Is Xero Limited (ASX:XRO) a buy?

Xero Limited (ASX:XRO) is an accounting software provider for small business. Its product provides an online ‘cloud based’ accounting system for invoicing, accounts payable, bank reconciliation & bookkeeping.
Xero is certainly a fast growing company with an ambitious strategy. Does that make it a good value buy at current share price levels?

The chart is stellar
From a technical perspective, the price action doesn’t get any better. And, congratulations to all share holders who have bought in prior to mid October, you are all winning.

**Arrows represent potential long term price action, this is not guaranteed of course**

The fundamental view is mixed

On the positive side:

  1. The company has a clear growth strategy which is global in scale
  2. The company is anticipating 80% revenue growth in FY14
  3. The company has what appears to be very savvy management
  4. The company has ‘by all accounts’ a great user-friendly product
  5. The company has reportedly spent seven years developing the product

On the negative side:

  1. The company reported a financial loss over $14 million in FY13
  2. The company has announced that it will incur a larger financial loss in FY14
  3. The company reports cash flow each quarter consistently less than ‘Xero’
  4. On 1 August, the company announced it had “sufficient cash for current plans”
  5. However, on 14 October, the company raised NZ$180 million from the market
  6. The company has spent seven years developing an online based product that is easily copied

Would you pay $3 Billion?
The company has 125.2 million shares at a current share price of $24.50 a share.
This makes the company worth a touch over $3 Billion !!!

Without looking at the price chart and getting wrapped up in the emotion of the moment, would you rationally pay the equivalent of $3 Billion for a company that in FY14:

  • Will generate a loss of over $14 million
  • Has negative cash flow
  • Had to raise NZ$180 million of new capital to keep expanding
  • And, it is unknown if the company will turn a profit in FY15

Benjamin Graham’s perfect example

Benjamin Graham said that in the short run the stock market behaves like a voting machine, however, in the long run, it acts like a weighing machine. Xero is currently winning the popularity contest that is the voting machine however, its true value will be reflected in the long run with the weighing machine of its profitability.

The risk
The company has spent a long time and a lot of money ‘building a better mouse trap’ in the online cloud accounting space. This is a space that is very difficult to create a long term sustainable competitive advantage.
How difficult would it be for existing competitors providing accounting software to add a ‘cloud-based’ product offering to their mix that may not be as good but just may be good enough?

Love vs Hate = Parabolic backwards
Being one of the most loved stocks on the ASX at the moment, the share price has gone parabolic in recent weeks. This does not mean it cannot go higher especially in the short term. In fact, it is my understanding that if the company reaches a market capitalisation of $10 Billion, all shareholders receive a tulip that has been cryogenically frozen since March 1637.

However, if love turns to hate as more shareholders realise they have paid a high and hopeful price for a loss making company, the parabolic share price could turn down as the positive energy for the share price dissipates (a little like the Gateway Bridge in St Louis, MI pictured). I hope that current shareholders will have found a chair if the music stops.

In closing
I think that the company will do well in the long run and wish current shareholders all the best. However, I also think that the current share price is many years ahead of the value of the business.

As the business does not currently generate a profit and will not for the foreseeable future, those buying shares in this business are speculating that someone will be willing to pay a higher price for their shares at the time when they wish to sell.

If a parabolic share price reversal move comes to pass over the next couple of years that coincides with the company turning a strong profit, I via the Edge Fund may be interested in one day being a shareholder of this growing business.

This article is published by Dean Mico.

The information provided in this article is intended for general use only. The article is intended to provide educational information only. Please be aware that investing involves the risk of capital loss. The information presented does not take into account the investment objectives, financial situation and advisory needs of any particular person, nor does the information provided constitute investment advice. Under no circumstances should investments be based solely on the information herein.

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