Xero Boosts Earnings with AI-Enhanced Accounting Software

About Xero Limited

Xero Limited (Xero, ASX:XRO) was incorporated in New Zealand in 2006 under the name “Accounting 2000” and in 2007 listed on the ASX and the NZX. Today the Group is a leading global provider of cloud accounting software for small-to-medium businesses and their accounting advisors. The Xero platform functionality enables SMEs to manage invoicing, inventory and payroll online and in real-time.

Digitisation and AI to support growth

The key to Xero’s rapid growth is that its software is a market-leading solution to the three most critical jobs to be done for small businesses – accounting, payroll and invoicing. Digitisation allows these functions to be performed remotely and in real-time, using a laptop computer or an iPhone. More recently, advancements in the application of Artificial Intelligence (AI) can streamline tasks, deliver insights in real-time, and reduce error rates and fraud.

Xero uses AI to perform labour intensive tasks like scanning invoices for coding, reconciliation, accounts payable and forecasting analytics, as well as recognising fraud.  For example, AI extrapolates patterns in accounts receivable and accounts payable to project future cash balances.

Xero pioneered cloud computing for accounting software used by small businesses, providing them with lower hardware costs and access to data anywhere, from any device. This feature and other innovative accounting and business management software features explain why Xero has achieved 25 percent per year average revenue growth over the past 5 years at a 30 percent EBITDA margin.

Lower bond yields support growth stock valuations 

Share market valuations of growth stocks like Xero are highly sensitive to changes in interest rates. This is because the discount rate applied to long-dated forecast cash flows falls in line with long dated bond yields. A lower discount rate increases the net present value of future cash flows, which in turn implies a higher theoretical valuation of shares that generate these cash flows. Because Xero generates long-term, dependable, recurrent revenues, its cash flow is considered “long duration” which accentuates the impact of lower interest rates on its share valuation. The Australian 10-year yield has declined from 4.9 percent ten months ago to 4.28 percent today and is likely to decline further over the next 2 years as the Reserve Bank commences its interest rate easing cycle. This should support a higher valuation of Xero shares.

Looking Ahead

Xero’s average rate of revenue growth is expected to decline from its current 25 percent per annum growth rate. This is entirely logical because revenue cannot outpace that of industry averages in perpetuity, otherwise investors strike certain mathematical problems, so a moderation in revenue growth is to be expected. Market consensus is for revenue to grow at an average rate of 15 percent a year for at least for the next 3 years. Operational leverage of Xero’s software is likely to see earnings grow at a higher rate over the same period.

Australia is Xero’s largest market with 45 percent of Group revenue, followed by the UK with 27 percent, New Zealand at 12 percent and North America at 7 percent. The rest of the world accounts for 10 percent of Xero’s revenue. This leaves considerable future market share growth opportunities for Xero’s software products.

Ongoing subscriber growth, especially in overseas markets where Xero is under-represented, and expanding the number of products sold to each subscriber, should support higher revenue and earnings at least over the medium term.