Further selling of US tech stocks has contributed to the recent drop in the Xero Limited (ASX: XRO) share price.
At the time of writing, Xero shares are trading at $91.45, down from a high of $103.00 at the beginning of the month. Does this represent a good buying opportunity?
The story so far
When you hear of accountants buying shares in Xero after using its products, it’s a good indication that the business is doing something right. The global provider of cloud-based accounting Software as a Service (SaaS) targeted toward small-medium enterprises has positioned itself as a dominant player in the industry.
One of the first criticisms you will hear of Xero is that its shares are expensive at face value. Sure, on a nominal value they are, but I think future developments need to be considered to factor that growth into the current share price to determine if it’s a good buying opportunity or not.
Growth outlook
Like other SaaS businesses, Xero’s business model can pretty much scale infinitely. The initial cost to bring on a new customer (customer acquisition cost) of $420 is more than paid off after the average lifetime value (LTV) of NZ$2,422 is returned to Xero. Because the customer acquisition cost is a once-off expense at the beginning of the customer journey, it allows margins to significantly increase over time.
Xero has demonstrated a solid track record of transitioning users in Australia and New Zealand to a cloud-based platform. However, in its most recent release of results, Xero indicated that less than 20% of the total addressable market in its overseas markets have adopted cloud-based applications.
To me, this represents a huge runway for growth, and if Xero can keep growing its revenues overseas, it will allow margins to expand even further over time.
Recent results
Xero has shown strength during the COVID-19 pandemic, with management indicating that there has been a relatively modest impact on its operating and financial performance in FY20.
FY21 will reflect a slight drop in annualised monthly recurring revenue (AMRR), but with a cash balance of NZ$108 million, I believe the company is positioned well moving forward.
Xero has recently reached an inflection point and recorded a net profit of NZ$3.3 million in its FY20 results.
Buy/hold/sell?
I’d be a buyer of Xero shares even at these current levels. If a share price is expensive but has high levels of growth priced in, I believe this price is then justified, and the nominal value shouldn’t be considered too much.
Xero is backed by a strong management team with a great track record that still has a lot more room to grow in terms of the total addressable market in overseas regions.
