Is XERO FPO NZX a blue-chip share of tomorrow?

Successful investing often involves looking to the long term as companies that are able to post strong growth over 3, 5, or even 10-year periods will tend to demolish the returns of the wider market.

Unfortunately these kind of companies are rare and identifying them is a hard task, although those that do succeed are likely to share certain qualities.

They are likely to be disruptive in nature, built for the future, scalable, able to build a network effect, and enjoy large global markets. Almost all of these types of businesses are incubated in the tech-savvy and venture-capital-rich US though, with Snapchat, Uber, Instagram and Slack examples of recent blockbuster successes.

One company that potentially ticks the boxes on the ASX is cloud accounting and software-as-a-service business XERO FPO NZ (ASX: XRO). It hales from New Zealand a country not known for its tech muscle, but that might change if Xero delivers on the world stage.

As at the end of March 2016 Xero had 717,000 subscribers globally with close to market-leading positions in both Australia and New Zealand thanks to the competition-thumping functionality of its software.

In the large UK market growth is accelerating with the company gaining 31,000 new customers for the six months ending March 31 2016 to take the total to 133,000.

Xero now has live data feeds connected into UK banks with significant market share in the small-to-medium size (SME) enterprise space. Barclay’s Bank signed up in February, while Natwest and Royal Bank of Scotland are among other partners already helping Xero build a network effect in the UK’s burgeoning fintech sector.

The US market remains a work in progress, where the shift to the cloud from the desktop in SME accounting services is actually far less advanced compared to the UK or ANZ, which suggests opportunity ahead. It is now also building sales in other parts of the world like Singapore, Malaysia and South Africa.


Given it just posted a net loss of $82.9 million for the full year (up $12.9 million over the prior year), Xero probably won’t be your parents’ idea of a good investment.

However, for every $1 it currently spends in ANZ on acquiring a customer it gets $9.10 back in gross profits over the expected average lifetime of that customer paying for the product. Outside ANZ it only receives a $1.80 back currently, as it is investing heavily for growth via staff expenses, marketing, and tech support or development.

The company has cash on hand of $184 million and the CEO says it will be managed to cash flow break even within the current cash balance. Given it just posted a net operating loss of $38.1 million for the six months ending March 31 2016 it could be expected to reach that target in FY2020 (or before) depending on how quickly operating losses are trimmed.

Shares sell for $16.43 today and the company has a market value of $2.2 billion. That’s around 10x last year’s revenues of $207 million with FY16 revenue growth of 67% over FY15 and a target to reach $1 billion in revenues in the future.

If Xero posted compound revenue growth of 40% over the next three years it would be just over halfway to the $1 billion revenue target with revenues around $568 million. I’m guessing it then could conceivably deliver more than $200 million in earnings.

I imagine it could easily trade on 30x earnings to give it a market value of at least $6 billion or more than 2.7x today’s valuation with (most importantly) a strong long-term outlook.

However, Xero faces stiff competition in the US from powerful incumbent Intuit (operator of the Quickbooks accounting product) and others like Myob Ltd (ASX: MYO), Reckon Limited (ASX: RKN) and UK-based Sage will want a slice of the action.

It also remains a loss-making business where plenty could go wrong over the next three to five years to leave today’s investors deep underwater. I picked up shares at an average price of $13.39 during 2016 and would happily pick up more at today’s prices of $16.25, although it remains only for investors prepared to take on more risk in pursuit of superior returns.

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Motley Fool contributor Tom Richardson owns shares of Xero. The Motley Fool Australia owns shares of Xero.

You can find Tom on Twitter @tommyr345

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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