Xero Ramps Reinvestment

Australia | May 18 2021

Xero is at a fork in the road, needing to reinvest to stay ahead of a competitive software market while also managing investor expectations

-Long-term profitability achieved during the pandemic
-Lack of commentary on actual trading so far in FY22
-Is the negative reaction in the share price warranted?


By Eva Brocklehurst

Can Xero Ltd ((XRO)) retain its exceptional growth path in accounting software, reinvest and still keep costs under control? This is the issue that prevails after the company lowered FY22 forecasts for operating earnings (EBITDA) margins.

As conditions improved throughout the second half of FY21 Xero progressively increased sales and marketing expenditure which in turn drove net subscriber growth of 280,000. Churn was also reduced significantly.

The company is increasing its investment in R&D to capitalise on a large global market that is under-penetrated, while the pandemic has accelerated the adoption of cloud software.

FY21 revenue of NZ$849m was up 18% while operating earnings rose 37%. Nevertheless, the earnings outcome was below many estimates because of a sharp increase in sales and marketing expenditure as well as product investment.

EBITDA margins have been pushed back to pre-pandemic levels and are likely to remain at lower levels, with management guiding for FY22 operating costs to be 80-85% of operating revenue.

Jarden, not one of the seven stockbrokers monitored daily on the FNArena database, has a Buy rating with a $150 target and remains comfortable with the growth outlook, believing investors should take comfort in the fact long-term profitability has been achieved during the pandemic.

Subscriber growth was offset by soft international average revenue per user (ARPU) and higher operating expenses. Ord Minnett notes the weak ARPU was driven partly by currency and a shift in product mix that is likely to persist over the medium term.

The broker expects a delay to material earnings growth and, although the company exhibits a number of good characteristics, the business is not generating enough growth and margin expansion to justify the current valuation.

UBS is of a similar view, although notes net subscriber growth was well ahead of expectations. The broker is positive about the structural tailwinds, and management's ability to execute, but agrees the valuation is well above levels where a fair risk/reward trade-off exists for investors.

Reinvestment Critical

The second half signalled a faster return to material reinvestment than Wilsons, also not one of the seven, had anticipated. While tempted to upgrade on fundamentals, the broker retains a Market Weight rating with a $107.54 target, highlighting the potential for technology multiples to ease back on macro factors.

The reaction to the results was negative yet Morgan Stanley recounts the early days when Xero was the challenger and MYOB the leader. Xero had two crucial advantages at the time: cloud-based, meaning no legacy desk-top to maintain, and low expectations about high margins and/or dividends.

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