Should you buy XERO FPO NZX after its outstanding results yesterday?

Shares in cloud accounting software provider XERO FPO NZX (ASX: XRO) closed effectively flat yesterday, despite releasing a solid annual report to the market yesterday.

Expanding gross margins (now 76%), revenue growth of 67%, very low customer turnover (1.2%) and an announcement that the company had enough cash to see it through to break-even point failed to excite investor imagination yesterday, and shares barely moved during the day.

Even though shares are up 9% today, the company still appears to offer great value to the long-term investor.

Where’s the value in Xero?

Investors who look past the $2 billion business that’s never made a profit will find a lot to like. Xero’s major operations are in Australia and New Zealand, although the company is also growing rapidly in the USA and the UK. A majority of growth in dollar terms is coming from the ANZ region presently, but this should change in the future if Xero can successfully scale up in international markets – in terms of overall market size, Xero has little more than a foothold at present.

A big attraction is Xero’s subscription model, whereby customers are acquired once, yet maintain their subscription for what is currently an average of 7 years. At ~$60 a month, Xero is a very low cost solution (compared to many other major business costs) that makes it one of the lowest priority expenses to be cut in a downturn.

Anecdotal evidence also suggests Xero’s apps and integration with service providers are capable of saving clients time and money, which (combined with its low price) is likely responsible for very high customer retention.

If the company can continue to improve its systems by integrating with more providers and using smart data analysis to identify and code transactions (a future area of development) the company will have a good shot at raising prices further in the future.

Despite a strong increase in expenditure, Xero actually experienced a similar cash outflow to the prior year (because sales rose), which indicates the company’s investment in growth is paying off – especially when we take into account the 7-year average customer lifespan.

The risks

Much of the value in Xero’s $2 billion market cap is likely due to anticipated future earnings as a result of expansion in the UK and USA, among others. Although US sales are growing strongly, Xero only sold $17 million worth of subscriptions there in the past 12 months, which is approximately 8.5% of total sales. Xero needs to achieve a change in the scale of its US sales, which could be a while away. Failure here is a key risk.

On the other hand, Xero is in a sound financial position with a lot of cash and no debt. As famed investor Peter Lynch once noted, it’s extraordinarily difficult to go broke if you haven’t got any debt. Should growth slow, the company can convert to a profitable business by reducing its investment in growth. While this would not be an ideal outcome, it does reduce the downside.

All things considered, Xero looks like great value today, although it is higher risk and will also require patience on behalf of investors.

Could one of these businesses be the Xero of tomorrow? 

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Motley Fool contributor Sean O'Neill owns shares of Xero. The Motley Fool Australia owns shares of Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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