Xero: Normalizing Business Failure Rates Expected to Consume Xero’s Sales and Marketing Budget

We maintain our AUD 75 per share fair value estimate for narrow-moat-rated Xero XRO as we approach the release of its half-year results on Nov. 9. At current prices, Xero shares screen as materially overvalued. We believe a normalizing business environment will result in Xero having to spend an increasingly large share of its sales and marketing budget to replace churned customers, which leaves increasingly less budget to fuel subscriber and revenue growth.

We believe Xero experienced a temporary tailwind after the onset of the COVID-19 pandemic, due to supportive fiscal and monetary policy artificially boosting business creation levels and suppressing business failure rates. The Australian Bureau of Statistics is showing that this tailwind is subsiding and reversing. Business exits rose 27% in the 12 months to June 2023 from the prior year and accounted for 15% of total businesses, from 12% in the prior year. Meanwhile, new business entries declined 14% during the same period.

Although the net result was a 3% growth in the total number of businesses, we believe this net number obfuscates the impact of business failures on Xero. If Xero were to grow its total number of subscribers by 5% over this period, which assumes some market share gains, against the backdrop of a 15% annual business failure rate, then this implies that 75% of its sales and marketing budget would have been spent on replacing churned customers, all else being equal.

We estimate that Xero has been spending an increasingly large share of its sales and marketing budget in Australia and New Zealand, or ANZ, on replenishing churned customers, which, due to high switching costs, we believe consists almost entirely of business failures.