Is Xero a potential Value3 target?
Value3 primarily looks to the United States for technology investments. However, there are several opportunities to be found in other parts of the world. One company that comes to mind is ASX listed accounting software company Xero.
Xero has been a lucrative investment for early shareholders but the capital gains have been based on a rising share price not earnings growth.
Is Xero a good investment today according to Value3? Let's find out.
Xero - A game changing business
Along with the likes of Wisetech and Atlasian, Xero is arguably one of Australia's most successful technology companies.
Founded in 2006, the New-Zealand based company provides cloud-based accounting software and other small business solutions.
It's been a game changer for small business owners. Accounting, tax and compliance work can be complex. Xero makes the process efficient while improving accuracy. This allows small business owners to focus their time on what they do best -- running their business.
Xero was a successful disruptor, primarily taking nearly all of the new business start-ups and overtime share from Recon and Myob and the old world companies. This was very difficult because these types of businesses have high 'switching costs'. This makes switching to an alternative very painful, time consuming and frustrating. Xero is to be commended for this success.
Of course, once this business is won, Xero gets to enjoy 'The High Switching Cost Moat'. This is reflected in Xero's extremely high customer retention rate, which sits at 99% each month. As seen below, this has also been pretty stable over time.
From the perspective of Value3, this metric is excellent.
Who are its customers?
While its customer base is primarily in Australia and New Zealand, it also serves overseas customers.
In FY25, the company boasted 4.4 million subscribers globally who pay an average of NZ$45 per month (up from $39 in FY24). Approximately half of those subscribers are located in Australia and New Zealand.
Is there room for further growth?
Xero continues to grow at healthy rates. In FY25, the company added 414,000 subscribers to bring its subscriber base to 4.4 million.
At a recent investor day, management estimated Xero's Total Addressable Market (TAM) to be worth around NZ$100 billion across five markets (AU, NZ, US, UK and CA).
With just around half a million subscribers in the region, Xero considers the US as its biggest opportunity (despite spending $270 million over the past decade trying to break into the market with little success).
Still - Xero maintains that US payments remains its most lucrative opportunity, with a TAM of approximately US$29 billion.
Its major competitor in the region is US based Intuit which offers Quickbooks (a comparable product to Xero). Going forward, Intuit is likely to remain the market leader in the region.
Intuit is a much bigger business, with a market capitalisation of around US$211 billion, compared to approximately US$18 billion (AU$28 billion) for Xero. However, it is also significantly more profitable.
Intuit reported NPAT of nearly US$3 billion in FY24. That compares to Xero which generated NPAT of US$137 NZ$227.8 million in its most recent full year result.
While there's certainly room for Xero to take market share, Intuit appears to be the superior business.
Melio Payments Acquisition
On 25 June, Xero announced it was acquiring US-based bill payments platform Melio for US$2.5 billion.
According to management:
"Acquiring Melio delivers a step change in Xero's US value proposition and scale, accelerating its 3x3 strategy and global high growth aspirations...the combined business is expected to significantly accelerate US revenue growth and gives us the opportunity to more than double Xero's FY25 group revenue in FY28 excluding anticipated revenue synergies."
Founded in 2018, Melio is a rapidly growing payments platform designed to help small businesses pay bills and manage accounts payable in the United States. It currently boasts around 80,000 customers. Similar to Xero, it's focused on small to medium business customers, and has substantial overlap with Xero's core customer base of 1-20 employees. The business generated US$153 million in revenue during the last financial year (predominantly through collecting transaction fees), however remains unprofitable.
A new era of leadership
In 2023, Sukhinder Singh Cassidy took over as CEO from Steve Vamos.
She comes with a wealth of valuable experience which has allowed her to excel in her new role. Singh Cassidy the former president of StubHub and has also held key positions at Alphabet and Amazon.
Under her leadership, the company has shifted its focus to profitable growth, a novel and welcome concept after focusing on non-profitable growth for 18 years!
Notably, the Melio deal is her first major deal since she became CEO. Melio is a big financial commitment and risk - in that it only generated US$153 million in revenue and last year made a loss of US$127 million. For comparison, in FY24, Intuit generated US$16.3 billion in revenue and made a profit of around US$3 billion.
Xero is paying US$2.5 billion (AU$3.9 billion) for Melio. The company is issuing 10.5 million shares at $176 per new share, a 9.4% discount to Tuesday's closing price of $194.21.
The rest will be funded through a combination of $US600 million cash, a $US400 million credit facility, and by issuing $360 million of Xero shares to existing Melio investors.
Xero made a Net Profit After Tax (NPAT) of NZ$227.8 million for the full financial year 2025 (FY25), so the purchase will immediately put them in the red.
Xero and the rule of 40
Last week, I introduced the Rule of 40.
As a refresher, the Rule of 40 is a popular metric used to evaluate the financial health of SaaS (Software as a service) companies. By comparing companies across different markets and growth stages, Value3 investors can gain valuable insights into various paths to sustainable value creation in the SaaS world.
It is calculated as follows:
Revenue Growth Rate (%) + Profit Margin (%) ≥ 40%
Companies that score above 40 are likely balancing growth and profitability well. While those that score below 40 could be growing inefficiently or sacrificing too much profit for expansion.
When Xero announced its FY24 result in May 2024, its CEO Sukhinder Singh Cassidy proudly posted on LinkedIn that the company had achieved a "Rule of 40" outcome.
"I'm excited to announce Xero's FY24 results today.
These results show we're doing what we said we would do.
We've delivered a strong and profitable FY24 result and Rule of 40 outcome, demonstrating our commitment to balancing growth and profitability. We have a clear and focused strategy to win on purpose, and Xero is positioned strongly as we move into FY25."
In FY24, Xero reported revenue growth (in constant currency) of 21%, and a free cash flow margin of 21%. This gave it a rule of 40 score of 41.
Fast forward to FY25, the company has only improved on that.
In FY25, Xero posted 20% revenue growth (constant currency) and a 24% free cash flow margin, giving it a Rule of 40 score of 44%.
Most importantly, as shown below, the trend for Xero's rule of 40 score over the past few years has been improving. As the company matures, Xero is improving the way it balances growth and profitability.
Is Xero a Value3 target?
As I flagged last week, while the Rule of 40 is a great starting point to identify potentially excellent SaaS companies, it's never the complete story. Rather, it should be used in a wider analysis tool kit. At Value3, we use V3 Val to value potential investment opportunities.
Xero ticks a few boxes, but it has failed to become the profitable business that it should be to justify a 137 PE ratio. The acquisition of the loss-making Melio - for what appears to be an exorbitant price - makes it easy for me to conclude Xero is way too risky for my capital, so I'll pass and drop it from my watch list.