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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“). Page 2 of 13 Xero: Build It and They Will Come | 23 June 2016 Page 2 of 13 Healthcare Observer | 23 June 2016 Page 2 of 13 Paper Title | 23 June 2016 Page 2 of 13 Healthcare Observer | 23 June 2016 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“). Page 3 of 13 Xero: Build It and They Will Come | 23 June 2016 Page 3 of 13 Healthcare Observer | 23 June 2016 Page 3 of 13 Paper Title | 23 June 2016 Page 3 of 13 Healthcare Observer | 23 June 2016 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“). Page 4 of 13 Xero: Build It and They Will Come | 23 June 2016 Page 4 of 13 Healthcare Observer | 23 June 2016 Page 4 of 13 Paper Title | 23 June 2016 Page 4 of 13 Healthcare Observer | 23 June 2016 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“). Page 5 of 13 Xero: Build It and They Will Come | 23 June 2016 Page 5 of 13 Healthcare Observer | 23 June 2016 Page 5 of 13 Paper Title | 23 June 2016 Page 5 of 13 Healthcare Observer | 23 June 2016 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“). Page 6 of 13 Xero: Build It and They Will Come | 23 June 2016 Page 6 of 13 Healthcare Observer | 23 June 2016 Page 6 of 13 Paper Title | 23 June 2016 Page 6 of 13 Healthcare Observer | 23 June 2016 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“). Page 7 of 13 Xero: Build It and They Will Come | 23 June 2016 Page 7 of 13 Healthcare Observer | 23 June 2016 Page 7 of 13 Paper Title | 23 June 2016 Page 7 of 13 Healthcare Observer | 23 June 2016 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“). Page 8 of 13 Xero: Build It and They Will Come | 23 June 2016 Page 8 of 13 Healthcare Observer | 23 June 2016 Page 8 of 13 Paper Title | 23 June 2016 Page 8 of 13 Healthcare Observer | 23 June 2016 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“). Page 9 of 13 Xero: Build It and They Will Come | 23 June 2016 Page 9 of 13 Healthcare Observer | 23 June 2016 Page 9 of 13 Paper Title | 23 June 2016 Page 9 of 13 Healthcare Observer | 23 June 2016 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 Page 10 of 13 Healthcare Observer | 23 June 2016 Page 10 of 13 Paper Title | 23 June 2016 Page 10 of 13 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“). Page 11 of 13 Xero: Build It and They Will Come | 23 June 2016 Page 11 of 13 Healthcare Observer | 23 June 2016 Page 11 of 13 Paper Title | 23 June 2016 Page 11 of 13 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 Page 12 of 13 Healthcare Observer | 23 June 2016 Page 12 of 13 Paper Title | 23 June 2016 Page 12 of 13 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“). Page 13 of 13 Xero: Build It and They Will Come | 23 June 2016 Page 13 of 13 Healthcare Observer | 23 June 2016 Page 13 of 13 Paper Title | 23 June 2016 Page 13 of 13 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“).