Xero (ASX: XRO) held an investor briefing to share more details on its AI efforts and to update the market on progress and plans for Melio, the US-focused payments company it acquired last year. Full-year guidance was reiterated.

Why it matters: We liked the various new artificial intelligence agents that Xero has implemented throughout its platform. We thought the Melio features demonstrated were underwhelming and the bare minimum.

  • Xero has implemented AI agents across the platform, including for cash flow forecasting, invoice generation, and bank reconciliation. We thought implementations felt natural, well-placed throughout the user experience, and useful. We believe customers will appreciate them.
  • We thought the Melio features shown were table stakes. We also felt the integration into the Xero platform was a poor user experience, requiring separate logins with Melio and with bank integration partners. We think native integration would be far more suitable for small businesses.

The bottom line: We maintain our fair value estimate for narrow-moat Xero of $100 per share. AI and payments don’t change our thesis. Shares screen as slightly undervalued, following a 50% drop since the Melio acquisition.

  • To us, AI agents seem like the cost of doing business rather than exciting business opportunities. Although we expect better monetization, we view them more as defensive moves against potential AI native new entrants.
  • Payment features seem to merely allow Xero to reach parity with wide-moat Intuit. We believe the low penetration of payment software among small businesses is primarily because they don’t have many bills to process or a desire to use expensive payment options.

Big picture: Xero’s ANZ business is well-protected by network effects but provides few growth opportunities due to saturation. The US market is the opposite: a large opportunity, but Intuit is protected by economic moats, leaving no clear path for Xero to succeed in market entry.

Investor update doesn’t change our thesis for Xero

We expect Xero’s near- and medium-term strategic focus to revolve around rationalizing its areas of investment, especially against a backdrop of normalizing demand for business software.

After the onset of the covid-19 pandemic, new business creation levels spiked while business failure rates plummeted, which we believe provided a temporary tailwind for business software.

In response to this tailwind, Xero’s nearly tripled its total expenditure on product design and development. However, we see little evidence of returns on these investments. Xero today operates mostly in the same markets as it did a decade ago. Therefore, we believe investments in country-specific adaptations of its products do little to explain the 10-fold increase in total expenditure on product design and development over the period. We also don’t see compelling evidence of returns on investment into new features and functionalities. New Zealand, Xero’s most mature market, should reflect increased average revenue per user, or ARPU, if new features and functionalities were valued by customers. Instead, the New Zealand market has only seen low-single-digit growth in ARPU over the past decade, leading us to believe Xero’s small and midsize enterprise, or SME, customers value simplicity, not features and functionalities.

Xero’s investments in sales and marketing in its international markets have also seen diminishing returns since the onset of the pandemic. Xero’s international customer acquisition costs, or CAC, per subscriber have grown by over 50% since the onset of the pandemic and are three times greater than its Australia and New Zealand markets. Although the lifetime value, or LTV, per international subscriber is still three times CAC, and CAC payback remains under two years, Xero’s overseas expansions have seen widely differing degrees of success over the past decade. Whereas Xero has successfully made inroads into the United Kingdom—where we estimate it is capturing around a third of new businesses created—in the United States, Xero’s market share continues to hover at just 1%. We don’t expect the Melio acquisition to unlock this opportunity.

Bulls say

  • Xero holds a dominant market position in Australia and New Zealand, where its business is supported by network effects.
  • Xero has successfully made inroads into the UK, where it is capturing around a third of new businesses being created.
  • Under new leadership, Xero has renewed focus on fiscal discipline.

Bears say

  • Xero’s customer base of SMEs is low-quality, due to the segment’s inherently high business failure rates. This will require constant spending into sales and marketing to replenish churned customers.
  • Xero has been unsuccessful at making inroads into North America, where it holds just 1% market share.
  • Xero has a chequered history when it comes to fiscal discipline, especially in product design and development.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

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Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.