3 reasons why Xero (ASX:XRO) has significant upside right now

Xero (ASX:XRO) is one of the ASX’s best-performing tech stocks over the last decade, offering accounting software helping SMEs do business. Although the company has been caught up in the Tech Wreck of 2022, we think it has significant potential to bounce back, given its importance to its customers and projected growth for the years ahead.

 

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Xero is useful to customers

Xero is all about helping small & medium sized businesses do business. The company, which has over 3 million subscribers, primarily sells accounting software that helps businesses keep books, pay bills and send invoices. But it has gradually developed features useful beyond book-keeping, such as storing files, converting currencies, keeping track of inventories and creating professional quotes.

 

Xero is set for outperformance and profitability

Xero uses the New Zealand financial year, which runs April to March and will be releasing its FY22 results in mid-May.

The only guidance the company has provided for the full year is that total operating expenses as a percentage of operating revenue will be towards the lower end of a range of 80-85%. Consensus estimates expect $1.4bn in revenue (up 27%), $287.2m in EBITDA (up 35%) and EPS of 28c per share (up from -6c).

 

Strong growth ahead!

Strong growth is projected for future years. In FY24, estimates call for $1.7bn in revenue (up 21%), $377m in EBITDA (up 31%) and 0.58 EPS (up 107%). In FY25, analysts expect $2bn in revenue (up 18%), $502.5m in EBITDA (up 33%) and $1.06 EPS (up 82%).

What’s important is not only the strong revenue growth expectations, but also that the company is finally set to become profitable. There are 16 analysts covering Xero and the average share price target is $90.47, although estimates range from $59.21 to $132.40. 

 

 

Our view is a bit more conservative

We have done our own valuation of Xero and think it can reach $110.65, using the DCF methodology.

We have gone slightly more conservative in revenue growth for FY23 ($1.3b which is just 15% higher), but are more bullish in future years with 35% growth in FY24 and FY25. We have assumed revenue per user grows by an average of 17% annually. Although subscriptions for single users are priced at just A$10 per user, many companies purchase larger packages that cover multiple users. Furthermore, pricing varies from jurisdiction to jurisdiction. 

Looking at EBITDA, we have gone more conservative with $228m in FY23, $314m in FY24 and $413m in FY25.

 

Valuation of ~$110.65 per share

Using a 3.5% risk free rate of return (the current level of the 10 year government bond), a 5% equity premium, an 1.1 beta along with an 0.92 NZD to AUD exchange rate, we derive a value of $122.96.

 

You can’t just switch off Xero

We think the biggest potential risks are worsening economic conditions and investor sentiment towards companies that are only just profitable. We do not think competition is a significant risk given the superiority of the platform.

So far as investor sentiment is concerned, we think this problem will disappear as the company is expected to become profitable right about now. And even though a downturn in economic activity is a risk, we think Xero is an essential service to its customers….it’s very hard to switch it off just to save a few bucks.

 

Other potential risks for Xero investors

We do acknowledge the company has recently hired a new CEO in Sukhinder Singh Cassidy, who started in February. Some investors may wish to wait and see how he performs, especially given that the company was founder-led for so long.

Some investors have been disappointed specifically with the company’s performance in the UK market and fear the poor state of the UK’s economy could mean that Xero continues to disappoint there. Although the UK is easily the company’s second-largest market, only behind Australia, it is responsible for only 26% of subscriber numbers and 27% of revenue. We don’t think this market alone should impact the entire company, barring some doomsday scenario.

 

Xero set for strong growth in the months and years ahead

Although longer term investors might be pre-occupied with Xero’s ~50% share price decline in the last 15 months, since October 2021, we believe the current levels may provide good entry opportunities for investors looking to get into a fast growing Tech stock with ample expansion opportunities globally.

Looking at the share price chart, we believe the stock has broken its downtrend and may test that breakout in the next few weeks in the $72-74 range.

 

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