Analysts, fund managers cautious on Xero's monster Melio acquisition

Xero's (ASX: XRO) decision to pay $US2.5 billion ($3.9 billion) in cash and scrip for US payments group Melio has left investors scrambling to digest the cloud accounting group's massive US bet.

The Melio acquisition priced on 13.4 times annualised revenue of $US187 million for a business that last printed a free cash flow loss of $US154 million is widely considered fully priced, as Xero aims to fast track its unlocking of the US small business [SME] market. 

"It's definitely a full price," said Sean Sequeira, the chief investment officer of Australian Eagle Asset Management. "But [Melio's] got strong growth and more importantly there was always an issue with how Xero tackled the US market. This potentially opens the door for them into US SMEs.

"It also opens the potential for different revenue streams under a transaction model, rather than subscription model. If they confirm they can do this then the total addressable market really expands for them."

After a record breaking share price run took the stock to $194.21 on Tuesday, Xero has entered a trading halt and will raise $1.9 billion from institutional investors at $176 per share to finance around half the deal's cost. Retail investors, debt and scrip will make up the remainder of the bid's funding. 

Xero says Melio posted a compound annual revenue growth rate of 127% between financial 2021 to 2025 and expects its US target to double the combined group's revenue by financial 2028. 

"I must say, given Sukhinder Singh's history as CEO and her being able to focus and drive profitability at Xero, the market should give her the benefit of the doubt on this deal," said Sequeria, who is a Xero investor via Australian Eagle. 

Another buy side Xero investor and fund manager suggested the price paid is full, but declined to comment on the record for now. 

Analyst views 

The tech team at RBC Capital Markets and Evans & Partners also suggested the acquisition multiple is high given Melio's significant losses. However, they added it may work if it paves a path for Xero to make big profits from payments over time by selling Melio's product to its cloud accounting customers. 

"The acquisition price itself at a higher level looks pretty full for the stand-alone business, but works if you think the company can pull of strategic synergies around greater distribution of both products on a combined basis," said Evans and Partners analyst, Paul Mason.

The analyst added US online accounting giant and Quickbooks operator Intuit (NASDAQ: INTU) has succeeded in driving average revenue per user (ARPU) higher by cross-selling accounting and payments platforms in a strategy Xero is set to copy. 

In total, the US still has 24 million SMEs that don't use cloud accounting software as its economy remains tied closer to paper cash, or old-fashioned accounting platforms such as Excel spreadsheets on a desktop. 

RBC cautioned the complexity and uncertainty around the proposed synergies combined with a new revenue model and sporty price price paid is likely to stoke a divergence of estimates on the street. 

"Our initial view is there is much to like in terms of bulking up US exposure with a leading, fast-growing payments player and longer term the proposed deal makes sense to us; however, it will take time to process the intricacies of the deal and the pathway forward," the broker said.