Deep Dive – Xero

Xero is an accounting software provider with a roughly $20 billion market capitalization and has been listed on the ASX since 2012. Over the past four years (FY21-24), the company has grown revenue at a compound annual growth rate (CAGR) of ~19%. This has been driven by subscriber growth of ~11% CAGR and average revenue per user (ARPU) of ~7.6% over the same period.

(Source: Company Reports)

Xero is the preeminent accounting software in Australia and New Zealand and is considered one of the top players globally. We think that the success of such software providers ultimately comes down to accessibility and affordability of the product. In our view Xero’s past track record and continued success has and will continue to be dependent on their ability to deliver product differentiation and be price competitive versus its peers.

Competitive Advantages

With its Australia and New Zealand market penetration now at ‘mature’ levels, Xero has begun to pull the ‘price lever’, having made double-digit price increases to its product across all tiers each year over the past several years. In its more nascent markets (UK and US being key), Xero continues to exercise more conservatism, choosing to price its starter product broadly with peers, if not significantly undercutting its US competitors. Xero’s product is well regarded globally for its holistic coverage of adjacent accounting functions (tax, payroll, and payment) and its integrations with other financial and technical software. We expect Xero to continue to maintain its competitive advantages despite pulling the ‘price lever’ through continued product development and enhancements.

(Source: Company Reports)

There are, however, other factors that cement Xero’s competitive advantages longer term. The accounting software industry has several barriers to entry. Namely, accountants and bookkeepers have large switching costs (new software is hard to learn and it takes weeks if not months to fully emigrate and consolidate data into a new system), software providers face increasing regulatory compliance (take the US for example where tax codes are state-specific and providers must adhere with each and every one of them), and economies of scale (Xero spent 30.7% of revenue on product design and development costs which amounted to ~$525m and is approximately 10 times the entire revenue base of its closest ASX-listed peer Reckon).

Such long-term advantages are strong qualitative reasons to think that important capital efficiency metrics (such as ROE) will remain sustainable and enduring longer term at present levels. In fact, we believe that the company is on track to be more and more capital efficient (as indicated by the higher forecast ROE metrics) as ARPU expands through further price increases and the shifting of customers towards higher tiered plans (if this sounds familiar, it was because one of our other Star Growth Stocks, Altium, implemented a similar strategy). This is happening as costs remain largely fixed in more mature markets and so we are seeing and should continue to see an uplift in lifetime value of a customer relative to the customer acquisition cost (LTV/CAC) in Australia and New Zealand but also at a group level longer term.

(Source: Company Reports)

Product Differentiation

Xero is primarily focused on the small-to-medium enterprise market, with its primary segments being micro and small businesses with 1 to 20 employees. Management’s strategy longer term is to grow Xero’s penetration in overseas markets by focusing on small business, accountants and bookkeepers by offering a holistic solution where adjacent jobs can be done on the one platform. For example, Xero’s payments system helps avoid the need for manual bank processes, reconciles transactions and provides cash flow visibility. Partnerships and integrations like the one with BILL.COM in the US add another layer of convenience by allowing clients to automatically integrate invoiced bills into the system without the need for further input. Xero is also developing a new generative AI solution (“Just Ask Xero” or JAX) to enhance the customer experience.

Geographic Expansion

Whilst Xero have struggled with their go-to-market strategy in recent years, the appointment of CEO, Sukhinder Cassidy and subsequent refinement of strategy and focus gives us greater confidence in the company’s ability to grow new markets – on which we admit its high growth multiple valuation is dependent on. We take solace that management have admitted to making two value destroying acquisitions (Waddle and Planday) in the past and no longer are looking to deviate from core operations or play in spaces where they do not have expertise. Discussions amongst industry experts suggest that the US remains a complex market to break into but Xero, under Sukhinder’s leadership, have structured and sensible plans in place and are ready to execute over the coming years.