Stock of the Week – Xero Limited (XRO)

Managing Director, Medallion Financial Group
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What is the stock?

Xero Limited (ASX: XRO)

How long have you held the stock?

Three months. It’s a fairly recent purchase for us.

What do you like about it?

We like Xero due to its capital-light business model that offers a high return on invested capital.

As a percentage of revenue, product costs which include operating expenses and capital expenditures have been decreasing over the last few years which enables the business to have high and expanding margins. The product is very sticky. Once the cloud technology is adopted, customer retention tends to remain high, helping to drive recurring revenues. The company benefits from a strong network effect, as the larger the platform becomes, the more attractive the solutions become to potential customers.

How is it better than its competitors?

In Australia and NZ, Xero has the first mover advantage in the cloud accounting software space giving it invaluable experience and data that incumbent competitors are struggling to overcome.

Ambitious and innovative management takes a unique approach. For instance, the company’s investment in marketing platforms, such as Xerocon London has helped to drive brand awareness.

The easy usability of the Xero platform has often been sighted as an advantage.

What do you like about its management?

Management has pursued an aggressive growth strategy unashamedly sacrificing profitability to chase growth. To date, you’d have to suggest that they have been proven correct, with the company usurping established competitors in Australia and the UK to establish itself as one of the market leaders.

What is your target price?

$54. (Current price $42.19)

At what point would you sell it?

If subscriber growth in the UK, Australia and the US started to stall or retrace. Should product costs (including operating expenses and capital expenditure) as a percentage of revenue start to increase. If the company remains unprofitable looking out two years, the business will then need to raise capital.

How much has it added (subtracted) to your overall portfolio over the last 12 months?

It is a recent purchase and to date the gains have been minimal. For some clients, the position would be up 5% on an approximate 5-7% portfolio weighting.

Where do you see the value?

We see potential for the business to double its revenue in the space of two years. The UK authorities are forcing digitisation of tax returns for small-mid size businesses driving uptake of cloud accounting platforms such as Xero. In Australia, similar developments with payroll reform are driving an uptake of digital business solutions. Finally, the business is still chipping away in the US trying to gain a foothold in a large but highly competitive market where adoption rates are slow.

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