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Could Xero Limited shares hit $700 one day?

First we had analysts at UBS reportedly claiming that cloud-accounting business Xero Limited (ASX: XRO) could hit a $100 a share in the future and now we have outspoken fund manager John Hempton telling The Australian Financial Review he thinks its valuation could reach a cool $100 billion.

Xero currently has a market value around $6.2 billion at $44.40 a share, so on a back of an envelope calculation a $100 billion valuation would mean a share price around $700 assuming the group’s issued equity stayed the same.

A $700 Xero share price might sound preposterous, but it’s not impossible if you consider the business would probably need to deliver profits close to $3 billion to get close to a $100 billion valuation on an earnings multiple around 30x.

As at its May 2018 full year Xero had annualised monthly recurring revenue of NZ$484.4 million, but importantly operates on a high and rising gross profit margin of 81%.

Of course the business won’t be able to grow at rates strong enough to get revenue more than NZ$5 billion and profit to NZ$3 billion without continuing to invest heavily in the marketing required to produce consistently strong top-line growth. Over FY 2018 sales and marketing expenses came it at 48% of operating revenue, with product design and development costs at 35% of total revenue.

However, both these expenses as a percentage of revenue are falling over time and the kicker is the subscription or recurring revenue nature of the business will compound the group’s earnings growth.

In other words if Xero’s total cost of signing up a customer in a new market is say $30 and that customer pays it back $25 in its first year, Xero would book a net loss of $5 on the deal.

However, in year two and beyond Xero’s support costs to serve the customer are minimal (thanks to its software-as-a-service nature) and all the marketing expenses are backed out. This could mean for example that the customer pays back Xero $30 in year two, while it incurs operating costs of serving the customer only around $6 on an 80% gross profit margin.

Still, for Xero to 10x or more its current monthly recurring revenue it is going to have to grow like nuts in the UK and in new markets ex-ANZ and the U.S. While it’s also worth remembering if Xero has a best-in-class product it has the opportunity to lift product prices on a regular basis, without customers leaving it.

It’ll have to do all this while managing marketing and product development costs that’ll be required to grow if the business is to gain the truly global scale that Mr. Hempton think could make it the “backbone” of a global small business accounting system.

This Panglossian view of Xero should be put in the context of the competitive environment in which it operates with a powerful and well funded rival in Intuit as the operator of Quickbooks and others like the UK’s Sage or Australia’s own Myob Group Ltd (ASX: MYO) also fighting for market share.

And that’s not forgetting the fact that Xero is yet to post a profit.

Still it’s notable that Intuit is now valued at an FX-adjusted A$74 billion, with a forecast for an adjusted profit around US$1.95 billion on revenue of US$5.92 billion over its FY 2018.

While healthcare giant CSL Limited (ASX: CSL) is now valued at more than $90 billion, with it forecasting an FX-adjusted net profit around $2.3 billon on revenues likely to be north of $11 billion in FY 2018.

These comparables might sound exciting, but Xero has recently lost the man many considered the driving force behind the business after Rod Drury stood down as CEO in order to take up a non-executive director role.

Mr. Drury and other members of senior management have also sold down their own shareholdings in the business recently.

I don’t expect we’ll see Xero shares hit $700 over the decade ahead, but stranger things have happened in the share market before…

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Motley Fool contributor Tom Richardson owns shares of CSL Ltd. and Xero.

You can find Tom on Twitter @tommyr345

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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