If you buy now, will you pay later?

Under the Radar Report first recommended Afterpay at $2.51 in May 2017 and started taking profits in February 2018 at $7.40, more than trebling subscribers’ money. In hindsight we took profits too early, but when a company isn’t making profits, let alone paying dividends, it’s always prudent to take some risk off the table (how else are you going to cash in?).

Everyone knows that the buy now pay later provider has had a spectacular rise since listing in May 2015 and has exceeded even its biggest supporters’ expectations. At over $27 a share (at the time of writing) the company now known as Afterpay Touch (APT:ASX) has a market cap of $6.9 billion, making it bigger than regional banks Bendigo and Adelaide Bank (BEN:ASX) and Bank of Queensland (BOQ:ASX), which are capitalised at $5.7bn and $3.8bn respectively.

In that same issue in May 2017 we also recommended its smaller competitor Zip Co (Z1P) at 66 cents. And also like Afterpay and at the same time we locked in some profits too early, in this case at $1.18. Zip Co is now trading at over $3, giving it a valuation of over $1 billion.

In both cases they are trading at high levels, which I’ll go into, but also in both cases, if they achieve their aspirational targets (which are outlined below) we have little doubt that their share prices will shoot further towards the stars.

But what is the market pricing in? And how realistic are these aspirations? What happens if they’re not met? For good measure I’m also including another stock in the sector that we cover, the Israel-based ASX listed Splitit (SPT:ASX), which has some interesting variations. To start, let’s look at what’s driving the hype.

All these companies have been able to leverage growth in online retail and the insatiable appetite of millennials wanting instant gratification for material goods. Unlike the old layby plans that our parents used where you paid by instalments and had to wait to get the product, the current iteration means you get the product now and pay off the balance over time.

At the end, we look at how the business models are different, but the key thing for investors at current levels are the risks (I would argue first) and then the potential.

Regulatory risk

Afterpay and Zip Co’s Zip Pay do not come under the National Consumer Credit Protection Act (2009), so they have no obligation to do credit checks on customers. Tougher regulation is a risk but the recommendations in the Senate Committee Report have been well received by the sector with no material adverse impact on their businesses expected.

The first measure has been passed into legislation, which is for minimum regulatory standards of up-front customer due diligence, which gives ASIC more power to take action against the likes of Afterpay and Zip Co. The second regulation is yet to be legislated and is aimed at giving consumers the same level of protection that they have with traditional products such as a credit card.

We believe regulatory risk remains, particularly as the sector grows and gets greater scrutiny from regulators, politicians and the media. This was underlined when, post a $300 million- plus capital raising and days after a $100 million plus share sale by three directors, Afterpay announced it was served a notice by the financial transactions regulatory authority AUSTRAC, requiring an external audit with respect to its compliance in relation to anti-money laundering and counter terrorism finance.

Credit risk

This is arguably a much bigger risk over the long-term. The market has priced in huge growth expectations for Afterpay and Zip Co; companies that essentially provide unsecured credit. Both these operators have not been tested through a full credit cycle.

Australia has had a relatively dreamy economic run, sailing through the GFC and has not had a recession (defined as two consecutive quarters of negative GDP growth) since June 1991. Slowing economic conditions pose risks of higher loss rates and slowing revenue growth.

Competition, capital raisings and insider selling

Competition remains a threat. Afterpay’s growing customer and retailer base is building a network effect between retailers and their customers, much more so than its junior competitors. But new competitors such as Sezzle and Quadpay are putting pressure on margins. Update: And of course, there has been huge noise this week about the payments elephant Visa announcing that it will work with its issuer and merchant clients around the world to pilot instalment payment solutions (another term for BNPL).

There is also the dual risks of further capital raisings, which are almost a certainty, and insider selling. These risks were in full display during Afterpay’s $317 million capital raising at $23 a share in May. At that time the company’s founders and an executive director – Anthony Eisen, Nicholas Molnar and David Hancock – offloaded close to 2% of total shares outstanding to a US investor, realising over $100 million. Molnar and Eisen each retain an 8.1% stake. They first advised that they wouldn’t sell more shares “for at least 120 days” which isn’t long at all and then changed their minds, undertaking not to sell any shares during FY20.

What’s being priced in by the market?

The first table shows the key metrics, which investors look at that will make or bake these companies. As you can see Splitit is well behind, but what is notable are the aggressive “aspirations” Afterpay and Zip Co have made, which we have outlined below. These aspirations are reflected in the table that shows the elevated market valuations that they are trading on. Because Splitit is so far behind on the life cycle it has a huge revenue multiple.

TABLE 1

What is the market expectation?

Afterpay Touch

Management aims to exceed $20bn a year in underlying sales by FY22, known as gross merchant value (GMV), which is almost four times its current run-rate, while slightly diluting its margin on transactions from its current levels of 2.3% to closer to 2%.

Behind this figure the US is the key, where the company is generating $1.7 billion annualised GMV and the country contributes 17% of group sales.

Zip Co

Zip Co’s 3Q update (to 31 March 2019) highlighted its fourth consecutive quarter of positive net cash flow from operations and a cash profit (EBITDA) margin of 1.7% on average receivables (monies lent). When you compare’s Zip Co’s numbers to Afterpay’s they’re not great, but the key is that they’re still growing and the price you’re being asked to pay for Zip Co’s stock is much lower.

Customers grew to 1.2 million and merchants to over 14,000. Revenue for the quarter rose 20% to $$23 million on receivables of $$565 million. Bad debts were 1.75% of average receivables. However, transaction volumes (underlying sales) were 8% lower. The lower transaction number is a big concern because the market has such big expectations. If Zip Co reaches its target of expanding cash EBITDA margin from 1.7% to 7% these expectations may come to fruition, but we find this ambitious.

Splitit

Around 60% of revenues come from merchants based in the US, 30% in the UK. Unlike the other two operators, which target the mass market, Splitit’s product is niche because it requires customers to have a credit card and to make high value purchases. Sales volumes will be more volatile.

Splitit is also burning cash: US$2.5 million in the March quarter; US$1.6 million is expected to be spent in the three months to 30 June. At the end of March it had US$$6.5 million in cash and US$6.8m available in a debt capacity. We expected the company to come back to the market for more, having raised $30 million in late May at $0.80 a share. The SPP participation was extremely low, raising only$0.3 million, well short of the touted $10 million.

What company do we prefer?

APT is our preferred buy now pay later exposure given its more unique product, greater growth potential in the US market and growing competitive advantage from a network effect.

If you assume that customer numbers keep climbing to the point where they more than double over the next two years, it’s easy to get a cash flow discounted based valuation close to $30, but there is so much risk (especially regulatory). We rate this stock a Hold and believe that if you got in early, you should reduce your holdings but keep some exposure to what is clearly a phenomenon (remember: take your costs out and let your profits run).

In terms of portfolio exposure, when high risk positions start really outperforming and gaining a significant weight in your portfolio, this is a good indication that you should be taking profits. Because it’s such a speculative stock (here the speculation relates to price risk) it should always be a relatively small position, suiting investors with a high-risk appetite.

In contrast to APT, Z1P is a domestic play and has such has lower growth prospects; unlike APT it also hasn’t got first mover advantage; and has a less unique product as it’s akin to a credit card, which we explain in more detail below. We have a Take Profits rating at current levels.

SPT is very early in its business lifecycle and has much greater uncertainty. We have a Take Profits rating at current levels.

How the ASX listed BNPL providers are different

Afterpay Touch approves each purchase transaction separately at the point of sale (in store or online). A customer pays for a purchase in four instalments, due every two weeks. The customer is not charged interest but is liable for late fees. The merchant is paid straight in full by Afterpay away less commission (4%-6% commission plus a 30 cents flat fee).

Zip Co’s “zip pay” is similar to a credit card, being a digital wallet where a customer has approval to make purchases up to $1,000 at merchants. Again, no interest is payable, but there are fees: $6 a month if there is a balance on the account; a $5 late fee if the minimum monthly amount is not paid; and a 1.25% processing fee when paying bills using zip pay. Zip Co pays the merchant immediately less a commission (2-4%). Zip Co has another product “zip money”, which has a limit above $1,000 on which interest can be payable.

Splitit is different to Afterpay and Zip Co as they take on credit risk and Spilit does not (although it’s considering this option) so has less financial risk. However like the other two, Splitit’s technology allows customers to utilise their existing credit card/s to buy now and pay later in instalments with no interest or fees payable to Splitit or the merchant. Splitit makes money from transaction fees charged to merchants when customers use its service (our report from Issue 338, 3 April 2019 goes into detail).

A customer pays for the purchase using Splitit by choosing a monthly instalment plan of up to 36 months.  Splitit authorises the full amount of the purchase price and charges the first instalment to the customer’s existing credit card. Splitit then automatically charges the customer’s credit card for each subsequent monthly instalment and issues a new authorisation for the remaining balance after each instalment. The customer’s financial obligation is to their credit card issuer.

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