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How's this for a business model? Take the best bits of the credit card – convenience, acceptance and the loan component – and remove all that's bad, from the lengthy application process, to the hefty annual fee and exorbitant interest charges. What’s left is a product so revered that it practically sells itself.
Welcome to Afterpay, with a business model so simple it's simply brilliant. Afterpay's users lobby new retailers to accept it and create Facebook pages with hundreds of thousands of followers declaring their love for the company. No wonder the marketing budget to acquire Afterpay's 1.8m users was around $100,000, probably what Coca-Cola spends on coffee.
And yet this is a confounding business. Afterpay makes loans to its users but it doesn’t receive any interest in return. It exists so customers can delay payment for their purchases, despite the fact they usually repay their debt much sooner than required. And Afterpay’s retail partners promote Afterpay more than Afterpay itself.
There is no other business quite like it, which is why it’s time to unpack Afterpay.
If Afterpay were a movie it would begin with a familiar plot. It provides credit at the point of sale, both in-store and online, so users only pay 25% of the purchase's value upfront. Afterpay recoups the rest in three fortnightly instalments.
But then the plot twists like a Quentin Tarantino thriller. Instead of receiving interest from the customer, Afterpay receives a commission from the retailer worth 4% of the transaction’s value.
The logic is that customers are likely to spend more when their purchasing power is enhanced with free credit, and retailers should pay more in return for the larger transaction sizes Afterpay brings.
The time value of money tells us that Afterpay adds value for its users, but the benefits may appear slim to those of us who already exploit a credit card’s 30-day interest-free period. To understand this nuance we need to delve into the minds of Afterpay’s millennial user base.
A recent survey showed that 85% of Afterpay's users either don't want or can't get access to credit. Spotting attractive clients, where incumbent credit card providers could only see undesirables, has allowed Afterpay to build a loyal following by extending credit on highly favourable terms.
Users are increasingly using its merchant directory to decide where to shop, which is changing the natural order of things. It’s hard to fathom a new car buyer considering the financing options before the car’s make and model, but that’s exactly what Afterpay users are doing.
This phenomenon has not only added to Afterpay's bargaining power with retailers but it has instilled the fear of missing out in them too, helping boost the network to 14,000 retailers and counting.
Investors aren't salivating about Afterpay's margins, as the net transaction margin whittles down to just 2.3% after transaction costs, interest and bad debts. What is getting hearts racing, though, is the speed at which Afterpay recycles its capital.
Australian banks also make a net interest margin of around 2% on the difference between what they charge borrowers and pay to depositors.
But what they earn in a year, Afterpay earns in six weeks. Customers are contractually required to repay AfterPay over 56 days, so its net transaction margin amplifies to nearly 15% on an annual basis.
But, somewhat amazingly, customers are repaying Afterpay nearly twice as fast as they’re required to, which amplifies its annualised returns to nearly 30%. This gives Afterpay the returns of a payday lender without the disgruntled customers and pesky regulation.
By funding the majority of its customer's purchases with debt, Afterpay's model is capable of producing mouth-watering returns on equity.
So what might upset this lucrative applecart?
Everyone points to the risk of higher bad debts but fewer have considered the threat of a slowdown in its recycling of capital. After all, it's hard to imagine customers repaying much sooner – the benefit of using Afterpay reduces with repayment duration (and it provides no benefit with immediate repayment) – but it's easy to imagine them repaying more slowing. Afterpay's earnings power would halve if customers repaid as contractually required, and that's before operating leverage has taken its toll.
Afterpay's bulls are excited about its growth potential, and they've good reason to be.
For starters, Afterpay's userbase is heavily concentrated on young women – many of them teenagers. That offers a couple of obvious avenues for growth, by attracting more men and older users. It's also predominantly used to buy clothes, but the recent agreement with Jetstar highlights its broadening appeal. No money for groceries? Just 'Afterpay' it, or so the thinking goes.
Expansion into bricks and mortar stores – where expenditure dwarfs the amount spent in online stores – is arguably Afterpay's biggest opportunity. Afterpay made initial inroads online but it's being increasingly adopted in-store, even though in-store use is a bit more cumbersome.
To top it all off, Afterpay is also tempting fate with an expansion into the US, having already entered New Zealand via a partnership with Trade Me. International ambitions have brought many Australian companies unstuck over the years, so Afterpay is hoping its domestic experience, and assistance from Matrix Partners will improve the odds of success. To kick things off, Afterpay has partnered with Urban Outfitters and it has more retailers in the pipeline.
As the bulls salivate over rapid growth, the bears have their eyes out for steamrollers heading for Afterpay's slim margins.
A recent regulatory review into the 'buy now pay later' sector not only raised a few eyebrows but it's also added to Afterpay's operating costs, as they've started verifying their user’s identities to get onside with the regulator.
Whether this shaves or shatters the value of a first-time customer depends on the cost of third-party identity verification. Our scuttlebutt suggests the per person cost will be between $0.65 and $1, which is a lot for a business that makes around $3.50 from the average transaction.
Thankfully, 90% of Afterpay's transactions are from repeat customers (and you only need to verify a customer's identity once), so the total incremental expense is unlikely to put a large dent in earnings. But the implication is clear: if any other expenses pop up from increased regulation or countering higher competition, the impact could be more severe.
The bears also have a more pessimistic view on the categories of retail goods in which Afterpay might do well. One common thread between clothing and air travel – the two categories where Afterpay has had early success – is low resale value. Second-hand clothes shed a lot of their value and flights cannot be resold.
But if it was possible to 'Afterpay' a gold bar, for instance, a fraudster could make a motza by paying the first 25% instalment and then quickly reselling it. So Afterpay might be limited to categories with low resale value to reduce the risk of fraud.
The challenge Afterpay investors face is the lack of historical precedent. The business hasn't been around long enough to experience cutthroat competition or a recession, which makes estimating the downside risk more difficult.
Sometimes investing gets far more complicated than it needs to be. At the end of the day, all we're trying to do is assemble a portfolio of sensibly priced businesses whose earnings we're confident will be materially higher in five or ten years' time.
Afterpay could fit that description, but we struggle to have much confidence in that view – and with a market value of $1.5bn for a business just shifting into profitability, we don't have much margin of safety to protect us.
We'll be keeping an eye on the business, but we'll be doing so from the sidelines for now.
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