If you haven’t heard of Afterpay when you were shopping for that special gift on Valentine’s Day last month, you were probably born before the 1980.
Under the Radar talked about the payments phenomenon back in our article for the ASX in June last year. We highlighted that “Millennials”, or those aged between 25 and 37, crave instant gratification, but without getting into debt, having seen the carnage wrought through the financial crisis.
While the debt part isn’t true, what has been the case is the decline in card usage, and the shift towards online retailing by this key demographic, which represents about six million Australians and is predicted to earn two out of every three dollars in Australia by 2030.
We talked about the emergence of new point-of-sale payment providers: Afterpay Touch (APT) and Zip Co (Z1P). Since then the former has tripled in price, while the latter has climbed a “modest” 80%.
I’ll go through the business models again, but the key for investors is what’s in the price. Afterpay Touch back then had a market cap of about $450m and Zip’s was $157m. Fast forward to today and Afterpay’s equity is worth over $1.5bn on the ASX, while Zip is valued at a more modest $350m.
These are great businesses by definition: low capital usage; big profits. This was on display, to a degree in Afterpay’s Touch’s half year result on 22 February. As my friend, Graeme Carson of the small cap fund manager Cyan said, “the velocity of the growth is evident when you compare the numbers in this result to just 12 months ago.” Among the numbers which impressed were that the retailers or merchants using Afterpay have grown from 2000 to 11,500; and the fees generated from this have climbed from $6m to $37m. All in only 12 months!
In a market starved of “growth” opportunities, for fund managers like Graeme this is manna from heaven.
But how long can it keep going? What are the risks? Are the regulatory authorities such as ASIC taking any notice. These questions are even more important when you’re paying up on what even the Afterpay’s ardent admirers would admit are pretty steep valuations.
Even if we assume that that company can triple FY18 NPAT consensus estimates by FY20, it still trades at a lofty multiple over 25 times. The market is assuming the company will have the same level of success offshore as it has had in Australia. While Afterpay is the market leader in Australia, going into a new market presents major risks: competition and regulatory.
But first, let’s look at what these businesses are.
Afterpay and Zip are “Fintechs” or businesses that leverage technology to disrupt traditional financial services providers. They provide a fast and simple credit approval process by better leveraging data using proprietary decision making technology. The credit approval process is not as extensive or as robust as say a bank would do to approve a credit card. Purchases are typically for small tickets items funded for over short period and given the high degree of repeat business, customers are motivated to not default so as they can use the service again.
They both have their own differentiated business models, but each has grown by providing a buy now and pay later payment service which allows a new generation of consumers to instantly satisfy their appetite to buy the latest fashion simply using their smart phone or tablet, without going through the arduous traditional credit checking process. It is also advantageous for merchants or retailers, as offering these payment options gives them much better access to this growing consumer demographic. These providers have also expanded into other retail categories and in-store presence, which is allowing them to grow their demographic reach.
They’re effectively offering a reverse lay-by service.
Back in the day a person could buy something then pay it off it in instalments over a set period before receiving the good. Afterpay and Zip allow a person to receive the good upon purchase then pay it off later in instalments, typically over 60 days. A key difference between the two is that with Afterpay, purchases are approved on an individual transaction basis while Zip’s zipPay service approves customers to makes any number of purchases up to a $1000.
They make money by charging merchants commission and customers late fees. While the commissions are higher than what merchants pay for credit card transactions merchants see value on expectations of achieving higher turnover by accessing customers who prefer using this payment option. Merchants also have no credit risk as this risk rests with the payment provider.
Incumbents in the interest free lending space such as Flexigroup (FXL) and unlisted Latitude Financial (think the Alec Baldwin ad) have been slow to move, as have the major consumer credit providers: the banks.
Valuing these new credit businesses is especially relevant since it has emerged this week that the privately owned Australian based short-term personal loans company Nimble Money is up for sale by its two founders. This potential sale comes after a capital raising at a materially higher valuation three years ago. It might be that the market for short-term loans has peaked.
Being minor players in global payments provides these new, agile, tech savvy businesses with a huge growth opportunity by expanding in offshore markets however they come with risks and challenges making it difficult to replicate the success in Australia. Afterpay and Zip were early entrants in their home market, Australia. As a new entrant in a new market with existing players they are at a disadvantage. Other online businesses with strong market positions in Australia such as Carsales (CAR) and Seek (SEK) have encountered difficulties expanding internationally.
Technically Afterpay and Zip do not provide credit, as they do not charge interest, so consumer credit laws do not apply to them. There are however growing risks of increasing regulation as the sector has come under the radar of the corporate watchdog, ASIC, which is gathering data to better understand the industry and participants.
There are looming changes to the National Consumer Credit Protection Act for payday loans, known as “Small Amount Credit Contract and Consumer” which will come into effect in April, which limits the repayments of SACC to 10 per cent of a person’s net income; and caps the cost of consumer leases to the base price plus 4 per cent per month for a maximum of 48 months. The effect of these changes has been a key reason Money3 (MNY) is exiting out of payday lending.
Regulatory focus on this industry is reaching new levels of intensity, in terms of responsible lending. Recently Cash Converters (CCV) had an enforceable undertaking from ASIC to refund $10.8m advanced to 55,000 borrowers considered vulnerable.
The end result on new players like Afterpay and Zip Co could see the levels of commissions and late fees regulated along with higher disclosure and compliance requirements. In any case, it is increasingly clear that managing delinquencies and understanding performance of their underlying debtor book will be increasingly important.
A final word
The success of Afterpay is primarily due to a Millennial by the name of Nick Molnar. As a teenager he worked for his parent’s jewellery store. At university, which he attended on a rugby scholarship, he started selling excess stock from the shop’s suppliers online through eBay. He soon became the biggest Australian jewellery retailer on the site, moving about $1.6m of stock. He moved on to create his own site, Ice.com and would often be packing jewellery in the early hours. This caused his then neighbour, the merchant banker Anthony Eisen to ask what he was up to.
Eisen became a co-founder in Molnar’s next venture, Afterpay and the group was last year merged with the Eisen’s payment software provider Touchcorp last year and Afterpay Touch was born.
When Molnar (often) repeats the group’s philosophy is “really, really customer first, which comes from a love of retail,” I think he means it.