$XRO announced their 1H FY24 results this morning. These are the first results where we can see the full impact of CEO Sukhinder Cassidy's refocusing the business towards a strategy of profitable growth.
Their Highlights
Xero delivered strong operating results with operating revenue up 21% (20% in constant currency (CC)) to $799.5 million. This, along with disciplined cost management and restructuring outcomes, supported a 90% increase in EBITDA compared to H1 FY23, to $206.1 million. This reflected Xero’s ongoing focus on balancing growth and profitability, and resulted in free cash flow increasing to $106.7 million, representing a free cash flow margin of 13.3% compared to 2.4% in the prior period. This focus was also reflected in Xero’s net profit, which increased to $54.1 million compared to a net loss of $16.1 million in H1 FY23.
CEO Sukhinder Singh Cassidy said: “We’ve demonstrated good momentum this half. As we look forward, we’re sharpening our focus on Xero’s key levers of growth as we aspire to become a higher performing SaaS company. We will continue to balance growth and profitability, while delivering more value to our customers.”
My Analysis
The bottom line improvements (EBITDA +90%, Operating Income +225% and an NPAT result of $54m) are impressive, and they follow logically from the refocusing on to profit.
Interestingly, if I look across the consensus results (as reported a few days ago by GS):
- Revenue growth $800m (+21%) vs consensus of $814m
- Gross Profit $700m vs consensus of $710m
- EBITDA $206m (+90%)vs consensus of $211m
- EBIT of $79.5 vs consensus of $94m
- Subscribers 3.945m vs consensus of 3.964m
So on all metrics, expectations were high, and the result - while impressive, came in a little short.
$XRO has been pulling the pricing lever this year, adding $1.8bn on LTV by growing ARPU from $34.61 to $37.38 with additional assistance from FX and product mix.
Despite the price increases, churn has stayed comfortably low with monthly churn only nudging up from 0.90% to 0.94%.
Rather than go into lots of detail, I want to focus on a few important points.
Subscriber growth is moderating. In the graph below I have compared the 1H %y-o-y additions by region (blue and orange) and I've also added the 1HFY24 h-o-h comparison to FY23 (grey bar).
Its an interesting story.
Figure 1: % Subscriber Growth (1H y-o-y for FY24 and FY23 and 1H h-o-h for FY24)
Looking first at the Y-o-Y comparisons
The powerhouses in ANZ are holding up well, although growth is moderating.
The UK is maintaining solid subscriber growth, despite the depressed economic environment in that country.
North America is also slowing - with the growth rate trending down to the ANZ average, however, $XRO has only achieved a subscriber base in this market of 396k (vs. 584k in NZ!), and while 42k were added for the year, only 12k were added in the last half (NZ added 17k in the last half!).
International, once a hypergrowth segment as $XRO entered markets such as South Africa and Singapore, is cooling significantly.
Now look at H-o-H comparison (1H24/ FY23)
The grey bar shows a very mixed story.
Australia is holding up well. 8% h-o-h is actually 17% annualised!
However, NZ, UK and North America have slowed significantly, with international holding steady at 5%, which is 10% annualised.
The slowdown should not be suprising for three reasons:
- The macro-environment has continued to cool, with businesses tighening their belts and tighter credit conditions likely a brake on new SME starts
- Price increases over the last year have been significant. Although we are not seeing churn for existing customers, perhaps there is some price elasticity for new customers?
- Competition: $INTU has declared Australia, Canada and UK as its priorty markets for international expansion. But there are multiple competing offerings, all on SaaS, in all markets.
This story is supported by the chart below from $XRO's presentation. On the key SaaS value metrics, the international business is of much lower quality with a LTV/CAC of 3.0 compared with the stunning 14.6 in Australia and NZ.
$XRO has clearly broken through into positve earnings territory - a major milestone. The focus on profitable growth and control of costs is turning this into a cash gusher, with $107m FCF and a FCF of 13%....there'll be more to come.
With guidance on operating expenses, $XRO should continue to grow strongly both with cash generation and earnings growth as all three levers contribute: price, subscriber growth and cost control.
Valuation
However, $XRO is still priced as a high growth stock, with a forecast P/E going into this mornings result of 124x and EV/Revenue of 11x.
My Key Takeaways
Directionally, today's result was always going to happen given the strategy shift. We are staring to see the economic power in this business and that is going to drive earnings and cash for some time to come. But in the details, it is a softer result. How the market responds to a soft result and slowing subscriber growth remains to be seen.
Embedded in the presentation are further details of Sukhinder's strategic review of North America. Its simply about focus and discipline in execution. We were given a heads-up at the AGM, which triggered my exist from $XRO in RL and SM. While it makes perfect sense, its not enough. $INTU has a strong incumber position, and there are other alternatives.
$XRO is a quality business, with a great product. Its leadership in ANZ appears unstoppable.
But that's not enough to justify the valuation. The fact is that there are other offerings for SaaS accounting in the material target markets of UK and USA. While the UK is still progressing well, it is apparent that success in the US will be a long haul.
$XRO has started pulling the pricing lever to drive revenues earlier and harder than my thesis to account for moderating subscriber growth. That could have a negative feedback loop on growth and create further opportunity for competition.
So farewell from me for now, and thank you for being one of my best investments ever on the ASX in the last 7years. But investing for me is about numbers and not sentiment. For me, the numbers don't stack up.
Disc: No longer held in RL and SM
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%)
$XRO reported their FY23 results this morning. The table below from the release show their highlights.
The financials are messy, due to yet more write-downs of acquisition goodwill (Waddle and ... wait for it ... PlanDay). However, looking past the profligacy of the past, on an operating basis the result is strong, with 28% revenue growth, Operating Cash Flow of $390m (up 65%) and FCF of over $100m.
Costs have been well-managed, and we are yet to see the full benefit of the cost reduction effort initiated late in the financial year. The restructuring costs of $35m are also a drag on the financials.
As highlighted above, the operating leverage is now showing through strongly and with disciplined management, we will now start to see $XRO becoming a strong cash generator.
Growth was driven both by new subcribers, price increases and usage, and monthly churn stayed low at 0.9%. Importantly, as the major price rise was in September, with a small one in mid March, there is a strong revnue exit run rate for the year, which sets up FY24 with a good start.
Customer additions were strong in Australia (+15% yoy) and UK (+14% yoy), and were double digits across the board. North America still making steady but slower progress at +13% (competition from Intuit is just too strong).
Jumping on the Investor Call at 10:30 and will report any significant insights over the next day or so.
HIGHLIGHTS FROM RELEASE
CASH FLOW TRENDS
(Note my numbers for FCF are different from their reports, as it looks like we include/exclude different items in getting to FCF.)
Disc: Held IRL (4.8%) and SM (8.3%)
@TycoonTerry interesting perspectives. I am also a long term holder (9-Sept-16; $19.36; courtesy of Matt Joass, MF Pro)
I think it is important to understand how $XRO got to where they are and the strategy that drove the acquisitions - which I am sure you know.
$XRO started as an NZ small business accounting software provider that was the first to disrupt traditional accounting by providing a cloud solution that removed a bunch of on-prem hassles from business users, and more importantly transformed the way businesses could manage their book keeping and their relationship with their accountants. Both business owners and accountants appear to love it.
Starting in NZ, which has an entrepreneurial culture and is adept at rapid adoption of innovative home-grown solutions, over time it grew to dominate the market - achieving c. %60 market share in cloud accounting in NZ by 2021.
This provided the spingboard to enter Australia, where the incubment - MYOB - was not yet cloud-based. Rapid growth in Australia turbocharged an already profitable and focused NZ business, and delivered the operating cash surplus for reinvestment in the platform and international expansion.
The various acquisitions were part of building an overall integrated SME finance "ecosystem". At one stage around 2018-19, some pundits were saying the blue sky valuation was $100bn! I think we all got wrapped up in that story - I certainly did.
In truth, the various acquisitions to broaden the scope of the $XRO platform are essentially unproven in large part and international expansion faced inevitable competition, nothwithstanding the relative immaturity of cloud-accounting. As international expansion was taking off, everyone else (Intuit, Sage, etc.) also moved to the Cloud. So the initial point of difference in ANZ was lost.
Furthermore, each local jurisdiction requires a tailored implementation and, the relationship between businesses, book-keeping, accountants and tax professionals are different, requiring both localised code and local go-to-market strategies.
A further complication is that UK, where $XRO had a good initial run at a market that could be 2-3x ANZ, got bogged down in BREXIT and COVID blues. HMRC relaxed some of the MTD deadlines that provided initial impetus for small business and sole traders to go online, so growth there has slowed and they face more competition than in ANZ. However, they still have a strong position and are in the early days compared with ANZ. (See Figure 1)
See Figure 1 (UK), Figure 2 (USA) and Figure 3 (Canada). Competitive position looks strong in UK, very weak in USA and moderately weak in Canada. However, together USA and Canada are much larger markets than ANZ and UK combined, so even a small business here - if it is focused - might ultimately be profitable. Also, cloud accounting adoption has been relatively quick in ANZ, with other countries several years behind ... especially USA!
Figure 1: Google Trends Analysis for UK (Xero, Quickbooks, Sage; last 5 years)
Figure 2: Google Trends Analysis for USA (Xero, Quickbooks, Sage; last 5 years)
Figure 3: Google Trends Analysis for Canada (Xero, Quickbooks, Sage; last 5 years)
My concern, is that with Waddle, I wonder if we are seeing a foretaste of a future larger writedown of the more material PlanDay acquisition? There hasn't been much newsflow of $XRO kicking goals with PlanDay, and despite it being available in Australiasince 2021, Google Trends almost shows a flatline, when compared with Deputy and ELMO - other SME solutions in HR and workforce management. I also haven't met any Xero users who use it.
So why do I still hold $XRO? (albeit regretting not offloading at $150!)
At its core, is a set of functions valued by customers. Clearly the cloud accounting is core, and only $XRO management truly understand the respective value of each of the other functions in the platform. I believe that the expansionist mindset of previous management meant that they were not examining this core.
The new CEO appears to have got this. I believe there is headroom to grow the core adoption and value in the established markets: NZ, Aus, UK, USA, Canada, South Africa, Singapore, and the operating cashflow is strong enough for $XRO to continue to innovate and build its core offering, while also generating free cashflow.
I had been waiting for and hoping for this change of direction. I almost sold out last year despairing that we would ever see it under Thodey / Vamos, but I decided to hold on when the new CEO was announced.
In truth, I now have a much lower conviction on $XRO. I am going to give the new CEO 12-24 months to see whether she can move the dial. I will not hold any future write-downs of past acquisitions (e.g. PlanDay) against her, as that would be consistent with my overall thesis and in any event these costs are sunk.
Disc. Held