Xero (ASX: XRO) has acquired US-based fintech Melio Payments for USD 2.5 billion upfront with an additional USD 500 million in contingent consideration, deferrals, and rollovers. The deal will be funded 50% through an equity raise and implies an enterprise value/annualized revenue multiple of up to 16 times.

Why it matters: We believe the acquisition is value-accretive, as half of the acquisition is financed by the issuance of overvalued Xero shares, compared with our prior intrinsic assessment. Based on historical growth rates and margins, Melio appears to have been acquired at a seemingly full price.

  • Xero plans to integrate its accounting software into Melio’s payment platform and upsell its products, thereby hoping to lower the high customer acquisition costs that have hindered the firm’s expansion into the US. The CEO of Melio will stay on to run Xero’s US segment.
  • Xero’s penetration within the US market remains minimal at 1%, in contrast to 80% within Australia and New Zealand. We do not expect the acquisition of Melio to meaningfully change its market position and continue to forecast increasing marketing expenditure as it battles to gain market share.

The bottom line: We raise our fair value estimate for narrow-moat Xero to AUD 102 per share, an increase of 8%. The uplift is driven by the issuance of overvalued script to partly fund the acquisition. However, our current earnings forecasts are yet to incorporate the impact of the acquisition.

  • Despite this, Xero’s shares remain materially overvalued, trading 90% above our revised intrinsic assessment, and do not reflect the challenges the company faces in sustaining profitable growth.
  • Most accounting software used by SMBs is recommended by accountants, and within the US, wide-moat Intuit maintains a dominant position in this space.

Doubling down on US exposure

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%.

Xero 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.

Xero 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.