On-going investment in product development keeps a lid on free cash flow, but Xero’s fundamental operating metrics are all in good shape. Market expectations on earnings growth place a high bar on performance so that small misses attract outsized disappointment.
XRO’s 1H22 EBITDA of NZ$98.1 million was just shy of consensus expectations instigating a sharp negative response in the share price. But a more patient inquisition of the result would have shown a solid performance on the basic operational metrics with ARPU increasing 7% (in constant currency terms) to NZ$31.32 and annualised monthly recurring revenue hitting NZ$1,132 million up 29% year on year. This was on the back of double digit subscriber growth across all regions with total subscriber numbers growing 22.8% to just over 3 million for the first time.
Operating revenue was therefore up 23% to NZ$505 million the half year but XRO’s investment in sales and marketing and product development suppressed EBITDA and its free cash flow, leading to the market reaction. XRO added extra people (545) mostly to its product design and development team so that total headcount reached 4,187. This drove total R&D cost to $215.6 million, up 54% on last year. But this heightened level of operational spend has been well flagged by the company and should surprise no-one. The benefits are manifest in the unspoiled growth in subscriber numbers, although COVID probably messed around with actual outcomes during this period.
We highlight the ARPU growth which has plenty of runway ahead. Most small businesses spend less than 1% on their accounting software and indeed, at just over NZ$30 per month is less than a typical single mobile phone plan costs each month.
Subscriber churn is also very low at less than 1% indicating a high level of satisfaction with the product and also saving XRO plenty on its subscriber acquisition costs.
XRO announced it made a small acquisition costing US$19 million. LOCATE Inventory is a US cloud-based provider of real-time inventory management software. This is an example of the bolt-on businesses that can enhance XRO’s overall portfolio of products.
Investment view
The fundamentals drivers of XRO’s business have been undisturbed by COVID. Government initiatives to digitalise everything to do with payroll, tax and accounting encourages customers to adopt XRO’s user-friendly products. Subscriber growth and competition are the main earnings risks for XRO but the pie is still growing for everyone. We continue to recommend XRO as a Buy.
