I attended the investor call for the $XRO FY23 results. In my earlier straw today, I summarised the key metrics, which I’ll not repeat here. As a replay of the call is available on the IR website, I’ll just focus here on some of the key takeaways important to my investment thesis, rather than giving a summary of the entire results. I very much recommend all holders listen to the replay.

Overall, strong growth was driven by mid-teens subscriber growth (Australia 15%; NZ 11%, UK 14%, NA 13% and Int. 12%) and ARPU by 10% from $31.36 to $34.61 primarily due to price increases.

Australian growth was impressive, given the maturity in this market.

Growth in the UK has ticked up again, so the work to fine tune the model appears to be bearing fruit. Sukhinder believes that HMRC relaxing the framework for full MTD for small businesses is not essential, as small business are increasingly understanding the benefits (including business resilience) of cloud accounting. If this is true then, with a larger potential market size and much smaller penetration than ANZ, there could be a lot of running room ahead in the UK.

The presentation includes all the standard slides with some new ones added providing further transparency into the business performance, so that you get a good understanding of what is underlying and what is one-off. With the various write-downs and Waddle exit, the finances are messy, so this increased transparency is helpful.

Our first in-depth view of new CEO Sukhinder Singh Cassidy

Two words characterised the call and were repeated throughout the presentation and again in the Q&A more times than I can remember: “focus” and “discipline” as $XRO pivots from a seemingly unconstrained drive for revenue growth, to one of “profitable growth”. In a word, Sukhinder gave an impressive performance. Moreover, her presentation was well-structured and clear. In the Q&A where she had an answer to give, it was clear. Where she didn’t, she was candid and explained why.

Sukhinder has been in the CEO chair a little over 100 days, and has acted swiftly in reducing organisation costs, with a $35m restructuring charge in the P&L and the majority of cash costs to come in FY24. The benefits of these are yet to show through. I don’t think this is a slash and burn exercise, because I believe the $XRO cost base had gotten bloated as it tried to pursue too many initiatives as once.

The most important content of the presentation – for me – was Sukhinder sharing her key observations on: 1. North America, 2. Planday, and 3. Modernisation.

Observation 1.    North America

We’ve all watched over the years as $XRO has made grinding progress in North America, where it remains unprofitable and a distant fourth to Australia, UK and NZ.

Sukhinder has met with customers and accountants and said she has continued confidence that North America is a critical market and that customers value Xero. $XRO estimate their global TAM is 45m customers (English-speaking markets), of which 34.5m are in North America. Today, NA only has 384k customers - a penetration of 1%, compared with ANZ where 2.14m customers represent 57% of the TAM of 3.7m customers. Even in the UK, $XRO has 970k customers of a TAM of 5.5m, so 18%.

If its early days in the UK, then North America hasn't even really begun.

She was candid in saying that she doesn’t know what the right strategy for North America is, but she committed to focusing on this over the next 6 months and reporting back to investors in November. On the Q&A a couple of the analysts tried to push for more on North America, but with only 100 days under her belt, the internal restructuring and resetting of the cost base has been the right initial focus. So, Sukhinder would not be drawn further on what she believes the answer for North America is. She is clearly keeping all options on the table.

My reflection is that we have to recognise that $XRO was first with a cloud offering in ANZ and early in the UK. By the time it had got going in North America, Intuit (QuickBooks) had launched its cloud offering, and it is the 800lb gorilla in that market. (Just doa Google trends for Quickbooks vs. Xero in the USA and you'll see what I mean!)

However, Sukhinder reiterated the view of previous management, that NA is way behind ANZ on adoption of cloud accounting, and she considers the market opportunity is sufficient for several winners. So let's see what she concludes after her deep dive!

Observation 2.    Planday

$XRO took a write-down of $77.9m on Planday, reflecting a “reduction in valuation multiples along with an element of operational performance.” With the acquired Planday CEO leaving and a new CEO in place, Sukhinder noted that it had taken longer than planned to get Planday launched in Australia.

Planday (workforce management software) was acquired in March 2021 for up to Euro 183.5m, however, the upfront payment was only Euro 155.7m, and given performance to date I’m not sure how much of the performance payments were made, if any. However, as the table below shows, there is still $139m of goodwill on the books for Planday, so we might not have seen the end of this part of the story.

Waddle is now completely exited. In the Q&A, Sukhinder made clear that there are plenty of other aps available for lending against invoices, and that $XRO’s focus will be to connect to the aps customers use rather than to build an entire eco-system – an example of clear strategic focus.

Table 1: Goodwill

Source: $XRO FY23 Annual Report

In looking at the above numbers, we have to remember that these are sunk costs and while Planday may continue to muddy the financials, I am not concerned now that it is being managed within a disciplined resource allocation framework.

So where does this leave Planday? From my perspective, the original problem with the acquisition has not gone away. Most of its business is in countries where $XRO is not focused on, i.e., continental Europe. In Q&A as well as in the presentation, Sukhinder made clear that she sees a lot of opportunity in the existing (English-speaking) markets. She wants to focus on these first and importantly to find a way to crack North America. She is not looking to move into other markets in the short-to-medium term. Under Q&A she was asked about India and answered it is a “future option” that they will not be pursuing at this stage.

So $XRO will focus on seeing what Planday can achieve in Australia and in the UK, and presumably preserving the value of what it has elsewhere. There are many other workforce management platforms out there for the SMB sector, and so I expect the Planday CEO will be given a year or two (at most) to see what can be delivered and whether there is an offering that customers really value.

Sukhinder described her resource allocation strategy of a disciplined approach to “core”, “growth” and “emerging” parts of the business. I see Planday very much as in the “emerging” bucket, and it will need to prove whether it moves into the growth stage.

Observation 3. Modernisation

Sukhinder spoke at some length about the multi-year journey to modernise the software stack – its been around a while. This will be key to achieving driving greater productivity and efficiency, as well as bring greater value to customers. It sounds like this will be a core and significant ongoing part of the development spend.

Controlling Costs

Efficiency is a key new focus, measured by operating expenses as a % of operating revenue. This was 84% in FY22 and has been driven down to 80.7% for FY23, excluding the restructuring costs. The target for FY24 is “around 75%”.

If you assume revenue growth of 25% in FY24 (my target, not theirs), then for a FY24 revenue of $1.75bn, moving the cost base from 84% to 75% represents an incremental operating cash flow contribution on $158m before tax. If we use $XRO’s definition of $102m FCF this year, then that would indicate the potential for very strong FCF growth over the year ahead.

Of course, this requires efficiencies to be extracted without impacting revenue growth or investment in the platform. The good news is that Sukhinder has put a marker in the ground and I think this is what the market has reacted to positively today.

Sukhinder’s Growth Framework – Rule of 40

Sukhinder thinks about growth using the “Rule of 40”.Here the goal is to achieve annual revenue growth percentage + annual free cash flow margin percentage (FCF as a % of revenue) totalling 40%.

Under this model, the FY23 result was revenue growth 28% + 7% FCF margin (102/1400) = 35% (- even though I don’t agree with $XRO’s calculation of FCF, and I get a number more like $69m, incl lease payments or $85m if acquisitions are excluded).

If mid-20’s % revenue growth is achieved, this implies FCF getting to 15% of Revenue ... or $260m to hit Suhinders "target" (which she made clear is not a target for next year). But I think this could be do-able given what I've written in the costs section above.

 Valuation

With the SP breaking back above $100 for the first time since over a year ago, $XRO is not cheap at an EV/Revenue multiple of 12x or a whopping 55x $XRO’s "adjusted" EBITDA.

Prior to analyst revisions, target prices average $100 (n=16, min=$61 to max=$128; www.marketscreener.com ). It will be interesting to see what the revisions bring. It comes down to whether the analysts see more value in a more focused, higher margin set of markets vs. previous assumptions. What they assume about NA is anyone's guess, and this will likely explain a continuing wide divergence in views on value.

My own DCF – which requires significant updating – has a central value of $113.

For now, I am happy to have bought back into $XRO, and I am happy to hold and see what the team can deliver over the next year.

Finally, a Note on my journey with $XRO

I was a long-term holder (first purchase 9-Sept-2016) and $XRO has been my most successful ASX investment in absolute terms. However, I lost patience with the approach of previous management to fail to follow a more balanced approach to growth, bailing out of my last holding in June 2021 (RL only).

When the new CEO was announced I re-initiated a position in November 2022 (RL and SM). What had separated this business from my thesis was a management that didn’t appear to prioitise cashflow generation, and were following what was in my opinion a dilutive and unfocused strategy without addressing the key question of whether the core offering could succeed in North America. I felt $XRO needed a fresh set of eyes from someone not wedded to the decisions and statements of the past.

Sukhinder’s approach is exactly what I think is needed, and so my conviction for this business has increased today, and the thesis is restored. Let’s see if the team can deliver, and let’s tune in in November to hear what Sukhinder has decided about North America!

$XRO is unproven in terms of its ability to deliver shareholder value through sustainably growing Free Cash Flows. Therefore it qualifies for inclusion in my SM portfolio, which is why I added it in November 2022.

Disc: Held RL (5%) and SM (9%)