Xero Continuing to Create Value Despite Technology Sector Malaise

Business Strategy and Outlook

Xero has grown quickly since incorporation in 2006 to become the largest provider of accounting software as a service, or SaaS, to the SME market in Australia and New Zealand. The company is expected to continue leveraging this strong position to expand quickly in other regions such as the United Kingdom and the United States. SME accounting software users have historically shown little inclination to switch providers, and Xero enjoys annual customer retention rates of over 80%. The inconvenience and operational risks of switching accounting software providers have tended to outweigh the relatively modest potential benefits. The highly fragmented nature of SME and accountant customers and the relatively small annual value per customer mean that suppliers need scale to support ongoing research and development and marketing costs.

Incumbent providers typically have economic moats based on customer switching costs, with large enterprise software providers, like SAP and Oracle, reluctant to enter the SME market because of the level of customer fragmentation and switching costs. However, the transition from desktop- to cloud-based products offers a rare opportunity for relatively new providers to win market share via the transition of customers to cloud-hosted SaaS products that offer material productivity improvements. Switching costs are expected to recapture their earlier resilience once customers transfition to cloud products and accounting software becomes more integrated with third-party software. Relatively low profits are an acceptable price to pay for rapid growth and associated strategic benefits. The capital-light business model should enable returns on invested capital, or ROICs, to comfortably exceed the weighted average cost of capital, or WACC, from fiscal 2020, supporting the narrow economic moat rating. A revenue CAGR of 15% is forecasted over the next decade, driven by an 10% CAGR in subscribers, and an average revenue per user, or ARPU, CAGR of 3%.

Financial Strength

Xero is in good financial health but needs to maintain high revenue growth rates to increase profits and justify its market capitalisation. The company had net cash of NZD 51 million and available liquid resources of NZD 1.1 billion as at March 31, 2022. EBIT margins are projected to expand to around 26% by fiscal 2032, in line with peer companies. As the company matures, the capital-light business model is anticipated to enable strong cash generation. Strong customer retention rates of over 80% should mean earnings volatility will be relatively low in the long term.

Bulls Say’s

Xero is experiencing strong revenue and customer growth driven by the transition of desktop accounting software to the cloud, a trend projected to continue for at least the next decade.
Xero operates in the software sector, which is typically an industry with low capital intensity and strong cash generation. Xero is expected to generate strong returns on invested capital and free cash flow in the long term.
Xero has already achieved dominant positions in the New Zealand and Australian cloud accounting markets and is a leading competitor in the U.K. and U. S. markets.

Company Profile

Xero is a provider of cloud-based accounting software, primarily aimed at the small and medium enterprise, or SME, and accounting practice markets. The company has grown quickly from its base in New Zealand and surpassed local incumbent providers MYOB and Reckon to become the largest SME accounting SaaS provider in the region. Xero is also growing internationally, with a focus on the United Kingdom and the United States. The company has a history of losses and equity capital raisings, as it has prioritised customer growth.

(Source: MorningStar)

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