Xero's big breakout – and Morgan Stanley says there's more upside to come

Xero (ASX: XRO) is trading above the $140 mark for the first time since January 2022 after Morgan Stanley reiterated an Overweight rating and hiked its target price from $140 to $170.

Morgan Stanley says its upgrade reflects an attractive structural growth story with improved profitability and free cash flow as a result of ongoing price increases and low customer churn.

Xero has spent the past five months trading sideways, struggling to push above the psychological $140 level.

Xero daily chart (Source: TradingView)

It seems like Morgan Stanley's target price upgrade and bullish investment thesis have helped the stock tick over to a fresh two-year high.

Xero weekly chart (Source: TradingView)

Key Takeaways

The bullish Xero thesis revolves around three key points:

1. A large and expanding total addressable market to provide cloud-based accounting software to SMEs globally. The analysts estimate the total addressable market in Xero's traditional and still-core ANZ market to be approximately $1.5 billion in FY25 and growing at a steady 10-15% per annum to FY30. Xero is now shifting its focus to other markets, where the UK SME market is estimated to be 2-3x that of Australia.

2. Profitably business model with low churn, rising average revenue per user and high customer lifetime values. Morgan Stanley says these qualities are characteristic of leading software businesses. With added scale, the analysts believe Xero's EBITDA margins will lift from 29% in FY24 up to 35% in FY27 and 40-50% by FY28-30.

"We continue to think that XRO is under-charging users for its mission-critical software for SMEs ... we see a long runway for further growth in Xero's and the cloud-based accounting industry's ARPUs over the next 3-5 years," the report said.

Consensus is expecting Xero's average revenue per user (ARPU) to grow 7% in FY25 but Morgan Stanley sees potential for even stronger growth. Xero's recent initiative to rename and repackage its plans could encourage SME users to upgrade to higher plans or take on additional add-ons, potentially boosting APRUs beyond current expectations.

3. Xero trades at an attractive valuation based on current growth assumptions for FY24-27 compound average growth rates (CAGR) of 11% for international subscribers, 18% for revenue and 24% for EBITDA. The stock is currently trading at a enterprise value to EBITDA multiple of 10x compared to its long-term average of 11x and its 2021 peak of 23x.

The main risk to the bullish thesis is competition.

"If either (or both) of the existing two major global competitors switch tack ... and move to aggressive price discounting ... that would immediately threaten our positive investment thesis," the report said.

Aggressive price discounting would result in a snowball effect amid matched discounting, higher churn and higher marketing spend.