Under the Spotlight AUS: Xero (XRO)

Xero’s ($XRO) strategy is simple: eliminate the bane of every small business owner’s life, the spreadsheet.

Simplifying book keeping has been at the heart of what this cloud accounting software provider does since its founding in 2006. But under CEO Sukhinder Singh Cassidy, the Kiwi company is building on its history of innovation. It’s evolving into a one-stop platform for small businesses to not only track cash flows, but also handle payments and payroll and make sure the taxman gets his share.   

Stake last put Xero Under the Spotlight in May 2023, just a few months after Singh Cassidy became CEO. Its shares have since rallied 85% to new highs as she unveiled the company’s FY25-27 strategy, revised plans and prices, plus signed off on new partnerships and an acquisition. In the space of 18 months, Xero’s market cap has risen $12b to $26b. 

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Xero’s rising share price reflects its ability to win new subscribers onto its platform. Its H1 earnings released last week showed an underlying 10% year-on-year (YoY) increase in subscribers to 4.2m. Three years ago, Xero had around 3m subscribers.

Xero has distilled the arithmetic of subscriber growth into a simple formula: 3x3. The first leg of the FY25-27 strategy outlined at February’s investor day aims to provide solutions for the three most critical jobs for small businesses: accounting, payments and payroll. The second leg involves winning subscribers in its three biggest markets: Australia, the UK and the U.S. Australia accounts for around 1.9m subscribers. And translating that strategy into subscribers has seen Xero focus on three things: product quality, user experience and market fit. 

The value of its offerings is underscored by customer churn being below pre-pandemic levels. H1 innovations include Xero becoming the first major cloud accounting platform to offer Tap to Pay. It has also launched an AI-powered business companion called Just Ask Xero (JAX). 

Xero has used partnerships and acquisitions to make it the go-to for all small business needs. It extended a partnership with Gusto to offer payroll solutions to U.S. clients and embedded a bill payment solution for U.S. customers powered by BILL. It acquired Syft for US$70m in September to bolster its insights, advanced reporting and insights offering. The aim is to lock in subscribers into one platform that does it all.  

The uptake of Xero’s products has also been helped by government policies. For example, the introduction of Single Touch Payroll regulations in Australia requires the Australian Tax Office to be digitally updated after every payroll. Another potential source of subscription growth is the Making Tax Digital regulations in the UK. This will affect around 2.7m small businesses and should drive cloud adoption. 

Rule of 40

Rising subscriber numbers mean strong top line growth. H1 revenue increased 25% YoY – or 23% in constant currency terms – to NZ$996m. Xero’s core accounting offering was responsible for 88% of revenue and grew 25% YoY. However, it was platform revenue that posted the biggest increase of 28%, thanks to strong payments revenue growth. That speaks to the value of added features.   

Revenue growth is great, but Singh Cassidy has a sharpened focus on balancing growth with profitability. H1 net profit rose 76% to NZ$95m. Moves to boost the bottom line include the removal of 160,000 long idle subscriptions – which depressed H1 net subscriber additions – and the introduction of new plans and pricing. The aim is to increase average revenue per user (ARPU), which rose from NZ$39.29 in March 2024 to NZ$43.08 in September 2024. Some analysts are concerned price rises are an attempt to offset slower subscriber growth, which cooled from 13% YoY in H1 FY24.  

Xero also has a sharp eye on costs, which is helping drive cash flow. While costs are up, they are not growing as fast as revenue. The company continues to invest in product development and marketing. Operating expenses as a percentage of revenue in FY25 are expected to be around 73%, slightly lower than the 73.3% delivered in FY24. 

The focus on growth and profitability is captured in what Xero labels the ‘Rule of 40’. This metric combines revenue growth and free cash flow margin. In H1, revenue growth was 23% (in constant currency terms) and the free cash flow margin was 21%, adding up to 44%. Above 40 equals good. That’s up from 27% from three years ago. 

Bottom line

Making life simple for small businesses is good business for Xero and its shares, which trade at a premium multiple to the market. The addition of new features is a smart way to appeal to potential subscribers keen to have one platform to take care of their finances.

Just as it helps businesses balance their books, Xero needs to reconcile its revenue growth ambitions against the need to offer enough value to keep attracting subscribers – and investors. 

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.