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Macquarie upgrades Xero Limited after FY2018 result

Shares in listed cloud accounting business, Xero Limited (ASX: XRO), have had a stellar run of late, but it may be a stock still worth looking at due to the group’s strong subscriber growth and accelerating earnings profile.

Xero shares have skyrocketed around 85% over the past 12 months, easily outpacing the around 4% gain in the benchmark S&P/ASX 200 Index and peers Myob Group Ltd (ASX: MYO) and Reckon Limited (ASX: RKN), which have declined 14% and 28%, respectively.

Macquarie is one broker that is backing the stock, upgrading Xero to “Neutral” from “Underperform” following the company’s FY2018 results on Thursday.

The broker says that Xero continues to demonstrate strong subscriber growth with the base having almost doubled in the last two years, largely driven by additions in Australia and UK.

“With growth continuing to accelerate, strong execution and discipline have seen margins improve with scale efficiencies in the cost base beginning to be seen, particularly in ANZ,” the broker said in a report.

In its FY2018 result, Xero reported a 351,000 increase in subscribers to 1.4 million for the year to March 31, 2018 and a 28% lift in revenues. The group also posted its first positive earnings before interest, tax depreciation and amortisation (EBITDA) of $26.0 million, compared to a $28.6 million loss in FY2017.

Macquarie says that Xero’s earnings are beginning to highlight the significant operating leverage opportunity within the business, while subscriber growth is translating into strong top-line growth.

At the same time, the broker notes the FY2018 result highlighted the scalability of Xero’s cost base, with an 11% contribution margin improvement to 57% in the company’s Australia and New Zealand business.

Another highlight was the fact that Xero is experiencing only modest average revenue per user (ARPU) decline, highlighting “the strong demand of Xero’s offering versus peers as well as focus on the higher margin customer, with an increasing product suite,” Macquarie said.

Macquarie is forecasting a net profit after tax lift of around $8 million in both FY2019 and FY2020.

UBS also notes Xero’s subscriber growth as a highlight and rates the stock “Neutral”.

Its reaction to the FY2018 result was more conservative, given it was in line with the broker’s forecasts.

UBS, however, sees potential for Xero’s subscriber growth to continue to accelerate, particularly in the UK market. It is forecasting subscriber growth to increase to over 149,000 in FY2019, compared to more than 100,000 in FY2018.

The broker’s upside scenario which gives the stock a fair value of $74.50, also could imply a $100+ valuation within five years if rolled forward, it says.

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Motley Fool contributor Gabriella Hold has no position in any of the stocks mentioned. 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 Scott Phillips.

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