Xero Limited (XRO) Earnings Call Transcript & Summary

Thank you for standing by, and welcome to the Xero Limited Full Year 2022 Results Conference Call. I'm joined by Xero's Chief Executive Officer, Steve Vamos; and Chief Financial Officer, Kirsty Godfrey-Billy. [Operator Instructions] I would now like to hand the conference over to Steve Vamos, CEO of Xero. Please go ahead.

[Foreign Language] from Wellington, New Zealand. Thank you for joining our investor briefing today covering Xero's financial and operating results for the year ending 31 March 2022. I'm Steve Vamos, CEO of Xero, and I am with Kirsty Godfrey-Billy, our CFO. The first item on our agenda is a business update, including a review of Xero's performance during the year. I'll then pass to Kirsty to cover our financial results in detail before I finish with Xero's FY '23 outlook, and then we'll move to Q&A. FY '22 has been another very important year for Xero, and we're really pleased with our strategic progress and financial performance. Our financial performance has been strong. The group's revenue growth profile rebounded, and our SaaS metrics, a measure of the value of our customer base, remain robust with good progress on subscriber growth and average revenue per user or ARPU. This performance reflects investment over a number of years in pursuing the very large opportunity we have. The use of digital solutions by small business is continuing to gather pace. We are confident in our strategy to drive cloud accounting adoption supported by significant trends, such as government initiatives to encourage digitization and innovation. So moving to a summary of our results on Slide 5. As I said, this is a strong result. Operating revenue exceeded the milestone of $1 billion, rebounding to grow 29% on the prior year, including 5% from acquired businesses. Subscribers grew to 3.27 million, up 19% on the prior year. Net subscriber additions totaled 530,000 over the year. Annualized monthly recurring revenue, or AMRR, grew to exceed $1.2 billion, increasing 28%, largely reflecting subscriber growth of 19% and higher ARPU. ARPU increased 7% versus the prior year. Kirsty will talk more about our actions that contributed to this movement in her remarks. Subscriber lifetime value, or LTV, increased to $10.9 billion from $7.6 billion, driven by good progress on subscriber growth, higher ARPU and monthly churn, which remains below pre-COVID levels at 0.9%. EBITDA increased 11% versus the prior year to $213 million, reflecting a balance between gross margin expansion, which increased to 87.3%, and increased operating costs in line with our outlook for the year. We reported a net loss of $9.1 million, which was down $29 million on the prior year, and free cash flow declined $55 million to $2.1 million. And these outcomes were consistent with our preference to reinvest capital generated back into the business. Our ability to invest is a function of the strength of our business model and sustained revenue momentum, which is shown on the next slide. You can see in the chart that Xero has delivered a high level of annual top line growth against what has at times been a challenging backdrop. The rebound in revenue growth this year reflects subscriber growth, price changes during the year and higher contribution from platform revenues. Platform revenues grew 113% or 43% if we adjust for businesses acquired during the year as take-up and usage of our financial services offerings and adjacent products continue to grow. Platform revenues are now at 11% of operating revenues, up from 7% in FY '21. Our continued expansion in platform revenues is evidence of our success in executing our strategy. Moving to Slide 7. I'd like to spend some time discussing the activity indicators for the 3 largest elements of platform revenues, Planday, Payroll and payments. Planday continues to perform well. We're working towards a launch in Australia and rolling out a closer integration between Planday and Xero for the U.K. market. On the left, we show the number of Planday employee users each quarter since March 2021. Average employee users increased by approximately 19% from the prior year period in the 3 months to end March 2022. The middle chart shows employees paid through Xero Payroll over the same time. This has grown by 19% since this time last year across Australia, New Zealand and the U.K. where we offer this product. The right-hand chart shows monthly invoice payment value has grown by 41% since March 2021. I'd now like to discuss the results of our operations by geography. So starting with Australia and New Zealand on Slide 8. Both countries delivered ongoing momentum in subscriber and revenue growth, a pleasing outcome in markets where cloud adoption is relatively high and demonstrating the potential for our International segment. In Australia, revenue increased by 26% to $483 million. We added 229,000 subscribers in the half, reaching 1.34 million subscribers in total. New Zealand revenue increased by 15% to $149 million. We added 66,000 subscribers in the half to reach 512,000 subscribers in total. As I said earlier, Australia and New Zealand are well ahead of our other markets in terms of the adoption of digital solutions by small business. We continue to see further support from government initiatives such as the technology investment boost in the recent Australian budget. Turning to our International segment. Starting with the U.K., revenue increased by 30% to $292 million. Net subscriber additions of 130,000 for the period brought subscribers in total to $850,000. We are well positioned in the U.K. and continue to deliver product enhancements such as our personal tax product this year. Revenue growth was pleasing. However, second half subscriber growth was disappointing. This reflected a subdued Q3 due to partner channel productivity and service-related challenges. Performance did improve in Q4. Additionally, take-up expected from the final stage of MTD for VAT has been slower to materialize than expected. And from what we can see, this is industry-wide and points to the potential for delayed sign-ups in FY '23 to materialize. While on the back of FY '22, there's reason to be cautious, we guide FY '23 with confidence and believe fundamentals for the long term remained very good with further rounds of Making Tax Digital ahead and overall cloud accounting penetration still low in this very important market. In North America, we added 54,000 net subscribers, and subscribers reached 339,000, which is up 19% on the prior year period. Revenue increased by 28% to $73 million. In constant currency, revenue grew 31%. We continue to further invest in the localization of our product for North America, as evidenced by our acquisition of LOCATE Inventory last half and the TaxCycle acquisition more recently. We've signed a partnership with cloud-based tax compliance solutions provider, Avalara, and will give further details of this at Xerocon New Orleans in August. In our Rest of World markets, revenue grew 85% or 90% in constant currency to $100 million. This included the majority of the revenue contribution from Planday. We ended the period with 226,000 subscribers in Rest of World after adding 51,000 during the year. So we are pleased with operational progress and the revenue momentum we're delivering. Over the next few slides, I'm going to update you on the progress we've made on key elements of executing our strategy in the year. Our strategic priorities are to drive cloud accounting adoption, grow the small business platform and build Xero for global scale and innovation. Let me touch on each of these. We continue to drive cloud accounting adoption. As we've said before, we estimate the total addressable market is more than 45 million small businesses in the markets we operate in currently. With low levels of adoption, this reflects substantial opportunities in our International segment. We also see further opportunities for growth in our more established regions, Australia and New Zealand. We're making good progress in growing the small business platform. Small businesses are increasingly seeking services beyond cloud accounting, and we're responding to this with investments to extend and enrich Xero's platform products and the wider ecosystem. To fulfill our purpose, we need to continually invest to build capabilities that enable innovation and our people to work productively at global scale. A key focal point has and continues to be investing in our people and acquiring new talent. On this front, we've had our biggest year yet in talent acquisition. Touching briefly on recent acquisitions. We've made good progress on the 4 businesses we acquired this financial year: Planday, Tickstar, TaxCycle and LOCATE Inventory. Overall, these contributed $41.7 million of operating revenue in FY '22. Acquired in FY '21, Waddle is a business with an early-stage revenue profile, which we have reduced after consideration of the progress made during FY '22. Kirsty will talk more about the detail on the related accounting adjustments. And while we're disappointed with this outcome, we continue to have confidence in the Waddle platform and the opportunity to provide small business customers with access to capital. I'd now like to touch on 2 areas of investment in our strategy this year in a bit more detail. Firstly, as I mentioned earlier, we continue to invest in the localization of our product for North America to better meet our customers' needs. Our product road map is key to our execution in North America, supported by acquisitions, such as TaxCycle and the partnerships, such as the one I just mentioned with Avalara. Regarding TaxCycle, the opportunity in Canada is very attractive. There are a number of similarities between Canada and other countries where Xero has been successful to date, including the tax systems and the roles that -- the role that accountants and bookkeepers play in supporting small businesses. Canada has a TAM, a total addressable market opportunity of about 4 million small businesses and low levels of cloud accounting adoption, representing a very important opportunity for Xero. We first established a presence there in FY '18 and now have office locations in Toronto and Calgary with a team of more than 200 people. It was great for me to be able to visit for the first time in over 2 years last month. The acquisition of TaxCycle in December 2021 provides immediate access to an income tax product that increases our relevance and connections with accountants and bookkeepers in Canada. This is also a step-up in localization by adding end-of-year tax capability in key filing categories with support for others to come. Now on Slide 12, I want to spend a little bit of time on the achievements we've made this year attracting talent. As I said earlier, Xero had its most successful year ever in terms of talent acquisition in FY '22. In a competitive hiring market, we've expanded our global team to 4,784 FTEs and with a focus on product and technology talent. Our FTEs increased 31% year-on-year or 24% excluding acquired businesses. Our ability to attract people to Xero reflects how our purpose to help make life better for people in small business and their advisers resonates with candidates, along with other aspects of our strong employee value proposition. These include the ability to continue to leverage our global footprint, our flexible working policy, and fully remote roles, which we introduced in August for product and technology roles and have already seen 25% of those hires choose to work this way since. So in conclusion, we're pleased with our progress on strategy. So I'll now pass to Kirsty to cover our financial results before coming back to you to talk about Xero's FY '23 outlook.

Thanks, Steve, and hi, everybody. I'll now provide some further detail on our financial results for FY '22, starting on Slide 14. The full result Xero has delivered show rebound in growth across the group following the disruption seen over the last 2 years. As you can see on the left, subscriber growth of 19% and ARPU increases of 7% contributed to an AMRR increase of 28% to just over $1.2 billion. The chart in the middle and on the right show EBITDA of $212.7 million and free cash flow of $2.1 million. The modest EBITDA increase versus the prior year is due to the increase in investment spend on product and customer acquisition being offset by the increased operating revenue performance. It also reflects the business maintaining a higher growth profile throughout the whole year. Our focus on reinvesting into the business also contributed to the positive free cash flow result that shows how we have balanced returns generated and our investment objectives. Overall, operating expenses for the year are consistent with the guidance provided at our FY '21 results, and these indicators reflect this. Moving to the next slide. Xero's customer franchise remains very strong as evidenced by the SaaS metrics we are reporting today and the continued growth in LTV. On the left, you can see Xero's total LTV increased by $3.3 billion versus the prior year to just under $11 billion, which is a 43% increase. Breaking this down by segment, in ANZ, LTV increased by 36%, and LTV of our international markets increased by 61%. Subscriber growth and growth in LTV per subscriber was strong in Xero's international markets, assisted in part by acquisitions in the period. Before I discuss the movements in LTV at a headline level, I want to touch on some of the related metrics, LTV per subscriber, CAC or customer acquisition cost months and LTV to CAC. You'll find these metrics in the appendix. The growth in total LTV has come from the 19% increase in subscribers together with a 20% increase in LTV per subscriber, bringing the LTV per subscriber to just over $3,300. CAC months increased slightly from 14.8 months in FY '21 to 15.5 months. This reflects stable trends within the ANZ segment and an increase in our International segment. The International increase was due to acquisitions and a higher contribution to subscriber growth from these developed markets such as North America. LTV to CAC increased to 6.9 from 6.4 in FY '21, reflecting an improvement across both segments of the group. CAC per gross subscriber addition was essentially unchanged in the period within the ANZ segment, as has been the case for some time. Overall, CAC per gross addition has increased due to strong subscriber growth within the less developed International segment. In particular, I would flag growth within our North American markets and the inclusion of CAC from Planday, which is a different ARPU and CAC signature when compared to the rest of Xero. In the chart on the right-hand side, we show development of Xero's LTV over the year by driver. ARPU represents the monthly recurring revenue per subscriber at the end of the period. This increased by 7% or 9% in constant currency to $31.36. Gross margin increased slightly to 87.3%. As we highlighted at the half year, churn has had a positive impact on the LTV, and I will discuss churn trends in a bit more detail on the next slide. New subscriber additions were the largest contributor to the movement in LTV with the acquisitions of Planday and Tickstar also adding to the overall movement, as shown on the slide. I now want to come back to ARPU and churn. As we show on the left-hand slide of Slide 16, ARPU has increased by 7% or just over $2 in the year. The main elements of the movement are the price increases, which came into effect during FY '22 across business addition plans in all markets and some partner addition plans in ANZ. Acquisitions, namely Planday, have contributed positively to ARPU. A typical Planday subscriber has a much higher ARPU than a Xero one. FX movements were overall unfavorable, reducing ARPU by approximately 2%. And product mix and other factors, including take-up of financial services and ecosystem, accounted for the remainder of the ARPU increase. As the right-hand chart shows, after the decline seen in churn over the last few halves, this has remained largely stable at below pre-COVID levels and under 1% per month. We continue to view the disruption caused by the pandemic as having contributed to greater awareness of the value and the importance of cloud accounting to our small business customers and accountants and bookkeepers. While these trends are reassuring, we're monitoring the macro environment closely, as you would expect. Having discussed our key SaaS metrics, I'll move on to gross profit and expenses. Together, these charts show the benefit that our continued disciplined investment has delivered in the form of gross profit. On the left-hand chart, our strong gross margin, combined with the revenue results for this year, has seen gross profit increased by 31% to $957 million. Total operating expenses increased by 39% to $922 million, as we show in the right-hand chart. This equated to 84% of operating revenue, inclusive of M&A integration costs equivalent to under 1%. This is consistent with the outlook commentary we provided at the prior year results. Digging into expenses by type. Sales and marketing costs increased by 32% year-on-year, just ahead of our operating revenue growth. Amounting to 37% of operating revenue, the cadence of CAC spend has normalized after the more varied pattern of spending incurred last year. While we have remained within a fairly consistent cost envelope overall, we have put sales and marketing dollars to use in many varying ways as the environment has changed and we have found new ways of connecting with new and existing customers. We have made a lot of great progress when it comes to brand awareness with campaigns across TV, online and out-of-home. There are plenty of examples of the work we've done here, but perhaps the most prominent is the recent partnership we announced with FIFA World's Football -- Women's Football. This multiyear partnership will cover the FIFA Women's World Cup Australia and New Zealand in 2023 and other tournaments through to 2026. We're really excited by the potential of this partnership to help build brand awareness for Xero around the world as we look to support the communities that work in and around the game. Building the products and the technology that will underpin the beautiful experiences our customers will enjoy long into the future means prioritizing investment today. On top of the more normal spend on product, we have also been supporting the 5 acquisitions that have completed since the start of last calendar year. Product design and technology costs accounted for 34% of the operating revenue, up from 29% in FY '21. Reflecting the increased level of corporate activity, G&A costs did increase slightly ahead of growth in the group, lifting to 13% of operating revenue. Overall, our results show healthy progress in gross profit and top line growth, which we have reinvested into CAC and product development to drive momentum this year and help build towards our longer-term objectives. Moving to Slide 18. Here, we present a summary income statement for FY '22 showing year-on-year changes. Operating revenue increased 29% to reach just under $1.1 billion. Revenue progress was above the growth seen in subscribers of 19%, with the ARPU drivers already discussed and the contribution from M&A, particularly Planday, both a factor. As I've already mentioned, gross margin increased to 87.3%. As we have in previous results, I thought it would be useful to provide some further detail on operating expense movements, which is shown in Note 5 of our FY '22 report. Employee costs, both in the form of salaries and in the form of share-based payments, increased by 34%. This included a onetime impact from the restructuring of equity-based compensation. Under this change, vesting of share-based remuneration has changed from 3 years to 1 year for all employees, except the Xero leadership team and senior leaders. The new vesting profile improves the competitiveness of Xero's total annual remuneration offering. Advertising and marketing costs increased by 36%, which reflects the varied level of spending on advertising in the prior year period. Spending contracted in H1 FY '21 but has remained consistent with top line trends over the following 3 halves. Travel costs have increased as travel has recommenced, but spend within FY '22 remains more than 80% below pre-pandemic levels. We expect a further increase in travel costs during FY '23 as travel returns and staff are engaged in supporting more in-person events such as road shows and Xerocons. Increasing consultant and contractor cost supports our strategic investment into people and the ways we have accessed people resources to build product and the integration of our recent acquisitions. All of this contributed to an EBITDA margin of 19.4%, which was a decrease of 3.1 percentage points versus the prior year. We recorded a net loss of $9 million, which was $29 million lower than the prior year net profit of $20 million. There are some one-off items to mention within this. Two of these relate to the treatment of Waddle that Steve has already talked to. Firstly, other income increased due mostly to the recognition of a fair value gain on contingent consideration relating to Waddle of $30 million. Impairment charges totaling $25 million relate mostly to the impairment of Waddle goodwill. The partial revaluation and restructuring of an element of contingent consideration relating to Planday had a total negative impact of $2.2 million. And finance costs at just under $44 million are largely consistent with the prior year when we adjust for the noncash loss in FY '21 that was incurred on the buyback of our first convertible note in December 2020. Moving to Slide 19. Cash generation offset by investing activity in the period leaves Xero's overall liquid resources at just over $1.1 billion at the 31st of March. This comprises cash and cash equivalents, short-term deposits and undrawn committed debt facilities of $150 million. Deducting our total debt liability of $885 million, our net cash position at the end of the year was $51 million, down $205 million from the end of FY '21. The main movement in our cash position over the period came from $196 million in acquisition and related payments. These payments mostly comprise initial cash consideration for acquisitions completed during the year. Before I hand back to Steve for the outlook, I wanted to again reiterate our approach to capital allocation. We continue to prioritize reinvestment in cash that we generate in order to support our strategy and the potential we have to create significant long-term value. Day-to-day, most of our investment will focus on the areas of go-to-market and product development to drive top line growth. We also continue to evaluate potential investment opportunities, including M&A that can further enhance or complement our strategy. I also wanted to express that we are delighted to share an expanded range of nonfinancial indicators with you in our FY '22 annual report. For the first time, our annual report has been prepared with reference to the value reporting foundation integrated reporting framework. We really hope you find it useful in understanding how Xero creates value for all of our stakeholders, and we look forward to your feedback in continuing to evolve and enhance our reporting. I'll now hand back to Steve to provide some more detail on our outlook for FY '23.

Thank you, Kirsty. I'll now cover the outlook on Slide 20. We are a business with a focus on growth, and our preference is to reinvest cash generated. In FY '23, total operating expenses, including acquisition integration costs as a percentage of operating revenue, are expected to be towards the lower end of a range of 80% to 85%. Now I'd like to spend a moment just touching on the longer-term evolution of Xero's financial profile and operating expenses. We've given you guidance for FY '23 in terms of what we anticipate from an operating expense ratio perspective. It will be natural to expect further progress as outlined on the slide in the form of our long-term aspiration. And while we haven't put a specific time line on this, our aspiration is to see significant improvement in Xero's operating expense ratio as Xero and the global cloud accounting industry continues to develop. Having said this, it's important to highlight that from period to period, our operating expense ratio and the other ratios on this slide could vary as we identify growth opportunities that are consistent with our long-term objectives and adapt to market conditions. I now want to talk through the factors that we see contributing to our operating expense ratio across 3 cost areas. With respect to sales and marketing, the strong SaaS metrics that Kirsty took you through earlier are evidence that significant investment here remains appropriate. We expect a modest improvement in this ratio in FY '23, and over the long term, we're confident that the efficiency we demonstrate in more developed markets will be more evident across our entire business. Moving to product costs. These increased to 34% of revenue from 29% in FY '21. Within our outlook guidance, we anticipate next year that these will be largely consistent with FY '22 as a percentage of revenue. In the longer term, we expect product costs to decline as a percentage of revenue, reflecting a more scaled and developed operating cost structure. I now want to give you a sense of what we've achieved in product delivery over the past year and expect to deliver with further investment over the next 12 months. In FY '22, we delivered a number of product initiatives such as our most comprehensive update to bank reconciliation and Analytics Plus. We enhanced our AI-powered planning and forecasting suite. In addition, we enhanced U.S. reporting, provincial tax in Canada and personal tax in the U.K. We also did a tremendous amount of work towards the development of products you can expect to see launch during the next 12 months. These include meeting the needs of customers with less complex needs, deeper product localization in North America and the launch of Planday in Australia and a tighter integration in the U.K. A few key areas we're continuing to invest in this year are building products and functionality to meet our customers' compliance needs in all markets, seamless access to financial services within Xero workflows, continued modernization of our platform and leveraging our recent acquisitions to further support our strategy, such as embedding inventory management. Moving to G&A expenses. These costs are smaller but critical part of our cost structure. We've invested in recent years to build important capabilities in strategy, corporate development and other support functions. And as we scale further, there is opportunity to improve this ratio. So in conclusion, I wanted to reiterate this year's strong performance. This has been delivered against what remains a complex and uncertain backdrop and highlights the strength of our business and resilience of our customers. During these times, customers continue to, and in many cases, increasingly consider Xero as fundamental to running their business and meeting their compliance needs. We remain extremely confident in the opportunity ahead for Xero to build our customer and partner relationships and to deliver on our purpose. We're looking forward to doing this in FY '23 in person for the first time in a number of years at Xerocon in London in July, New Orleans in August and Sydney in September. Before I conclude, I want to acknowledge our teams around the world, and I really want to thank them for their hard work as they continue to do all they do to support our customers and our partners. So that concludes the presentation, and I'm now going to pass over to Noel, our moderator, for your questions.

[Operator Instructions] Your first question comes from Garry Sherriff from RBC.

First question was on ARPU growth. Very strong this year, 7% on PCP or 9% on a constant currency basis. Can you tell us what those numbers were ex Planday? And how should we think about ARPU growth over FY '23?

Yes. Thanks for the question, Garry. Yes, as we said, we were really pleased with ARPU. And although we don't sort of specifically split out the breakup of the ARPU numbers, the price change was the most significant of the increase in ARPU over the period. Planday did, as we see it, have a positive impact on it, but not to the same extent as the price change. And then also, as we also mentioned, contributors were also the product mix and the increase in attach of our platform.

Understood. Capitalization, was there any change this financial year that either assisted or impacted the EBITDA number? And that's all I've got.

So no, I mean, as you'll see from the notes in the accounts, the capitalization rate for Xero moves around a bit year-to-year. This year, it was slightly higher than it was last, which was lower than the previous year. So we always sort of work in about the same sort of number. And there's a number of different things that contribute to it. We really direct our resources within product indeed. So for example, if someone is doing research on a particular new product, we're unable to capitalize, that's expensed immediately. So it really just depends on the mix of what we get these teams to work on. So there wasn't any fundamental change at all in that.

Your next question comes from Kane Hannan with Goldman Sachs.

Can you just talk a bit more about the churn trends you're seeing in the business, I suppose, whether the price rises you put through contributed to that increase in the second half? I suppose just how you're thinking about churn in FY '23.

Yes. So I mean churn was a number that we were really thrilled with for the year. 0.9 is world class in our opinion for -- particularly in the small business space because it does actually mean that we have our subscribers hanging around far longer than the normal survival rate of a small business. So based on our group churn of 0.9, it means that the average subscriber is with us for 9.3 years. So that's just a nice little fact point for that. As far as -- if you compare it to what happened, so we did put through our price increases in September and in November. And if you do the compare from H1 to H2, we did -- we saw a slight reduction in ANZ. And there was a slight uptake in international. But again, 12 months ago, we were at 1.43 in international. We now sit at 1.23. So we don't ever really see any significant change in churn at all when we put through price increases.

Perfect. And maybe just one follow-up, just on the platform revenue growth acceleration. Is that all the step-up in payment values in that chart that also had the really strong March numbers? Or is some of that coming from the App Store revenues building up over time?

There's a number of contributors. You touched on 2 of them. But it's also, as we said, the contribution of the acquisitions like Planday to that growth of over 100% year-on-year. But the organic growth was 43%, which does relate to the payments revenue and some of those other adjacent revenue streams.

Your next question comes from Roger Samuel with Jefferies.

My question is around your outlook commentary. So prior to FY '20, so before the pandemic, you gave your guidance around free cash flow. And nowadays, your outlook commentary is more focused around cost. So how should we be thinking about free cash flow going forward? Are you still trying to improve your free cash flow? Are you managing it sort of the breakeven level?

Yes. So Roger, what we -- within our outlook, we do continue to say that we will have a preference of reinvesting our cash generated. And so therefore, a few years ago, we were certainly working towards a breakeven cash flow -- free cash flow position. We then made it. And since then, we have really been saying that we will reinvest that generation back into the business. And the reason for focusing on operating expenses now is really to show that we are considering our spend on cost and that we -- the guidance that we're giving around the change from last year, I suppose, which was 80 to 85 plus also the additional 2% for acquisitions, now we are within the band of 80 to 85, and we are suggesting that you look sort of towards the lower end of that, showing as many are wanting to see, particularly now, that we are really focused on ensuring that we deliver the right products and services to our small businesses but doing it at a way where we are considering efficiency all the time.

Okay. And maybe just a follow-up question on your cash flow. So the income tax paid in this result was $20 million, which is roughly double the amount last year. Can you tell us what happened there? And how do we reconcile that with the P&L tax expense?

Yes. So I'll start with the P&L and then I'll go back to the cash. So from a P&L perspective, the large swing that you see there is due to the fact that we recognized the deferred tax asset last year. And so that's the biggest swing. So this year is more of a business as usual income tax provision. And within the amount of tax paid, there is an amount there for TaxCycle. It's about $7 million. And there's a bit more detail if you want to have a look at it on -- it's actually Page 74 on the annual report, if you want to have a look at that.

Your next question comes from Rohan Sundram with MST Financial.

Just a couple for me. Firstly, on the talent acquisition, how far into that are you? Are we past the peak or are you still ramping up on that?

Look, I won't -- the way -- I guess the best way to look at this is that talent acquisition is very much aligned with our review of our plans each year in terms of how we're executing, how we set our expense envelope. And we continue to look to add talent for sure as we go forward because we continue to be very much growth-oriented. So in terms of the scale, it was a big year last year, and we certainly have got objectives set for this year as well to continue to add talent to Xero around the world.

Okay. And last one for me. Just given all the D rate we're seeing in tech stocks, has that impacted the way you think about that balance between reinvesting into the business versus wanting to show ongoing EBITDA growth?

Well, our orientation is really, I guess -- well, I guess it's very much focused on the significant opportunity that we have in executing our strategy. And that remains our focus because the opportunity we have around the world to continue to invest and support the development of the small business cloud segment, which is an emerging segment still in many parts of the world, is really the focus because the opportunity then, for us, as we said in the presentation, to, over time, in the long term, show the kind of improvement in those operating ratios, expense ratios, as we talked about, is really aligned with that. It's really aligned with the continuing maturity of our -- a maturing of our business and our -- the segment in which we operate. So you can look to the achievements we've made in Australia and New Zealand and points to that is reflecting improved efficiencies as markets for the cloud accounting software and cloud software to small business continue to mature. So still, our orientation is, as we said in the outlook, about investment and growth. But clearly, we want to make sure we're responsible about that in the short term and the long term. And we really want to send the message that we are super focused on it and appreciate the need for us to be responsible with the way we approach it.

Your next question comes from Siraj Ahmed with Citi.

Can you just talk to the U.K. subscriber growth in the second half? It was flat in the first half. Typically, it's second half-weighted. So can you just talk to the third quarter issues that you flagged? And just on Making Tax Digital, the benefit in FY '23, I mean, do you think you've lost market share? You did mention some industry issues. If you can just expound on that, that would be really helpful.

Yes, Siraj. Look, I think that the things I touched on really -- against the backdrop of a business we feel very good about, and we're very pleased with our revenue performance in, the ongoing challenges to engaging with our partner channel and particularly in markets which are developing markets and where we're essentially helping accountants and bookkeepers on their journey of practice and digital transformation, it is tougher when you're going through the kind of interruptions to connecting physically and being in person. That's so much a part of the historic approach we've taken to building relationships and driving the growth of our business. So we found that particularly hard in Q3. There was just a lot of fatigue that we could sense and still interruptions to people returning to work. We saw improvement there in Q4. I think it's important to say that. The issue that I mentioned in terms of service was really a minor issue, but it did have a little bit of an impact where we implemented multifactor authentication as a way of protecting our customers. And that was, in a sense, extended to trialists for a period of time until we reverse that. And so trialists clearly are not as keen to give you the sort of levels of information that you would expect from someone who is a customer wanting to deploy multifactor authentication or needing to. Finally, on MTD, look, it's really -- now from all the insight and the information we have, it has been a slower take-up. We think that there's still well -- around 2/3 of the businesses that fall into the category of businesses that are under GBP 85,000 and needs to comply with Making Tax Digital for VAT that are still out there. And we -- it is industry-wide. We have pretty good intelligence on that, and we hope to see that flow through in FY '23 as you get closer and closer to the point in time where compliance, noncompliance becomes an issue for a small business.

Can I ask just a last one? Sorry, go ahead.

Go ahead. No, no, you go ahead.

Just on Avalara as well, the partnership. Is that a new partnership? And can you just talk to the significance of that? I mean does that make your product market fit in terms of sales tax much better now, much stronger in the U.S.?

Yes. Look, it is a new relationship. And I won't say much about it today, but we'll be talking more about that in the future. You're essentially on the right track there in terms of how it contributes to us, continuing to do the things we're doing through partnerships, through acquisitions and through the products we build to meet the needs of U.S. customers.

Your next question comes from Tom Beadle with UBS.

Just first one. I know a key driver of your increasing investment this year is in North America and Planday. But I'd like to also talk about the foreign language capability. I mean we haven't spoken about that for a while, but how much are you investing there? When might we expect this capability to be built? And do you need to increase the level of investment there to complete building that capability?

Yes. Look, Tom, thanks for the question. We continue to do work that will put us in a position where language localization is something that we can do efficiently in the future. Ultimately, however, it comes back to prioritization and a real understanding of the opportunities that we have and competition between many different growth and investment opportunities that we have at Xero. So at this particular point in time, there's not much to say about that in terms of how we're prioritizing, but it does remain, in the longer-term context, something of interest to us and something that we are definitely keeping in mind.

Great. And just probably a follow-up from Rohan's question, I think it was, just around employee share-based compensation. You've obviously reduced that vesting period from 3 years to 1 year. So what's driven that? Is that competition for talent? And I guess with that lower vesting period, could that potentially impact your ability to retain talent? Or could it actually drive costs higher? And also just generally, could you just talk about the inflation that you're seeing in employee compensation, just given obviously how much competition there is out there for talent at the moment?

Yes. So we are continually looking at the way in which we can provide remuneration to our employees. And we did look, and it's more market standard to have a 1-year vest rather than a 3-year vest. And so listening to our people, we made the change. So I think that puts us in good stead. We're certainly doing well on the recruitment front at the moment. You can see from our growth that we're doing -- that we are able to do that recruitment. And we'll continue to look at it in the future. As far as the cost base goes, we had a large hump at the beginning as we made the change, but it should -- of about $23 million, but that should -- that's not something that's going to continue.

Your next question comes from Paul Mason with E&P.

Just wanted to ask a bit about some of the sort of bookkeeping service relationships you guys are building in the U.S., like H&R Block was an announcement you guys made earlier in the half. Could you just talk to us a bit about sort of the -- what the actual product is and sort of what the strategy is behind these partnerships that you're doing?

Paul, so we've always said our focus in North America is on building the partner channel. The -- and building the partner channel is ultimately working with them to transform their practices so they can more efficiently support their clients and also then encourage their clients to come on to the Xero platform. So one of the areas where many of these large firms provide service is in the area of outsourced bookkeeping. And we have a very, very, very good product for that. And so there's also a narrative that goes with many of them, the ones we formed deep partnerships with, a longer-term opportunity to help them continue to broaden the way that Xero and they collaborate. So in terms of how it fits into our strategy, it's really part of since the -- let's call it, the cycle of getting both accountants and bookkeepers promoting Xero to their clients but also the other work that we do to encourage small businesses more directly to promote Xero to their accountant and bookkeeper. And so in the North American market, where we are at this particular point is really the focus there. And so those relationships, I think, are real endorsement for a number of aspects of why we're doing what we're doing, endorsement of our product and endorsement of their desire to have a relationship with a company like Xero that can help them on their transformation journey. And they're very supportive of the work that we're doing and wanting to see us succeed.

And can I just ask as well on the new Ultimate plans you guys are releasing, just your general view on sort of the proportion of your customer base that those plans might be targeted at?

Yes. Look, I think in terms of the -- one of the most important things we can do in terms of, again, driving ARPU is to really make sure that we're evolving our SKUs, if you like, to meet the needs of customers, both those with lesser needs and those with more complex needs. So the Ultimate package is really addressing that customer with more significant needs where we can do a couple of things, provide value to them but also drive additional elements to the Xero proposition through that Ultimate package.

Your next question comes from Eric Choi with Barrenjoey.

I just wanted to drill into some of the points that Tom and Garry brought up actually. The first one is I guess some of the other tech stocks are calling out mid- to high single-digit wage inflation. I'm just wondering if you're seeing something similar and if any acceleration in wage growth is baked into your expense ratio guidance.

Yes. I mean it is -- we are certainly around the globe living in a very interesting time at the moment, particularly off the back of the last couple of years, too, where we've been able to show the market that we can move, pivot, reprioritize to really fit within what's happening within the market. So absolutely, we are -- we have set our capital envelope for FY '23 as we say, between the 80 and 85, looking at the low range, and that certainly includes what we see at the moment that will happen from sort of inflationary pressures. And if something happens that we don't expect then, as I say, we've already been able to show that we'll be able to work within the capital envelope that we've got and ensure that we still maintain within that outlook statement.

And on the capitalization element of those costs, I think it was sort of 45% of R&D this year. Do we just sort of assume the same sort of ratio into '23?

Yes. I mean, again, we don't give guidance on it. But if you look back in the past, you'll see that we -- there's a tiny bit of volatility between each year, as I said earlier, just about the prioritization of what we get our staff to be working on. But it is generally always around that sort of rate. Some years, it's a bit higher. Some years, it's a bit lower, as we've seen over the last couple of years.

Awesome. And I wonder if I could fire off the last one. Just wondering if we go into a macro environment, maybe where blunt price increases get a bit harder. Just thinking if there's other sort of innovative ways for you guys to lift yield, and I mean, thinking specifically about the tech investment boost, could you guys launch multiyear subscriptions or promote up-tiering or some sort of -- some other sort of product innovation we're not thinking about?

Yes. I mean we're always looking at our pricing strategy. As we've said, our philosophy is always around providing additional value to our small businesses and accountants and bookkeepers. And so we are -- as you can see in the financial statements, we are heavily investing in product and technology, which ultimately ends up in increases in the amount that we are delivering through our -- for each of our -- not only our sort of our core Xero but across the whole entire platform. And so we do always look to see when we can put price increases through. And to your latter part of the question, we're always looking at ways in which we can change things in the future, but there's certainly nothing that we are looking to announce now which is in addition to the way in which we do our subscribers on a monthly basis at the moment.

Your next question comes from Bob Chen with JPMorgan.

Just a quick one around the overall M&A strategy. Can you talk a little bit about how has the TaxCycle sort of performed compared to your expectations going into that business? And just broadly, are we likely to see more similar type of acquisitions like that in North America?

Yes. Bob, TaxCycle, very, very early stage. Like literally, we've -- only talking about a handful of months. I was fortunate enough to get to Calgary recently and spent a couple of days with the TaxCycle team and the Xero team in Calgary, visiting partners and learning more about the business there really validated for me, seeing firsthand the quality of the relationships, the capabilities they have and the relevance that it adds in terms of our presence in Canada and relationship with accountants and bookkeepers. So at this stage, a bit early to say. Sorry, mate, I've just forgotten the other part of the question. It was about Tax Cycle and what was the other part? Was it M&A in general?

M&A in general.

Yes. Look, we're really pleased with the progress we've made with the acquisitions over the course of the last 12 months. Again, you start with post acquisition, do you -- in practice, do you feel that the strategic rationale was right and strong, and we can say yes to that, for sure. The other thing is possibly -- not possibly -- the other thing that's more important is how are the relationships like with the people in that business and are we culturally aligned. And again, we've been very pleased with the collaboration and also just the quality and consistency of the cultures of those businesses and how they're working really well in the Xero environment. So -- and again, there's some really nice plans around each of them to continue to evolve and deliver on that promise for our customers, which is what this is ultimately all about. And looking forward, we'll continue to look, consistent with our strategy at opportunities that are out there, but very pleased with what we've accomplished in the last 12 months.

Okay. Great. And then just probably on the competition front, can you talk a little bit about what you're seeing from -- yes, maybe on the pricing side or just competitive intensity, especially in the U.K.?

Yes. Look, I'd say more of the same really. I don't think that -- and that's not to say the competition isn't a factor. It is something that we watch and think about. But we don't -- we haven't seen significant changes in the approach of competitors. And the U.K. has been an environment where all participants have been advertising and pursuing the journey of adding customers. And nothing much has changed really.

[Operator Instructions] Your next question comes from Stephen Ridgewell with Craigs.

Congrats on the results, guys. Steve, I just wanted to circle back on the discussion on Making Tax Digital in the U.K. So some of the improving [ trends that you're seeing ] more recently? Is it going to continue into Q1?

Sorry, Steve, the line was not great then. Can you just say that again?

Sorry, apologies. Just in terms of U.K., Making Tax Digital -- can you hear me?

Yes, I can. It's a bit -- why don't we have a shot at it. We should be able to get there.

Okay. So just on the U.K., on the U.K. Making tax Digital -- comments on Making Tax Digital earlier, are you starting to see improving trends in terms of adoption into Q1?

Yes. Look, at this point, it's, again, still very early in the period. And we'll talk more about that obviously in the half -- at the end of the half. But I think that where I left it was really much -- very much to say that the opportunity is still there. We didn't see it flow through at the level that perhaps everyone expected. But then again, it would have assumed that people are moving early, whereas now the compliance deadlines are coming closer. And so we'll just see how it plays out during the course of the half. There is still 2/3 -- there is still -- to our -- the best knowledge we have, there's about 2/3 of small businesses in that, that have to comply that are yet to comply.

And just one really quick one. Just for North America, are you able to give us a sense of whether Canada was growing a bit faster than the North America as a whole? Are you sort of seeing good signs in that market, which is obviously a more recent entry than the U.S.?

Yes. Look, we don't break that out. I think that what I would say is they are different markets. And certainly, the work we're doing in Canada gives us -- has given us a really good understanding of the opportunity. And we're really approaching the 2 -- they are at different stages and with very different characteristics. But at this point, we don't break out the 2. But we are definitely focused on both markets and have a real focus on making sure we continue to evolve our product offering for customers in those markets.

Your next question is a follow-up question from Garry Sherriff with RBC.

Steve, have you seen any impact from -- in the U.K. in relation to Ukraine and Russia conflict? And has there been any behavior change that you've seen on the SME level that you can attribute to, I guess, what's going on in that part of the world? And if so, please provide some detail.

Yes. Not really, Garry. Nothing that I could add that's helpful there. I mean other than when you talk -- I spent a week in the U.K. And obviously, people in Europe are concerned. So to the extent that, that plays out in everyday life and business, but it's very hard to say. Nothing that we can point to or would point to.

Your next question is another follow-up question from Roger Samuel with Jefferies.

Can I just dig deeper into your outlook for ARPU growth? So you mentioned about price increases. But how should we be thinking about the mix of the product going forward? So you've launched a new product called Ultimate, which I presume will be priced at a premium to the premium product. And -- but also in your slide, you mentioned that you're building something to meet the needs of customers with less complex needs. Are you sort of launching like a more basic product there? And also another dynamic is Planday. It seems like you haven't really rolled out Planday through the rest of the world. So maybe Planday can drive ARPU growth as well going forward.

There's a lot in that question.

Just what would be the driver of your -- yes, high mix.

Yes. Look, I think we've always said that ARPU and the construct of ARPU is really the outcome of a number of things. It's obviously the mix of the subscriptions that we sell. And so to the extent that we get smarter and smarter over time in the way that we manage the pricing and the packaging of our product, that's definitely something that we're focused on. There's obviously the adjacent categories that we've touched on today that are really important as well. There is the ability for us to upgrade and sell more to customers as they're using the product, and that's certainly something that's an area we focus on developing as well. And ultimately, there's certainly opportunities. If you look at Planday, you mentioned that, can we do things with Planday ultimately to serve more of that small business segment with lesser employees that wants a really simple integrated solution. Definitely an opportunity for us there, along with other things we might do. And yes, we are looking to find ways to meet and reach more businesses with our products in the most effective way. And we'll -- as I indicated, you'll hear a bit more about that during the course of the year. But it's a little tricky one. I'm not sure. I'll let Kirsty maybe add a comment to that, but...

Yes. I mean we see ARPU as only one component of our growth. And so if you talk about the small businesses with less complex needs, that's really about growing our revenue through additional subscribers, maybe not at the level of the ARPU. And then on the flip side, we do have now -- and we continue to increase the level of different service offerings across the bridge of our platform. And so you do have this see-saw between increasing ARPU but then also looking at potentially decreasing ARPU but increasing volume. So I think longer term, our business should ultimately be about driving an increase in ARPU. But it will just depend on the mix as we go through the journey over the next few years and how successful the product for lower needs is because if it was incredibly successful, then it may have a bit of a headwind against our ARPU. But it would have to be large growth.

I think what I would say, it's fair to say, is that regardless of the size of the subscription or the customer, we are very much focused on making sure that we are effective in adding services and making sure that customer is using more and more over time. So ARPU is a focus area for continued improvement for sure. But in terms of giving you more detail on how that plays out, it's going to be a factor of many different elements that Kirsty just touched on.

Your next question is a follow-up question from Siraj Ahmed from Citi.

Steve, just on the less complex needs and expanding the TAM, can you just give us -- elaborate on that? Because, I mean, you did relaunch the start-up plan in September '20 with the same idea. So just keen to understand, is that not working? Do you need to actually [ integrate ] further? If you can just elaborate on that, that would be really helpful.

Yes. Look, that has worked for us. So we are pleased that we did extend Xero in that form to customers. I think it's interesting when you look at Australia and New Zealand and the way that our business there is growing, I think the point is that the whole notion of TAM and the relationship between TAM and a number of small businesses is maybe a more historic view. I think that in reality, there are many, many different forms of enterprise and people who want to get access to tools to help them manage their money better. And so we do see an opportunity there to go broader in that context and provide an even more simple solution going forward. So something that we are working on, and again, something that we hope to see in the course of the next 12 months.

Can I ask one more, if that's okay?

Sure, you can.

So just on churn, just looking at the accounts in the annual report, in your LTV calc, you're calling out average 3-year churn now, just saying LTV is pretty sensitive to churn. Just keen to understand whether you're sort of implying that you think churn is a bit too low, it should tick back up to the 3-year average.

No, I think we just felt that it was a good thing to be able to provide that level of detail and also, I suppose show that it has come down over time. So I wouldn't read anything into it about what we think churn will be in the future. As I said earlier on, we are really thrilled with the way that churn has been particularly over the last couple of years through a global pandemic. And there'll be a number of factors around that, some external to us and also what we're doing to support our small businesses through it. So I wouldn't read anything into that statement.

Thank you. There are no further questions at this time. I'll now hand back to Mr. Vamos for closing remarks.

Well, thank you. Thank you, everyone. Really appreciate you taking the time to join us today. Appreciate your support, your interest and look forward to connecting again in the not-too-distant future. Thanks very much.

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