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Xero deep in overvalued territory despite strong result

Lex Hall  |  23 May 2019Text size  Decrease  Increase  |  
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Cloud-based accounting software firm Xero has booked a strong result but the WAAAX club member  remains deep in overvalued territory, says Morningstar.

Xero this week reported a solid first half 2019 result, which included a 36 per cent boost in revenue and a 31 per cent jump in subscriber numbers.

But still, 2019 marks the 11th consecutive year of losses for Xero, which is a member of the so-called Australian tech stock club, known as the WAAAX, which include WiseTech, Afterpay, Altium, and Appen.

The boost to Xero's subscriber numbers, which now stand at 1.8 million, propelled the company's share price to a record high of $60.15—up $5.84, or 10.75 per cent. And it continues to climb, trading up 1.87 per cent today at $60.33.

Xero office in Auckland

Xero's products are used in more than 180 countries

In the wake of the subscriber growth, Morningstar equity analyst Gareth James has increased his fair value estimate for Xero by 10 per cent but continues to blink at its share price. It is trading at a 115 per cent premium to his fair value estimate is $28.

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“We still struggle to justify the market price of $60.33 per share, which implies an enterprise value to revenue multiple of around 11 times,” James says.

Such high multiples are causing anxiety among analysts, some of whom fear a repeat of the dotcom boom—and ensuing bust—in 2000.

James Holt, senior investment specialist at fund manager Perpetual Investments, last week warned that price-to-earnings ratios of local growth stocks are among the highest in the world, and that a “serious sell-off” was on the horizon.

“There’s a real concern around these stocks,” Holt told the Australian Shareholders Association.

“They’re very popular, but we think … there’s a great danger here.

“This is a time that fear is low, greed is high, crazy decisions get made and often the worse decisions are made at this time of the cycle.”

A report from Canaccord Genuity echoed these fears, noting that the WAAAX stocks—with the addition of aerial mapping company Nearmap—had risen in value more than seven fold since 2015.

This is more than double the growth of the FAANGs—the US tech stock group comprising Facebook, Apple, Amazon, Netflix and Google.

Still, there are positives for narrow-moat Xero. Since its incorporation in 2006, it has become the largest provider of accounting as a service, or SaaS, to the small and medium enterprise market in Australia and New Zealand, and its products are used in more than 180 countries.

And James expects it to leverage its strong position both here and, in the UK, and the US – although he stresses it will face competition from the likes of industry giants such as Sage, in the UK, and Intuit in the US.

“Current losses are an acceptable price to pay for rapid growth and associated strategic benefits and we forecast a maiden profit in fiscal 2020,” James says.

“The capital-light business model should enable returns on invested capital to comfortably exceed the weighted average cost of capital from fiscal 2020, supporting our narrow economic moat rating.”

is senior editor for Morningstar Australia

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