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Aussie tech stocks overhyped

Glenn Freeman  |  04 Mar 2020Text size  Decrease  Increase  |  
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The trio of stocks are part of the grouping collectively known as WAAAX – Australia's answer to the FAANGs (Facebook, Amazon, Apple, Netflix and Google). 

Their share prices climbed more than 40 per cent, on average, in the 12 months to mid-February.

  • WiseTech: from $20 to $30 - gained more than 30 per cent
  • Afterpay: from $19.60 to $38.90 - climbed 50 per cent
  • Xero: from $48.60 to $87.30 - up 44 per cent

Amid the coronavirus pandemic, they've sold off in recent days, but still rank among some of the most overvalued stocks within Morningstar Australia's equities research universe.

Share price growth of WiseTech, Afterpay, Xero 

WAAAX stocks

Wisetech (ASX: WTC)

Economic Moat: Narrow | Morningstar Rating: 1-star | Price-to-Fair value: 2.1

Logistics software company WiseTech's share price fell more than 27 per cent on the back of a weak result announced on 19 February. But it remains massively overvalued in the eyes of Morningstar equity analyst Gareth James, trading more than 85 per cent above what he believes it's worth.

James slashed his full-year forecast for earnings before interest, tax, depreciation and amortisation by 13 per cent on the back of the result.

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Morningstar's fair value estimate was held at $8.10.

"Our earnings revisions aren't sufficient to justify changing our fair value estimate but, at the current price, we still believe the stock is materially overvalued," James says.

He earlier tipped the first-half result would be "explosive" – largely because WiseTech management was expected to tackle damning assessments from short-sellers J Capital and Bucephalus Research. The two firms criticised the company's growth figures
James says he wasn't "entirely convinced" by the accusations.

"But the market was clearly nervous going into the result and needed evidence and reassurance that the business is performing well.

"The guidance downgrade therefore came at a particularly bad time for the stock, although the high price-to-fair value ratio arguably increased the probability of share price weakness anyway," he says.

James questions how well some of WiseTech's acquisitions have been performing, pointing to a $33 million fair value gain on "contingent consideration liabilities". These relate to performance bonuses WiseTech management included in deals struck with some of the many businesses the company has acquired.

WiseTech has made 12 acquisitions since July last year, the latest a $92 million purchase of Singaporean supply chain software firm Containerchain.

Many of these deals include clauses where WiseTech undertakes to make additional payments if the newly acquired company beats its targets. The higher dollar value of the contingent liabilities suggests companies haven't performed as well as anticipated.

"Although management surprisingly claimed this wasn't the case on the investor call," James says.

Misgivings about the strategy are among criticisms levelled at WiseTech by J Capital and Bucephalus Research.

The 26 February update from J Capital claims WiseTech is "plumping up profits as fair value gains".

"That means acquired companies are not achieving their targets, and therefore not making their earnout milestones," J Capital says.

J Capital also accuses WiseTech of "double dipping" by failing to write down the goodwill assets when they reverse these contingencies on their balance sheet. "But that would be a loss on the income statement and cancel out the fair value gains."

Morningstar's James is following the criticism from J Capital and Bucephalus, but he isn't currently factoring it into his analysis.

"At this stage, we don't feel there's enough evidence to justify revising our long-term forecasts," he says.

Xero (ASX: XRO) share price boost 'unjustified'

Economic Moat: Narrow | Morningstar Rating: 1-star | Price-to-Fair value: 1.62

Accounting software company Xero is also a Morningstar one-star stock. It's $79.74 share price at the close on Tuesday is 62 per cent above the $46 fair value estimate set by Morningstar's James.

Xero announced its interim results in November, when its reported earnings were largely in line with what James expected. A 30 per cent increase in Xero's subscriber numbers was a highlight of Xero's first half for fiscal 2020, but was already priced into James forecast.

The market greeted the early November result with a 10 per cent share price boost – which James believes was "not justified by the company's first-half performance."

"At the current market price, Xero trades on an expensive fiscal 2020 enterprise value to revenue multiple of 15 and price-to-earnings ratio of 266."

A change in payroll rules meant subscriber growth in Australia was particularly strong, outstripping Morningstar's expectations.

"But this strong performance was somewhat offset by a fall in net subscriber additions in the United Kingdom versus the prior period that benefited from the Making Tax Digital reforms," James says.

He singles out two metrics that Xero management emphasised within the interim result:

  1. A gross profit margin that rose to 85 per cent
  2. Improved free cash flow that hit $4.8 million.

Management attributed the lift in margins – which was largely in-line with James' expectations of 84 per cent – to "economies of scale".

"But we've been under the impression that Xero's cost of sales is largely variable," James says.

"Management appeared coy about the likelihood of gross margin improvement continuing, which suggests margin expansion was mainly driven by one-off cost savings."

And on Xero's reported free cash flow, James says the figure was well down on the NZ$28 million achieved in the second half of fiscal 2019.

But he isn't panicking and remains confident in Xero's balance sheet, which he says "remains in excellent shape, with around NZ$100 million in net cash."

Afterpay (ASX: APT) posts solid result but rivals, watchdogs circle

Economic Moat: None | Morningstar Rating: 2-star | Price-to-Fair value: 1.39

Australian buy now, pay later provider Afterpay is trading at a 40 per cent premium to the fair value estimate set by Morningstar equity analyst Chanaka Gunasekera.

Its share price has rebounded slightly to $34.66 after delivering a solid first-half 2020 result at the end of last week, from $33 before the earnings call.

Gunasekera upgraded his forecast for sales growth to $43 billion from $37 billion by fiscal 2024 – as management announced plans to expand into Canada in 2021.

But his fair value estimate has been held at $23.50 because sales growth is expected to be offset by higher than expected operating expenses.

"We expect Afterpay will incur an underlying net loss after tax of about $32 million in fiscal 2020, compared with our previous forecast of profit of $6 million," Gunasekera says.

Costs are rising across various parts of the business, including:

  • Employment
  • Marketing
  • Technology
  • Customer service
  • Legal.

Employment costs alone are up 72 per cent, and the other costs combined are 217 per cent higher.

"As a result, the firm is unlikely to earn its first profit until fiscal 2021," Gunasekera says.
But he maintains it is sensible for management to focus on future top line revenue as competition in the buy now, pay later segment intensifies. "Importantly, Afterpay was successful in acquiring new customers, with 7.3 million active customers in the half, 134 per cent higher than a year earlier."

Gunasekera expects Afterpay to continue growing financed sales, given the popularity of its product with both consumers and merchants.

"The company's BNPL has proven particularly attractive to millennials, a cohort it is targeting particularly through major beauty and fashion brands," he says.

"The early success in its expansion to the US and UK also suggests its platform is scalable into overseas markets."

But the success Afterpay is enjoying also attracts more competitors. This competition is coming from a range of players including new online and digital finance companies, other BNPL companies like Flexigroup, Swedish company Klarna and established payment provider PayPal.

"We also expect Afterpay’s rapid growth will result in more intense scrutiny from regulators.

"It and other BNPL providers have already been subject to reviews by ASIC and the Australian Senate."

Afterpay emerged relatively unscathed from the watchdog's scrutiny, but there may be others on the horizon. These include a Reserve Bank of Australia review of card payments regulation. Submissions to this inquiry closed at the end of January, and the review is ongoing.

"One of the risks is that regulators will require Afterpay to change its procedures that make transacting less convenient, resulting lower growth and more costs," says Gunasekera.

"Another source of uncertainty is Afterpay’s reliance on debt and equity markets to finance ongoing high receivables growth."

If the rate of sales slows down, the firm may struggle to attract the same investor support it has enjoyed so far.

"Afterpay’s processes and algorithms have also not yet been tested in a major economic downturn, so there is still some uncertainty on their effectiveness," says Gunasekera.

 

is senior editor for Morningstar Australia

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