Down 46% in 2022, why ASX 200 tech share Xero is still my hero

Like many ASX tech shares, the Xero Limited (ASX: XRO) share price has been battered and bruised this year.

So much so that Xero shares are wearing a 46% fall since the beginning of the year. By comparison, the S&P/ASX 200 Index (ASX: XJO) has dropped 15%.

Despite the recent turbulence, here are a few reasons why I’m holding onto my Xero shares for the long term.

Mission-critical products

I love investing in companies that offer mission-critical products. Companies with products that are so deeply embedded in their customers’ lives that they’re hard to give up.

These products are sticky, leading to high levels of customer retention and recurring revenue. Not only does this help companies to weather economic storms, but it can also give them lucrative pricing power.

I believe Xero fits this bill to a tee. Its software plays an integral role in the operations of its small to medium size business customers. 

Plus, there are also meaningful switching costs involved in moving to another cloud accounting provider. Users would have to learn an entirely new system, move all of their old accounts to another platform, and set up various processes and workflows all over again – a daunting and disruptive process.

So, Xero’s revenue is very sticky. And the company has consistently flexed its pricing power over the years, increasing the prices of its monthly subscriptions without drastically impacting the number of customers going out the door (also known as ‘churn’). 

It helps that Xero continues to roll out new features and integrations for its customers, providing more value while also embedding itself even further into customers’ workflows.

Attractive unit economics

This pricing power has helped Xero to increase its average revenue per user (ARPU) over time. Which, combined with stable churn, has boosted Xero’s customer lifetime value (LTV).

Put simply, LTV is the gross profit Xero estimates it will collect from a customer over the expected lifetime of that customer. I should add that Xero boasts high gross margins, which came in at 87% in FY22.

In my view, Xero is a company with very attractive underlying economics. The beauty of these economics is best seen through the relationship between its LTV and customer acquisition costs (CAC).

In other words, how much it costs Xero to acquire a customer compared to how much that customer is worth.

In FY22, Xero reported an LTV-to-CAC ratio of 6.9. This means that Xero estimates it gets NZ$6.90 back for every NZ$1 it spends to acquire a new customer.

So although Xero has a hefty marketing spend, it makes sense to invest in these channels at such attractive rates of return.

A large opportunity

Xero has nearly all but gobbled up its local markets of Australia and New Zealand. But the international opportunity remains large. And with many businesses overseas yet to shift to cloud accounting, this opportunity is ripe for the picking.

Competition is certainly fierce, especially in the US, where Intuit (NASDAQ: INTU) reigns supreme.  But with a leading cloud-native product, more than 1,000 app integrations (where Xero now clips the ticket, à la Apple), a broad and growing set of tools, and heavy investment into product design and development, I believe Xero is in a strong position to gain market share as more companies take their business to the cloud. 

The UK and Canada are particular regions of focus, with low cloud accounting penetration and industry tailwinds blowing in Xero’s favour.

The opportunity for Xero lies in adding to its 3.3 million-strong subscriber base. And from there, continuing to extract more revenue from its existing customers. 

Where to from here?

Although it’s very capable of generating free cash flow, Xero continues to reinvest cash back into the business for future growth. So, it’s not a surprise to see market sentiment turn against Xero this year.

Xero is a business that will require patience. But, much like management, I believe it pays to think long term. 

In my mind, Xero is one of the highest quality businesses on the ASX. And as long as the economics remain attractive, and it continues to take market share, Xero is a business I’ll be happy to hold in my portfolio for many years to come.

The post Down 46% in 2022, why ASX 200 tech share Xero is still my hero appeared first on The Motley Fool Australia.

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Motley Fool contributor Cathryn Goh has positions in Apple and Xero. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has positions in and has recommended Apple, Intuit, and Xero. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has recommended the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool Australia has positions in and has recommended Xero. The Motley Fool Australia has recommended Apple. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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