Under the Spotlight AUS: Xero Limited (XRO)
Warren Buffett’s advice on how to better understand financial statements is to study the language of business - accounting. This industry’s shift to online platforms by companies like Xero has changed the game for small firms. Let’s put it Under the Spotlight.
Contributions from the fifteenth century Italian Renaissance had a significant impact on artistic, political and scientific fields. These achievements across a wide range of fields was epitomised by the life of Leonardo da Vinci. He learned from and collaborated with many contemporaries, like mathematician and Franciscian friar Luca Pacioli, who wrote the first book on double-entry accounting.
In late 2003, tech entrepreneur Rod Drury and his accountant Hamish Edwards thought back to the ‘father of accounting’ when starting the Pacioli Software firm. They were frustrated at the cumbersome ways financial data was shared and wanted to help their clients determine how to run businesses more efficiently. Processes were manual and repetitive, with the burdens of tax compliance taking up most of their time instead of strategic decisions.
There was a clear need for their product, but the idea ended up being left on the backburner as both men pursued other ventures. Edwards was busy growing his accounting firm and Drury focused on email-archiving service AfterMail. Once AfterMail was sold for US$45 million to a U.S. company in 2006, Drury returned his attention to Wellington, New Zealand. Xero’s ($XRO) precursor, Accounting 2.0, started with a small team of six later the same year.
Deferred income
Xero has always been a growth oriented enterprise and experienced rapid ascent in its early life. The team gathered enough funds from their network to list on the New Zealand Stock Exchange (NZX) by June 2007. It’s considered to have gone public relatively quickly and issued large amounts of capital to raise funds rather than stay private and rely on venture capitalists. In 2012, they reached the top 50 stocks by market cap on the NZX and dual-listed on the ASX.
Xero even attracted funds from their competitor, MYOB’s founder Craig Winkler, who was impressed by their rapid move to the cloud, and Paypal ($PYPL) co-founder Peter Thiel’s investment group. Not all industries had realised the potential of web-based software applications, as the team looked to software-as-a-service (SaaS) companies like Salesforce ($CRM) as guidance. Things would greatly change for small and medium sized organisations owners now able view outgoings and revenues in real time, rather than waiting for an accountant to bundle results together every few weeks.
Despite ongoing fear that technology could replace many aspects of their jobs, Xero actually used accountants as a key sales channel. Practices could be moved onto the cloud for free, with the idea that they could provide more value-adding services to their clients instead of only computations. It took ten years for user numbers to reach 1 million in 2017. This was also the first time they turned a profit.
Additional provisions
Xero’s success has come with some difficult decisions and it remains under pressure to keep up high growth rates. While the stock price has appreciated, Xero’s growth strategy means that investors haven’t received any dividends. They’ve decided to reinvest profits back into the company to further support this journey. NZ investors were disappointed to see the local darling de-list from the NZX in 2018 to focus on international markets from the larger ASX market.
Their headquarters are still in Wellington and the ANZ region hosts bulk (57%) of Xero’s clients. Uptake has been lower than expected in the UK and possible regulatory changes around digitising tax reporting could limit its future prospects there. It’s also struggled to gain traction in the U.S., where financial software Intuit’s ($INTU) Quickbooks is the dominant player. However, the push into other markets will likely continue and after taking over in February 2023, CEO Sukhinder Singh Cassidy remains based in San Francisco, U.S.
At Xero’s centre is a single unified ledger, which allows users to work on the same set of books from various locations and operating systems. While core accounting activities were responsible for 86% of revenues in H1 2023, they plan to diversify and become a platform that caters to a variety of small business needs. This involves opening up their systems for third parties through features like the Xero App Store and acquisitions of ventures such as workforce management platform Planday.
Present value
The team hopes that this shift will help recover the same innovative drive that led to its initial successes. Taxes are famously one of the few certainties in life, but they haven’t been able to insulate Xero against all risks. Like many SaaS corporations, their stock price was particularly hit in the recent tech downturn as the market shifted to value profitability over growth. A higher interest rate environment has spurred plans to streamline the firm’s structure.
This has come with the layoffs of around 15% of their global workforce in March 2023. The value of cloud-based lending platform Waddle, acquired in 2020, will also be written off to zero, which will amount to losses between $30m and $40m in FY23. Investors expecting a comeback from the tech industry could see this as an opportunity to invest at a low entry point. Others might want to wait for more clarity about whether Xero can show resilience if inflation sticks and interest rates stay high.
This does not constitute financial advice nor a recommendation to invest in the securities listed. The information presented is intended to be of a factual nature only. Past performance is not a reliable indicator of future performance. As always, do your own research and consider seeking financial, legal and taxation advice before investing.
Megan is a markets analyst at Stake, with 7 years of experience in the world of investing and a Master’s degree in Business and Economics from The University of Sydney Business School. Megan has extensive knowledge of the UK markets, working as an analyst at ARCH Emerging Markets - a UK investment advisory platform focused on private equity. Previously she also worked as an analyst at Australian robo advisor Stockspot, where she researched ASX listed equities and helped construct the company's portfolios.