This company shows tech can pivot to profitability, and the market is loving it with 55% return year to date

When markets sell off, it's easy for good companies to become victims of their own sector's stigma. As inflation and rates have ravaged markets, the tech sector has received this kind of treatment.

Tech stocks are heavily geared growth stocks, operating at a loss. Or so the stereotype goes. And like that, the baby gets thrown out with the bathwater.  

But there's one ASX-listed tech company that is demonstrating that it is possible for tech to pivot away from growth. 

Last week, Xero (ASX: XRO) announced a $106.6 million loss. But the stock is up 55% year to date, and 15% in the past week alone. 

So why did the stock surge after posting a sizeable loss? To help answer that, I brought in Donny Buchanan from Lakehouse Capital. 

New game, new strategy

Xero has posted losses since it started by continuing to reinvest and chase growth. 

This is CEO Sukhinder Singh Cassidy's first result since taking the reigns in February, and she's wasted no time pivoting the company from growth to growth and profitability. 

The $106 million loss can be put down to two write-downs - SME lender Waddle (which has since been shut) and rostering software business Planday. 

More importantly, revenue growth hit 28%, contributing to adjusted EBITDA of 45% compared to FY22, while free cashflow hit $102 million with a free cashflow margin of 7.3% (compared to 0.2% in FY22). 

"It's early days for the new CEO, but the business is doing a good job of pivoting to profitable growth and growing free cashflow," says Buchanan. 

Furthermore, subscriber growth came in ahead of market expectations - especially in the UK, where 76,000 subscribers were added to the books in H2 FY23. 

"Although the UK looks like an economic basket case, Xero have put some good runs on the board with re-accelerated subscriber growth," says Buchanan. 

"The [UK] government has the 'Making Tax Digital' program which they've pushed out, and that had been a bit of a tailwind for the business. And that being pushed out on top of the headwinds they were facing, the market was surprised Xero was able to do what it did with the subscriber growth."

Looking forward

Revenue is $1.4 billion and highly recurring, so Xero is in a position to make the pivot from growth to profitability. 

Buchanan reckons the stock is a HOLD at its current price. 

"The stock is around fair value," says Buchanan. 

"There's a few more runs that the new CEO needs to put on the board in terms of executing the strategy and what profitable growth looks like. They talk about the rule of 40 - they're hitting the mark on growth but there's a bit more they need to do on profit margins. They haven't given a timeframe to deliver that, but I expect they'll be able to do that within a reasonable timeframe."

What does Xero's turnaround portend for the tech sector more broadly? It's mixed. 

"There are many smaller tech companies that don't have that scale. It's not impossible, but it's harder at small scale to make the transition."

"[Lakehouse Capital have] always had an affinity towards businesses with high levels of returning revenue, and Xero is one of those."

Disclaimer: Donny Buchanan is a unit holder of the Lakehouse Small Companies Fund which, which at time of publication holds shares in Xero.