Xero Limited

Thank you for standing by and welcome to the Zero Limited H1 FY21 results conference call. All participants are in a listen only mode. There will be a presentation followed by a question and answer session. If you wish to ask a question you will need to press the star key followed by the number 1 on your telephone keypad. I would now like to hand the conference over to Mr Steve Vermoss, CEO. Please go ahead.

Well thank you and hello and welcome to our investor briefing covering Xero's financial and operating results for the six months ended 30 September 2020. I'm Steve Mamos, Xero's CEO and I'm joined by Kirsty Godfrey-Billy our CFO here at our headquarters in Wellington. Before I go over today's agenda I really do want to start by acknowledging the continuing uncertainties and challenges that COVID-19 has brought upon us all in different ways. I hope you and those you care about are all safe and well. On today's agenda, I'll provide a business update including our performance during the half before passing to Kirsty to cover our financial results in detail. I'll then close our presentation with an update on Xero's outlook before we move to the Q&A. So with respect to business update, let me start by giving an overview of Xero's results for the half. Business conditions during the first half of FY21 were challenging and highly uncertain due to the health and economic impacts of COVID-19. In reflecting on these operating conditions, we are pleased to report continued revenue growth of 21% and subscriber growth of 19% versus the prior year period. As Kirsty and I will discuss, the conditions in the period also saw positive movements in our profitability. which under more normal circumstances would have been offset by increased levels of spending and investment. Xero's total subscribers grew by 396,000 year-on-year to reach almost 2.5 million subscribers globally, and all our geographies recorded positive net subscriber additions over the half. Operating revenue increased to just under $410 million during the half. A 15% increase in annualized monthly recurring revenue, or AMRR, to $878 million was an outcome of the 19% subscriber growth offset by a small fall in ARPU, or average revenue per user, of 4%. Alongside the top line growth we're reporting today, Xero delivered a strong set of profit indicators. EBITDA of $120.8 million increased by 86% from the previous comparable half year period. Xero also delivered a net profit after tax of $34.5 million which was a $33.2 million increase following our first-ever full-year net profit in FY20. Free cash flow also improved by a similar degree, rising by $49.4 million to $54.3 million. These profit outcomes are a reflection of top-line growth combined with disciplined financial management during a highly uncertain, and I'd like to emphasize, unusual period. These results also reflect the ongoing support of our subscribers, underscore the importance of our service to them, and reflect some of the benefits of scaling our business. Kirsty will further elaborate on the approach we took to spending and investing during the period. Moving to the next slide, we maintained an intense focus on our customers and partners during the half. We prioritised and directed investment into product development and delivery across a number of areas. In September, towards the end of the half, we enhanced our small business starter plan and increased or removed the limits on plan inclusions. This allows us to better serve existing customers with less complex needs and to extend our product reach and serve more small businesses, including sole traders and new startups. We outlined our ongoing roadmap to Xero's practice management tools and delivered the first set of features in our vision of the next-gen practice. For example, in Xero HQ, we rolled out the monthly revenue export to make it easier for advisors to identify clients across their practice that needed government or additional support. We continue to build a platform experience for our partners that really streamlines their workflows from onboarding all the way to lodgements. We also announced further improvements to our existing integrations with payment service providers Stripe and GoCardless to make it even easier for small businesses to accept card and direct debit payments. At a time when sharing information and staying connected is more important than ever, we made sure to look after the well-being of Xero people as they transitioned to working from home and implemented a range of measures to support them in doing their best work for our customers and partners. We created our first ever digital customer and partner engagement series called Xero On Air, which covered key product announcements, shared best practices in how small businesses and accountants and bookkeepers were operating in response to COVID and insights into the current and evolving economic conditions around the world. We published zero small business insights research reports that showed how the small business economy was faring. These reports were based on zero anonymized and aggregated customer data across our largest markets, Australia, New Zealand and the UK. This data is being provided to governments and policymakers to help them understand the impacts of COVID on small business and plan for the future in supporting small business recovery. In navigating through COVID-19, we rolled out payroll product enhancements to ensure customers could efficiently administer their access to the latest government wage subsidies or other stimulus benefits. In Australia, for example, Xero is the first major cloud accounting provider to become JobKeeper-enabled for customers. Updates were also made to ensure other kinds of payroll changes were accommodated, such as new COVID-related leave types in the UK. We provided support to customers and partners where we could in areas including business performance, managing cash flow and helping them to apply for and access small business loans. A great example was a free business finance pack application which we developed to help our customers in New Zealand pull together the information they needed to apply for new finance. So moving to slide seven, I'll now elaborate a little bit on what we've seen in our customer base as they have traversed the COVID-19 environment. It has been a tough time for many businesses. It's also been different in each geography. However, it's clear from our observations that the small business community continues to demonstrate remarkable resilience and determination to get through this. The data on this slide show three customer activity indicators that illustrate what's been happening. Firstly, MRR, or monthly recurring revenue churn. We did see some elevation in churn over the first few months of the half, but it trended back towards pre-COVID-19 levels as the half progressed. As you can see from the table on the left, MRR churn stayed flat year on year at just over 1.1%. The second chart shows weekly usage levels by our subscribers based on average weekly logins per subscriber from January to September. These have remained steady overall, trending at levels similar to those before and during the onset of COVID-19. The third chart shows monthly invoice payment activity measured in total payment value where subscribers have attached a payment service such as Stripe or GoCardless. Invoice payment value for the second quarter of the financial year was up 33%. In the month of September, invoice payment value increased by 44% from the low seen in April. Overall, we're seeing that customers continue to make extensive use of Xero during challenging times and the business-critical tools for managing and administering small business finances have increased in relevance during COVID-19. While these metrics on the slide show that our customers have remained engaged over the six months to September, considerable uncertainty does remain and we'll continue to monitor conditions closely and respond to the operating environment with agility. So now moving to slide eight and framing the remainder of my presentation are Xero's three strategic priorities. These are to drive cloud accounting, which is about increasing the penetration of small business cloud accounting software. Secondly, to grow the small business platform, which is about extending and enriching Xero as a platform to help small businesses run their business. And then third, to build for global scale and innovation, which is about preparing Xero for realising our aspirations to become the most insightful and trusted small business platform. So first of all, to drive cloud accounting on slide nine, we're focused on executing our strategy to address the very significant long-term opportunity for Xero. We estimate the global rates of cloud accounting adoption still sit at less than 20% and that we are early in our journey. On this slide, you can see that the progress made in subscriber growth reflects a relatively less disruption from COVID-19 in the Australia and New Zealand segment when compared to the international segment. Let me cover each segment in more detail in the next two slides. Australia became Xero's first geography to pass through 1 million subscribers, growing 21% to reach 1.01 million subscribers. Revenue in Australia grew 18% to $184 million, or 17% on a constant currency basis. We were able to deliver this outcome with the support from a further push in the Australian Government's Single Touch Payroll, or STP, initiative for the smallest of employing businesses. Many small businesses also sought to become STP compliant in order to electronically apply for and access the Australian Government's JobKeeper wage subsidy payments. New Zealand also delivered a pleasing result with net ads in the half re-accelerating for the first time since the second half of FY17. Subscribers increased by 22,000 and a half, bringing total subscribers to 414,000, an increase of 13% year on year. Operating revenue also grew by 13% in New Zealand, which demonstrates ongoing opportunity for Xero in the market where we were founded. In New Zealand, we have seen an increased interest in partner migration to the cloud by those who have not yet adopted. We believe this is linked to the impact that COVID-19 has had on their practices This dynamic is also interesting because it could be an early indication of a potential for increased migration by later adopters as markets become more penetrated. Moving on to our international segment, the international segment broke through 1 million subscribers, another milestone that signposts the increasing scale of our global operations. This also came despite major markets in the international segment being more impacted by COVID-19 disruptions over the last six months. To break it down by region, in the UK we continue to make progress in the half, growing subscribers by 19% to 638,000. However, in making comparisons to the prior year, keep in mind the net additions were boosted last year by the first phase of making tax digital, or MTD, for VAT. Revenue in the UK increased by 33% to 107 million. During the half, the UK government revised its compliance deadlines for the next phases of MTD. These are now coming up in April 2022 for the second wave of VAT and April 2023 for income tax. We expect this to be a further catalyst for small business digitisation and cloud adoption and continue to prepare for the upcoming phases of MTD with further development of our zero tax product in the UK. In North America, we also saw continued growth and progress. A North American business passed a quarter of a million subscribers in the half, growing by 17%. Revenue grew to $29 million, an increase of 4% on the prior year. As Hubdoc subscriptions were most concentrated in North America, there was a more pronounced impact to revenue from the bundling of Hubdoc into core subscriptions near the end of FY20. The absence of any North American zero-con revenues also reflected in this revenue outcome. Without the impact of these factors, revenue growth in North America would have been in line with the growth seen in subscribers. Beyond the wider disruption from COVID-19, North America was also impacted by a prolonged tax season in the US. The end of the US tax season is usually a catalyst for new subscriptions. However, this year's deadline was extended from April to July due to COVID-19, which meant partners had less time than usual to migrate or onboard clients. We also signed a bank feed agreement with Bank of America, which completes our coverage of all top tier banks in the U.S. We continue to focus on growing subscribers through our partner network in the U.S. and Canada. And partner channel capacity continues to expand to over 1.5 million estimated small businesses in the half. Before I move on from North America, I also wanted to flag that we recently launched Canadian dollar billing for our Canadian customers as part of our local product market fit playbook. In the rest of the world markets, South Africa and Singapore, two of our newer geographies, contribute to total subscribers across the rest of the world, growing 37% to 136,000 and revenue growing 38% to $27 million. Government initiatives continue to drive the digitization of small business compliance in Singapore, including incentives related to the adoption of e-invoicing under the e-invoicing registration grant and other software solutions under the Digital Resilience Bonus, which was introduced during COVID-19. And in South Africa, we've signed a bank feed agreement with a major South African bank, Nedbank, and released improvements to our VAT solution, enhancing our local market product fit in South Africa. Now moving to the next slide. Our second strategic priority is to grow the small business platform. And platform revenues comprise 6% of total group revenues, which is the same percentage as a year ago, however reflecting the inclusion of Hubdoc in our core business edition products now. Looking beyond this one-time revenue movement related to Hubdoc, the actual growth of the other two contributors to platform revenues was more than 50%. Our ambition remains to grow the small business platform and drive growth through additional revenue streams including adjacent products such as payroll expenses and projects and financial services related revenues such as payments and bill payables. Also with our physical events like Xeracon and roadshows which we typically hold in the period, non-recurring revenues fell by 87% when compared to the prior year. Now with this in mind I'd like to touch on our recent acquisition of WADL. We announced this acquisition back in August and completed it in October, after the end of our half-year balance date, and as such, there is no Wattle-related contribution to our H1 results. Wattle is a cloud-based lending platform that helps small businesses access capital through invoice financing by addressing pain points in the traditional invoice lending process. For a small business, this means they're able to unlock capital that's otherwise tied up in their invoices to get access to finance, and often, This means they can source working capital for their business without having to put up their own home as security for loan. WADL aims to streamline the flow of information interaction between the small business customer and the lender, automating many of the manual processes involved in assessing credit, underwriting and monitoring. The access to a small business customer's accounting data that a lender gets through a connection to a platform like Xero is at the core of the proposition with WADL. Currently with a presence in Australia and the UK, we are excited about the potential benefits that Waddle can bring over time to our customers and banking partners around the world. We're keen to have a range of lenders participate on the platform. Greater choices benefits for our small business customers. We're excited about this acquisition. We'll continue to grow the small business platform to help solve the customer financial needs like managing cash flow and accessing capital. So I'll now close my presentation by outlining some of the progress we've made against our third strategic priority, which is to build Xero for global scale and innovation. As I outlined at our FY20 results, for Xero to scale and innovate effectively and at speed, we need to really focus on the strategic investments we need to make to drive this outcome. We made good progress during the half in a number of investment areas that support this priority. When it comes to attracting, inspiring and retaining world-class talent, Despite COVID-19, we continue to build and enhance our people capabilities by acquiring new talent and developing our teams. In particular, we focused on hiring people in our technology, data and product teams. Optimising Xero's operational financial structure is effectively a continuous improvement project that alongside our work on talent, considers how the right people are doing the right things in the right way within our business. I've previously detailed changes we made to the operation of our global sales and customer functions under Xero's Chief Customer Officer, Rachel Power. In the half, Rachel and her team have continued to ensure that there's alignment of global and regional sales and customer teams as Xero's customer base grows globally. As Kirsty will outline shortly, when it comes to our financial structure, we ended the half in a strong financial position. Our need to assess the capital requirements to execute our strategy remains an ongoing area of focus. I also wanted to highlight the progress we've made in integrating and aligning our social and environmental impact activities with our wider business functions. Our efforts in this area are an important element of pursuing Xero's purpose, which is to make life better for people in small business, their advisors and communities around the world. This is a purpose we believe in deeply and drives us to do what we do. Our approach is outlined by the framework shown on this slide and I wanted to elaborate briefly on three elements. When it comes to the environment, we remain committed to maintaining a net zero carbon footprint through our carbon offset program, Net Zero at Zero. In terms of our communities, in July we launched the Zero Community Appeal that supports multiple charities across our regions around the world. And in the center of our framework are our people. During the half, we appointed a global head of well-being who's dedicated to developing and leading programs that provide our people with the support they need. With that, I'll now hand over to Kirsty, who is going to take you through the financial results.

Thanks, Steve. Hi, everyone. I'm Kirsty Godfrey-Billy, Xero's CFO, and I'll now take us through Xero's financial results for H1 in further detail. As we outlined at the FY20 results back in May, in the uncertain COVID-19 environment, we have taken a somewhat different approach when it comes to running the business. To recap, at the start of this financial year and just after COVID-19 was declared a pandemic, we implemented a scenario-based spending and investment plan. This approach looked to manage the business for a range of potential revenue scenarios while continuing to drive progress on our strategic priorities. I'm really pleased to report today that this approach has had a positive impact on performance over the last six months, with Xero reporting strong EBITDA, net profit and free cash flow results. However, it's important to consider that should we see a return towards more normal operating conditions, we would expect to see an increase in our spending and investment levels as we look to address the opportunity. In particular, this would result in higher sales and marketing costs with a resultant shift in our profitability indicators. In terms of the headline financial measures, the top-line results we are reporting today reflect the resilience of Xero's business model and that of our customers and partners. Annualized monthly recurring revenue, or AMRR, increased by 15% versus H1FY20 to $878 million. The growth seen in AMRR reflects the 19% growth in subscribers, offset by a 4% drop in APU versus the prior year period. The year-on-year movement in ARPU was driven in part by the previously communicated decision to bundle Hubdoc into all business edition plans and to defer a related price rise in the majority of regions from March 2020. This change was undertaken prior to the end of FY20 and so, when compared to the end of FY20, H1 ARPU was effectively unchanged at the group level. When it comes to profitability indicators, EBITDA for the half almost doubled to $121 million. This was a record result for a six-month period, but as I've mentioned and will discuss further, specific factors have contributed to this outcome. Free cash flow for the half increased markedly, rising from $5 million to $54 million over the prior year period. This is equivalent to 13% of Xero's first-half operating revenues and reflects the top-line progress made combined with the dynamic and relatively conservative spending and investment plan the business has operated under. It remains our priority at Xero to reinvest significant majority of capital generated by the business to drive long-term growth. The additional funds generated during the half, combined with our existing liquid resources, represent significant optionality as we drive the business forward. On slide 16, zero SAS metrics continue to show the strength of the business model, despite the difficulties of the COVID-19 environment. I'll discuss each of the customer-level metrics on the left-hand side before moving to the group-level movement and total lifetime value, or LTV. ARPU of nearly $30 was flat against the prior half, with a 4% year-on-year decline as already discussed. As Steve has already mentioned, churn varied in the half, but an aggregate was consistent with the first half of FY20 at 1.1%. Gross margin increased slightly to 86%. In aggregate, these changes brought about a 3.9% reduction in LTV per subscriber versus the same period last year to just over $2,500. Total lifetime value increased by 15% over the last 12 months to reach $6.2 billion, adding almost $800 million. When it comes to CAC or customer acquisition cost, our reported efficiency metric were as follows. CAC months increased from 14 months at the end of FY20 to 14.9 months, and LTV to CAC decreased slightly from 5.7 to 5.7 from 5.8. Most of the softness in our CAC efficiency measures came in our international segment, where the business was more impacted by COVID-19 disruption when compared to the Australia and New Zealand segment, where our CAC efficiency measures actually improved. It's important to note that CAC spending in any period targets both future growth as well as the subscribers added in that period. Against a tough backdrop, reported SAS metrics continue to demonstrate the resilience of Xero's business model. Gross margin improved slightly versus the prior year period, driven by continuing efficiencies in Xero's customer support team and minor improvements in security and bank fee costs. The second chart shows a marked shift in CAC trends that reflects the settings under which we have run the business, and also the slower rate of subscriber growth seen over the first half of the year. CAC is a percentage of revenue reduced by more than 11 percentage points to an all-time low of 32%, down from 43% in the prior year period. As I have already mentioned, this trend is largely a function of the current circumstances and does not represent a change in how we are running or plan to run the business. Looking to product spend in the right-hand chart, as a percentage of revenue, product costs, including both OPEX and CAPEX, increased to 34%. This was a two percentage point increase on the prior year period and reflects our unwavering prioritisation of investment into product development and commitment to support customer needs as signalled at the end of FY20. Turning to slide 18, H1 segment contributions from both our Australia and New Zealand and international segments increased markedly. This was primarily due to the responsive spending and investment management approach we have taken in the period. The Australia and New Zealand market segment contribution grew by $38 million, or 29% year-on-year, to $169 million. Revenue growth for this segment of 17% was achieved alongside a conscious focus on cost, particularly in the first few months. This resulted in an absolute fall in sales and marketing costs, but the segment still added 122,000 subscribers, similar to the level of additions achieved in H1 FY20. This demonstrates the benefits of our focus on CAC efficiency in our most developed markets and the opportunity which still exists within these markets. In our international segment, there was also a significant improvement in contribution. This was again due to a fall in sales and marketing spend that would otherwise be expected to rebound under more normal operating conditions. The decline in CAC spend combined with a 28% increase in revenues for international contribution improved by $40 million to $51 million over the prior year period. Echoing my earlier comments, I also wanted to briefly mention how we might expect contribution margins to evolve going forward. Contribution margins incorporate the cost to serve customers in each segment and the cost of growing the subscriber base through sales and marketing, or CAC. All else being equal, we would expect to return to higher rates of subscriber growth in both the current and future periods to be driven by a necessary increase in sales and marketing expenditure. This, in turn, would moderate any improvement in segment contribution results over the short to medium term. Moving to slide 19. Here we have a summary income statement for H1 showing year-on-year changes from H1 FY20. There are some different outcomes this half year that I'd like to highlight. Operating revenue increased 21% to just under $410 million. This result connects relatively closely to the 19% growth seen in subscribers across all markets. Revenues were impacted by the absence of non-recurring revenues, which declined to almost nil, primarily due to cancellation of planned in-person events such as Xerocon Sydney in the first half. XeroCon revenues are typically offset by costs within the sales and marketing line. In addition, our XeroCon UK event, originally planned for later this month, has also been cancelled. As I've already called out, gross margin improved versus the prior year period by 0.5% to 85.7%. Moving to expenses, I want to mention a couple of specific examples of variable expense management that contributed to our performance. Advertising and marketing costs declined by 46% from $50 million to $27 million, and travel-related costs fell by 99% from $8 million in H1FY20. Further detail of our expenses can be found in Note 5 on page 27 of the interim report. EBITDA for the first half was $121 million, which is a $56 million improvement year-on-year. The EBITDA margin of 29.5% improved by 10 percentage points year-on-year. The significant margin improvement has flowed down to the bottom line with our fourth consecutive net profit for a six-month period of $34.5 million. Moving to slide 20, cash generation and other movements in the period brought total liquid resources to $723 million. These consist of cash and cash equivalents, short-term deposits including proceeds from convertible notes, and also the undrawn committed debt facilities. Operating cash flows increased by 77% over the prior period year to $127 million, ahead of the EBITDA result and indicative of zero strong monetization profile. Investing cash flows increased by 9% to $72 million. Spending on fixtures and fittings was an example of spend that has been largely paused. Cash flows relating to the acquisition of water will be presented in our FY21 accounts as the transaction closed in October after this period end. Total cash and short-term deposits at September 2020 were $573 million. Deducting our term debt liability of $395 million associated with the US $300 million convertible notes we issued in 2018. Our net cash position at the end of the half was $178 million, up from $101 million at the end of H1 FY20. The uplift in our cash position has strengthened our liquid resources. However, as Steve has already mentioned, we remain focused on optimising Xero's financial structure. This is to ensure we have the right settings to power growth and deliver on our strategic priorities. We continue to prioritise reinvestment of capital generated and we don't believe this position will change for some time. This is driven by the potential we have to create significant long-term value through successful execution of our strategy. When it comes to organic growth, most of our investment will focus on the areas of go-to-market and product development. We also continue to evaluate potential investment opportunities that can extend and enhance our small business platform and broader ecosystem. I'll now hand back to Steve to take you through our outlook before we move on to Q&A. Thank you.

Well, thanks a lot, Kirsty. Moving to Xero's updated outlook, Xero is a long-term oriented business with ambitions for high growth. We continue to operate with disciplined cost management and targeted allocation of capital. This allows us to remain agile so we can continue to innovate, invest in new products and customer growth and respond to opportunities and changes in our operating environment. The continued uncertainty created by COVID-19 means it remains speculative to provide further commentary on our expected FY21 performance at this time. And before I conclude, I really want to acknowledge and thank the entire team across Xero for all their hard work during what has been a challenging time for all. I'd also like to thank all of you on the webcast and the phone for joining and listening in today. I'll now hand back to the moderator for your questions.

Thank you. If you wish to ask a question, please press star 1 on your telephone and wait for your name to be announced. If you wish to cancel your request, please press star 2. If you are on a speakerphone, please pick up the handset to ask your question. Your first question comes from Siraj Ahmed from Citi. Please go ahead.

Thank you. Steve, just to touch on trends in subscriber growth, if you could. Just in Australia, in the first half, how much of the subscriber additions actually came from just the payroll-only plan? Because you've flagged that as one of the reasons for ARPU to decline.

Yeah. Hi, Siraj. Look, we don't break out the details. I think, you know, we're pretty clear that STP has been a driver. But, no, at this stage, we don't break out the specifics of the subscriber, the subscription mix.

Yeah, maybe, Steve, another way is, I mean, because that would have been in first quarter and maybe through June. Just keen to understand overall, I guess, maybe Kirsty did mention that you expect subscriber growth to accelerate. Just keen to understand if that's the expectations overall in second half, given... you have seen an increase in COVID cases in the UK and US. So just how are you thinking about the near term?

I'll take that and Steve can add if he wants. Yeah, so what we were discussing earlier was, I suppose, just mentioning in Australia, I think, you know, we have, as the results show, we have had an incredibly strong You know, this has been the second best half in Australia ever. And so that was, you know, obviously a consistent story through the half and incredibly pleasing based on the COVID backgrounds that Australia was dealing with. If you look more towards the northern hemisphere, you know, that has been hit, as we're all aware, far harder than ANZ, and so therefore, you know, we did really see, you know... a very difficult Q1, and this was at the time when we were, you know, ensuring that we were able to pivot our cost base to match into the opportunity that we've seen. I think, you know, it is questionable as to what's going to happen with COVID-19 in the Northern Hemisphere through H2. I suppose, you know, we have seen resilience, we've seen growth in all of our regions throughout the HAVS, And I think, you know, looking forward, we still all very much see the opportunity of further cloud penetration across, you know, particularly that northern hemisphere, which has, you know, such low cloud adoption. And, you know, conversations around vaccines can only help with that.

Thanks. And just moving on to our pool and price increases. You've announced price increases in the US. Just keen to understand how you're thinking about other markets, if you could.

So with price increases, we announced that we were going to put a pause on the price increase back in the middle of March when COVID hit. 19 was hitting around the globe and still very much believe in the increase in value that we have provided our small businesses and accountants and bookkeepers through not only the bundling of HubDoc, but also through the additional products that Steve mentioned throughout his presentation. both helping in COVID, but also just increasing the value of the product. And so therefore, we, as we always do, continually look to see when is the right time to put appropriate pricing through. And so, you know, very carefully watching each region on a region by region basis at the moment. And, you know, we'll give notice to our small businesses, accountants and bookkeepers when we believe it's the right time.

And just last one, just on the same topic about attached rates, just on slide seven where you show the payment or the invoices activity for your attached Stripe and GoCardless, just keen to understand, I mean, there will be some seasonality compared, given it's indexed to Jan compared to September. Just keen, if you can just talk to penetration versus just seasonality. You are, how is adoption increasing in the payment space? Because that's a key driver for your growth going forward.

Yeah, look, I think that that graph, the way that's presented, actually reflects a couple of things. It does obviously reflect seasonality because that will flow through to usage, but it also does also reflect increased usage of the service. So it does reflect penetration and underlying growth as well as an individual customer's seasonality of use.

All right. Thanks, Steve.

Thanks, Kirsty. Thank you. Your next question comes from Paul Mason from E&P. Please go ahead.

Hey, guys. Just a couple from me. So the first one, I just wondered, on payroll in regions where you sort of bill that separately instead of having it bundled, it sort of looks like you basically didn't take any really material impact. I'm just wondering if you could provide some colour there on whether you've seen payroll-related revenues decline and then return back up or what the pattern's been.

So we, I mean, Paul, we don't, as you're aware, go down into that level of detail, but, you know, I think I can certainly say that we haven't seen where it's that variable payroll revenue. We certainly haven't seen that drop, and I think, you know, a note that can be made is that our ancillary revenue has actually seen a slight, you know, increase from the half, definitely between H1 last year and H1 this year, and the variable component of payroll was part of that.

Yeah, great. And just the second one for me relates to reinstatement of your sales and marketing costs. And so I was just wondering if you could talk through some colour on sort of how you're going to assess, say, relaunching XeroCon in Australia, for example, and then more broadly what the sort of trigger points are. that you're thinking about are for lifting your sales and marketing back up closer towards sort of 40% of sales, you know, maybe region by region, obviously given Australia and New Zealand are in a very different position to Northern Hemisphere.

Yeah, look, great question, Paul, and essentially it's an ongoing watching brief in terms of the overall environment around the health and the health of the community in each region and also the economics and the economic impact going forward. It's really an ongoing process. It's a very active process between our finance organisation, all our go-to-market and customer teams. So we are, you know, I think that as you can kind of assume that as the environment improves, so will our level of investment. And, you know, we did see a pick-up, as you know, in the second half of the half, and we'll just keep a watch on that and as Kirsty said, you'll see those levels return to more normal levels as we go forward. Okay, great.

Thanks. Thank you. Your next question comes from Craig Wongpan from CLSA. Please go ahead.

Morning. My first question, just on sales and marketing costs, could you just give some examples of areas that you've pulled back in? So I guess zero cons one, but could you give any other examples of what's been pulled back? And then also just related to that, the different regions, like it looks like your CAC months declined in ANZ but increased in international. So is that right to say the international market still had increased spending around sort of on sales and marketing?

So, yeah, just to give you some examples of sales and marketing costs, as you rightly, you know, referred to the in-person events. Now, there are also other in-person events. So we have ZeroCon, which is, you know, the large event, but then we also do run regular roadshows. And so then there's travel associated with that as well. And then, you know, obviously from a straight marketing perspective, we also, as we do always, really look to make sure that, we are going to be driving a benefit out of any marketing campaign that we do. And so, you know, we run the same level of rigor over that now as we have done in the past. So I think, you know, that's from a sales and marketing perspective, it's really just looking at that variable cost base. And, you know, Xerocon was a major factor for the first half on that.

I think also it's fair to add that, you know, look, early in the half, tempering our advertising investment felt totally appropriate given our focus was really on supporting our customers and the environment was very, very challenged. So that's just another area where we tempered relative to what we would do normally.

Okay, thanks for that. And then my next question, just around the North American markets, could you make any comments about how the US compares to Canada?

USA and Canada, we have separate subsidiary leaders now and operations are at very different markets. US clearly is multiple regions in one region when you look at compliance, payroll and tax and other forms of interaction between business and government. Whereas Canada is very much more like what you find in the Commonwealth countries, more consolidated banking sectors and governments that are very focused on advancing digitisation. So penetration rates in Canada are a lot lower than they are in Australia, New Zealand and the UK, so very good opportunity there. But clearly our strategy and approach to both markets needs careful thought in terms of making sure we leverage where it is the same as where we've done before and also making sure that we are in tune with and adjusting to and really responding to the differences in both markets.

Sorry, I kind of meant more in terms of the kind of dynamics there and I guess impacts from COVID, are they sort of being impacted similarly or are you seeing kind of much change in the different dynamics there between both markets?

Look, I don't know. I think there's two things you're talking about. One is the impact of COVID, which both have been impacted more than Australia and New Zealand. There's no question about that. U.S. has been tough, as you know, in that respect. In terms of the market dynamics, we don't really see that as a different thing, and that's why we really focused on each market individually, having teams focused and executing go-to-market and product plans that really reflect the differences between the two.

Okay, thank you.

Thanks.

Thank you. Your next question comes from Quinn Pearson from Credit Suisse. Please go ahead.

Hi, good morning. Thanks for the time and the questions. You touched on this in the prepared remarks, but I was hoping you could maybe elaborate on to what degree you think there might be a COVID boost that you're benefiting from. And things would be helping customers access various government support, whether it's wage assistance or PPP loans and the like. or supporting cloud adoption to help accounting customers work remotely. I was just hoping you could talk us through how you're seeing that from kind of a structural impact, both on this half and how that plays through from here. Thanks.

Yeah, look, I think it's very clear in the context of New Zealand that there is something happening across the accounting and bookkeeping community where those who have been slower to adopt are now really engaging and keen to adopt, given what they've experienced with COVID-19. And more broadly, I think that when we consider the trends that drive growth for us and adoption, we do think that the experiences at large of what's happened to all of us through this have heightened, as we can see in many contexts, the importance of digital platforms and employing digital technology. In fact, even with our zero small business index report, we were able to show the correlation between multiple app usage and lower impact of COVID on business performance and jobs. So they're important, so that's an example of that. In terms of really getting into the details specifically, it's very hard to say in a quantitative way what we expect, but we do think that certainly new businesses being formed, we've seen an increase there and highly likely those businesses will be created and built with digital platforms in mind. I think overall, whilst there's no question it's created significant challenges for all, there is some elements here to driving the adoption of digital technologies faster in the future.

Helpful. Thanks. Maybe if I could just confirm how to be thinking about the margin profile of the business. You're comfortable of I guess a normalization of conditions if you will That the tax spend will then return I mean do we think of that spend returning to similar levels as a percentage of sales and therefore Should think about the free cash flow margin kind of reducing back into that, you know single-digit level So, yeah, so, you know as we have been clear about in the past we certainly see a

plenty of opportunity for reinvestment back into the business and that is primarily looking at CAC and product and technology spend. As far as whether or not CAC will return back to that 43% that it was H1 last year, It is, you know, the expectation is that it will return to a similar-ish number. You know, the number that we look very closely at is our LTV to CAC to ensure that we're getting the right level of efficiency out of our CAC dollars. And so, you know, I focus more on that rather than the percentage of revenue. But then also I think, so as far as the free cash going forward, we then would be looking at opportunities to, either grow our top line by investing in CAC or by, as we have through the COVID period, putting more investment levels into products and technology for future growth.

That's helpful. Thank you.

Thank you. Your next question comes from Tom Beadle from UBS. Please go ahead.

Hi, guys. Thanks for the questions and good result. Just the first one. I mean, the trends obviously appear to have improved towards the end of the half. I'm just wondering, everything's obviously fairly fluid at the moment. So just wondering, could you maybe give some observations as to what you've seen in the first five or six weeks of the second half? Obviously, you know, there's lockdowns in the UK. You've had the US election. Is there anything worth highlighting there?

Tom, clearly at this point, no. It's too early in the half and you'll be hearing more from us, I guess, full year results. So, no, nothing to comment on that at this point.

okay no problems and and maybe just the second question i mean i know while you plan to to reinvest there's um obviously going to be some temporary reductions in your costs until covert finishes so if i put all that together um with your amr growing um should we expect to maybe see some degree of free cash flow that's higher than it otherwise would be in the short term and sort of following on from that you know just given the strong position of your balance sheet You know, liquidity's strong. So then, obviously, can you talk about, like, your views on M&A and even things like how would you approach capital management given that you're continuing to generate capital?

Yeah, so I suppose just from looking at sort of what you can expect in the future, we certainly, you know, the plan wasn't for H1 to look like this pre-COVID. You know, we certainly see so much opportunity both within CAC and also within products and technology today. to really be able to drive the future growth of Xero. And that's not just within the current year, but in future years to come. And so therefore, through H2, we will certainly be looking at ways in which we can deploy the capital for future revenue growth. Now, we will still apply the same level of agility within the cost base, but certainly with talk of vaccine and the hope around COVID being able to improve in the Northern Hemisphere, after they pass through winter, we certainly want to make sure that we are ready and available to capture the opportunity that we see, as Steve's been talking around, that cloud penetration and further enhancement into digitisation of small business. So I think we are definitely not looking at running our business as it has been over the first half. We've done a good job of managing through a very, very difficult time. an unusual time, but would love to be able to get back to what we previously were doing, which was really driving investment to be able to really take opportunity of the future growth.

Okay, great, thanks.

From a balance... Oh, sorry. Sorry, just on the balance sheet. So we do, as you pointed out, we do have reasonably strong liquidity. It includes that unborn standby facility, the $723 million. But we're also constantly looking at the way in which we should... look at our balance sheet and maximise the value within the balance sheet and we see, as we've seen for, and been focusing on now for a while, looking at different M&A opportunities to really ensure that we're able to enhance the service offerings out to our accountants and bookkeepers and and small businesses, and so very much looking at a pipeline of M&A opportunities at the moment. Obviously, nothing to announce today, but really, really driving hard in that area as well.

Okay, great. Thank you.

Thank you. Your next question is from Roger Samuel from Jefferies. Please go ahead.

Good morning all. Thanks for the question. My first question is on the subscriber growth in North America and the UK. So you've added about 36,000 subs over the last 12 months in North America. And when I look at the numbers from QuickBooks Online, they added about 360,000 subscribers. over the last 12 months, ending in July. And I know that you were not comparing like-for-like periods here. But I'm just wondering, how can you accelerate your growth in North America? And the second part of my question is, do you think that you have gained or lost any market share in the UK?

So do you want to take that, Stu?

Yeah, yeah. Well, thanks, Roger. Look, I think, you know, with both markets, we see tremendous opportunity. And so I think you have to, in a sense, you know, reflect beyond the impacts of COVID-19 to what we are doing and the way that we see that opportunity. Certainly in the UK, you know, we think we've performed strongly in those difficult circumstances, you know, relative to the opportunity. And similarly, in North America, we are continuing to evolve our business. We are really happy with the progress our go-to-market teams are making. And also, certainly, as we go forward and we really connect more and more with customers and understand the differences in each market. We've also got product roadmaps that we're investing in that evolve very much with a focus on each side. Our position with tax in the UK is a very strong position. We're looking at other markets in a similar way to make sure that from a compliance and a core accounting application perspective, we're really delivering the value customers want. So we're still very positive about the progress we're making. Certainly the environment was tough through the last six months and it's one again that is not about changing our strategy. Our strategy is very clear and we're executing it. It's really just about making sure we're adapting in the shorter term to the realities that our people and our customers are facing.

Thank you. Your next question is from Lucy Huang from Bank of America. Please go ahead.

Hi, Steve. Hi, Kirsty. Thanks for taking questions. I just have three. So, firstly, you mentioned you're starting to see new business formation. I'm just wondering if you can give us some early insight into whether you're seeing a similar rate of new businesses being formed versus other years in a more normal environment. I just wanted to see, you know, what the cadence of that is like at the moment. And then just secondly, you've launched the new starter pack in Australia. Just wondering if you've seen, you know, much take-up of that since the launch in around September and whether you've seen any existing customers migrate down, given that we are still in quite a challenging COVID period at the moment? And then just my last one, sorry, to touch on free cash flow again, assuming that things do improve in the second half or whenever it does improve, where will most of the free cash be deployed? Is the focus going to be on new market entries or do you think it'll be more geared towards platform products or kind of just penetrating the existing markets? Thanks.

Yeah, hi Lucy. On new business formation, there are data sources that you can access through government around the world that do indicate there is an increase in new business formations. Where that flows in terms of how those businesses actually operate and what they acquire is you know, still to be seen. We do certainly track the interest that we get through our direct digital funnel in terms of trial volumes and those trial volumes have held up. So there's definitely interest there in adoption of cloud accounting. So that's encouraging but too early to be drawing any specific conclusions from. On the starter, I'm really pleased with the progress there. In our decision to progress with that, we were aware that there was going to be some aspect of potential downgrade, but you look at that in the holistic sense of, well, what additional customers are you going to bring to the Xero platform by virtue of having that offering, and really pleased with the performance to this point, and the business case that we made has held up very nicely, so we're pleased that we did that. And I'll let Kirsty handle question three on free cash flow.

Cool. Thanks, Lucy. So as far as when we're looking at what's going to happen with free cash flow going forward, I suppose if you think around what we've done within our cost base for H1, we have brought in, really pleasingly, we've been able to actually hire new people through this process and most of those have been within the product and technology area and so you will see an annualised impact of those even just in H2. And then as far as where we are likely to put the remainder of the cash that we generate in H2, We will continue to focus on increasing also our product and technology spend through driving different strategic initiatives, and that is to not only just improve the core product that we've got, but also, as you mentioned, to enhance the adjacencies and the connections that we've got with our ecosystem partners. We will also see an uptick, you know, all things going well on the CAC side as well. We're not announcing any new markets that we're entering today. You know, we still very much see there's a lot of opportunity within the markets that we're in at the moment. So, you know, in the short term, definitely sort of doubling down, making sure that we're taking all opportunity that sit within the markets that we're in currently and ensuring from a product and technology perspective we're in the best shape to take the opportunity that comes out the back end of COVID.

Thank you. Your next question comes from Rowan Sundram from MST Financial. Just a reminder, if we can please try to limit to one question per participant. Please go ahead, Rowan.

Hi, Steve and Kirsty. Just the one question from me, just on the capital management side of things, a follow-up there. Can I ask about dividends? And granted that you're still in a growth phase and best spend at present is to reinvest into the business, but is the commencement of dividend payments at all the discussion point internally? And if not, or if so, what are some of the key considerations that you have to think about internally before even determining when that is the right time to commence payments?

Yeah, so Rowan, you know, as we have, as we've been quite clear about, we certainly still consider that the best place for us to be allocating capital is back into the business because we are a long-term orientated business with ambitions for high growth now and into the future. And so, therefore, we do not discuss dividend policies at this stage.

Thank you. Your next question comes from Wei-Wang Chen from JP Morgan. Please go ahead.

Hi, guys. Just a question for me about, I guess, is the feeling right now from Xero that we're past the worst of the pandemic in terms of impact on your business, or are you concerned about sort of an increase in business failures as we sort of see the gradual lifting of government support initiatives?

Hey Wei-Wing, thanks for the question. Look, I think at this stage we'd say it's too uncertain to say. The uncertainty remains. I mean we don't have a different view into the future than others. It's really too hard to say.

Thank you. Your next question comes from Andre Myranenko from Alfinity Investment Management. Please go ahead.

Thank you. Just to understand, so your operating revenue has increased by 21%, while your subs have increased by 19%, yet your AMRR by only 15% driven by our pool reduction. So given this strength in operating revenue per sub, but weakness in our pool, does it mean that operating revenue per sub kind of kept declining throughout the half? And what does it mean for the next half?

Yeah, so I think, thanks for your question, Andre. If you look at constant currency, our operating revenue grew by 19%, so we did have some upside there on the FX, which then is consistent with the subscriber growth. I think, you know, we've talked around the variances within our APU, and, you know, that has held at a constant currency perspective held around flat over the six months as well, you know, which has been really pleasing, and I think you know, opportunity for us to really drive further platform attach, further growth in our platform side, you know, as we've been driving towards over the last few halves as well, will, you know, will then flow through into APU.

Thank you. That does conclude the question and answer session for today. I will now hand back for closing remarks.

Well, look, thanks, everyone, for listening today, for your time, your questions. Really appreciate it. Appreciate your support. And thank you very much from everyone at Xero for being here today. Thanks very much.

Thank you. That does conclude the conference for today. Thank you for participating. You may now disconnect.