Xero Rally Doesn't Add Up For Brokers
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Xero ((XRO)) posted a maiden positive earnings in the first half, although an unexpected decision to de-list from the NZ Stock Exchange in favour of a sole ASX listing is suspected behind a negative reaction in the share price, which fell -2% post the result. The company also suggested that after cash break-even is achieved, it will reinvest in growth. Strong subscriber growth in Australia and a continued ramp-up in the UK are the highlights of the results.
The company may be one of the fastest-growing software as a service (SaaS) businesses globally, with dominant positions in New Zealand and Australia, but the stock has appreciated by around 90% since the beginning of the year.
As a result UBS downgrades to Sell from Neutral. To justify valuations above NZ$35 requires overly optimistic assumptions on market share, in the broker's opinion, as well as a reduction in churn and acceleration in revenue growth. Macquarie agrees that an aggressive set of valuation assumptions is not enough to justify a positive stance on the stock, and downgrades to Underperform.
UBS expects momentum on the cloud to continue and translate into strong market share but this strength is likely to be shared with MYOB ((MYO)). Moreover, while growth off the base can accelerate and a sustainable presence be built, failure to do so quickly will pose difficult questions regarding investment.
Credit Suisse also downgrades, to Underperform from Neutral, and suggests the main question posed by recent strength in the share price is whether further upside can emerge in the near term and, on this subject, strategically, not much has changed. The company's dominant in Australasia and has a firm position in the UK, with technology advantages that can be monetised in time.
Nevertheless, the model is not completely de-risked and scale in North America is still required for ultimate success. While adopting more optimistic forecasts, Credit Suisse finds its valuation still well shy of the current share price and suspects the market is ascribing significant value to long-dated growth for which further evidence is required.
Citi remains focused on the longer term. The broker found core business trends solid, with a first half gross margin of 80.1% slightly above expectations amid better subscriber growth in Australasia. Mild share gains are envisaged versus competitor MYOB.
The broker continues to forecast positive free cash flow in FY19, a key inflection point for the stock, and removes its "High Risk" rating given ongoing improvements in the financial profile and ample cash. The broker remains attracted to the company's first mover dominance of cloud accounting in Australasia and the high growth outlook.
Customer Growth Preference
Citi suspects average revenue per unit growth is more of a story for FY19, as management has limited price increases given the new products being launched. Macquarie also notes the company's intention to pursue customer growth rather than near-term profits and suggests the cost to acquire each new customer is the number to focus on when reviewing the efficiency of sales and marketing expenditure.
The company has reduced its cash burn, moderating growth in product development investment over the past two years. Macquarie considers this aspect more important than whether the business is breaking even at the net profit level. The broker gives the company the benefit of the doubt and retains a strong growth outlook in its forecasts.
The company plans to remove its NZ Stock Exchange listing by the end of January 2018, stating this will focus all liquidity on one market and should make trading the shares easier. The company will move to a sole primary listing on the ASX as of February 5, arguing the ASX has a deeper pool of capital and expertise. Brokers were surprised by the decision, with Macquarie stating it is unconventional and perhaps should have been done after a formal poll was carried out.
Deutsche Bank suggests this is a significant loss to the NZX. Typically, when a company moves its listing, it creates some churn in the shareholder register. NZ-based individuals and institutions currently hold 37% of the shares and Xero now accounts for 3.5% of the benchmark NZX50 index.
Deutsche Bank does not expect the change of primary venue will result in a meaningful increase in valuation, with the stock already been priced consistently with valuations for other platforms. UBS points out that Xero will become an Australian listed company with an NZ domicile and NZ dollar reporting, and remains sceptical there is a valuation arbitrage based on location or size of the primary listing exchange.
There are three Sell ratings now on FNArena's database versus none prior to Xero's results. There is one Hold remaining (Deutsche Bank) and one Buy (Citi).
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