Xero’s Growing Cash Balance In Focus

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Analysts raise targets for Xero after FY24 results demonstrated management’s commitment to balancing growth with profitability.

-Xero’s FY24 results beat consensus expectations
-Higher future investment may limit market upgrades
-Rule of 40 achieved years ahead of schedule
-A growing cash balance provides potential for dividends

By Mark Woodruff

Last week's FY24 results for Xero ((XRO)) exceeded consensus estimates, with analysts welcoming robust revenue growth, effective cost controls, and significantly lower-than-expected capital expenditure. Revenue trends into FY25 are also much stronger-than anticipated, particularly for the International segment.

Despite a material rise in 12-month target prices across the broking community, Buy-rated Citi felt consensus upgrades may be limited due to higher product investment requirements. Some analysts also expressed concerns regarding valuation.

Earnings grew by 75% year-on-year to NZ$526.5m, courtesy of a higher earnings margin due to a lower full-year operating cost ratio than originally guided by management, while free cash flow (FCF) increased by 250% to NZ$342m.

Xero provides a cloud-based platform for online accounting plus business services to small businesses and their advisers primarily across the A&NZ region, as well as in the UK and the US, along with some South-East Asian markets.

The Australian operations provided around 45% of total operating revenue for the company in FY24, though the customer base is growing rapidly overseas.

At the close of FY24, there were 4.16m subscribers, an 11% increase compared to the previous corresponding period, led by 13% growth in Australia, while UK and North American subscriptions jumped by 11% and 10%, respectively.

More bullish brokers cited the annualisation of price rises (both current and future) and noted tailwinds provided by annualised savings from staff cuts, as well as a much trimmer overall cost base.

Wilsons is less convinced, and lowered its rating to Market Weight from Overweight, in recognition that Xero is now more reliant on price rises to maintain high-double-digit topline growth due to incrementally slower subscriber growth over the past three years.

Churn also increased by 9bps to 99bps in FY24. This measure continues to normalise back towards post-pandemic levels, where it averaged 115bps, explained the analysts.

Sell-rated Ord Minnett, which whitelabels Morningstar research, has been a long-time critic of the company’s valuation.

Morningstar/Ord Minnett believes Xero struggles to achieve positive unit economics in international markets, noting International customer acquisition costs in FY24 were -14% worse compared to FY23, and are three times higher than the company achieves in the A&NZ region.

While valuation has been raised by 9% to $85, it is still well short of the $155.30 average target of the five other covering brokers in the FNArena database. Macquarie's $180.70 target is the highest after a 16.9% upgrade following the FY24 result.

The Rule of 40

Hold-rated Morgans highlights how management has achieved the aspirational 'Rule of 40' years ahead of schedule, largely due to stronger-than-expected cost control, resulting in significant margin and FCF expansion.

Management at Xero looks to this rule (which states a software company's combined revenue growth rate and profit margin should equal or exceed 40%) as its north star for delivering and balancing profitable growth, explained the broker.

UBS has warned investors to expect some near-term slippage in this metric. Before accelerating towards 27% in FY27, FCF margins are expected to fall to 17% in FY25 from 20% in FY24 as management invests for growth, particularly in markets like the UK and US.

Opex/sales ratio

In a key negative arising from FY24 results, according to Goldman Sachs, management provided guidance the opex/sales ratio would increase to 73% in FY25 from 68% in the second half of FY24 as Xero accelerates product investment.

Certainly, Jarden was somewhat surprised by the 9% share price lift on results day given this projection. While supportive of investment for the long-term, Jarden analysts suggest Xero's next update needs to provide more colour on where it is investing.

Goldman concedes an acceleration in product investment is the key to supporting ongoing subscriber/price growth, and based on management's recent positive performance, FY25 guidance will likely prove conservative.

Capital management

As there was NZ$1.5bn in cash and equivalent on hand at the end of FY24, Jarden would like to see an evolution of thinking around Xero’s capital management and structure, given the transition underway to meaningful and growing cash flows.

The company’s equity FCF is forecast to grow by 10% year-on-year in FY25 to NZ$432m, or 211cps in Australian dollars, based on the analysts’ forecast.

When this FCF forecast is combined with Xero's current net cash position, the broker sees potential for dividend payments and includes a small second half payout in its base case forecast.

Price rises and the outlook

Price rises are again looking robust for FY25, in Wilsons view.

Pricing plan changes for the Australian market were announced on May 1, and will be implemented from July 1, entailing average price increase across the company’s Australian plans of 13%.

Average revenue per user (ARPU) growth was up 8.6% year-on-year in FY24 on the back of recent price increases, and Macquarie sees good prospects for FY25, given three additional months of A&NZ price rises and a positive mix shift.

Group average revenue per user (ARPU) was 14% higher at NZ$39.29 per month in FY24, with International pricing up by 17% to NZ$41.05.

While acknowledging a strong FY24 result, Jarden noted a less favourable near-term risk-reward proposition for Xero due to the recent share price rally.

In setting a $144 target, the analysts apply a 50% weighting to a $125 base case, and 25% to each of the broker’s downside ($50) and upside ($275) scenarios, given uncertainty around long-term outcomes for Xero.

UBS anticipates significant headroom for FCF margins to lift over time, with global SaaS peers already delivering an average of around 30% compared to the 20% registered by Xero in FY24.

The average target for Xero in the FNArena database has now risen to $138.58 from $127.25 suggesting 3.4% upside to yesterday's closing share price. The impact of Ord Minnett's lowball $85 target on this average should be allowed for as mentioned previously. Also, Morgan Stanley is yet to refresh its research following the FY24 result.

Of the six covering brokers updated daily in the database, four have Buy (or equivalent) ratings, while Morgans is on Hold and Ord Minnet is Sell-rated.

Jarden, Goldman Sachs and Wilsons (three covering brokers not updated daily) have an average target of $146.54. Jarden is Overweight, Goldman Sachs keeps a Buy rating, and Wilsons is now Market Weight, down from Overweight.

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