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Afterpay – The New Way To Pay (OTCMKTS:AFTPF)

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Via SeekingAlpha.com

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This article will provide a long positional view for Afterpay (OTCPK:AFTPF) due to its exposure to the BNPL (buy now/pay later) payment vertical as the number of millennial’s grow and their spending power grows. The business model is a cross between a lay-by system where customers used to pay in installments and then pick up their goods once payments had been completed and credit cards/short-term loans that allowed consumers to consume now and pay later over time.

Total card usage has been rising in a digitized world, however, in this trend, the growth in debit card usage has far outstripped the growth in credit card usage in Australia. This demonstrates the millennial’s aversion to debt/credit cards or interest-based loans.

AFTPF’s competitive advantage for the consumer is an easy to use payment/budgeting tool that allows immediate consumption. The app is consumer friendly and doesn’t require the company to do background credit checks leading to a faster approval time (approximately 2-5 seconds for an existing user). There are no fees payable by the consumer to use the financing tool and late fees are fixed at $7 per week and a maximum total of $68 in total late fees due. There are no interest based payments.

AFTPF generally offers their platform to a merchant who pay AFTPF a percentage of the products sold through their offering. This ranges from 3-7% of the product value. AFTPF pays the merchant who in turn sells the good/service to AFTPFs customers. Currently, merchants are not allowed to pass on this cost to their customers according to their agreements. AFTPF’s competitive advantage for the merchant is threefold:

  1. Increase in the average order size per customer
  2. Increase in the number of customers/leads to the store/website
  3. Analytics for their products and easy on-boarding

AFTPF’s target market started with females ages between 16-40 and their spending into the online fashion market, however, this has expanded to include all millennial’s discretionary spending. New verticals are still being identified such as healthcare treatments. The current markets they operate in are:

  1. ANZ – Dominant player with first mover advantage. Online sales $27.5bn AUD.
  2. U.S. – New entry with first mover advantage, still scaling. Very large online market $587bn USD.
  3. UK – Second entrant, still scaling. Online market £106bn.
  4. Canada – Will enter in 2020/2021. Online sales $50bn USD.

Source: emarketers.com, ANZ stats from AusPost

Additional markets are available for AFTPF to enter but this will depend on their merchants desire to enter new markets. They also have an offline presence in ANZ to complement their online presence. The offline market opportunity is significantly larger than the online opportunity, however, it is likely to take longer to penetrate and generate lower returns relative to their online only model.

Financially speaking, AFTPF runs a loan book with a tech angle to attract customers. This means the risks for AFTPF are similar to that of a loan book:

  • Loss rates and provisioning
  • Availability of funding
  • Balance sheet leverage

The core financial competitive advantage for AFTPF is their ability to generate higher sales from a fixed loan facility. AFTPF pays a fixed annual interest rate fee for their loan facility which is secured against their receivables and generates income through transactions by customers on which they make a fixed percentage of sales (3-7% paid by the merchants). Their receivables are very short dated (<30 days) but their costs are fixed on an annual basis, this means if they are able to increase the number of transactions on their fixed loan facility, they generate higher income per $ of loan capital they draw thereby increasing their ROIC. This is also supported by the fact that the number of transactions per customer per annum increase the longer a customer is with AFTPF.

Valuation will be a challenge at present as the business is being run on a cash neutral basis. A view will be taken on the profitability of the business when the hyper expansion mode finishes. Key drivers will be NTM and EBITDA margins over the medium term as well as the view on what cash flows and loss rates look like through a cycle.

Variant Perception

The market is currently caught up in the COVID-19 panic and is focusing on the short term loss rates expected to arise from AFTPFs loan book. The bull thesis is that the loan book is a self cleaning mechanism which eliminates weak customers and retains loyal customers who are more likely to stick to their payment obligations. The bear thesis is that the model hasn’t been tested through a cycle, especially one which has come to an end so abruptly.

Target Price

My target price for the stock is $33.5. These are my assumptions:

  • NTM – 2%
  • EBITDA – 5%
  • Able to capture 39% of addressable market in NAM, ANZ & UK
  • 6% loss provisions (in terms of loan book)
  • Average transaction size $175
  • Book turn of 11.4

AFTPF is undervalued due to:

  • The uncertainty about its future loss ratios from COVID-19
  • Drop in discretionary spending by customers, the duration this goes on for and this impact this will have on the growth rate of new customers
  • Shutdown of most shopping malls in the U.S. and ANZ
  • Sudden increase in the unemployment rate
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Growth in the BNPL industry is likely to continue despite the COVID-19 headwinds. AFTPFs business model is predominately (75% rev) online thereby providing a buffer against mall closures and making AFTPF ever more vital for merchants who will be under pressure in this environment.

The table below shows the potential loss rates arising from this event and AFTPF’s ability to whether this on their balance sheet. As most of the revenues are generated from ANZ at present, the increase in the unemployment rate is expected to rise mid to high single digits vs. the U.S. where it is expected to rise potentially in double digits.

Afterpay loss sensitivity test

Source: Internal Modeling

The ability of AFTPF to whether a loss cycle is the key question at the moment. Above is an estimation of loss rates that could arise from their book. The business model effectively stops a customer from using the platform again if they miss a payment, thereby limiting future losses from the customer. The average loan outstanding per customer is also relatively small with limited ability to increase. The above is based on 10.5m active users. Below we examine the balance sheet’s ability to handle this loss as a going concern.

Source: AFTPF HY20 Report

The above note means the warehouse facility only becomes available upon the growth in receivables therefore any additional funding requirements must come from non-warehouse funding lines. The only non-warehouse facility is an AUD 50m Bond that was due on April 22. Funding also matches the duration of the receivables and therefore comes due when repayments are due, in the event the consumer defaults, this must be funded by cash. Cash as of Dec. 31 was $402m.

Source: Internal Modeling

According to their cash levels and an estimated loss of $104m, AFTPF still have plenty of cash to endure more than 12 months of 0 revenue generation. Zero revenue is not the base case, we expect AFTPF to generate some revenue as 75%+ of the business comes from online vs 25% of physical stores. The base case is for revenue to continue to grow but not at the rate of 100% p.a that it was growing at last year.

Future transactions will require a higher level of provisioning and higher loss rates. To mitigate this, AFTPF has moved to collect the first payment upfront vs. two weeks from purchase, which was the previous policy in AU. This should deter some purchasing but the risk remains that distressed individuals will still use this for unaffordable purchases. The large proportion of spending through AFTPF is discretionary so this should act as a natural buffer against unaffordable purchasing in this environment.

The effect of recent events is likely to hit short-term growth rates but is unlikely to dent future growth opportunities.

Risk Price

The risk price I’ve come up with is $5. These are my assumptions:

  • NTM – 1%
  • EBITDA – 30%
  • Able to capture 39% of the addressable market in NAM, ANZ and UK
  • 6% loss provisions (in term of loan book)
  • Average transaction size $175
  • Book turn of 11.4

The valuation is very sensitive to NTMs and EBITDA margins in a stable state. The business case rests on AFTPF being able to contain their loss rates to ensure through the cycle NTMs are above 2%. This valuation assumes a bear case scenario for through the cycle loss rates, lower NTM and EBITDA margins and a negative competitive environment through regulation.

The business model has never been tested through a credit cycle and therefore provides no insight into how the company’s risk mitigation systems perform under stress. The key risk for AFTPF here is that their risk systems are inadequately prepared for defaults across the board. While the receivables books is short (<30 days) and the company claims to have risk insights for each and every transaction, thereby enabling a data based live risk analysis, there remains the issue of most transactions being discretionary in nature on AFTPFs platform.

A second core risk is regulation. Currently, AFTPF doesn’t allow merchants to pass on the merchant fee to their customers according to their contractual agreements. However, should they be mandated to allow the retailers to pass on this charge, it would expose the end customer to a 3-7% increase in the price of their goods, which would result in a drop in the number of transactions per person per annum. This would be a large hit to their ROIC and long-term profitability.

Key Risks to My Investment Thesis

  • Low barriers to entry – allows various copy cat competitors to enter the industry thereby increasing competition and lowering returns.
  • Increased loss rates – inability or unwillingness of customers to meet obligations resulting in defaults which drain cash and limit future growth opportunities.
  • Regulation – hinders AFTPFs ability to be an easy access budgeting tool and requires extensive credit checking upon each transaction thereby limiting ROIC growth.
  • Negative funding environment – AFTPF relies on the ability of their warehousing facilities to fund their receivables books, an inability of theses facilities to operate normally or to be replaced would result in significant transaction losses, customer losses and merchant losses.
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Positive Catalysts

  • Proof of risk mitigation abilities of the platform limiting loss rates and maintaining cash profitability
  • Introduction of new market geographies
  • Introduction of new verticals where AFTPF is usable
  • Driving increased penetration into new verticals
  • Increasing target market away from millennial’s through new verticals
  • Introducing a loyalty program
  • A regulatory determination that BNPL providers don’t need to be regulated
  • Slow-down in competitor roll out across US/UK
  • Reduction in long term loss ratios and provisioning

Insider Buys/Management Ownership

Directors recently bought shares in the sell-off with the lowest at $9. All board members own significant holdings in the company. The CEO and CFO hold 8% of the company each, thereby aligning management and shareholder interests. The CEO/CFO did hold much higher proportions of the company, but sold $50m worth in a June 2019 capital raising to U.S. private equity firms.

Industry Analysis – Michael Porter’s Five Forces Analysis

Porter’s analysis is critical to this investment thesis as it allows us to understand where the value sits and more importantly to identify where the greatest risks are to the BNPL industry. As this is a new and evolving industry, this analysis should help identify key decision points for the industry as it develops.

Threat of New Entrants – High

Barriers to Entry – Low

Supply Side economies of Scale will reduce borrowing costs, provide diversification from regional defaults and encourage brand loyalty (unproven and will be hard to measure).

Demand Side benefits of scale (network effect) will result from an increased number of merchants on the platform which in turn drives increased number of customers which drives merchant additions as a BNPL offering becomes the norm. Merchant’s who don’t offer a BNPL solution miss out on sales to merchants who do thereby driving uptake. As the number of merchants increase, this should drive a higher number of transactions per customer which in turn should increase ROIC.

Customer Switching Costs (Product differentiation) are low to zero as a BNPL offering is free for the customer. The only differentiating factor could be a number of exclusive retailers on the platform which would encourage users to stay with AFTPF. This could also be addressed with a loyalty program.

Capital Requirements are low as borrowing parcels are small. The technology isn’t overly sophisticated and can be easily replicated by moderately resourced competitors, however, the analytical capability to ensure loss ratios remain manageable required a moderate sized book. ANZ is excluded due to first-mover advantage and the established brand awareness.

Government policy is a key advantage BNPL players have, for example in ANZ they have the advantage of not being covered under Responsible Lending Obligations and the National Credit Act. This allows them to lend without having to do a credit check thereby enabling BNPL providers to have a competitive advantage over traditional financiers.

Expected Retaliation on new entrants:

  • Increased cost of customer acquisition
  • Reduced benefit from having AFTPF for the merchant (driver of customers). Can get the same service from other platforms
  • Reduced NTM from merchants to make AFTPF more attractive, not currently observed but possible on market saturation

Overall, new-entrants unlikely to have an impact on current NTM margins due this being a new and growing industry.

Threat of Substitutes – Medium

BNPL is a payment method and so is exposed to payment substitution risk from other payment streams. The exact impact is hard to determine as the method of payments mix is evolving with cash decreasing and electronic forms of payments increasing.

There is no cost for the buyer to switch and utilize alternative forms of payments.

Bargaining Power of Buyers – Low

Buyers are Merchants who individually have very little bargaining power. The competition is against other payment types to see which provides the best net sales growth for the merchant. Current AFTPF growth is driven by the millennial cohort who prefer non-interest-bearing debt.

The second buying cohort is customers who make purchases through the AFTPF platform. Individually they possess no bargaining power, however, there are no switching costs to other forms of payments or other BNPL providers. This can be changed through a loyalty program.

Bargaining Power of Suppliers – Medium

The suppliers to AFTPF are the funding houses who fund the AFTPF receivables book. They have moderate bargaining power, while they are not concentrated, they are critical to AFTPF’s operations. Their power is expected to reduce as the receivables book grows and the funding parties diversify.

Rivalry Among Competitors – Low/Medium

An increasing number of competitors, in a fast-growing industry with 2 large competitors and several smaller players.

Price competition is not evident presently, multiple BNPL options at checkouts could facilitate product discounting for the end customer but unlikely to see merchant price discounting.

Introduction of exclusive BNPL for merchants could change this but present risk of this is low as no single merchant controls a large proportion of the overall market.

Margin of Safety Analysis

Below I outline the factors that could put the company’s existence at risk and thereby damaging the overall investment outlook for the company:

  • Excessive regulation
  • En-mass defaults of customers on their platform from an external shock
  • In-ability to refinance their revolving facilities which are secured against receivables
  • Major risk weighting errors in their internal platform
  • Mass scale backs on discretionary spending
  • Mass merchant defaults
  • Large incumbents deciding to introduce and replicate the AFTPF product offering
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The three key threats and weaknesses to highlight are:

  • Regulation
  • Lager competitors enter the BNPL space
  • Copycat companies take first-mover advantage in other addressable markets

Regulation is a key threat for AFTPF. The two forms it can take are either credit checks for customers or freeing merchants to pass on the merchant fees to their customers. Both of these would increase the time of approval and the cost of a transaction for the customer thereby lowering overall ROIC per customer.

Large competitors pose a threat to AFTPF because they already have exposure to end merchants through either online payment portals or point of purchase in store. Should these competitors decide to enter the BNPL space, it would pose a credible threat to AFTPF due to the low barriers to entry established earlier and their existing relationship of larger players with merchants. Key threats are Mastercard (NYSE:MA), Visa (NYSE:V), and PayPal (NASDAQ:PYPL).

New competitors targeting other addressable markets is a key threat for the business. As AFTPF’s growth needs to be funding by a growing balance sheet, their growth potential is limited by the amount of equity dilution the shareholder are willing face. This opens the door for copy-cat first movers in other addressable markets where AFTPF is not currently focusing on but could at some point target.

Moat

Customers:

The core competitive advantage for AFTPF is that it is free, easy to use and provides an easy budgeting solution for credit card averse cohort. It also offers “interest-free” loans which are extremely important optically for the users. The users don’t see this as debt and so interest is not something they want to see associated with their BNPL provider.

Merchants:

Core competitive advantage is providing increased sales, data analytics, risk management and reduced lay-by monitoring for SMEs. For larger SMEs, it is increased basket size and an additional avenue of leads generation.

Loan book:

Financially the company is attempting to increase their ROIC by increasing the number of transactions per customer p.a thereby earning higher merchants fees and income over a fixed cost base (warehouse facility). So far the number of transactions p.a per customer increase the longer customers are on the platform.

The company culture is focused on analytical expansion with employees going above and beyond what they would do in other companies.

Valuation

As the company is being run on a cash-neutral basis, EBIT is usually 0 or negative. Therefore we will take an assumed maturity EBITDA margin of 40% excluding share-based payments. This has been demonstrated with underlying EBTIDA margins of 73% (2017) and 49% (2018). This is also different from the terminal value EBITDA margins as we assume AFTPF will be investing for future growth up to maturity.

It has a blended forward EBITDA multiple of 70. This is very high and unreliable as we cannot reliably estimate what the mature margin profile looks like for AFTPF.

Traditional ROIC metrics are not useful here as AFTPF doesn’t have hard assets, AFTPF generates returns by taking a facility and generating income through increased turnover from the facility. The cost of the facility is 2.5% for AU & 3.7% p.a in the US. Therefore as a proxy for ROIC, we will calculate EBITDA/Net Receivables. Another key metric to watch will be book turnover, the higher the number of turnover, the higher the ROIC becomes.

2018 2019 2020 2021 2022
17.5% 13.3% 6.8% 8.2% 9.7%

Source: Internal Modeling

The dilution from 2018 is due to expansion into new geographies, the fall in 2020 is due to higher losses from COVID-19 impacts and an estimated recovery from there on in.

The implicit safety margin is moderate to high as the stock is trading at 50% from the highs due to COVID-19 impacts. EBITDA multiples are hard to rely on so we will focus on balance sheet risk for a going concern business and major issues derailing the long term BNPL structural growth story.

As demonstrated earlier, the balance sheet has enough provisioning to handle close to 15% increase in unemployment (a proxy for when people won’t pay their debt) to make a serious cash dent in the business. While this is possible, we see the risk filters in the platform mitigating this from churning for the whole year and limiting possible losses. A cursory EBITDAx for 2022 is 30x on current modeling.

Conclusion

AFTPF is a first mover in the key U.S. market in a new structurally growing payment segment that is increasingly growing in popularity. AFTPF provides the opportunity to gain exposure to this trend at an attractive point in the cycle where perceived risks are high and uncertainty around future growth is high. This is presents an opportunity for the patient long-term investor to accumulate a position around current levels.

To view my checklist before investing, click here and scroll to the end of the article.

Disclosure: I am/we are long AFTPF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.




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