A key factor that has led to re-rating in Xero (ASX:XRO) shares over the last ~18 months is that the Company achieved – and sustained – the “Rule of 40”. The “Rule of 40” is defined as the sum of annual revenue growth percentage and annual free cash flow margin percentage (free cash flow as a percentage of revenue).

The recently-announced acquisition of Melio results in XRO not meeting the “Rule of 40” benchmark in FY26 & FY27. This factor has been a key reason why the shares have retraced from its recent highs. Accordingly, we recently researched the Company in The Dynamic Investor to assess the prospects for a recovery in the shares.

About Xero

Xero is a New Zealand-based software company that has developed cloud-based accounting software for Small & Mid-size businesses (SMBs) and accounting practices. Since listing in NZ in 2007, the Company has expanded into Australia, the UK, the US, SE Asia and South Africa.

Revenue is reported across five geographical regions of exposure. The largest is Australia & NZ (ANZ), which comprises 38% of group revenue. Aside from the exposure in major markets – North America, UK and NZ – the Company also sells its software in other markets which it classifies as Rest of World.

In June 2025, XRO announced the acquisition of North American Digital Payments business, Melio, for US$2.5b. The acquisition (which is still subject to completion) represents the first sizeable acquisition in North America.

Key Fundamental Drivers

Melio Acquisition has Strategic Merit

Melio is a US-based payments platform that offers digital accounts payable and receivable solutions. Similar to XRO, it is focused on SMB customers and has significant overlap with XRO’s core customer base. Mileo’s Average Revenue Per User (ARPU) is US$250 per month compared to Xero’s average SMB payments ARPU of US$180 per month. This suggests a skew towards larger SMBs/partners. Melio also services accountants and bookkeepers by offering specialised tools and a centralised dashboard to manage their clients’ bill pay workflows.

While the acquisition appears to be fully priced, there is strategic merit:

i. The acquisition strongly aligns with Xero’s 3×3 strategy, which entails growing three core product groups – accounting, payroll and payments – in three core markets – North America, the UK and Australasia.

ii. Helps build critical mass in North America, where XRO has been focused for many years but has not made meaningful progress.

iii. Stronger product offering. The acquisition brings product innovation and makes XRO’s North American product more compelling due to combining digital payments and accounting. According to Xero, >60% of their North American customers (SMBs, accountants, and bookkeepers) want accounting and accounts payable integrated. Adding Melio brings these two integrated solutions together in one place, given Melio’s position as a leading US SMB bill payment platform.

Do the Risks Outweigh the Strategic Merit?

The acquisition is dilutive to earnings over the next two years, as XRO is acquiring a loss-making business. Melio is EBITDA and free cashflow negative. However, with significant revenue growth forecast, Melio is expected to become EBITDA positive in three years.

It is estimated that XRO’s Pro Forma FY26 revenue will rise by ~15% from, from consensus estimates of NZ$2.5b to NZ$2.9b when annualising Melio’s revenues. However, EBITDA will fall 12% from NZ$787m to NZ$692m. Melio is expected to reach EBITDA break-even by FY28, but in order to achieve EPS neutrality, XRO needs to achieve material annual EBITDA synergies (~NZ$102.5m) by FY28.

On a Pro Forma basis in FY26 and FY27, XRO is likely to fall short of the key SaaS industry performance metric used to determine if a business is balancing growth and profitability, the “Rule of 40”, which states a company’s revenue growth rate and profit margin should sum to 40% or greater. However, in FY28, XRO’s targets imply Melio’s revenue will have more than doubled, setting XRO up to meet its implied target of at least NZ$4.2b in group revenue – with potential upside to this revenue forecast once cost savings and revenue benefits from Melio are captured.

The acquisition has also increased financial risk. Payment for the Melio acquisition shifts the balance sheet from a net cash position to a gearing position of 2.3x (on a net debt to EBITDA basis). Deploying cash on the Melio acquisition – as well as funding ~$700m of the overall transaction cost via debt – also moves XRO from generating interest income to paying interest expense.

Stronger FY26 Outlook for Existing Business

FY26 revenue assumes stronger ARPU growth to reflect better product mix and stronger international subscriber growth. Xero’s discounting strategy for new customers (e.g. 90% off for six months) seems to be working, as it is resulting in improved mix. However, this was likely is the reason why FY25 ARPU growth was lower than anticipated. This impact is likely to spill over into 1H26, especially as the discounting strategy lifts the Annualised Monthly Recurring Revenue but does not fully convert to revenue until later. There is further upside to ARPU globally, as XRO transition its extensive back book to higher tier plans.

Fundamental View

Market valuations/sentiment at present are focusing on the FY28 period when XRO is expected to exceed the “Rule of 40”. Notwithstanding, we consider that a more cautious view on the shares is warranted in light of:

i. Risks associated with the Melio acquisition, namely, a) The integration risk of what is essentially the largest acquisition in XRO’s history and b) That the targeted uplift in revenue and cost synergies in order to return Melio to EBITDA break-even is delayed beyond FY28. To this end, a more favourable view on the shares requires significant faith in management, which investors are prepared to grant, given management’s recent track record.

ii. Uncompelling valuation metrics – XRO is trading on an Enterprise Value (EV)/EBITDA multiple of ~38x, which is above the 3-year average of ~35x. On an EV/Sales basis, the shares are trading on a multiple of ~11.5x, which is in line with its long-term average of ~12x, but above the 3-year average of ~10.5x.

Charting View

Since the low in 2022, Xero has been trending higher in a clearly defined channel. It is now in the middle of that channel having fallen from the peak a few weeks ago. A move back towards the bottom of the channel near $160 would make for a better entry point and traders could then run a close stop loss.

 

Michael Gable is managing director of Fairmont Equities.

 

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