Xero now has 2.3 million subscribers globally. It has been delivering strong top-line growth and (more recently) positive free cash flow.

Digitization of tax and compliance is a key driver of demand for Xero’s cloud-based accounting solutions. Recent examples include the ATO’s Single Touch Payroll initiative in Australia, and the UK’s Making Tax Digital VAT initiative. Xero’s marketing initiatives are often based around such regulatory changes.

Xero’s CEO Steve Vamos was appointed in 2018 and has more than 30 years’ experience in global technology and digital media. He previously held roles at Nine Digital, Apple, IBM and Microsoft. Xero’s Board is chaired by David Thodey, the former CEO of Telstra.

Xero delivered a strong FY20 result. For the 12 months ended 31 March 2020, operating revenue rose 30% (or 29% in constant-currency terms) to NZ$718.2m. Subscriber numbers increased by 26% to 2.285 million.

EBITDA increased 88% to NZ$137.7m. Xero reported a small net profit of NZ$3.3m, compared to a loss of NZ$27.1m the year before. The company reported free cash flow of NZ$27.1m and a net cash position of NZ$111m.

When delivering the FY20 result in May management was cautious about the outlook, stating, “While Xero has performed strongly in FY20, trading in the early stages of FY21 has been impacted by the COVID-19 environment. The continued uncertainty surrounding COVID-19 means it would be speculative for us to say anything more at this time on its potential impact on our expected performance for FY21.”

As a result, analysts downgraded their earnings forecasts but Xero’s share price remained fairly resilient.

Many SMEs are exposed to the COVID-19 pandemic and SMEs account for most of Xero’s customers. However, remote working is becoming more prevalent and digitization of the small business economy and government compliance is increasing around the world.

Xero already has a market-leading position in Australia and New Zealand. Whilst it will be possible to provide additional services in these markets, the key to continued strong top-line growth will be further penetration of international markets, which will require investment and marketing spend.

Xero is still quite early on its profit path and has attracted a large market capitalization already. Analysts expect strong earnings growth over the next 3 years but, even so, the forward multiples are still very high.

At a share price of A$92.55, XRO trades on a FY23 PE ratio of 105x and a FY23 EV/EBITDA multiple of 39.9x based on the latest consensus earnings forecasts.

Xero’s share price has benefited from strong demand globally for tech companies that can compete on the world stage. Xero is one of those companies and has the capacity to grow into its valuation longer term if it can execute well on its strategy.

But the consensus analyst recommendation is Hold, with analysts worried that the weak economic outlook for many SMEs could potentially result in further earnings downgrade risk for Xero at a time when its valuation is so high.

Analysts have factored in a particularly steep ramp-up in Xero’s profits over the next 3 years, with NPAT forecast to rise from NZ$3.3m in FY20 to NZ$134m in FY23. Using a simple EPS-discount model with a discount rate of 7.5% and a terminal growth rate assumption of 4.5% p.a., XRO would need to grow its EPS by a CAGR of nearly 26% for the following 7 years after FY23 to justify its current share price. That is not necessarily impossible but a lot would need to go right for that to happen. The error rate in analyst forecasts tends to be a lot higher than the industry cares to admit.

With further near-term earnings downgrades still a real possibility, it would not be surprising to see a pause in Xero’s phenomenal momentum.

The author does NOT own shares in XRO.

Neither The Super Investor nor the author has received [or will receive] any benefit whatsoever from any party at all for the publication of this article.