Why Xero is tipped to invest for US growth, switch from Rule of 40 to Rule of X

Shares in business Xero (ASX: XRO) hit a record high on Wednesday as Jarden analyst Tom Beadle suggests the online accounting pioneer is set to lift its investment in the giant US business market.

Beadle even says Xero may abandon the traditional Rule of 40 in terms of performance measurement to favour a Rule of X that would reflect a pivot to emphasise on revenue growth ahead of margin expansion as a proxy for profitability.  

Traditionally software businesses target a revenue growth rate and free cash flow margin (expressed as percentages) above 40 to symbolise that they're best-in-class growth businesses every investor should look at. 

For example, Xero reported a Rule of 40 result of 44.3% over the 12 months to March 31 as it posted a revenue growth rate of 23% on a free cashflow margin of 21.3%. 

This means it's growing free cash flow at high rates and it's fair to assume its software-as-a-service business model positions it to do so into the future. 

As a result of its success, Jarden has a $197 valuation on the stock, versus Wednesday's record high of $193.78. 

While Goldman Sachs value the shares at $205 largely by applying a 42 times multiple to its estimate for EBITDA of $NZ781 million in financial 2026, and adding on net debt of $NZ1.1 billion, before dividing the $NZ33.9 billion equity valuation by 152 million shares on issue. 

What is the Rule of X?

The point to note about a potential switch to the Rule of X as flagged by Xero's chief financial officer Claire Bramley is that would effectively signal Xero's intention to invest for revenue growth over margin expansion in the short term. 

This is because the Rule of X is a fancy new software business rule that applies a multiple to revenue growth rates (between 1.5 to 3 times) before adding free cash flow margin. 

So, to achieve your Rule of X targets you need to deliver stronger revenue growth. Beadle says this means Xero is likely to invest heavily in the US market, which has proven a big challenge and something of a capital sinkhole for the company in the past.  

Xero primarily operates in New Zealand, Australia and the UK. It also has a significant subscriber base in the US, but the market has always remained a tough nut to crack. 

This is because Xero faces fierce competition in cloud accounting from US giant Intuit as the provider of the Quickbooks platform and as the Kiwi challenger is little known in the vast country. 

The US also has complex accounting and legal rules across 50 different states, with different payment systems to make Xero's accounting platform harder to sell. 

Still, Beadle seems to think Xero is not giving up on the US. On the contrary, it's set to ramp investment and perhaps even adjust its operating performance metrics to Rule of X. 

"The US represents the largest opportunity for Xero, we support heavy investment at the right time," Beadle said in a June 2 research note. 

The analyst also said applying the Rule of X logic to Xero means it "will prioritise top-line growth over margin expansion in the short-to-medium term, given its already strong cash flow." 

Jarden has also hiked its forecasts for average annual subscriber growth in the US from 50,000 per year between FY 2025 to FY 2035 to 90,000 a year as a result of its expectations Xero is going to throw the kitchen sink at the US market. 

It's also worth noting its chief executive Sukhinder Singh Cassidy is based in California so a US push on the horizon makes sense. As a software business it also has a sky high gross margin of 89% to mean it has a lot of cash left over to invest for growth if it chooses to. 

Downside risks

As a word of warning, the US is an infamous graveyard for a lot of Australian companies that have invested in a complex market for no return. 

Xero also trades on very high profit multiples and it's no secret some big investors have wanted it to scale back its investments in the US. Its recent surge higher also came as investors cheered its move to rein in costs and spending in favour of free cash flow growth. 

As such, I'd suggest the share price could prove volatile ahead as investors scour for more detail on its US plans. 

Other businesses though have succeeded in particular mobile app Life360 (ASX: 360) that now reports an astonishing 79.6 million monthly active users mostly in the US. This is another stock I'd suggest to keep an eye out on.