expects the company will continue to generate rather than burn cash through the current crisis. The broker anticipates the cost focus of SMEs will be on larger ticket items such as wages, rental abatements, and reductions to less-critical operating and capital expenditure.

Moreover, even if a business is closed temporarily, financial aspects still need to be maintained. Morgan Stanley points out companies will need to complete their tax returns in order to obtain government incentives. UBS agrees that SMEs, needing to meet these requirements, are unlikely to pause subscriptions.

The broker moves to a scenario where subscriber growth is flat in FY21. This will still drive 9% growth in revenue, given the annualisation of FY20 subscriber growth and price increases. UBS expects there is flexibility in the cost base and sufficient liquidity to endure extreme scenarios.

Business Failures

Looking at the historical turnover for SMEs in Australia, the UK and US shows a spike in business failures during an economic downturn. However, Morgan Stanley notes new enterprises are also formed as people turn to self-employment and start up their own operations.

Therefore, the overall decrease in the number of businesses is not likely to be as great as many fear. Still the broker does factor in short-term headwinds from hardship, including higher churn, lower revenue per unit from price delays and fewer subscribers.

Macquarie reduces subscription growth estimates for the first half of FY21, expecting the company will retain existing subscribers. Moreover, there is flexibility in R&D investment levels and sales & marketing if subscriber numbers deteriorate significantly.

While the current situation is very different, Macquarie believes the GFC is the best proxy for what is likely to happen in terms of business attrition rates for SMEs in times of financial distress. Data from Australia showed no material increase in attrition during 2008-09 whereas the UK showed a 24% increase in attrition into 2009 before normalising in subsequent years.

As a result, while expecting the impact of the coronavirus crisis will be more pronounced, the broker interprets the data to mean that SMEs fail for a variety of reasons, not just because of working capital or cash constraints.

Morgan Stanley expects the business climate will gradually improve from FY23 and, with valuation having pullback below historical averages, has a high conviction Overweight rating on the stock.


UBS flags a risk that structural changes resulting from the pandemic could lower SME numbers but also highlights the benefits of cloud accounting software and/or regulatory changes that may benefit Xero.

Looking further out, globally cloud penetration across the applications market is still less than 50%. In Australasia, the broker estimates accounting software penetration on the cloud is around 66% in the 0-19 employees market. In the UK, this is still around 20%, and around 10% in the US.

Hence, even with turnover challenges, the uptake of the cloud software may provide growth even during a downturn in overall business.

While UBS is comfortable with the long-term opportunity and supports management's strategy, the valuation is considered above the level of which there is a fair risk/reward trade-off for investors, particularly in the current uncertain market. Hence, the broker retains a Sell rating on a fundamental valuation.

FNArena's database has three Buy ratings, one Hold (Citi) and two Sell. The consensus target is $72.25, suggesting 10.0% upside to the last share price.

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