Deciding whether to WAAAX on or off in this market is testing even hardened contrarians.
Few doubt that WiseTech Global, Afterpay Touch Group, Altium, Appen and Xero (Australia’s version of the fabled US FAANG stocks) are mostly exceptional businesses. They quickly became billion-dollar companies and captivated the market.
As happens in tech booms, valuation insanity prevailed. At its peak, Afterpay, essentially an innovative layby service with significant regulatory risk, was worth $5.2 billion. WiseTech, a high-quality provider of logistics software, was worth more than $7 billion.
For perspective, WiseTech’s peak market capitalisation was rapidly approaching that of Seek, one of Australia’s great entrepreneurial companies. Is it any wonder that investors hit the sell button on WAAAX stocks when the US tech boom deflated?
But every stock has its price. WiseTech has fallen by about a third to $17. Afterpay has shed almost half its price from the 52-week high. Altium has roughly lost a third of its valuation and Appen has shed a quarter. Xero is down by almost a third from its high.
Chart 1: WiseTech Global
Source: ASX
Early investors in WAAAX stocks will not be too worried. The stocks are still sharply up on prices two years ago and, even after the recent sell-off, trading well above their 52-week lows. Afterpay, for example, soared from a 52-week low of $4.70 to $23 and is now $12.76.
Chart 2: Afterpay Touch Group
Source: ASX
So is it time to buy the WAAAX stocks?
With the exception of Xero, I’m avoiding them for now. Share market momentum is against them, valuations still look relatively high on a global basis and it’s hard to find a re-rating catalyst to spark an imminent turnaround and get prices heading back to peak levels.
It is hard to get excited about WAAAX stocks when you can buy Microsoft Corporation on a price-earnings (PE) multiple of 26 times forward earnings; Apple on 14 times; Facebook on 18 times, Alphabet (Google’s parent) on 25; and Intel on 11 times, using Bloomberg data.
Investors wanting to add tech exposure to their portfolio during the market correction should focus on global tech, preferably through an active managed fund or exchange-traded fund (if you are content with cheaper, passive exposure to global tech).
The local exception is Xero, the New Zealand provider of accounting software that is listed on ASX. Xero looks interesting after recent price falls and is near share price targets of investment banks with a bearish view on the stock.
I have followed several NZ companies on the ASX for the Super Switzer Report (Xero is solely listed on the ASX these days). My favoured NZ stocks included Auckland International Airport, Kathmandu Holdings, Trade Me Group, The A2 Milk Company, Restaurant Brands NZ, Vista Group International and New Zealand King Salmon Investments. They have mostly done well.
I have been reluctant to include Xero principally because of its high valuation (for a loss-making company) and concerns about whether it could crack the US market. When brokers described Xero as the “Apple of accounting” it looked like tech hype had overtaken reality.
But a 28% fall from its 52-week high, based on what seems to be general tech-sector weakness rather than company-specific news, has sparked renewed interest in Xero.
Xero appeals
To recap, Xero provides accounting software for small business owners, accountants and bookkeepers. Some I know who use it rave about the cloud-based software’s simplicity and ingenuity. Xero is building a global platform to roll out its Software-as-a-Service (SaaS).
Xero has grown quickly since its 2006 launch. It is the largest provider of accounting SaaS to small and medium enterprises (SMEs) in Australia and New Zealand. Almost 1.6 million subscribers used its software at September 2018, up by 380,000 in 12 months.
About 980,000 of those subscribers are in Australia and New Zealand. Another 355,000 are in the United Kingdom and 178,000 are in North America. Xero’s high valuation is built on market expectations it can grow quickly in the UK and US.
Like other SaaS stars, Xero has a powerful business model. Accounting software, by its nature, is sticky and has high switching costs. Once SMEs and their advisers get used to the software, and used it to compile financial accounts, they are reluctant to move to a new system.
Xero is able to acquire customers at low marginal cost (because its main software is built), grow revenue per subscriber, expand margins and retain customers for longer period. These “capital-light” business models provide large, recurring revenue and much excess cash.
Great tech companies use this cash to fund future growth, meaning they do not have to borrow as much (or at all) or issue slabs of equity that dilute shareholders, to raise capital.
Often, SaaS companies are loss-making for many years because they are reinvesting so much cash to drive growth and exploit their opportunity. Some could quickly become profitable if they took their foot off the growth pedal.
Xero estimates the lifetime value (LTV) of each of its customers at $2,494. That is based on average revenue per user, monthly recurring revenue churn, and gross margin. The LTV of each customer is rising as Xero adds more services to its platform.
Xero’s estimated LTV of its customer base rose almost $1.1 billion in 12 months as it acquired more customers.
Xero’s revenue and cash flow will continue to compound rapidly if it can get more traction in the UK, US and other global markets. Overseas subscribers are a key metric for Xero. If growth in trans-Tasman subscribers slows (which I expect), Xero will need faster growth in the UK and US, a difficult market to crack, to drive its valuation higher.
My main concern is Xero taking longer and having to invest more than the market expects to build a larger US subscriber base. Accounting software’s switching qualities work both ways: Xero benefits when it acquires a new customer who then uses the software for years. But getting a US SME that has used Intuit for years, to change to Xero, is hard work.
Long-term growth tailwinds
The market may be underestimating global growth in SMEs and micro-businesses in this age of technology disruption. Xero looks like a winner from the boom in the gig economy as millions of people work for themselves and need easy-to-use, cloud-based accounting software. An expanding market for SME accounting software could underpin Xero’s growth in the US.
Moreover, Xero has made some smart acquisitions this year, has a good balance sheet and plenty of capital after a convertible notes issue.
Brokers have mixed views on Xero. Credit Suisse has an underperform rating at a $35 target price. Morgan Stanley has a buy at a $50 target. An average share price target of $45.39, based on the consensus of 11 broking firms, suggests Xero is undervalued at the current $37.51.
Like the other WAAAX stocks, Xero deserves a spot on portfolio watchlists of patient investors and should be the first stock to “WAAAX on” when the global tech stock rout runs its course.
If Xero’s price keeps falling, do not be surprised to see a US competitor (possibly Intuit) bid for it. Xero is a fabulous business and potentially more valuable in the hands of a US accounting software provider with a ready-made customer base in that market.
Xero won’t go without a fight if an opportunistic bid emerges, given its long-term potential.
Chart 3: Xero
Source: ASX
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. All prices and analysis at 27 November 2018.
