Xero, a cloud-based accounting software provider based in New Zealand, is now available (OTCPK:XROLF) remains a compelling option to gain exposure to the secular small/medium business (SMB) growth tailwind. Having already cemented its foothold in Australia/New Zealand, the company is now in the midst of expanding overseas via a ‘platform’ strategy Over key growth markets One of the key markets is the UK, which recently experienced a setback in the economy. announcement of a multi-year ‘Making Tax Digital’ (MTD) delay. The revenue line will feel the most impact, with lower sales and marketing costs likely to support profitability. It also marks a challenging start to new CEO Sukhinder Singh Cassidy’s international growth ambitions, though the massive SMB addressable market means Xero has ample opportunity to refocus its efforts elsewhere. All in all, I like the fundamentals but paying ~7x fwd EV/Revenue (~10x trailing) in this environment for <20% top-line growth seems pricey; I think a wait and see approach makes the most sense here.
MTD Delay is a Blow for the Near-Term UK Growth Hopes
The UK government has seen several regime shifts in the last few months. But, announced delay in implementation of the next phase of its ‘Making Tax Digital’ (or MTD) initiative for income tax self-assessment for self-employed and landlords came as a negative surprise. The target date for April 2026 will now be announced. This is a two-year delay from the April 2024 target. For Xero, this reduces the immediate need for its software significantly – the phased approach will push a portion of demand (sized at >4m taxpayers) into the first phase in April 2026, followed by a higher amount in the second phase in April 2027.
Net, the news will come as a blow to Xero’s growth plans in the UK – recall that the stronger H1 revenue result was helped massively by the UK business, which has seen better average revenue per user (ARPUs) than the group. This delay could mean that Xero fails to meet its near-term growth targets. It will depend on the offset benefits from market improvements and the MTD of VAT tailwind in H2 2023.
Beyond FY23, this news introduces uncertainty to the sub growth trajectory – with an election due before MTD implementation (likely in late 2024/early 2025), it remains uncertain if current policies will remain intact. It seems unlikely that voluntary software adoption will be possible, with the available budget space for SMBs for accounting software being limited in the current inflationary climate. Bulls will advocate for some level of adoption while the deadline is still a few weeks away. However, I expect most potential subs to choose to delay. To reflect the delay in the next phase MTD, I would support a more conservative sub-growth outcome for FY24/FY25.
Silver Linings in the MTD Announcement
Although the MTD delay could be a headwind for the UK subs, there could still potentially be upside as Xero Go gains traction on the freemium end. ARPU will be diluted for Xero Go growth in the near-term. However, revenue momentum could slow before picking back up in H2 2023 as more price hikes in North America (scheduled in November) kick into. Positively, the HMRC announcement does not change the timeline for VAT-related tax due to penalty points in effect January 2023 for noncompliant businesses. This is a clear tailwind for adoption in the UK (albeit a smaller one than self-assessment).
On the profitability side, the impact to Xero from the MTD delay could even be positive – while Xero will lose growth, it also has the option of scaling down sales and marketing spend, as well as related product development costs in the UK. The company is also reducing headcount growth in an effort to increase efficiency. Therefore, EBITDA margins should be protected through FY24. I believe that more headcount reduction could also pose an upside risk to the margin outlook due to guidance due at H2 2023/FY23 results. Relative to the guided ‘lower end’ of the 80-85% opex target, the 84% result in H1 2023 leaves the bar fairly low for H2 2023; a very achievable <80% ratio would be sufficient to get the company to the full year ratio target.
Sukhinder Sing Cassidy is not the ideal CEO
The timing of UK’s announcement could not have been better. Remember that Xero announced The surprise departure by Steve Vamos, prior CEO, and subsequent appointment of Sukhinder S. Singh Cassidy as H1 result. Singh Cassidy, who has a Silicon Valley tech background and was likely hired to expand the market outside of the Australia/New Zealand stronghold. As she will be US domiciled, this could be an indication of where Xero’s focus lies, although the recent strength of the UK market could point to it being an additional focus area as well.
Plus, her compensation (see table below) has been aligned to growth, with ~75% of long-term incentives tied to revenue growth outcomes, suggesting the company’s path forward is on further expansion rather than optimizing earnings. For now, uncertainty remains over the three-year strategy – former CEO Vamos executed well on his plan through FY23 and the onus will now be on Singh Cassidy to follow up with her FY24-FY26 strategy. In the interim, there will be some volatility in the stock, pending clarity.
All Eyes on International Growth Potential
Xero’s leadership in cloud-based accounting software leaves it poised to capitalize on the secular SMB digitization trend globally. Leveraging a ‘platform’ strategy to replicate its success in Australia/New Zealand overseas, the company has also hired a new CEO with Silicon Valley experience to spearhead the execution. The company’s recent MTD announcement in UK is a setback as it was a key growth market. However, the huge global addressable market opportunity means that there are still plenty of opportunities to expand. The key hurdle for me is the valuation – at ~7x fwd revenue (~10x trailing) for a <20% top-line grower, the stock is already priced for success. In the interim, I have been removed from Xero in order to find a more attractive entry price.
Editor’s Note – This article discusses securities that do not trade on major U.S. stock exchanges. These stocks can pose risks.