Investment Matters

No. It's not laybuy.

Let’s look at the remarkable share price graph of Afterpay Touch Group, ASX code: APT (Afterpay), since its IPO on 29-Jun last year (the date of the IPO of the combined Afterpay and Touch merged companies).

 

Source: IRESS, First Samuel

Last week (see What Matters) the company announced an earnings upgrade.  Subsequently, and as can be seen above, the share price has rallied further to be up a total of 28.1% since the upgrade announcement (as at Close of Trading (COT) yesterday).

As at COT yesterday, the company has a market capitalisation of $3.1 billion, and FY-18 expected earnings (EBITDA) between $33m and $34m.  Yes, you are correct, that plainly doesn’t make sense. 

And this earnings number excludes interest on debt, one-off expenses and share-based expenses (the latter two could be the subject of their own rant by your Investment Team, but not today). So the true FY-18 Profit Before Tax (PBT) looks like being between $4.2m and $5.2m (assuming depreciation/amortization and one-offs for H2 are equal to those of H1, which is a conservative assumption).

So this week we look a bit deeper.

The majority of Afterpay’s business is its Pay Later offering. 

How Afterpay Pay Later works – Purchasers

It allows a purchaser to impulse buy almost anything (most medium to large retailers offer Afterpay now) – a t-shirt or whatever – and make 4 payments over the subsequent 8 weeks (which can be from your credit card…).  In other words, Enjoy Now Pay Later (the catchcry of Afterpay) = get now, worry about the consequences later.

How Afterpay Pay Later works – Retailers

Retailers incur huge fees compared to a customer paying via EFTPOS, Visa, Mastercard, and it seems more than double even AMEX.  Merchant fees are reportedly 30 cents plus 4% to 6% of the transaction value (higher for low volume and low dollar value sales).  Wow!  Visa and Mastercard are mostly up to 1%, and considerably lower for high transaction volume / transaction value businesses.

But Afterpay allows retailers to attract the more marginal customer or to entice a customer to buy more.  There is reportedly a meaningful benefit to retailers in metrics such as basket size, the likelihood of proceeding with a purchase, and repeat purchases. 

There doesn’t seem to be a discretionary retailer who isn’t offering Afterpay – or at least one of its competitors.  It has ~16,500 retailers signed up as at 30-Jun-18.  Bottom line is retailers will do almost anything (legally) to increase their sales figures.  And their competitors are offering Afterpay, so they deem they have to too.

How Afterpay makes money

Approximately 62% of Afterpay’s total revenue comes from merchant fees (as detailed above).  (Note: In FY-17 79% of Pay Later’s revenue was merchant fees.  Afterpay also has a Pay Now business, a payment platform that is understood to currently not make a profit.  It generated $12.9m of the $60.7m in revenue the company expects to deliver for FY-18.)

Approximately 17% of Afterpay’s total revenue came from late fees charged to customers for not making repayments on time.  From 30-Jun-18 (i.e. not impacting FY-18) fees have been capped at $10 for a purchase under $40, and the lesser of 25% of the transaction value and $68 for purchases over $40.

Competition

Competition is ramping up in the sector.  The main one is probably zipPay.  Its model is slightly different in that is offers a 55-day pay as you choose-term.  Given the available returns, competition is expected to increase - although Afterpay does have first mover advantage.

Regulation

So by now you are probably wondering how Afterpay can basically lend to anyone it chooses irrespective of their credit risk, their income, and how much other debt they have (as long as they 18 years or older).  Well guess what?  Afterpay et al get out of responsible lending obligations (that the banks seem to ignore quite readily anyway) through a loophole in the National Credit Act legislation – provision of credit for less than 62 days is exempt.

So for Afterpay, there is no assessment of capacity to pay, no credit check, no consideration of other debt the purchaser has, etc.  And no, having “sufficient funds on your card (generally we look to see 25% of the order value available to spend)”, i.e. can Afterpay debit the upcoming repayment successfully, is not an assessment of credit worthiness.

And if you make one purchase with Afterpay, you get an Afterpay account. That makes it very convenient for the next but technically separate purchase / credit provision, say 30 days after the first.  Another purchase 20 days after that, and bingo, Afterpay is providing credit on an ongoing basis. Yet is exempt from credit regulations, regulatory oversight and responsible lending obligations.

Regulatory changes?

New regulation has been mooted – a small detail that may have been missed by purchasers of Afterpay’s shares.  Under the proposed legislation, ASIC could stop or require change to products even if they are not encompassed under the existing legislation.

[But then again, the Financial Services Royal Commission has proved what a damp squib ASIC has been when using its powers.  So maybe Afterpay shouldn’t be that worried after all …]

Valuation

Let’s consider Afterpay in the context of being a growth stock (it clearly isn’t a value-oriented investment).  A reasonable metric would be terminal EV/EBITDA of around 10x.  That would mean Afterpay would need to grow EBITDA to $306.4m (EV = market cap as at COT yesterday + net debt as at 31-Dec-17).

Afterpay's Pay Later offering is seen as the principal driver of the company's future earnings growth (it is understood that the Pay Now offering is not yet profitable, and will also be at a meaningfully lower margin than the Pay Later offering). 

So, simplistically, the required EBITDA represents $19.9 billion of underlying sales over a year, assuming the same ratio of EBITDA to underlying sales as for the FY-18 forecast earnings i.e. their fee structure doesn’t come under pressure.  Yes, they are expanding to the US and should be able to grow earnings from there.  But to put some context around the growth required, total retail sales for clothing, footwear and personal accessories in Australia was $24.5 billion for the year to 31-May-18 (source: ABS 8501.0 Retail Trade, series ID A3348609W).  It needs to be mightily successful in the US…

Investment bottom line

It might be sexy.  But it is stupidly expensive.

The earnings growth expectation built into Afterpay’s share price is extraordinary.  And it has a business model that is likely to come under outside pressure – whether it be from competition and/or consumers reining in their behaviour (i.e. change in consumer / debt culture) and/or regulation.

So Afterpay is not for us.  Thanks, but we’ll stick to boring businesses with favourable valuations – a strategy that we believe (and has historically delivered) a better outcome for your wealth over time.