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Why the Xero share price could be in for a rough ride next week

The risk-reward doesn’t favour the Xero Limited (ASX: XRO) share price when the cloud-accounting software company hands down its first half profit report next Thursday.

The Xero share price is trading close to a record higher as it soared over 70% over the past 12-months to $68.33 compared with a 14% increase by the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index.

Xero is part of the high-flying WAAAX cohort of tech stocks. The group is made up of WiseTech Global Ltd (ASX: WTC), Afterpay Touch Group Ltd (ASX: APT), Altium Limited (ASX: ALU), Appen Ltd (ASX: APX) and Xero.

Xero isn’t the best performing (in fact it’s the second worst over the past year), but Xero shareholders have experienced far less volatility than its peers.

Volatility around results

This could be set to change and Morgan Stanley has calculated that there is more downside risk to the share price than upside when management hands in its earnings report card.

“The market’s experience in tech stocks has shown us that a strong share price run can create additional volatility around a results release,” said the broker.

“We expect an in-line result, but highlight upside and downside scenarios that could see the stock -12% to +5%.”

The thing that investors will be watching like a hawk are subscriber numbers followed by revenue. Morgan Stanley’s prediction on the share price movement is predicated on how these numbers play out and there are three possible scenarios.

Three possible outcomes

It’s much like Goldilocks and the bowls of porridge. One is too hot, the other too cold and one that’s just right.

The first is total subscriber growth of 25% and revenue growth of 32%. This is the base case and the broker thinks there is a 60% chance of this result.

The second scenario is for subscriber and revenue to beat with a more 35% and 40% growth, respectively; while the third is a miss with subscriber’s increasing less than 20% and sales by under 25%.

In the first scenario, the stock is likely to stay relatively flat as that is what the market is expecting. In the second instance of a beat, the stock could rise between 3% and 5%. Morgan Stanley estimates there is a 25% chance of this happening.

But in the third scenario of a miss, the stock can potentially tank 8% to 12%, and there’s a 15% chance of that occurring.

Is it time to sell Xero?

If Morgan Stanley is right, it means there isn’t much point hanging on to the stock in the short-term as the upside is limited while the downside can give you vertigo.

However, this doesn’t mean it’s time to dump the stock – not if you are a longer-term investor. The broker thinks that any weakness is an opportunity to buy the shares as it has an “outperform” recommendation on the stock even though its price target of $65 a share is below where the Xero is currently trading.

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Brendon Lau has no position in any of the stocks mentioned. Connect with him on Twitter @brenlau.

The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of AFTERPAY T FPO, WiseTech Global, and Xero. The Motley Fool Australia owns shares of Altium and Appen Ltd. 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.