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Why Xero Limited shares hit a record high & 2 reasons it could climb higher

Xero Limited (ASX: XRO) shares climbed to a record high recently – at $47.81 a share valuing the business at more than $6 billion.  

Xero is a cloud software company providing SaaS solutions for small to medium-sized businesses. In the latest financial results, the company announced a 38% increase in revenue together with its first ever positive EBITDA of $26 million.  

Investors clearly prefer Xero’s decision to seek global growth over rival Myob Group Ltd’s (ASX: MYO) decision to remain largely focused in Australia with a rather old-fashioned hybrid mix of installation software and cloud data retention. 

Here are two reasons why I think the upward momentum in Xero’s share price should continue. 

Valuation  

The numbers from the annual report for year ended 31 March 2018 are impressive –  1.4 million subscribers with an annual growth rate of 33%. Free cash flow of $41.2 million – an increase of $46 million from 2017. 

Net cash receipts per subscriber for 2018 were $29. This is expected to increase, however for the valuation I assumed this remains constant with a 33% increase in year-on-year subscribers. This should be achievable with markets in Europe and North America still largely untapped. 

I calculate a valuation at about $57 per share on a discounted cash flow basis, provided the company continues to grow at the same rates over the next 5 years. 

Growth  

What is exciting about Xero is the truly global ambition. In the UK over the past year it has added 312,000 subscribers resulting in 47% subscriber growth annually. The opportunities are still massive for Xero in the Americas and Europe.  

The subscriber base in the United States is only 132,000 at March 2018, whilst the total addressable market in terms of small to medium sized businesses has been estimated at about 28 million.  

In Australia and New Zealand, Sage and MYOB have previously dominated the important accountants and tax agents market with practice management software.

Xero is aggressively targeting this market with Xero Practice Manager, Xero Tax and Xero Workpapers, and the capture of this market should continue to grow exponentially over the next few years. 

Foolish takeaway  

There are very few opportunities to invest on the ASX in SaaS businesses that are best in market with global opportunities. As with Facebook and Google, Xero is shaping up to be the dominant global player in its business. 

The scalability with Xero is also impressive with more than 700 apps now working in conjunction with the company to provide ad-on services. These apps provide a stickiness to the software and ensure its wide functionality over many different industries. 

I cannot see any downside and only upside to the Xero share price in the next few years, although remember Xero is yet to make a profit and as such carries considerable risks around its operational performance, competition, and current valuation. The value of any invesment in Xero shares could move considerably up or down therefore.

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Motley Fool contributor Matt Reynolds 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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