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Afterpay has been the absolute standout global growth story on the Australian markets over the past few years. This article explores the attributes that have allowed the company to become such a rip-roaring success.
Afterpay commenced operations in early 2015 and listed on the ASX via an IPO raising $25 million in mid-2016 at a share price of $1. Today the company's shares trade at over $70, an astonishing 190% per annum return over the past four years for participants in the IPO who have held on through thick and thin.
We were relatively late to the party, first purchasing Afterpay shares around the $7 mark in mid-2018. At that time, we shared what was then a controversial view that the company could be worth between $25 to $50 within 12 months. Then the company only took 10 months to reach the $25 mark. We recall being so excited by the company's potential that we sent hard copies of our research and letters to a number of prominent US investors such as Berkshire Hathaway.
Afterpay’s features are by now well known. They provide a tweak to the traditional lay-by model by allowing consumers to pay for products in four instalments while being able to use the product straight away. Afterpay removes the need for retailer to track and hold stock and payments in return for a small percentage-based fee. Afterpay then 'owns' the customer who pays the instalments to Afterpay rather than the retailer.
Effectively, Afterpay then becomes the 'destination' for the consumer who can efficiently compare product offerings at the Afterpay website. It leads to a virtuous cycle of lower customer acquisition costs, better credit quality over time and greater brand awareness and loyalty.
Strategically, we feel the value proposition Afterpay bring to the table is nothing short of brilliant. By being a 'no-cost' payment method to the consumer, it circumvents any claims of usury and reduces consumer costs via a no-interest model, driving incremental demand for retailers.
The datasets of consumers and their behaviours are also extremely valuable intellectual properties that are not reflected on Afterpay’s balance sheet. We view the platform as an equalising tool that independent retailers can use to differentiate themselves against the might of Amazon and other large online aggregators. In a nutshell, Afterpay is the antithesis of the traditional finance business model predicated on 'screwing the customer' to a business model that empowers customers to responsibly spend and budget without incurring a cost.
The core driver of the Afterpay model is its extreme capital efficiency and the uniqueness of its model to capture value. Conventional lenders turn over their loan books one to three times a year, depending on the nature of their lending activities. They typically charge an interest charge solely based on the time duration that a loan is drawn down.
Conversely, Afterpay has historically turned over its loan book approximately eight times a year whilst collecting a fixed return per cycle. This allows the company to squeeze a much higher return out of a much smaller capital base.
The company enjoys strong and scalable unit economics driven by a high level of automation. Its initial core target markets were skewed towards discretionary consumer markets, which typically have high gross margins thereby making Afterpay's merchant fees supportable. It also makes incremental demand from the Afterpay system especially valuable. Interestingly, we have seen significant extension into other industry verticals (with similar dynamics) such as health services over time, as the service has become more mainstream.
The viral nature of the product is a strong attraction with demand from both customers and merchants alike. Customers are attracted by the cost-free nature without the stigma of conventional lay-by. Merchants are attracted by increased customer spending via larger basket sizes as well as higher repeat purchase rates. In addition, the use of Afterpay draws new customers to merchants as well as reducing the financial risk of charge-backs and fraudulent payments as Afterpay bears the financial risk post transaction.
A dynamic we have observed in real time has been the 'peer pressure' in terms of merchants’ deployment of the service. For example, we noticed that early merchant adopters of the service quickly obtained a competitive advantage versus competitors who did not offer Afterpay. This forced merchants to adopt the service or risk losing business to competitors. It has resulted in a huge, long-tail of merchants who have adopted the service over time and leading to near ubiquitous offering in its target markets and sectors.
The story goes that Afterpay's two founders, Nick Molnar and Anthony Eisen, met fortuitously when Eisen noticed another night owl across the road from his residence working late into the night and introduced himself to Molnar one morning.
Molnar at the time was selling and distributing jewellery from his family business on eBay, whilst Eisen was a seasoned corporate executive. The two got along well with Eisen mentoring and introducing Molnar to a variety of individuals in his business network. By 2015, Molnar had built his business into one of the largest local distributors of jewellery online. Molnar was frustrated by the low conversion rate of website visitors and ruminated on how to increase sales via larger and increasing repeat orders. After rolling out a basic instalment plan option on his website, he noticed that a large improvement in the specific metrics that were key drivers of his business. He noted that breaking down a $100 purchase into four instalments of $25 was perceived as a more attractive proposition for his customers than paying a single lump sum. This was the genesis of the Afterpay system, with the company launched in mid-2015.
The two founders had the perfect blend of skills: Molnar the young entrepreneurial talent coupled with Eisen the experienced and street savvy corporate executive. Joined by a talented supporting team consisting of Craig Baker (technical lead), David Whiteman (product), Fabio De Carvalho (Sales), Barry Odes (COO) and David Hancock (finance), the company was impeccably positioned to support hyper-growth.
Molnar and Eisen fostered an excellent culture within the company founded on humility, agility and focus. We noted uniquely that both founders have been the CEO, with Molnar initially holding the position and being replaced by Eisen once the company reached a certain scale. This demonstrates the good working relationship and lack of ego between the founders, which we consider to be the ideal dynamic. The company have been open to ideas put forth by its customers, merchants and investors; as well as being sensitive to the needs of regulatory changes in a novel industry. The focus the company has demonstrated can be exemplified by the single product status of the company. The temptation to monetise its customer base in the short-term has been overcome by focusing on the key longer-term value drivers.
Given that Afterpay transfers the credit risk from the merchant to itself and bears the subsequent credit risk, prudent risk management is essential for long-term survival.
Afterpay rewards users who comply with the terms and conditions of the offering, by allowing continued use of the service which provides utility to the user. Non-compliant users, such as users who default on payments, are now banned in contrast to the earlier approach of charging late fees to ensure compliance.
This stricter adherence approach has been hugely beneficial to the company for a variety of reasons. By weeding out bad players continually in real-time, Afterpay increases the quality and therefore value of the existing user base. A harsher compliance regime also ensures that bad players bear a real opportunity cost, as being banned means paying for competing services versus Afterpay's free service. This opportunity cost also ensures that the user base is sticky and compliant. Over time this leads to superior outcomes in terms of risk and shareholder value.
The vanilla product offering makes mathematical risk modelling very simple. The system can be viewed as a large number of small transactions on fixed terms, providing alignment with mathematical theorems such as the Law of Large Numbers (LLN), a core element in the insurance industry.
This principle holds that the average of a large number of independent identically distributed random instances tends to fall close to the expected value. The entry of additional instances to a pool tends to reduce the variation of the average loss per instance to around the expected value. Thus, an increase in the number of instances strengthens the pool by reducing the probability that the pool will fail. This is the 'magic' of insurance, increasing predictability and reducing risk via the principle of LLN. Insurers have learned the wisdom of insuring the largest number of similar risks possible, and Afterpay investors appear to have recognised this dynamic at work within its business model.
Understanding that Afterpay was the first mover in a novel industry, now branded 'buy-now-pay-later', was the first building block of our investment thesis. We were familiar with the notion of novelty and how quickly it may spread throughout a society. In this case, we had a novel, technology-driven service that was convenient and without stigma. The multiple angles of utility provided by the service were self-reinforcing and was recognised by the typical early adopters in any society, young adults—branded millennials in our era.
Securing its first-mover advantage involved Afterpay capturing as much of this demographic as possible, as quickly as feasible in a straight out 'land-grab' scenario. Organically as expected, we saw later adopters in the older demographics adopt the use of the service as its use became increasingly more mainstream. Its ubiquity in Australia now is a testament to the formation and execution of the business strategy.
Considering the industry segment and the business model itself, the company's 'moat' is the size of its user base. The ability to continue to grow this user base until maturity is a core part of the bull thesis.
The novelty of the business model and the development of the industry sector has not been without its regulatory challenges. To its credit, Afterpay has made the necessary amendments to remain compliant with regulations as well as making contributions to the development of the regulatory environment. We will discuss these issues in future articles.