Commitment to growth boosts Xero's fair value
Morningstar has increased its fair value estimate for narrow-moat rated cloud accounting software company Xero by 6 per cent to $25.50 on the back of its pledge to boost revenue.
Mentioned: Xero Ltd (XRO)
Morningstar has increased its fair value estimate for narrow-moat rated cloud accounting software company Xero by 6 per cent to $25.50 on the back of its pledge to boost revenue.
The increase follows the Xero's (ASX: XRO) commitment to maintaining high-revenue growth rates via the issue of US$300 million worth of debt
Xero recently acquired Hubdoc - a website that helps organise financial documents - to add functionality to its platform and further acquisitions are expected, which, while they may prolong losses from an income statement perspective, are likely to maintain or accelerate high revenue growth rates.
The new debt takes the form of convertible notes which mature in 2023 with a coupon rate of 2.375 per cent a year, lowering Xero’s cost of capital. Note holders have the option to request repayment of the debt in Xero shares instead of cash at maturity, based on a stock price of about $65 a share in five years’ time.
The structure of the capital raising is complicated and involves the costly involvement of investment banks. There is also the possibility of shareholders being materially diluted in five years’ time if Xero has to effectively repay the debt by issuing shares.
On balance, Morningstar is reasonably comfortable with the transactions around the notes issue but would have preferred a pro-rata equity issue open to all shareholders.
Current losses are an acceptable price to pay for rapid growth and Morningstar forecasts a maiden profit in fiscal 2019. The capital-light business model should enable returns on invested capital to comfortably exceed the weighted average cost of capital from fiscal 2019.
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Roger Balch is a Morningstar contributor
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