When reviewing accounting software provider Xero (XRO) in May (see https://switzerreport.com.au/how-much-higher-can-a-re-rated-xero-go/), I concluded:
As a SaaS (software as a service) business, Xero is probably without peer amongst ASX listed companies. In an environment where the technology lead from the US markets is so strong, Australian investors will seek out quality Australian tech companies. With its re-rating, Xero again fits that bill.
This means Xero can go higher. If the US markets continue to stay positive (which we expect because of the anticipation that interest rates will fall), I expect Xero to test the $150 level again shortly.
Last Thursday, Xero delivered its first half result (half year to 30 September). The market loved it, sending its share price 7% higher to $172.94 before closing the week at $172.61.
Xero (XRO) – 11/19 to 11/24
Source: nabtrade
At a headline level, revenue for the half of NZ$996m was up 25% (23% in constant currency terms) and adjusted EBITDA up 57% to NZ$312m. On the ‘Rule of 40’ metric, Xero achieved 43.9%, a 10.3% improvement.
The ‘rule of 40’ is a favourite metric used by high performing global SaaS (software as a service) businesses. The rule suggests that revenue growth (%) plus free cash flow as a % of revenue should add to over 40%.
The market liked the revenue growth in all major markets (Australasia, USA and UK), revenue growth across both accounting and platform services, subscriber growth in all markets, continued low churn and an expanding margin.
Operating expenses as a percentage of operating revenue fell to 71.2% (compared to 79.1% in the corresponding half), and below Xero’s full year guidance for FY25 of 73%.
Demonstrating its enormous pricing power and customer stickiness, ARPU (average revenue per user) increased by almost 10% from NZ$39.29 at March 24 to NZ$43.08 at September 24. While this was assisted by removing 160,000 “long idle” subscriptions, most of this was achieved through price increases.
But it wasn’t all “roses and skittles”. Adjusted EBITDA actually fell compared to the preceeding half year (2H24) from NZ$322m to NZ$312m and sequential subscriber growth (adjusted for the clear out of long idle subscriptions) slowed from 5.3% to 4.5%.
Looking ahead, Xero reconfirmed guidance that it expects operating expenses as a percentage of revenue to be around 73% for FY25. It improved guidance on product design and development costs, now expecting them as a percentage of revenue to “be broadly similar to FY24” rather than “higher”.
Xero continues to see significant growth opportunities. Firstly, in devceloping its platform business (revenue from payments and non-accounting software services like payroll, hr and businees planning). In the UK, as the Government rolls out ‘Making Tax Digital’ and customers need to upgrade their accounting software. And finally, in the biggest market of them all, the USA.
In the USA, Xero has about a 4% market share of the SMB (small and midsize businesses). Intuit has an 80% share. Yet remarkably, only about 20% to 25% of customers are using software ‘in the cloud” – Xero sees this as the big opportunity.
But building distribution muscle and penetrating the US market is an expensive exercise and remains Xero’s biggest challenge. Net additions in the USA in the first half (after adjusting for the removal of long idle subscriptions) were only 12,000, taking the total base to 365,000.
What do the brokers say?
The brokers were generally impressed with the result. Highlights were beating the ‘rule of 40’, robust revenue growth, the increase in ARPU, free cash flow expansion and the improvement in operating margin.
Four of the major brokers lifted their price targets. Ord Minnett downgraded from a “buy” to a “hold”, mainly on valuation grounds. There are 4 “buy” recommendations and 2 “neutral” recommendations. According to FN Arena, the consensus target price is now $188.15, about 9.0% higher than its closing price on the ASX of Friday of $172.61
The main concern from the brokers is delivery of profitable growth in the USA and to a lesser extent, the UK.
What’s the bottom line?
Xero is a great company, and I have no doubt it is Australia’s best SaaS stock. But it is starting to look expensive.
With a market cap of around $25bn and next 12 months EBITDA of around $700m, it is trading on a multiple of around 35 times EBITDA. That looks pretty steep! But in this market, expensive growth stocks just get more expensive, while out of favour “cheap” stocks just seem to get cheaper.
I am wary of putting a “sell” on it, but I really want to see Xero show substantive progress in the USA before I go overweight on it again. I think it makes sense to take some profit at these levels.
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