Xero (ASX:XRO) 57% Off Highs, Is the “AI Shock” Overdone?

Systems of Record Do Not Get Replaced Overnight

A couple of weeks ago, we published an article on Xero (ASX:XRO). It has been a tough year for the stock, now down roughly 57% from its highs and trading around $82.

In our view, the sell-off has been driven less by a collapse in the underlying business, and more by expectations resetting. The market had priced in very aggressive growth, and when operating expenses lifted, largely due to one-off items, it created margin compression that hit sentiment hard.

Over the past few weeks, we have gone deeper on the name. That work accelerated after the recent “AI shock,” where the market priced in a wave of uncertainty following Anthropic’s new coding capabilities and the broader wobble across SaaS.

But if you understand how software actually works, including APIs, integrations, and plugin ecosystems, that reaction feels overdramatic. In reality, the most likely outcome is AI layering on top of existing platforms and vendors embedding AI into their own products, not wholesale replacement of systems of record. That is why we think it is time to start taking a closer look at Xero again.

On the sell-side, sentiment remains supportive. There are currently 8 analysts with a Buy rating, 4 with a Strong Buy, and 1 with a Hold, with an average price target around $162.

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Growth Is Strong, Costs Spiked, Here’s the Real Read

Looking at this year’s half-year result, the top line is still doing the heavy lifting.

Subscription revenue rose 18%, and total operating revenue grew 20% year on year, which tells you demand has not fallen off a cliff.

Costs did rise, but the context matters. Cost of revenue increased about 24%, which is slightly faster than revenue, yet gross profit still lifted 19% because the revenue base expanded so strongly.

The bigger swing factor was operating expenses. Total operating expenses were up roughly 30%, which is ahead of the top line.
A large portion of that spend sat in product design and development, which aligns with management’s focus on accelerating product velocity and embedding AI deeper into the platform.

On the AI front, the company is now pointing to real adoption. Xero says more than two million subscribers are benefiting from its full AI features, with 300,000 plus using newer GenAI capabilities. It also claims customers are saving roughly 22 hours per month through bank feeds and automated actions, and that engagement with JAX is rising.

Strategically, we also saw the acquisition of Melio, with transaction costs called out at about $50.6 million in the period. The intent is clear: strengthen the US proposition by pairing accounting with payments, and lean into a larger addressable market over time.

Importantly, management is guiding to operating expenses stepping down as a percentage of revenue, with FY26 operating expenses expected to be around 70.5% of revenue. If that plays out, it supports the idea that earnings can grow faster than the top line as operating leverage starts to reassert itself.

And despite the reinvestment cycle, Xero is still throwing off cash. Net profit after tax increased 42%, and free cash flow reached $321 million in the half.

So the clean read is: the business is still growing strongly, it is deliberately reinvesting in product and AI, the US strategy has been reinforced via Melio, and cash generation remains a core strength.

Australia Still Growing 19%, The “Mature” Narrative Looks Wrong

When you break the result down by geography, the growth profile is still very healthy across the board, and it also tells you where the next leg of the story has to come from.

Australia remains Xero’s largest market and it is still growing strongly, up 19%. That is an important anchor because it shows the core franchise is not mature in the way the market sometimes assumes.

Internationally, the UK is the standout. It is Xero’s fastest growing major region, up 25%, and it is increasingly meaningful in the group mix. UK revenue is now around $338 million, which is large enough to start moving the needle at a group level rather than being a “nice to have.”

North America is also growing at a strong clip, up 21%, but this is the region that matters most for long-term upside and is also the hardest to win.

The reality is simple. The North American SMB accounting ecosystem is more competitive, switching costs can be lower at the micro end of the market, and distribution is expensive. Winning here requires sustained product differentiation, clean positioning, and disciplined customer acquisition.

If Xero can consistently compound in North America, it does two things at once.

It expands the total addressable market materially, and it validates the durability of Xero’s moat outside its home markets. That is why North America is the proving ground. (but growth wont come easy)

The Investors Takeaway for XRO

The key risks for Xero still sit in North America. It is the biggest prize, but it is also the hardest market to win.

The competitive landscape is intense, and distribution is expensive. Xero may need to spend heavily to build brand, partnerships, and product localisation, and there is no guaranteed payoff. That is the core risk: higher investment up front, with uncertainty around how quickly it translates into durable market share.

The offset is that the business is not a one-track story. Strong growth in Australia and the UK provides a meaningful hedge. Those regions can keep compounding and generating cash flow while management funds the US push, which reduces the “all or nothing” nature of the North America thesis.

A second risk is cyclical sensitivity at the customer level. Small and medium-sized businesses are exposed to macro volatility, and during downturns or recessionary periods cash flow tightens. That can increase churn and slow new customer adds.

Accounting software is generally sticky, but the smallest customers are still the most price sensitive. If times get tougher, some micro businesses will cancel, downgrade, or delay adoption, even if the product remains mission-critical for the customers that stay.