Xero Limited (ASX:XRO): A Hidden Gem in the Cloud Accounting Software Space

When Xero Limited (ASX:XRO) reported its stellar earnings in early 2024, investors were left wondering if the company's stock price had already priced in its impressive growth potential. With a year-to-date share price increase of over 30%, compared to the S&P/ASX 200 Index's rise of less than 9%, Xero has certainly caught the attention of investors. However, the question remains: is Xero Limited (ASX:XRO) potentially undervalued, or has the market already recognized its true worth?

Strong subscriber growth and retention rates drive revenue growth

Xero's impressive revenue growth can be attributed to its strong subscriber growth and high retention rates. In FY24, total subscribers grew by 11% to 4.16 million, with notable increases in key markets such as Australia, New Zealand, the UK, North America, and the rest of the world. This growth in subscribers directly contributes to Xero's revenue growth, as more users adopt and pay for the company's services.

Moreover, Xero's retention rate of subscribers was just over 99% in FY24, indicating that the company is effectively retaining its existing customer base. This high retention rate ensures a steady stream of recurring revenue and demonstrates customer satisfaction with Xero's services. Additionally, Xero achieved a 14% increase in average revenue per user (ARPU) to NZ$39.29 in FY24, further contributing to its overall revenue growth.

Strategic acquisitions enhance Xero's offerings and drive revenue growth

Xero's commitment to enhancing its platform through strategic acquisitions is another key driver of its revenue growth. In 2024, Xero announced the acquisition of Syft for up to US$70 million to boost its reporting and insights capability for subscribers. This acquisition aligns with Xero's focus on providing the best business technology platform for current and new subscribers, ensuring it remains at the top of its industry.

By acquiring Syft, Xero aims to improve its platform by providing better reporting and insights capabilities, which are crucial for small businesses to make informed decisions. This enhancement can lead to increased customer satisfaction, higher retention rates, and potentially more subscribers, as Xero continues to attract new customers with its improved offerings.

High gross profit margin and strong operating leverage support revenue growth sustainability

Xero's high gross profit margin and strong operating leverage contribute significantly to its revenue growth sustainability. In FY24, Xero reported a gross profit margin of 88.2%, which is an increase from 87.3% in the previous year. This high margin indicates that the majority of new revenue is turned into gross profit, which can then be reinvested into growth activities such as advertising or software development. This allows Xero to scale its business efficiently and sustainably.

Additionally, Xero's profit growth rate is very pleasing, with adjusted operating profit (EBITDA) growing by NZ$224.9 million in FY24. This growth in operating profit is higher than the revenue growth, indicating strong operating leverage. This means that as Xero's revenue grows, its operating profits grow at an even faster rate, leading to increased profitability and cash flow.

Analysts' positive outlook and upward revisions support Xero's undervalued status

According to a consensus from nine Wall Street analysts who provided 12-month price forecasts for Xero Limited, the average target price is set at AU$147.02. Predictions range with a high of AU$196.91 to a low of AU$77.82. This average price indicates a potential upward movement of 22.06% from the company's last traded share price of AU$120.45.

Analysts' positive outlook on Xero is further supported by the upward revisions of their sales and EPS forecasts. Over the past year, analysts have regularly revised upwards their sales forecast for the company, reflecting a renewed optimism among the analysts covering the stock. Additionally, analysts covering the stock have been revising their EPS expectations upwards in a significant manner, with EPS revisions remaining quite promising over the past four months.

Key takeaways

With Xero Limited (ASX:XRO) trading at a significant discount to its peers and boasting impressive subscriber growth, high retention rates, strategic acquisitions, and strong financial performance, it's hard to argue with analysts' assessment that Xero is dramatically undervalued. The company's commitment to investing in its platform and enhancing its offerings, combined with its high gross profit margin and strong operating leverage, positions Xero for long-term success. Investors who are willing to be patient can reap sizable returns by getting in at Xero's current, post-earnings share price.