Michael Vi
I award a Hold rating to Xero Limited (OTCPK:XROLF) [XRO:AU] stock. My rating for XROLF is upgraded from a Sell earlier to a Hold now, considering the company’s improved revenue growth outlook in view of the recent performance of Australian small businesses. However, I am unwilling to assign a Buy rating to Xero Limited, as the company’s future profitability might be affected by its investments in the US.
My previous February 18, 2024 write-up was focused on analyzing Xero Limited’s financial prospects and valuation metrics. The current update looks at XROLF’s top line growth and operating profitability.
Readers can deal in the company’s shares on the Over-The-Counter market and the Australian Securities Exchange. Xero Limited’s Australian and OTC shares boasted average daily trading values of approximately $35 million and $20,000, respectively for the past three months, as per S&P Capital IQ data. Investors can engage the services of US brokerages such as Interactive Brokers to buy and sell the company’s relatively more liquid Australia-listed shares.
Xero Limited’s Revenue Outlook Has Become More Favorable
Xero Limited’s top line outlook has become better than what I anticipated previously.
In my February 2024 article, I noted that “the near term demand for XROLF’s accounting solutions will most probably be weak in the face of macroeconomic uncertainty.” I turned out to be wrong.
XROLF’s top line rose strongly by +22% to NZD1,714 million in FY 2024 (YE March 31, 2024), and the company’s most recent fiscal year revenue beat the consensus forecast of NZD1,698 million (source: S&P Capital IQ) by +1%. Looking forward, the sell-side analysts’ consensus FY 2025 (April 1, 2024 to March 31, 2025) revenue estimate was revised upwards by +4% in the past three months to NZD2,077 million. This implies that the market expects Xero Limited’s top line to expand by +21% for FY 2025, which will be roughly on par with its actual FY 2024 sales increase of +22%.
Australia is Xero Limited’s biggest market, accounting for 45% of the company’s latest fiscal year revenue as disclosed in its FY 2024 annual report. As a provider of accounting software solutions, XROLF’s financial performance is closely linked to business confidence and health of small- and mid-sized businesses operating in the country.
XROLF released its “Small Business Index Australia Update” report for the second quarter of calendar 2024 in late July. As per Xero Limited’s research, there was an improvement in the key metrics for Australia’s small enterprises in the latest quarter. Specifically, the revenue expansion for small businesses operating in Australia accelerated from +3.8% YoY in Q1 2024 (calendar year) to +3.9% YoY for Q2 2024. Australian small businesses also saw overall jobs growth improve from +3.4% YoY in the first quarter to +4.5% YoY in the second quarter.
Separately, National Australia Bank’s June 2024 business survey published last month indicated that Australia’s “business confidence rose 6pts to +4 index points” which represents the “highest level since early 2023.”
In summary, businesses in Australia, XROLF’s largest market, have performed well in recent times, and this has boosted the revenue growth prospects of Xero Limited. Therefore, I have chosen to upgrade my rating for XROLF from a Sell previously to a Hold now.
But XROLF’s US Investments Are A Concern Pertaining To Profitability
My view is that a Buy rating for Xero Limited isn’t justified, even though the company’s revenue prospects has improved as mentioned in the previous section. Specifically, I am worried about the negative impact of Xero Limited’s expansion plans in the US on its profitability.
At its earlier 2024 Investor Day at the end of February, XROLF highlighted that Australia, the UK, and the US are the three key markets that the company will be focusing on in the future. It is worth noting that the UK and Australia accounted for 27% and 45% (source: annual report) of Xero Limited’s FY 2024 revenue, respectively. In contrast, XROLF derived a mere 7% of its most recent fiscal year top line from the US.
As such, it is reasonable to assume that the majority of Xero Limited’s growth capital expenditures will be allocated to the US market, since its revenue contribution is low as compared to that for Australia and the UK.
A key risk for XROLF is that investments in the US become a drag on the company’s overall profitability.
The management’s commentary at recent investor events does raise some concerns. Xero Limited stressed at the 2024 Investor Day (transcript sourced from S&P Capital IQ) that it will “try and be reasonable” with its “burn rate” in the US market and emphasized that being “profitable” is “not our goal in the US.” At the company’s FY 2024 earnings briefing (transcript obtained from S&P Capital IQ) in May, XROLF indicated that it will “keep our investment rate reasonable relative to our top line expectations”, although it acknowledged that it has established an “onshore team in the U.S. in engineering and product” to enhance its “execution in the US.”
Also, there are unfavorable read-throughs from Xero Limited’s actual FY 2024 performance and its FY 2025 guidance. XROLF’s product design & development expenses increased by +7% YoY from NZD490 million in FY 2023 to NZD526 million in FY 2024. In its FY 2024 investor presentation slides, Xero Limited guided that its “product design & development costs as a percentage of revenue” will be “higher” in FY 2025 vis-a-vis FY 2024. Xero Limited mentioned in its FY 2024 earnings call that it “will continue to localize key bookkeeping and compliance features” for the US market. This investment in localization explains why it anticipates an increase in product design & development expenses for the new fiscal year.
More significantly, XROLF’s past investment track record for the US market has been unimpressive. Xero Limited is estimated to have invested around NZD300 million (source: FY 2024 earnings call) in the US for the past decade, but the company’s US market revenue contribution of NZD112 million represented a single-digit percentage of its total FY 2024 top line.
The market is now expecting Xero Limited’s normalized EBITDA margin to contract slightly by -0.8 percentage points from 30.7% in FY 2024 to 29.9% in FY 2025 according to S&P Capital IQ data. This seems too optimistic, in my view, taking into account XROLF’s US investments. I remain cautious on Xero Limited and have decided to rate the stock as a Hold (rather than a Buy), considering the risk of a FY 2025 EBITDA margin miss. Xero Limited’s next earnings release (1H FY 2025) is expected in November this year, as the company reports its results on a semi-annual basis.
Bottom Line
A Hold rating for XROLF is fair in my opinion. I have a mixed view of Xero Limited’s prospects in terms of both top line expansion and operating profitability.
The risk-reward for Xero Limited also seems balanced with its PEG (Price-to-Earnings Growth) metric of 1.57 times. A rule of thumb is that average companies are deserving of a 1 times PEG. Considering XROLF’s strong growth profile (revenue expansion of +20% or above), Xero Limited can probably command a higher PEG of 1.5 times, which is where the stock is trading at now.
The 1.57 times PEG for XROLF is calculated based on the stock’s consensus forward one-year P/E ratio of 55 times and the company’s consensus FY 2024-2027 EPS CAGR projection of +35% (source: S&P Capital IQ).
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