Researcher bullish on Xero's outlook

Xero will start turning profits from 2020 as it continues to grow its customer base in North America and the UK, says Morningstar.

The research house's fair value estimate for Xero is $21 a share, a premium to the current trading price of $18.50, on expectations the Wellington-based accounting software developer will start making money soon and probably won't have to raise more capital.

Morningstar predicts Xero's annual loss peaked this year, and that it will go on to post a maiden profit of $87.6 million on revenue of $754.1 million in 2020. By 2021, profit is seen rising to $147.2 million on sales of $923.6 million.

"We expect the company to continue leveraging this strong position to expand quickly in other regions, such as the United Kingdom and the United States," analysts Gareth James and Andrew Lange said in a note. "Current losses are an acceptable price for rapid growth and associated strategic benefits and we forecast a maiden profit in fiscal 2020."

That's slightly slower than local brokerage First NZ Capital is picking, with analyst James Schofield projecting positive operating earnings in 2018 and a bottom line profit the following year. He also has a $21 price target for the stock.

Morningstar's James and Lange said a potential takeover bid by accounting software groups Intuit or Sage is underpinning the share price, though would be more likely to come from North America's Intuit, which has the scale to take over a rival and become dominant in Australia, as UK-based Sage has been pulling back from acquisition-led growth.

Xero estimated the long-term value (LTV) of its existing subscribers at more than $2 billion as at March 31, based on future cash flows and excluding customer acquisition costs, they said.

"If an acquisition were to proceed, it is unclear how much cost reduction an acquirer could undertake, but we expect it would be significant, considering gross margins are around 80 per cent," James and Lange said. "We expect an acquirer would be prepared to pay at least the value of capital invested in the business to date, around $500 million, and expect a lower limit of around $1 billion, or a 50 per cent discount to the LTV figure."

The software company's current market value is $2.53 billion, and at Morningstar's target price it would be worth $2.88 billion.

Xero reported an annual loss of $82.5 million in the 12 months ended March 31 on revenue of $207.8 million.

Xero has eschewed chasing profits to build a global-scale business. As at March 31, it had built a customer base of 717,000 paid subscribers from 475,000 a year earlier.

Morningstar expects rapid customer growth will continue, and by 2021 it estimates Xero will have 80 per cent of New Zealand's market, 48 per cent of Australia, 21 per cent of the UK and 5 per cent of the US.

Once it starts turning a profit, James and Lange anticipate Xero will pay dividends of 10c per share.