Morningstar equity analyst Roy Van Keulen raised his fair value estimate on narrow-moat Xero (ASX: XRO) following interim fiscal 2024 results. Following the results shares plunged over 12%.

Van Keulen raised his fair value estimate by 4% to $78. Subscriber growth was in line with his expectations while growth in average revenue per user, or ARPU, was slightly stronger than expected. His upgrade was primarily driven by lower-than-expected churn in Xero’s international segment which may hint at a maturing customer base.

Despite the increase in fair value Xero shares remain materially overvalued as share are currently trading at just over $100.

Van Keulen views Xero as a marketing-led company, as opposed to a product-led company. This is due to their customer base of small and medium enterprises inherently valuing simplicity, rather than additional features and functionalities. He therefore sees revenue growth largely as an output of sales and marketing spending.

According to Van Keulen Xero will increasingly struggle to grow subscribers and revenue as an increasingly large share of its sales and marketing budget is being consumed by replenishing churned customers. This is a result of normalizing customer churn rates, lower business creation levels and increasing customer acquisition costs in geographies where Xero lacks a competitive advantage.

Subscriber growth was in line with his expectations and reflects Van Keulen’s thesis of the importance of network effects to lower customer acquisition costs.

In Xero’s moatier geographies, Australia and New Zealand, where accountants and bookkeepers recommend their customers to use Xero products, subscriber growth marginally exceeded his forecasts. In Xero’s other geographies, which lack similar network effects, Xero’s subscriber growth marginally underperformed expectations.

Customer churn in Xero’s international segment was lower than his forecasts. Although Van Keulen is cautious to read too much into this decline, given business failure rates remain well below pandemic levels, we now assume a slightly more mature international customer base.