Download Xero offers an attractive combination of growing

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Xero: Build It and They Will Come
Xero offers an attractive combination of growing recurring global
earnings protected by an economic moat.
Morningstar Equity Research
23 June 2016
Executive Summary
Xero (ASX:XRO) has grown quickly since incorporation in 2006 to become the largest provider of
accounting software as a service, or SaaS, to the small and midsize enterprise, or SME, market in
Gareth James
Senior Equity Analyst
+61 2-9276-4583
[email protected]
Andrew Lange
Equity Analyst
+1 312-696-6036
[email protected]
Brian Colello
Director of Telecommunications,
Media, and Technology Research
+1 312-384-3742
[email protected]
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 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 ROIC, to comfortably exceed the weighted average cost of capital, or WACC, from 2020,
supporting our narrow economic moat rating. We believe the shares offer value at current levels,
and at the current market price of NZD 18.85, they are 10% below our fair value estimate of NZD
21.00 per share.
Key Takeaways
× Xero has a sustainable competitive advantage, or economic moat, based on customer switching
costs and annual customer retention rates of over 80%. The narrow moat rating reflects our view
that excess returns should be sustainable for at least a decade and is in line with ratings for peers
MYOB (ASX:MYO) and Sage (GB:SGE). Intuit's (US:INTU) wide moat rating reflects its leading global
position and dominance of the large U.S. market.
× Xero is currently loss-making but offers strong revenue and earnings growth. We forecast a
subscriber CAGR of 17% over the next 10 years and a 10-year revenue CAGR of 23%, and we expect
positive net profit after tax from fiscal 2020. Our fair value estimate assumes a terminal EBITDA
margin of 30% and an enterprise value, or EV/EBITDA multiple of 10.5 times.
Xero's recent financial losses represent investment in future earnings rather than a flawed
business model, as customer acquisition costs are expensed at the initiation of subscriptions, but
revenue is earned over the life of the subscription. We expect Xero's share price to be underpinned
to some degree by the potential for the company to be acquired by a larger software company,
such as Intuit or Sage.
Companies Mentioned
Name
Ticker
Economic
Moat
Currency
Xero
MYOB Group
Reckon
Intuit
Sage Group
XRO:NZ
MYO:AU
RKN:AU
INTU:US
SGE:GB
Narrow
Narrow
None
Wide
Narrow
NZD
AUD
AUD
USD
GBP
Fair Value
Estimate
21.00
3.50
1.75
90.00
5.03
Current Uncertainty Morningstar
Market
Price Rating
Recommendation Cap(Bil)
18.85
3.35
1.51
105.36
5.91
High
Medium
Medium
Medium
Medium
Hold
Hold
Accumulate
Reduce
Reduce
2.6
2.0
0.2
27.0
6.6
Note the Morningstar rating for non-Australian companies represented in this table has been converted from a star rating to a recommendation
for the purpose of comparison.
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the
content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar Australasia
Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more
information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New Zealand products)
before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product’s
future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 (“ASXO“).
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1. Executive Summary
Our Fair Value Estimate of NZD 21.00 per Share Implies Xero Shares Are Undervalued
At the current market price of NZD 18.85 per share, our fair value estimate of NZD 21.00 per share
implies Xero shares are undervalued. Our discounted cash flow valuation model includes a
terminal-year EBITDA margin of 30% in fiscal 2026 and a terminal EV/EBITDA multiple of 10.5 times.
The fiscal 2017 EV/sales multiple is 9.7 times, based on our fair value estimate, compared with 5.2
times for Intuit, 4.3 times for Sage, and 6.2 times for MYOB; this reflects Xero's relatively high
revenue growth rate. We stress that our terminal value for Xero comprises 58% of the enterprise
value, meaning our valuation is sensitive to terminal assumptions and leading to a high fair value
uncertainty rating.
Evolving Moats Are a Key Trend to Watch
We believe Xero has an economic moat built on strong customer switching costs. However,
network effects could be created in the sector if customer bases become sufficiently large and
customer interaction increases. The large amount of data created by such a platform could be used
to provide more accurately priced financial products, for example, or the customer base could be
used to effectively provide liquidity for financial products such as peer-to-peer lending. Xero's
strong customer growth positions it well in this regard.
Impressive Shareholder Register
Xero is well funded, with NZD 184 million in cash and short term deposits as at March 31. The
company is also backed by highly successful technology entrepreneurs, such as Craig Winkler,
founder but no longer a shareholder of Xero's key competitor MYOB; Sam Morgan, founder of
TradeMe (NZX:TME); and Peter Thiel, cofounder of PayPal. Winkler's involvement with Xero adds
significant insight into the Australian and New Zealand market and major local competitor MYOB,
while Peter Thiel brings international financial technology expertise and relationships with large
technology investors. Xero's founder and CEO Rod Drury's 15% shareholding means his interests
are also aligned with shareholders.
Additional Capital Unlikely to Be Required
Xero's management team does not expect the company to require additional capital to meet
existing growth aspirations. Our base-case scenario also assumes existing cash balances will be
sufficient to avoid the need for additional capital. However, if revenue growth does not meet our
expectations, additional capital may be required. If capital were needed, we think the preferred
option would be an institutional equity placement.
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
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2. Business Model
2.1. Company Background
Xero is a New Zealand-based software company that specialises in cloud-based SME accounting
software delivered via an SaaS model. Since incorporation in 2006 the company has attracted
717,000 subscribers (as at March), implying market shares of around 55% in New Zealand, 21% in
Australia, 4% in the United Kingdom, and less than 1% in the United States.
Xero was founded by Rod Drury and Hamish Edwards in 2006; Drury remains the CEO, a director,
and the largest shareholder. Drury has over 20 years' experience in the information technology
sector including founding and selling successful companies. Edwards remains a shareholder but
resigned as a director in 2011. Xero has been listed on the New Zealand stock exchange since 2007
and on the Australian Securities Exchange since 2012. Significant shareholders include successful
technology entrepreneurs Craig Winkler, founder of Xero's key competitor MYOB; Sam Morgan,
founder of TradeMe; and Peter Thiel, cofounder of PayPal.
In the early 2000s, Drury and Edwards recognised the impending disruption to incumbent desktopsoftware-centric providers, such as Intuit, Sage, MYOB, and Reckon (ASX:RKN), by cloud-based
SaaS business models, made viable by growing Internet penetration, faster download speeds, and
increased use of mobile computing devices, such as smartphones and tablets. This disruption
created a window of opportunity to surmount incumbent providers' competitive advantages, or
economic moats, before the re-establishment of switching costs in the SaaS market.
Accounting software is an important component of SME management, and desktop-hosted
software has historically had high switching costs that act as a barrier to new market entrants. The
financial benefits of changing accounting software provider have typically been small and
outweighed by operational risks. Software was also often chosen on the recommendation of
accountants, making accountants key gatekeepers to the SME market.
The transition from a one-off upfront fee for a perpetual licence towards monthly subscription fees
also presented an opportunity to increase customer retention rates, historically around 80%, as well
as customer lifetime value, or LTV, thereby justifying higher customer acquisition costs, or CAC, to
some degree. The SaaS model also enables more seamless product upgrades and associated price
increases, thereby removing the need for and cost of explicit upgrade sales, in turn supporting
retention rates.
Xero's strategy of granting third-party access to its application programming interface also
differentiated the company from competitors and encouraged development of third-party
applications, adding functionality to Xero's core accounting product. We estimate that SME
accounting software is used by around 70%-80% of all SME businesses in Australia and New
Zealand, including nonemploying businesses, and that cloud software comprises around 40% of this
currently, or around 30% of all businesses.
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
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Modern User-Friendly Product Suite Supports Growth
Xero sells cloud-based SME accounting and accounting practice management software delivered
via an SaaS model. In contrast to traditional one-off upfront perpetual licence fees, Xero's software
is sold on a monthly subscription basis, with no contract lock-ins. Customers can access Xero via
any web-enabled device and can grant access to others, such as their accountants. Xero's SME and
accounting practice management software offerings are highly integrated with each other and with
over 450 third-party applications, or apps, which offer additional functionality such as specialised
inventory management, payments, and reporting functionality. Xero estimates that around 20% of
all customers, and 40% of premium customers, use third-party apps, increasing customer switching
costs. These figures highlight the greater upsell opportunity for larger SME customers relative to
micro businesses. Xero's simple and user-friendly interface is shown in Exhibit 1.
Exhibit 1 Xero Screenshot
Source: Morningstar, Xero.com
2.2. Xero Business Edition
Xero Business Edition is Xero's core SME accounting software offering and includes a wide range of
features, some of which are listed in Exhibit 2. Customers pay on a monthly basis for access to the
cloud-based software and have no upfront or subscription break fees. The principal difference
between subscription costs relates to the number of employees using the payroll software, as
shown in Exhibit 4; however, as SME numbers are skewed towards micro businesses, this
somewhat limits upsell potential for subscriptions.
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
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Exhibit 2 Xero Business Edition Features (Australia)
Online accounting
Multi device access
Dashboard
Live bank feeds
Bank reconciliation
Quotes and Invoicing
Invoice reminders
Inventory
Payroll
Expense claims
Reporting
Payments
Source: Morningstar, Xero.com
2.3. Practice Management Software
In addition to its core Business Edition product, Xero also provides accountants and bookkeepers
with business management software for use in their own businesses, and SME software for sale to
their clients. Xero's business-management software offering comprises the following:
× Xero Partner Edition is cloud-based business-management software primarily for smaller single-
partner accounting firms and bookkeepers, and is used to manage SME clients that also use Xero
software.
× Xero Practice Studio is cloud-based business-management software primarily for larger
accounting firms with multiple partners and comprises the following four key modules:
× Xero Practice Manager includes timesheet management, job tracking, quoting, report
generation, and invoice management, and generally enables more accurate work-inprogress management.
× Xero Tax enables easy preparation and lodgment of activity statements of up to 1,000
individual and nonindividual tax returns per month for Xero and non-Xero clients. Users
can import client information from Xero SME software, other SME accounting software,
and the Australian Taxation Office.
× Xero Workpapers provides streamlined workflow management tools and simultaneous
collaboration. The software's cloud-based nature means accountants can work remotely
and outsource work and can communicate easily with clients online. Accountants can
prioritise workflow, easily gain access to data, maintain an audit trail, upload
documents, and send questions to clients.
× Xero Reporting enables report generation via personalised and reusable templates
integrated into client data, removing the need to migrate data from other systems or
post alignment journals.
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
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3. Growth Strategy
3.1. Rapid Customer Growth Likely to Continue
Xero was an early mover in the SME accounting SaaS segment and grew quickly, owing to the
productivity benefits of its software relative to incumbent desktop products. Desktop SME
accounting software customers still present a large and key near-term growth opportunity for SaaS
providers. In the Australian and New Zealand market, for example, we estimate that around 30% of
SME businesses with fewer than 20 employees use cloud SME accounting software, and a further
50% of SMEs use desktop accounting software, as illustrated in Exhibit 3.
Xero's opportunity in Australia and New Zealand therefore primarily lies in the replacement of
desktop accounting software with cloud-based software. The number of SMEs in Australia and New
Zealand has not grown over the past four years, and we forecast only a 1% CAGR over the next five
years. The functionality benefits of cloud-based software are helping to increase penetration of the
Australian and New Zealand market to some degree, particularly in the micro business segment,
which has historically been the least likely segment to use accounting software. Xero's extensive
and user-friendly educational resources, such as Xero U, Xero TV, and regular Xerocon conferences,
also help in this regard.
Exhibit 3 Australian and New Zealand Accounting Software Market
Desktop users
3,000,000
Cloud users
AUS/NZ SME's (<20 employees)
Xero users
2,500,000
2,000,000
1,500,000
1,000,000
500,000
2012
2013
2014
2015
2016 2017 F 2018 F 2019 F 2020F 2021F 2022F 2023F 2024F 2025F
Source: Morningstar estimates, company data
Xero's competitors have released cloud SME software in recent years, thereby eroding its unique
selling points to a large degree. Nevertheless, Xero sits in a rosy position. The company now
benefits from a strong brand and scale in research and development, sales and marketing, and
third-party applications, which continue to underpin sales momentum. Xero's timing was spot-on,
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
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as the window of opportunity to enter the SME SaaS market and achieve scale has also arguably
closed now that incumbents are competing in the market. Additionally, incumbent providers also
face the distraction of transitioning other legacy desktop products to the cloud.
Xero's customer numbers grew at a CAGR of 59% to 717,000 in the two years to March, and we
expect a CAGR of 18% over the next decade to over 3 million, as shown in Exhibit 4. However, we
estimate that this customer base will still represent less than 20% of the total addressable market
across Xero's four key markets in 2026, comprising market shares of 86% share in New Zealand,
54% in Australia, 29% in the United Kingdom, and 8% in the United States. The United States forms
an important component of Xero's growth strategy but is arguably the most challenging market in
which to compete, given the dominance of wide-moat provider Intuit. Intuit is the world's largest
provider of SME accounting software and previously defended its position against software giant
Microsoft.
Exhibit 4 Customer Growth
New Zealand
Australia
United Kingdom
North America
Rest of World
Customers
4,000,000
Morningstar Forecasts
CAGR: 17.5%
3,500,000
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
0
FY26 F
FY25 F
FY24 F
FY23 F
FY22 F
FY21 F
FY20 F
FY19 F
FY18 F
FY17 F
FY16
FY15
FY14
FY13
FY12
FY11
FY10
FY09
FY08
FY07
Source: Morningstar, Xero company announcements
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
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4. Industry and Moat Analysis
4.1. Market Opportunity
Exhibit 5 illustrates the number of SME businesses in each of Xero's key markets. It shows that the
vast majority of businesses in all markets are nonemploying businesses, a segment that has
historically been relatively difficult to penetrate and monetise, given low software needs and low
potential revenue per customer. These businesses historically had the least need for accounting
software and were more likely to instead use Microsoft Excel or paper records. However, we expect
the increased use of mobile computing devices to increase penetration of this huge segment. We
have estimated a total addressable market in each of Xero's four key markets, based on discussions
with market participants and analysis of small businesses' data, excluding businesses with very low
revenue.
Exhibit 5 Number of Businesses in Xero's Primary Markets as at April
Customers
(millions)
Nonemploying businesses
Employing businesses
TAM ~ 11
TAM = total addressible market (green highlight)
30
28.2
5.2
25
20
15
10
23.0
TAM~ 0.34
TAM ~ 1.5
TAM ~ 3
5.3
5
0.5
0
New Zealand
0.1
0.4
2.1
Australia
1.2
0.8
1.3
4.1
United Kingdom
United States
Source: Morningstar, Australian Bureau of Statistics, Statistics New Zealand, United Kingdom Office for National Statistics, United States Census
Bureau
The huge self-employed segment is likely to have less appeal to software providers from a revenue
perspective than for the potential liquidity it could add to a SME financial services platform, and the
associated network effects this would create. We estimate that around 80% of SMEs in Australia
and New Zealand use accounting software, and that around 40% of these, or 30% all businesses,
use cloud software. This creates a significant growth opportunity for SaaS providers to win market
share, not only from desktop software users, but also from higher market penetration.
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
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Cloud-based accounting software offers a step change in productivity for SMEs, simplifying and
automating time-consuming manual processes. This reduces dependence on accountants, who will
need to change their value proposition from an outsourced labour model towards becoming expert
advisors. This could lead to a reduction in accountants on a per capita basis.
However, while the outlook for accounting practice software could be threatened, opportunities in
the SME segment appear promising. In most economies, SMEs comprise over 90% of all businesses,
but monetisation of this segment has historically proved difficult, given SMEs' relatively minimal
software needs and the relatively high cost of perpetual software licences. However, the
emergence of monthly SaaS pricing has significantly reduced the initial cost, and functionality
benefits (such as multiuser mobile access, cloud-based invoicing, payments, and bank integration)
have created material productivity benefits. In addition, younger generations increasingly live their
lives on the Internet and expect services to be web-based and interactive with other services they
use. These attributes are helping to increase penetration of the very large SME market,
underpinned by growth in the "sharing economy" and new platforms such as Uber, Airbnb, eBay,
and freelancer.com.
4.2. Xero Has a Narrow Economic Moat
We have awarded Xero a narrow economic moat rating based on switching costs, underpinned by
annual customer retention rates of around 85% and in line with peers Sage (narrow moat stemming
from switching costs) and MYOB (narrow moat stemming from switching costs). Intuit benefits from
a wide moat rating as a result of its position as the largest provider in the world and associated
scale benefits, and because of its dominance of the U.S. market, where its TurboTax product is also
the leading personal taxation software product. Following the ending of its relationship with Intuit
in 2014, Reckon lacks an economic moat, and we believe that it will struggle to keep pace with its
much larger competitors' spending on research, development, sales, and marketing. We don't
believe either network effects or brands are sufficiently developed at this stage to be a source of
competitive advantage. We consider Xero's moat trend to be stable, in line with those of peers, as
we don't believe customer retention rates are sufficiently improving, or switching costs
strengthening, to justify a positive trend at this stage.
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
Page 10 of 13
Xero: Build It and They Will Come | 23 June 2016
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Healthcare Observer | 23 June 2016
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Paper Title | 23 June 2016
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Healthcare Observer | 23 June 2016
5. Financial Forecasts
5.1. Income Statement
Exhibit 6 Xero Income Statement Forecasts
FY15
FY16
FY17 F
FY18 F
FY19 F
FY20 F
FY21 F
Revenue
127.2
207.8
313.5
437.3
587.5
754.1
923.6
Cost of sales
(37.4)
(49.9)
(70.7)
(94.9)
(122.1)
(149.5)
(183.4)
Gross profit
89.8
157.9
242.8
342.4
465.4
604.6
740.2
Gross profit margin
71%
76%
77%
78%
79%
80%
80%
Sales and marketing
(93.5)
(148.3)
(191.1)
(250.4)
(298.7)
(309.3)
(357.1)
Product design and development
(49.0)
(69.7)
(89.8)
(117.7)
(140.3)
(145.3)
(167.8)
General and administration
(24.5)
(30.8)
(39.8)
(52.1)
(62.1)
(64.3)
(74.3)
(167.0)
(248.8)
(320.7)
(420.2)
(501.1)
(518.9)
(599.2)
Sales and marketing
73%
71%
61%
57%
51%
41%
39%
Product design and development
38%
34%
29%
27%
24%
19%
18%
General and administration
19%
15%
13%
12%
11%
9%
8%
(54.4)
(61.7)
(40.1)
(32.5)
16.6
145.5
207.7
n.m.
n.m.
n.m.
n.m.
n.m.
19%
22%
(77.2)
(90.9)
(77.9)
(77.8)
(35.7)
85.7
141.0
n.m.
n.m.
n.m.
n.m.
n.m.
11%
15%
7.7
8.1
5.3
2.6
0.7
1.9
6.2
Profit before tax
(69.5)
(82.7)
(72.6)
(75.2)
(34.9)
87.6
147.2
Unrecognised tax losses
144.9
241.1
313.7
388.9
423.9
336.3
189.1
18.1
23.2
20.3
21.1
9.8
(24.5)
(41.2)
Underlying net profit after tax
(51.4)
(59.6)
(52.3)
(54.1)
(25.2)
63.1
106.0
Statutory net profit after tax
(64.7)
(82.5)
(72.6)
(75.2)
(34.9)
87.6
147.2
Weighted average shares
127.3
136.4
136.4
136.4
136.4
136.4
136.4
Underlying earnings per share
(0.37)
(0.44)
(0.38)
(0.40)
(0.18)
0.46
0.78
-
-
-
-
-
0.10
0.10
Operating expenses
As a percentage of revenue
EBITDA
EBITDA margin
EBIT
EBIT margin
Net finance income
Underlying tax
Dividends per share
Source: Xero, Morningstar Forecasts
Key Revenue Drivers
We forecast a 35% CAGR in revenue over the next five years, driven by a 28% CAGR in subscribers,
and an average revenue per user, or ARPU, CAGR of 3.2%. This compares to a subscriber CAGR of
59% over the past two years. Subscriber growth assumptions vary by region and comprise a CAGR
of 9% for New Zealand, 19% for Australia, 38% for the U.K., 53% for North America, and 50% for the
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
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Xero: Build It and They Will Come | 23 June 2016
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Healthcare Observer | 23 June 2016
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Paper Title | 23 June 2016
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Healthcare Observer | 23 June 2016
rest of the world. We estimate that Xero will have 80% of the addressable New Zealand market by
2021, along with 48% of the Australian market, 21% of the U.K. market, and 5% of the U.S. market.
As at March 31, Xero had unrecognised tax losses worth NZD 241 million; we expect the firm to use
these to reduce tax once it becomes profitable.
Key Expense Drivers
Xero's cost of sales comprise bank feed costs, hosting costs, and employee costs. Gross profit
margin increased from 65% in fiscal 2013 to 78% in the second half of fiscal 2016, and management
targets a long-term margin of over 80%. In fiscal 2016, Xero's expenses predominantly comprised
labour, at 52% of total expenses, or 57% including capitalised expenses associated with product
development. Advertising and marketing costs were the second-largest expense, at 16% of total
expenses. We expect employee and sales and marketing costs to comprise similar proportions of
expenses in future, but to fall as a percentage of revenue. Product design and development
comprised 34% of revenue, with sales and marketing at 71% of revenue in fiscal 2016; however, we
expect both to fall as a percentage of revenue despite increasing in absolute terms.
Cash Flow
Software companies typically have high-quality earnings with good rates of cash conversion, owing
to the relatively capital-light nature of their business models. This also means that capital is usually
available for dividend payments or investment. We expect Xero's operating cash flow to comfortably
exceed investing cash flow in the long term. Our base-case financial model assumes no additional
capital is required; however, if revenue growth does not meet our expectations, the company could
need to undertake an institutional equity placement.
Balance Sheet
Xero has been entirely funded with equity since inception, meaning that the company remains
debt-free and had NZD 184 million in cash and deposits as at March 31. Our base-case scenario
assumes the company has sufficient capital to undertake existing expansion plans.
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
Page 12 of 13
Xero: Build It and They Will Come | 23 June 2016
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Healthcare Observer | 23 June 2016
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Paper Title | 23 June 2016
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Healthcare Observer | 23 June 2016
6. Valuation
6.1. Discounted Cash Flow Valuation
Our fair value estimate for Xero's New Zealand-listed shares is NZD 21.00 per share, based on our
three-stage DCF financial model, cross-checked against market- and fair-value-estimate-based peer
company earnings multiples. At the current market price of NZD 18.85, we consider the shares to be
undervalued. Our model assumes Xero turns profitable in fiscal 2020, but the majority of its
valuation is dependent upon the terminal value. We assume a terminal-year EBITDA margin of 30%,
which is between international and local comparables. The terminal EV/EBITDA multiple of 10.5
times also seems reasonable in comparison with peers and history, and we discuss it further below.
The company is considering listing its shares on a U.S. stock exchange at some point, which may
result in higher market-based earnings multiples.
6.2. Long Term Multiple Analysis
In addition to current earnings multiples, we have analysed multiples over the past decade, as
shown in Exhibit 7. Since the global financial crisis, EV/sales multiples for SME accounting software
peers have expanded from a median of around 2 times to around 4 times. However, the collapse in
central bank, or "risk free", interest rates during the global financial crisis has justified yield
compression and earnings multiple expansion globally and across asset classes. We don't expect a
material increase in interest rates any time soon, and so we don't expect a material mean reversion
of multiples as a result of rises in interest rates; however, multiples would be likely to fall materially
if this were to occur.
Exhibit 7 Peer Company Valuation Metrics
EV/Sales
8x
EV/EBITDA
Multiple
20x
7x
18x
INTU
SGE
RKN
WKL
MYO
INTU
SGE
RKN
WKL
MYO
16x
6x
14x
5x
12x
4x
10x
3x
8x
6x
2x
4x
1x
2x
0x
Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16
0x
Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16
Source: Morningstar, Reuters Datastream
Note: The Intuit EV / EBITDA multiple spike in 2014 is due to large asset sales during the year.
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).
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Xero: Build It and They Will Come | 23 June 2016
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Healthcare Observer | 23 June 2016
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Paper Title | 23 June 2016
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Healthcare Observer | 23 June 2016
6.3. Potential Acquirers of Xero
Xero's quickly growing customer base could make the company an acquisition target for larger
competitors, particularly Intuit and Sage, which would benefit from Xero's large and quickly
growing customer base. Intuit certainly has the scale to fund an acquisition that would remove a
key competitor in the global market and possibly enable Intuit to become dominant in the Australian
market at MYOB's expense. For Sage, the logic is less obvious, and MYOB may make a more logical
target, considering that Sage tried to acquire MYOB in 2011. However, Sage appears to be pulling
back from acquisition-driven growth to focus on better integration of its existing businesses.
We have not created a detailed acquisition model, but Xero estimated the LTV of existing
subscribers at over NZD 2 billion as at March 31. This value is based on future cash flows and
excludes CACs. If an acquisition were to proceed, it is unclear how much cost reduction an acquirer
could undertake, but we expect it would be significant, considering gross margins are around 80%.
We expect an acquirer would be prepared to pay at least the value of capital invested in the
business to date, around NZD 500 million, and expect a lower limit of around NZD 1 billion, or a 50%
discount to the LTV figure.K
Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar or your adviser. © 2016 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor
the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. Any general advice or ‘class service’ have been prepared by Morningstar
Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG)
for more information at www.morningstar.com.au/s/fsg.pdf. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement (Australian products) or Investment Statement (New
Zealand products) before making any decision to invest. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily
indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523
782 (“ASXO“).