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Xero Ramps Reinvestment

Australia | May 18 2021

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

Xero is at a fork in the road, needing to reinvest to stay ahead of a competitive software market while also managing investor expectations

-Long-term profitability achieved during the pandemic
-Lack of commentary on actual trading so far in FY22
-Is the negative reaction in the share price warranted?


By Eva Brocklehurst

Can Xero Ltd ((XRO)) retain its exceptional growth path in accounting software, reinvest and still keep costs under control? This is the issue that prevails after the company lowered FY22 forecasts for operating earnings (EBITDA) margins.

As conditions improved throughout the second half of FY21 Xero progressively increased sales and marketing expenditure which in turn drove net subscriber growth of 280,000. Churn was also reduced significantly.

The company is increasing its investment in R&D to capitalise on a large global market that is under-penetrated, while the pandemic has accelerated the adoption of cloud software.

FY21 revenue of NZ$849m was up 18% while operating earnings rose 37%. Nevertheless, the earnings outcome was below many estimates because of a sharp increase in sales and marketing expenditure as well as product investment.

EBITDA margins have been pushed back to pre-pandemic levels and are likely to remain at lower levels, with management guiding for FY22 operating costs to be 80-85% of operating revenue.

Jarden, not one of the seven stockbrokers monitored daily on the FNArena database, has a Buy rating with a $150 target and remains comfortable with the growth outlook, believing investors should take comfort in the fact long-term profitability has been achieved during the pandemic.

Subscriber growth was offset by soft international average revenue per user (ARPU) and higher operating expenses. Ord Minnett notes the weak ARPU was driven partly by currency and a shift in product mix that is likely to persist over the medium term.

The broker expects a delay to material earnings growth and, although the company exhibits a number of good characteristics, the business is not generating enough growth and margin expansion to justify the current valuation.

UBS is of a similar view, although notes net subscriber growth was well ahead of expectations. The broker is positive about the structural tailwinds, and management's ability to execute, but agrees the valuation is well above levels where a fair risk/reward trade-off exists for investors.

Reinvestment Critical

The second half signalled a faster return to material reinvestment than Wilsons, also not one of the seven, had anticipated. While tempted to upgrade on fundamentals, the broker retains a Market Weight rating with a $107.54 target, highlighting the potential for technology multiples to ease back on macro factors.

The reaction to the results was negative yet Morgan Stanley recounts the early days when Xero was the challenger and MYOB the leader. Xero had two crucial advantages at the time: cloud-based, meaning no legacy desk-top to maintain, and low expectations about high margins and/or dividends.

The broker asserts that, for a software provider to capture and sustain a leadership position, continual reinvestment is required. Therefore, Xero's decision to revert to early expenditure/investment ratios is strategically and financially sensible.

The broker acknowledges there needs to be re-basing of the consensus expectations over the short term and lowers FY22 EBITDA estimates by -7.3% and FY23 by -17.4%.

Macquarie takes a middle course, noting the stock is trading at a premium compared with other software peers in terms of valuation but that could be justified by stronger earnings per share and sales growth rates over the forecast period.

The broker expects the downgrades to the earnings outlook will be a negative for the short term as the market adjusts to management's guidance on operating costs. Over the longer term this will be countered by demonstrating that pre-pandemic revenue growth rates can be restored.

Historically, Xero provided some commentary about trading but Macquarie notes this was not the case for FY22. The company has reaffirmed an intention to reinvest the cash being generated, which the broker assumes will involve both acquisitions and organic development.

Credit Suisse is upbeat, agreeing with Morgan Stanley that the negative reaction reflected in the share price is unwarranted. The broker lauds the recent Planday acquisition as this segment has a substantial market opportunity amid low levels of penetration and it compliments the existing business.

Credit Suisse points to user growth and broad geographic strength, noting revenue per user held up, gross margins increased and churn was reduced. The broker is comfortable looking through the soft FY21 margin and FY22 guidance, because of the strength in the top line.

Goldman Sachs, too, is upbeat, reiterating a Buy rating with a $151 target. The broker, also not one of the seven, assesses the company's products are increasingly important in an accelerating period of global digitisation.

FNArena's database has something for everyone, with two Buy ratings, two Hold and two Sell. The consensus target is $116.83, level with the last share price. Targets range from $81 (UBS) to $135 (Morgan Stanley).

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