The 300 Club

Glenn Freeman: I'm Glenn Freeman for Morningstar and I'm joined today by Morningstar's Senior Equity Analyst, Gareth James to discuss accounting software company Xero.

Gareth, thanks for joining us.

Gareth James: Thanks Glenn.

Freeman: Now Gareth in your view what is it about Xero that gives it it's narrow moat of competitive advantage over other companies in this space.

James: Xero benefits from customer switching costs. So what that means is that their software is very sticky. So once people start using Xero's accounting software, they tend not to change, because they've become dependent on it. And it's those switching costs that give Xero the competitive advantage.

Freeman: Our rating on the company has varied slightly, since initiating coverage in mid-June, from hold to accumulate and back to hold again. Can you just talk us through that?

James: Sure. So, at Morningstar we value companies and then that valuation tends to be reasonably stable and then as the share price moves around the valuation that determines our recommendations.

So what we have seen in recent weeks is the stock market has been weak, because of Brexit amongst other things.

That pushed shares down including Xero and that meant that recommendation became positive. Since then, the share price has recovered a little and so the recommendation has moved into the hold range.

Freeman: Now Gareth in terms of price to earnings ratios -- how do technology stocks compare to some of the most popular stocks in Australia such as resources and financials?

James: Sure. So, technology stocks tend to be higher growth companies and higher growth companies tend to trade on higher P/E ratios.

If you compare that to other sectors such as resources, particularly at the moment, resources are a bit out of favour, the growth outlook isn’t particularly good, and so the market tends to pay low P/E ratios for those kinds of companies.

And so with technology stocks I think the higher P/E ratios tend to be justified, because if you have a company that's going to achieve very strong EPS growth, then it absolutely makes sense to pay a higher P/E ratio for that company.

Freeman: How have technology stocks rebounded from the tech wreck of the 1990s to become once again favoured stocks in the Australian market?

James: Sure. So, we have technology companies because they tend to have extremely strong earnings growth potential. That means that they can trade on very high P/E ratios.

But the risk with those stocks is that if they are unable to achieve strong growth or live up to their expectations, then the share prices can come down quite sharply.

Obviously in the late 90s what we saw was a lot of excitement around the potential for the Internet. And it was really excessive excitement, and valuations were pushed to extreme levels. And then in the dotcom crash that followed, people realised that earnings were going to grow at slower rates.

So in Australia in recent years what we have seen is a big focus on the resources sector and the technology stocks have been out of favour a bit.

But with the fall in commodity prices, we've seen that rotation back towards technology and technology has had a good run.

But we do feel that technology valuations have increased to levels that are a little bit on the expensive side now, as a result of that demand. And we are seeing quite a few stocks that are a bit overvalued.

Freeman: And Gareth just finally, in your view what type of companies will own the future in this space. For instance, will it be those in the cloud, platform creators, or others?

James: Sure. So, I think one thing that's a very clear trend in technology currently is globalisation. So if you look at technology – the successful technology companies such as Google and Facebook and those kind of businesses, they are very much globally focused businesses and so it can be hard for companies if you've really got a domestically focused business to succeed in tech.

And you are obviously also vulnerable to those large global businesses moving into domestic markets.

A couple of key things at the moment that we are seeing, in particular the cloud, is a very strong thematic and there are few companies in Australia that are really benefitting from this trend. And basically this is the transition of software from desktops to the cloud for companies that operate in that space it can be extremely scalable. So they can have incredible earnings growth.

For example, Xero out of New Zealand, they are doing very well. They have got a global business. So that’s a tick on that perspective. But also they are benefitting from the transition of software to the cloud as well. So that’s another positive for that business.

Freeman: Gareth, thanks for joining us.

James: Thanks Glenn.

Freeman: I'm Glenn Freeman for Morningstar.