Xero margin for error in the current environment

Investors in accounting software group Xero took out the axe with the long handle yesterday and gave the company’s shares a good whack after what they thought was a disappointing annual result.

The company, which started in New Zealand and is now global, lifted revenue past the $NZ1 billion mark for the first time with a 29% surge to $NZ1.1 billion.

But on a statutory basis the company lost $NZ9.1 million as the company continues to invest heavily in expansion and doesn’t pay a dividend.

It was that pursuit of growth that upset investors and saw the shares sold off yesterday, dropping by more than 11% to $76.90.

It’s not the first time that investors impatient with the growth first approach from Xero have spat the dummy.

It is a business approach quite common in the huge US tech sector and yet quite a few Australian investors don’t get it.

Total subscriber numbers rose a solid 19% to 3.3 million and annualised recurring revenue was up 28% to $NZ1.22 billion.

Xero said its gross margin rose by 1.3 percentage points to a still tasty 87.3% which in turn saw EBITDA rise a sedate 11% to $NZ212.7 million from $NZ191.2 million in 2021.

Free cash flow tumbled to just $NZ2.1 million from nearly $NZ57 million the year before – a disclosure that analysts didn’t like.

Costs seemed to be a concern but Xero and its management were upbeat in the accompanying commentary.

They said the company “delivered strong progress across multiple performance indicators with revenue growth rebounding to 29% (30% in constant currency or CC), or 24% excluding acquisitions.

“The quality of Xeros performance, delivered against a backdrop of varying market conditions, is underscored by robust software as a service metrics.

The 29% rise in operating revenue came from a 23% rise in core accounting revenues which were driven “by subscriber growth and ARPU (average revenue per user) increases.

“Platform revenue increased by 113% to account for 11% of total operating revenue, up from 7% in FY21. This was driven by growth in payments, payroll and revenues from recently acquired businesses including Planday.”

The 11% rise in EBITDA (was described as ‘modest’) and “representing a balance between further gross margin expansion, which increased to 87.3%, and increased operating costs. A net loss of $9.1 million and free cash flow of $2.1 million are consistent with Xeros preference to reinvest capital generated back into the business.”

“Total operating expenses, inclusive of acquisition integration costs, increased as a percentage of operating revenue to 84.0%. This is consistent with the guidance range provided for FY22 and the profile of Xeros expenditure in the pre-pandemic period.

“Xeros full-time equivalent employees increased to 4,784, up 31%, or 24% excluding acquired businesses. These ambitious talent acquisition targets were achieved within a challenging hiring market.

“Overall sales and marketing costs grew by 32% in FY22 to $405.7 million or 37.0% as a proportion of operating revenue.”

This was driven by solid growth across all markets, with the Australian and UK segments arguably the standout performers

In Australia, revenue increased by 26% to $NZ483.3 million with 229,000 net subscriber additions, bringing the total to 1.34 million subscribers.

In NZ revenue rose 15% to $NZ149.4 million with 66,000 net subscriber additions, bringing the total to 512,000 subscribers.

In the UK, it delivered a 30% increase in revenue to $NZ91.6 million thanks to 130,000 net subscriber additions over the year to a total of 850,000.

In the huge North America market, Xero remains a small player. It reported a 28% increase in revenue to $NZ72.6 million after adding 54,000 net subscribers which now total 339,000.

And in the Rest of the World segment, Xero reported an 85% increase in revenue to $NZ100 million with the addition of 51,000 net subscribers, which took the total to 226,000. This segment was also boosted by the inclusion of the majority of Planday’s revenues, which was acquired at the start of FY 2022.

And looking to 2022-23, the company was cautious – no guidance on revenue or earnings, only a conservative costs estimate.

It sees total operating expenses (including acquisition integration costs) as a percentage of operating revenue for 2023 towards the lower end of a range of 80% to 85%. This compares to 2022’s ratio of 84%.

Shares in Xero (ASX:XRO) are currently trading 8.4 per cent higher at $83.39.