Too Low For Xero?

Australia | May 16 2022

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

Amidst weak market sentiment, Xero reported earnings last week and the market response was poor and while brokers acknowledge the reasoning, the longer term theme remains attractive to most.

-Xero beats on earnings and revenue
-Misses on subscriber growth
-Plans further reinvestment for growth

By Greg Peel

It’s been a tough year for the Australian market and a particularly tough year for the technology sector. And even tougher for companies within the sector considered “growth” stocks.

For stocks still in the growth phase – many of which have yet to post a profit – future earnings forecasts are critical to valuation. Those forecasts are undermined if the cost of money through the period increases, and that is brought about by higher interest rates.

The ASX200 technology sector is very much beholden to the Nasdaq, and whether or not this is justifiable on a daily basis, there is no doubt Fed monetary policy aggression has impacted heavily on the US technology sectors in 2022 and the same is now apparent for RBA policy.

Accounting software company Xero ((XRO)) picked a bad day to release its FY22 earnings result, as the mood last Thursday wreaked of capitulation and no where was this more evident than in another big sell-off for the technology sector.

Problematic Subs

Xero shares fell -12% on the day following its result amidst very weak market sentiment encouraging trigger-happy sellers.

The reason for the response was twofold.

It was not about earnings, which rose 11% on FY21, nor revenues, which rose 29%, in both cases exceeding broker forecasts. It was not about average revenue-per-user growth, as this also beat expectations. ARPU rose 2% in Australia & New Zealand, 14% in the international markets and 7% at the group level.

It was partly about lower than expected subscriber growth, which fell -0.5% in A&NZ, -3% in the UK, -1% in North America and -10% in Rest-of-World. But of those results, the UK was the surprise.

Brokers had assumed a better result given regulatory tailwinds offered by the country’s new Making Tax Digital policy. Management noted, nonetheless, that the weakness was not Xero-specific, rather industry-wide, and that two-thirds of small businesses in the UK still needed to make the change into FY23.

Investors were also disappointed that Xero plans to continue reinvesting for growth. Brokers had assumed FY23 would be the year the company began to see the benefits of recent investment, but operating leverage will have to wait longer. Instead, management will continue to focus on reinvesting cash to drive long-term shareholder value.

Yet in the absence of new acquisitions, Macquarie believes Xero will still be able to deliver positive free cash flow in FY23.

In Ord Minnett’s view, Xero has a good case to make these reinvestments, as the opportunity set remains large and untapped in Xero’s offshore markets. In addition, cloud accounting is becoming increasingly vital for small businesses as they adapt to regulatory change and users are incredibly sticky, with less than 1% churn. Hence the broker believes monetisation and operating leverage will come, although first you need to capture the customers.

To that end, and considering the share price plunge on the day of the release, Ord Minnett upgrades to Buy from Accumulate.

Morgan Stanley notes that like all software peers, the market is reassessing the right way to value Xero shares amidst the turbulence of the current climate. But Morgan Stanley also sees longer term value, noting an enterprise value-to-sales ratio of 9x (with stock price at $86.97) compares with a long-term average of 12x and a peak of 25x.

Morgan Stanley retains Overweight.

But Macquarie notes Xero is still trading at premium relative to online accounting peers based on a one-year forward enterprise value-to-sales ratio, and the broker is more cautious on weaker than expected international subscriber growth, which adds to concern about Xero’s high penetration in an increasingly mature A&NZ division.

Macquarie sticks with a Neutral rating.

Citi choruses the view that Xero should deliver strong growth in the UK driven by cloud adoption, especially due to the Making Tax Digital regulatory changes. Citi retains a Buy.

UBS is not convinced, going into the result with a Sell rating and making no change.

With an increasing market focus on free cash flows and rising bond yields, valuing Xero on a discounted cash flow basis remains challenging, UBS concedes, albeit Xero's share price is significantly less stretched than it was six months months ago. With earnings margin guidance implying only a marginal increase versus FY22, and Xero highlighting a similar rate of reinvestment in product design and development, investors should assume only modest free cash flow in FY23. The broker continues to view the risk-reward balance as unfavourable.

As a result of the subscriber-growth miss, covering brokers in the FNArena database have cut the consensus target to $110.50 from $120.77, which suggests 26% share-price upside. However, high-market Credit Suisse, with a target of $160, has not updated on the stock in 2022. Removing this target takes consensus down to $100.60.

And on the market recovery on Friday, particularly in the tech sector (up 8%), Xero’s share price recovered 9%, and is up another 4% today at the time of writing.

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