Xero: Fair Value Estimate Raised 14% to AUD 75 on Transfer of Coverage

We raise our fair value estimate for Xero XRO 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 believe the market overestimates the quality of Xero’s business and underestimates the ongoing spending on sales and marketing required to maintain the business, especially in its international markets and especially as the business environment normalises.

The core challenge for Xero is the relatively low quality of its SME customers, which inherently have higher business failure rates than larger corporates. During each of the past three years, Xero lost around 10% of its customers, which, due to high switching costs, we expect consisted almost entirely of business failures. This implies around 40% of sales and marketing spending over the period was required just to replenish churned customers.