Morgan Stanley sets aggressive price target for Xero

Morgan Stanley has initiated coverage of Xero with an overweight rating and a 12-month target price of $A50 – a new high for analyst coverage.

After the bull run that followed its move to an ASX-only listing, and a positive full-year result, Xero is already up 40% for the calendar year to date, versus a 1% decline for the ASX200 overall.

The Morgan Stanley team of analysts reckons it will rise another 22%.

Xero shares were up 2.2% to $A44.57 in early midday trading.

Morgan Stanley sees accounting software’s move to the cloud as a disruptive moment that will benefit Xero at the expense of rivals like MYOB who do not have an all-cloud product suite (it’s a line that will be familiar to anyone who heard Rod Drury’s ra-ra speech during his time as chief executive).

The investment bank’s team of analysts say Xero’s enterprise value to sales multiple of 11 “seems high” next to other listed accounting software companies.

But it says (and again this is theme very familiar to Rod Drury followers) that a more appropriate comparison is software-as-a-service companies in different fields that have “similar characteristics” to Xero. Examples include Nasdaq-listed SaaS starts like Salesforce and Workday, with EV/sales ratios in the 14x to 19x range.

Xero [ASX:XRO] five-year share performance. Volume has picked up notably since it went ASX-only in January and its entry into the ASX100 in March (click to zoom)

Analysts split overall
More broadly, analysts had a mixed reaction to Xero's full-year result last month.

The company reported solid numbers last week. It halved its net loss to $27.9 million as it added 351,000 customers for a new high of 1.4m.

Chief executive Steve Vamos said it could and would reach breakeven without the need for any more capital or debt funding (although, like his predecessor, he did not put a timeline on the push for profit).

Craigs Investment Partners Stephen Ridgewell left Xero on neutral after digesting the result, with a $A41 12-month target while JP Morgan's Russell Gill and Joylon Wellington maintained their neutral rating and $A42 target.

Neither Craigs nor JP Morgan saw any major negatives in the result. In fact, they saw a lot of positives. Margins are increasing, they note, and cash burn reducing. Both see Xero squeaking into the black next year.

But both also see the stock as fully valued after its bull run since going ASX-only in January (Xero closed at $A40 on Friday; shares were briefly over $A42 in intra-day trading during the run-up to earnings, giving the company an all-time market-cap high of just under $NZ6 billion).

Xero analyst recommendations. Source: Reuters.

Credit Lyonnais' Roger Samuel and Jason Tanza are more bullish. They maintained their buy rating and lifted their 12-month target from $A45.10 to $A48.50 after the full-year result was posted.

They say cashflow-positive is now in sight and they see Xero making its first net profit (of $7m) in 2020.

They also make the interesting observation that Xero broke out its platform revenue for the first time – that is, revenue-sharing with companies that make software and apps that plug into Xero, forming a Xero ecosystem, plus revenue share with financial partners.

Examples of software in Xero's ecosystem (and note many apps also integrate with rivals, such as MYOB), include New Zealand companies, Timely, which makes appointment scheduling software for small businesses; and Vend, a maker of point-of-sale software.

Platform revenue was a modest 3% of Xero's total revenue for its 2018 financial year, which closed on March 31.

But that represented 94% year-on-year growth, and Messrs Samuel and Tanza predict platform sharing revenue will account for 10% of revenue within five years as the Xero ecosystem develops.

They also praise Xero for reining in costs in the US. There is no longer talk of a full-frontal assault on Intuit, which dominates the North American market (it's also notable that Mr Vamos says a Nasdaq listing is now off the table; it had long been an ambition of his predecessor).

RBC Capital Markets' Paul Mason also sees upside potential. He kept his outperform rating and bumped his target from $A45 to $A48.

Mr Mason says Xero's "overachieving" in the UK, where revenue rose 60.1%, was a highlight. He sees the company using its success in Britain as a springboard into continental Europe.

The RBC analyst sees Xero achieving its first net profit ($6.5m) in 2019, followed by profits of $45.2m in 2020 and $81.2m in 2021.

And he sees revenue ($406.6m in 2018) rising to just under $1b by 2021.

With their various forecasts, all of the analysts were left to their own devices.

Xero offered no formal guidance with its ASX filing, and Mr Vamos's later comments were restricted to his pledge not to raise any more capital or debt before hitting breakeven, at an unspecified time.

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