| EV/EBITDA | |
|---|---|
| FY1 | 14.4 |
| FY2 | 14.4 |
US software has rebounded. Xero hasn’t yet, and we think it’s overdue
The US-listed iShares Expanded Tech-Software Sector ETF (US: IGV) software stocks have recovered losses from this year’s AI disruption sell-off to trade at levels last seen in late 2025, but Xero (ASX: XRO), and many other Australian-listed stocks, for that matter, have not followed. Xero shares are down ~61% over the past year and at a multi-year low. In our view, the gap is the combination of the sentiment recovery not reaching Australian shores yet and lingering concern about the Melio acquisition impact on near-term reported profit, not a weaker core business. Guidance is unchanged since our July note, and the shares are cheaper. We reiterate our BUY rating on Xero.
Xero provides accounting, payroll and payments software to 4.9 million (a number we expect to have increased since March) small businesses, mainly in Australia, New Zealand, the UK and the US. It completed the acquisition of US bill-payments business Melio in October 2025, reported its FY26 result (year to 31 March) in May and reaffirmed FY27 guidance at its August AGM.
The FY26 result showed the original business in good shape. Operating revenue rose 31% to NZ$2.75bn, or 21% excluding Melio. Adjusted EBITDA rose 18% to NZ$757m, and excluding Melio it rose 30%, faster than revenue, so the core business became more profitable. Free cash flow was NZ$554m, up 9%.
However, Melio was a drag on the reported numbers. Payments revenue carries a much lower gross margin than subscription software. Group reported net profit fell 27% in FY26. FY27 guidance implies a lower EBITDA margin again, as Xero absorbs a full year of Melio and lifts US brand spending. Management expects Melio to reach run-rate breakeven in the second half of FY28, and until then investors are waiting for evidence. The Chair acknowledged this at the AGM, citing “a desire from the market to see the financial returns from our Melio investment play out.”
The balance sheet consequence of Melio was that Xero swung from net cash of NZ$683m to net debt of NZ$383m, though at ~0.5x adjusted EBITDA, leverage remains conservative.
The AGM also produced a governance setback. 70.6% of votes cast opposed the remuneration report, after proxy advisers objected to the CEO’s pay structure and her recent share sale. Xero is a New Zealand-domiciled company and the vote was advisory, but the message was clear. The Board has since required the CEO to build a shareholding worth five times her base salary within three years to better align interests.
FY27 guidance is for operating revenue of NZ$3.62–3.73bn and adjusted EBITDA of NZ$860–920m. The EBITDA range includes up to NZ$55m of additional US brand spending, which began in the first half. Management expects a heavier second-half profit weighting than usual. We expect the half-year result, due next month, to show strong revenue growth with weaker profit growth. However, this is already priced in, and in our view, the FY guidance will likely be the bigger influence for the share price.
On the AI risk that has hurt Xero and many peers, the main concern for software companies has been that agents reduce the number of human users, and therefore paid seats. However, as Xero points out, it bills per business subscription, not per user, so that risk does not apply in the same way. Additionally, more than 500,000 customers were using its new generative AI features by March, and FY27 guidance includes some initial revenue from them.
Xero trades on 14.4x forward consensus EV/EBITDA. The Board has also authorised up to A$550m of on-market share purchases in FY27 to offset staff share issuance. At current prices, that buys many more shares than it would have a year ago and will help underpin per-share metrics.
Turning to the technical picture, we see overseas developments as relevant. US-listed IGV (iShares Expanded Tech-Software Sector ETF) has rebounded strongly from the depths of the AI disruption fear selloff earlier this year. The question the rebound raises is whether Australian large-cap technology stocks will also follow suit. Our base case is that similar to the US software stocks, the sector is oversold with real value emerging after the valuation reset.
Since our last update, Xero has fallen to a new low near $56, but the recent rebound might point to an important bottom being traced out. Xero has since last year fallen from record highs around $200. However, overbought conditions since then appear to have now been fully worked off. Additionally, the global internet and SAAS tech sector appears to have passed through the worst of AI disruption fears, and upward momentum is resuming. Our technical base case is that Xero will follow suit. Xero needs to successfully hurdle key resistance above $75/$80 to confirm an inflection. If confirmed, we remain of the view that Xero has decent scope for a significant recovery potential initially towards $100/$120.
Summary
Xero’s guidance has not changed since July, the core business is growing profitably, and the shares are cheaper. At 14.4x consensus forward EV/EBITDA, with a larger total addressable market opportunity after the Melio acquisition, we see the shares as underpriced at current levels, with a favourable risk-reward. The near-term risks are a soft first half and any delay in Melio’s path to breakeven. However, our base case is that Xero delivers on FY27 guidance, and we expect sentiment to follow the recovery already seen in US software. We reiterate our BUY rating on Xero (ASX: XRO) for members without exposure.
Disclosure: Interests associated with Fat Prophets hold shares in Xero.
