Xero Sees The Value Of Profit

This story features XERO LIMITED, and other companies. For more info SHARE ANALYSIS: XRO

Announced lay-offs are a step toward reducing Xero’s operating expense in order to shift from investing in scale to making money.

-Xero to lay-off staff
-Revenue should not be impacted
-Technology function to be redesigned
-Subscriber growth trajectory unclear

By Greg Peel

The biggest victims of the global push by central banks to swiftly hike rates to combat inflation have been technology companies, for which a higher discount rate applied to future earnings has led to steep valuation de-rating. Hit hardest are those companies still in their growth phase, reinvesting revenues and thus yet to make a profit.

Last week accounting software firm Xero ((XRO)) announced a -14-17% reduction in its headcount, representing some 7000-8000 roles. The reduction now implies FY24 operating expense guidance as 75% of revenue, down from FY23 guidance of “the lower end of 80-85%”.

Brokers have cheered what they consider to be a positive if not unsurprising move from the new CEO. Citi notes Xero’s revenue/earnings per headcount has been limited to around 1% over the last two years and growth is expected to slow going forward due to delays in the UK government’s Making Tax Digital initiative and generally softer macro conditions.

Management has also flagged a redesign of the company’s Technology function in the upcoming quarter which could see the potential for further, albeit much smaller-scale, efficiencies, UBS notes, with full organisational design to be completed by July this year.

Revenue

Brokers assume the headcount reduction will have no impact on revenue growth, although in announcing the cost-outs Xero provided limited detail on growth trajectory or subscriber growth profile.

Jarden’s research has found that global tech sector lay-offs to date, of which there have been many and the announcements keep on coming, have ranged from -6% to -50% of the existing workforce for an average of -17%. Xero’s midpoint -15% is thus in line with the average, and Jarden notes Xero generated materially less return per employee than local tech peers WiseTech Global ((WTC)) and Altium ((ALU)), as well as US rival Intuit (Quickbooks) and customer relationship management leader Salesforce.

The implication is there may have been “additional capacity” in the business, Jarden suggests, which is consistent with Xero's commentary that the cost-cuts will come predominantly from non-revenue generating areas.

Brokers agree the headcount reduction marks a potential step-change in the direction for Xero towards profitable growth and a clear statement from the new CEO that she is prepared to make strong changes to deliver more free cash flow.

UBS nevertheless remains watchful of Xero's longer term growth strategy, particularly in the US, as the company likely weighs up the significantly larger subscriber total addressable market opportunity of at least 33 million SMEs (beyond existing penetration in A&NZ, UK and Canada), with likely reinvestment costs required in Product and Sales to more effectively compete with Intuit.

UBS notes Xero has recently hired a new Chief Product Officer, based in the US, who has extensive experience in tech.  

International subscriber growth is likely to remain positive but mildly moderate with the reduced investment in Macquarie’s view. The impact is more muted given the low return Xero achieves internationally compared to A&NZ – providing opportunities for the group to execute on the announced cost-out. This broker has partly tempered its subscriber growth forecasts in the US and UK to 70% of prior forecasts to reflect this.

The FNArena broker database has three Buy (or equivalent) ratings and two Holds for Xero. Ord Minnett (Morningstar) has downgraded to Sell from Lighten on a technical share price move vis a vis target price.

The consensus target is $88.76, suggesting limited upside. But we live in uncertain times, and Morningstar's (Ord Minnett) valuation is a negative outlier at $54, depressing the average for what otherwise is a range between $90.85 (Citi) and $105.70 (UBS).

Jarden, which is not a database broker, has an Overweight rating and $87.00 target.

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