Xero (ASX: XRO) is acquiring US-focused financial technology firm Melio Payments to try to break into the US market, following insufficient organic traction there thus far.

Why it matters: Xero has already sunk close to NZD 500 million into the US over more than a decade and has decided to chase this with a further NZD 5 billion through the Melio acquisition. But Xero is up against well-entrenched, wide-moat Intuit, which enjoys strong network effects there.

  • We don’t expect Melio’s functionality will make a material difference in Xero’s customer conversion or retention. Nor do we expect the ratio of lifetime value to customer acquisition costs, or LTV/CAC, to turn attractive from the combined offering.

The bottom line: We decrease our fair value estimate for narrow-moat Xero by 2% to $100 per share. Despite a sizable decline in Xero’s share price following the announcement of the acquisition, shares still screen as materially overvalued.

  • We believe the market does not fully appreciate that the company is fast approaching market saturation in Australia and New Zealand, as evidenced by fast-deteriorating returns on sales and marketing spending there.
  • With the company’s strong commitment to the US now, which we consider unwinnable, we also believe the company will no longer have the same level of resources to commit to other international markets, which we consider more winnable.

Big picture: Xero is up against Intuit’s QuickBooks, which enjoys strong network effects in the US, whereby accountants and bookkeepers recommend the use of QuickBooks to small and midsize businesses, and the large SMB userbase of QuickBooks pulls in more accountants and bookkeepers.

Coming up: The acquisition is expected to close before the end of this year. We will look for management commentary about the attach rates of the new financial services to its existing product suite.

Melio acquisition unlikely to make much difference

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.