Investment keeps Xero strong as a market leader

Founded in New Zealand in 2006, Xero has arguably been one of New Zealand’s most successful businesses, and may well be characterised by some as the Phar Lap of our generation. Founder Rod Drury has proven to be a visionary founder and leader, generating significant value for shareholders over the company’s listed journey. NZD$1 invested in the 2007 IPO would have yielded investors a whopping AUD$118 per share as of 20 June 2023.

Source: Bloomberg

Most readers would be familiar with the fact Xero provides online accounting software to SMEs, accountants and book-keepers. From inception, it has delivered its product exclusively via the cloud, with the company being the leading cloud provider in New Zealand, Australia and the UK. It has also invested into the US, albeit it has not reached the lofty heights as a market leader there. In the US market it is competing with a well established, well run and well invested innovative American competitor called Intuit, the owner of products “Quickbooks” and “TurboTax”.

The small business accounting software market continues to transition from traditional desktop products being replaced with easier to use, cloud-based systems which provide a nice industry tailwind for Xero’s cloud native solution. We have been invested in Xero at varying weights over the years, including helping to fund growth through supporting capital raises undertaken by the company.

What do we like about Xero?
Xero was one of the pioneers of cloud accounting software. It has consistently invested heavily behind its business and technology, and out-invested many peers. This has allowed its products to keep extending the company’s position as market leader in respective markets. Its customers generate significant value out of the software, with seamless integrations to bank feeds, payments and an ability to generate an array of real-time data that helps business owners to efficiently manage their companies. Customers and accountants typically become loyal to their software, which results in low churn, a high degree of stickiness and provides a predictable revenue base. The revenue can then be used to keep extending innovation and product, whilst simultaneously being used to invest and extend distribution. This arguably creates a flywheel-type effect that helps to extend Xero’s leading market position, and makes it harder for competitors.

What’s happened over the past 12 months?
As business conditions have changed and interest rates have risen, the recent environment has forced a rethink by a number of software businesses that had been pursuing growth with a lower focus on near-term profitability. Given the shift in the monetary environment over the late 2021 and early 2022 period, we had become cautious about Xero given its lack of near-term cash flow, and we had become aware the general market was having concerns about businesses with lower cash flow.

We felt Xero would need to shift its approach to growth in order to ensure it was managing for the new market conditions. In our view, this would force the company to think more about profitability, cash flow and balancing the competing priorities of all stakeholders. We had been anticipating a shift would likely come after seeing similar patterns emerge at some large offshore US tech companies such as Meta. We had therefore looked to increase our exposure in late 2022 and early 2023 as we saw Xero limit new hiring, which we thought might be a precursor to a broader rethink of its cost base in light of a newly appointed CEO.

In many respects we were therefore unsurprised when new CEO Sukhinder Singh Cassidy looked to manage the cost base more proactively and announced significant job cuts. We think this makes a lot of sense given the significant investment Xero has made over the past few years. The investments meant the business wasn’t generating the returns expected on investment vs its industry peers.

Our read so far is that we don’t expect the recent reductions to have crimped longer-term growth. Rather, the 15% headcount reduction should end up focusing the organisation around remaining more nimble, removing management layers and ultimately focusing on core priorities. Moving forward, we will be monitoring for signs the cost reduction efforts have gone too far, depleting important innovation and product development.

What about the US opportunity?
The US has proven a difficult market for many Australasian businesses to expand into, and this has been echoed by Xero. So whilst the opportunity in the United States remains large, it also remains a very competitive market. Institutional investors remain cautious on the US opportunity for Xero given their track record and the strength of its key competitor, Intuit. From our perspective, Xero has a product that has matured a lot since first entry. The company has developed multiple technology and distribution partnerships and, more recently, it has appointed a new US-based CEO with significant in-market experience. So, while we believe Xero looks to have a better chance for success than it has historically, it is by no means a given. We therefore welcomed Sukhinder announcing a deeper review on execution and strategy in the US, and we expect it to lead to a sharpened focus on what success looks like in the large US market for Xero.

Outlook
Xero continues to be a great business and investment, supported by a long runway of digital transformation for accountants. The strength of its product for both SMEs and accountants gives it a strong market position that we believe will continue to support it taking market share in what is a large and growing addressable opportunity.

Notwithstanding, we need to continually reassess what the market is implying in a company’s share price. To that point, our current view is that the recent rally has largely been driven by cost reduction announcements, with this information largely captured in the share price today. So, whilst we are impressed by the business and remain positive on Xero as a company, its strategy and management, we feel the risk reward in the short term is more balanced where we are today versus a few months ago, and despite our favourable long-term view of the business prospects.