Company Reports

Last year, narrow-moat Xero’s new CEO announced that under her tenure, the company would “look to” the so-called Rule of 40, which is a commonly used metric to assess software-as-a-service, or SaaS, businesses. Although management was reluctant to set the rule as a hard target at the time, the company did end up meeting the Rule of 40 in fiscal 2024, at least by its own measurements. We believe Xero’s well-publicized pursuit of the Rule of 40 has spurred greater interest in the metric across the technology landscape in Australia. We therefore review and discuss the performance of other Australian SaaS companies against this metric. Our fair value estimates for these companies are unchanged.

We expect Xero’s near- and medium-term strategic focus to revolve around rationalizing its areas of investment, especially against a backdrop of normalizing demand for business software.

We increase our fair value estimate for narrow-moat Xero by 9% to AUD 85 per share. The increase is primarily driven by better-than-expected improvements in Xero’s operating leverage, borne out in the fiscal 2024 result. Operating expenses, excluding nonrecurring costs, declined to 73% of revenue during fiscal 2024 from 81% the year prior. This exceeded management guidance of 75% for the full year, which it reiterated in its half-year results—already an ambitious implied improvement from 79% in the first half. We had expected a more gradual improvement and for Xero to report operating expenses equating to 77% of revenue for the full year. Given Xero’s rapid improvement, we raise our midcycle operating margin assumption for the company to 34% from 32% previously.

We expect Xero’s near- and medium-term strategic focus to revolve around rationalizing its areas of investment, especially against a backdrop of normalizing demand for business software.

Narrow-moat Xero’s investor day offered no material updates to its current strategy. We believe Xero’s strategy is spreading the group’s resources too thin. CEO Sukhinder Cassidy, who has now been in the position for a little over a year, highlighted the group’s “3 x 3” strategy focusing on three core solutions of accounting, payroll, and payments, and three core markets of Australia, the United Kingdom, and the United States.

We raise our fair value estimate for narrow-moat Xero by 4% to AUD 78 per share following interim fiscal 2024 results. Subscriber growth was in line with our expectations while growth in average revenue per user, or ARPU, was slightly stronger than expected. Our upgrade is primarily driven by lower-than-expected churn in Xero’s international segment which may hint at a maturing customer base. At current prices, Xero shares remain materially overvalued.

We expect Xero’s near- and medium-term strategic focus to revolve around rationalizing its areas of investment, especially against a backdrop of normalizing demand for business software.

We maintain our AUD 75 per share fair value estimate for narrow-moat-rated Xero as we approach the release of its half-year results on Nov. 9. At current prices, Xero shares screen as materially overvalued. We believe a normalizing business environment will result in Xero having to spend an increasingly large share of its sales and marketing budget to replace churned customers, which leaves increasingly less budget to fuel subscriber and revenue growth.

We raise our fair value estimate for Xero by 14% to AUD 75 per share following a transfer of coverage to a new analyst. We maintain our narrow moat rating for Xero but add network effects as a moat source in addition to switching costs, derived from the relationship between SMEs and accounting and bookkeeping practices, especially in Australia and New Zealand. The increase in our fair value estimate is primarily derived from our evolved understanding of Xero as a sales-and-marketing-led company, as opposed to a product-led company, due to SME customers inherently valuing simplicity, rather than additional features and functionalities. We therefore expect Xero to sharply reduce expenditure on product design and development, and to bring its research and development spending in line with global peers Intuit and Sage. We forecast revenue to grow at a 10-year CAGR of 10% during the explicit forecast period and EBIT margins to increase materially to 29% in fiscal 2033 from 4% in fiscal 2023. We maintain our Standard Capital Allocation Rating and High Morningstar Uncertainty Rating. At current prices, Xero shares screen as materially overvalued.

We increase narrow-moat Xero's fair value estimate by 11% to AUD 60 per share with its new plan to reduce costs and focus on disciplined growth. Our fair value increase reflects a reduction in our ongoing cost assumptions, specifically for product design and development.

We maintain our AUD 54 fair value estimate for narrow-moat Xero following the company's interim financial results. Xero’s share price fell 11% following the announcement, which we think was due to heavy reported losses and uncertainty introduced by the resignation of CEO Steve Vamos. At current prices around AUD 65, the shares screen as overvalued.

We have increased our fair value estimate for narrow-moat-rated Xero by 9% to AUD 50.00 per share, despite significantly cutting our near-term earnings forecasts following the full-year result. Although the short-term earnings outlook is worse than both we and the market previously expected, we don’t believe the long-term outlook has materially changed. Our fair value increase reflects the positive time value of money effect on our financial model combined with slightly higher long-term earnings forecasts, as subscriber growth is tracking ahead of our expectations. However, at the current market price of AUD 112 per share, we continue to believe Xero is materially overvalued.

We have maintained our fair value estimate for narrow-moat-rated Xero at AUD 46 per share following its EUR 156 million, or AUD 235 million, acquisition of employee scheduling software provider, Planday. At the current market price of around AUD 113, we continue to believe Xero shares are significantly overvalued.

Xero has grown quickly since incorporation in 2006 to become the largest provider of accounting software as a service, or SaaS, to the SME market in Australia and New Zealand. We expect the company to continue leveraging this strong position to expand quickly in other regions such as the United Kingdom and the United States.

Xero has grown quickly since incorporation in 2006 to become the largest provider of accounting software as a service, or SaaS, to the SME market in Australia and New Zealand. We expect the company to continue leveraging this strong position to expand quickly in other regions such as the United Kingdom and the United States.

Narrow-moat Xero will not report its interim financial results until November 2020, but we have reviewed our financial forecasts following several reasonably minor announcements during the past month. We have cut our short-term revenue and earnings forecasts as a result of the coronavirus pandemic, but Xero’s fair value depends largely on its long-term prospects, which are not sufficiently affected to justify changing our AUD 46 fair value estimate. At the current market price of around AUD 93, we continue to believe the stock is significantly overvalued.

Unlike most other ASX listed companies, Narrow moat rated Xero did not report a financial result last month because it has a March financial year-end. The company has announced little of any significance since its interim result last November and we don’t expect much to be announced before the full year result in mid May 2020.

Xero has grown quickly since incorporation in 2006 to become the largest provider of accounting software as a service, or SaaS, to the SME market in Australia and New Zealand. We expect the company to continue leveraging this strong position to expand quickly in other regions such as the United Kingdom and the United States. Current losses are an acceptable price to pay for rapid growth and associated strategic benefits, and we forecast a maiden profit in fiscal 2020. The capital-light business model should enable returns on invested capital, or ROICs, to comfortably exceed the weighted average cost of capital, or WACC, from fiscal 2020, supporting our narrow economic moat rating.

We don’t believe the 10% share price jump that followed narrow-moat rated Xero’s interim result was justified by the company’s first-half performance. Generally speaking, the result was in line with our expectations, and we have maintained our earnings forecasts. Our fair value estimate has increased by just 1% to AUD 46.00 due to the time-value-of-money effect on our financial model, and we continue to believe the shares are significantly overvalued. At the current market price of AUD 73.89, Xero trades on an expensive fiscal 2020 enterprise value to revenue multiple of 15 and price/earnings ratio of 266. We expect Xero will report a maiden annual profit in fiscal 2020 and an EPS CAGR of 35% over the subsequent nine years, albeit off a relatively low base.

Xero has grown quickly since incorporation in 2006 to become the largest provider of accounting software as a service, or SaaS, to the SME market in Australia and New Zealand. We expect the company to continue leveraging this strong position to expand quickly in other regions such as the United Kingdom and the United States. Current losses are an acceptable price to pay for rapid growth and associated strategic benefits, and we forecast a maiden profit in fiscal 2020. The capital-light business model should enable returns on invested capital, or ROICs, to comfortably exceed the weighted average cost of capital, or WACC, from fiscal 2020, supporting our narrow economic moat rating.