The Xero Story (a 2023 update)

In early 2016, I published a piece on Xero where I posited that it was emerging as an exceptional capital compounding machine despite large headline losses. I suggested that its valuation made sense if you took the view that its aggregate customer lifetime value (“CLTV”) was a highly valuable asset that was being rapidly accumulated by the company.

Seven years on, and with Xero’s share price having grown from $14 to $73 today (after briefly touching $150 during the pandemic tech rally), I thought it may be worthwhile to revisit the Xero story.

The Xero story revisited

Xero has certainly lived up to its promise with respect to growth – having increased its revenue 5 folds since 2016. In fact, over the past 12 months Xero grew its total revenue by an amount that was greater than its entire FY16 revenue. It has achieved dominance across Australasia along with varying degrees of penetration into all major English speaking countries globally.

We can see that its operating margins rapidly improved between FY16 and FY18 as revenue grew, demonstrating its operating leverage. However, this trend appears to have come to a stop in recent years:

Note that Xero typically capitalizes an amount of R&D expenses ($212m in FY22) that exceeds what it amortizes through the P&L each year ($115m during FY22). This means that Xero’s reported operating profit margins contain a fair degree of subjectivity and is much less conservative compared to peers such as Intuit (who expenses all R&D).

Given that Xero’s Gross Profit Margin has materially expanded over the past 7 years (from 76% to 87%), our attention should be on Xero’s operating expenses (i.e. its theoretically non-direct costs):

In particular, Xero’ reported Product design & development expenses appears to be growing a lot faster than its revenue:

And this trend looks likely to continue into the foreseeable future:

The implication here is that if we were to formulate our investment case around the notion that Xero generates high returns in the form of incremental CLTV (i.e. the sum of expected incremental gross margin from new subscribers), then we have implicitly made the assumption that its indirect operating expenses are largely fixed once the business reaches scale.

But wait, isn’t software unique in that once you write the code, incremental cost of delivery becomes negligible? What happened to the operating leverage?

Xero comprises of a number of separate geographical businesses

The answer I think lies in the fact that accounting software is not a horizontal product that can be sold seamlessly across borders with a minimal amount of localization (unlike say JIRA or Zoom). It requires a significant amount of customization for local laws, regulations, tax codes.

After the extra code is written and deployed, you then have to find a bespoke “go-to-market” that works within long-standing business processes and come up with a way to incentivize the local SME eco-systems (e.g. tax accountants, partners etc) to insert your software into their workflows.

This is obviously not an easy undertaking. The good news is that once you manage to cross this barrier, you then have the privilege of sitting comfortably behind the barrier protected from new competitors.

In Australasia, Xero was able to execute a highly effective go-to-market strategy notably through the accountants network. This was assisted by (1) a technological inflection point where software delivery shifted from on-premise to cloud; and (2) the incumbent accounting software vendor MYOB being in “harvest mode” necessitated by its own capital market considerations.

Unfortunately, the US is a much larger and complex market with each state jurisdiction having different tax laws and regulations requiring customization. It is also defended by a 500 pound gorilla known as Intuit. Last year, the amount that Intuit as a group spent on R&D was more than 3 times the size of Xero’s FY22 revenue.

Against this backdrop, we can see that as Xero’s core Australasian markets mature, more and more of Xero’s capital is being deployed into its international markets:

And we can see via Xero’s CLTV / CAC months (a rough directional proxy for ROIC) that the returns from Xero’s international markets is significantly lower than Australasia. More importantly, international returns appear to be diverging rather than converging with Australasian returns:

What’s next in the Xero story?

Xero is now 17 years old. Impressively, it is still achieving 25%+ revenue growth underpinned by subscribers growth in the high teens. But unlike back in 2016, the end of its subscriber growth pathway is now in sight.

The shift to cloud software delivery provided insurgents like Xero with a rare opening to build a multi-billion dollar company. Industry structures and market shares were reset accordingly where Xero was able to “win” Australasia and is close to winning the UK. However, by the same token, drastic market share changes from here is much more difficult in absence of another technological inflection point.

One thing to highlight is that for a subscription based business like Xero, its ROIC on customer acquisition (represented roughly by CLTV/CAC) is not static. It is a snapshot estimate at a single point in time. Whilst CAC is fixed (i.e. it has already been spent), CLTV can and does move significantly during a customer’s lifetime as ARPU and churn rate changes.

The below slide from Salesforce, the granddaddy of SaaS companies, shows that its FY07 cohort has grown ARR by a massive 47.7x!

Whilst being careful not to draw comparisons between different software businesses that serve different customer segments (i.e. SME vs. Enterprise), what is relevant here is that Salesforce’s estimate of its customer CLTV back in FY07 would have been very far off.

On the other hand, it has been surprising to see that Xero’s ARPU has barely changed in Australasia after 7 years and arguably this is a product where its value to SMEs is significantly higher than the ~NZD$30 a month it charges (to this point, Xero’s most recent price hikes have not resulted in noticeable increases in churn rates):

Being now firmly embedded within millions of SMEs with realtime access to their core financial data and possessing a direct billing relationship, there is no one better positioned than Xero to capture and facilitate more of their business processes.

This is a pathway that was unavailable to the previous generation of packaged software vendors and crucially this is where Xero is yet to demonstrate traction in its KPIs (which are worth close watching):

In a world where the cost of capital for software companies have evidently step-increased, finding high return capital deployment pathways will be crucial for Xero going forward. I suspect the most compelling opportunities from here are to be found internal within Xero’s customers rather than external.

The stakes at hand is whether Xero can fulfil its mission of becoming a beautiful business.

Note: The above article constitutes the author’s personal views only and is for entertainment purposes only. It is not to be construed as financial advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. Being obviously passionate about investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this article. Disclosure – I hold no position in Xero at the time of publishing this article (This is a disclosure and NOT A RECOMMENDATION. Any position held by the author may, for example, be part of a pair trade or a hedging position so it is not informative in isolation).