Often we come across growth investment opportunities where (1) current valuation does not make sense under any traditional valuation frameworks, yet; (2) the company is clearly gaining traction in the real world and will “get to the valuation” just by continuing on its hyper-growth trajectory.
How does one assess such an investment?
In Zero to One, Peter Thiel suggests that:
Great companies can be built on open but unsuspected secrets about how the world works.
Afterpay is a young company that is currently being built around an unsuspected secret.
Afterpay’s value proposition
There is no question that Afterpay has “hit the spot” with its customer value proposition and as a result is gaining significant traction in the real world:
Essentially, Afterpay provides a payment option for customers of online retailers to spread the cost of their purchase over 4 equal fortnightly payments (i.e. 56 days) at no additional costs to them. The social media commentary below illustrates the consumer psychology driving the uplift in sales:
Here, Afterpay has enabled a customer who previously did not have the financial capacity to make this discretionary purchase to do so. In other words, Afterpay has stimulated incremental consumer demand via the provision of credit to a demographic where credit was previously unavailable to them.
Online retailers pay Afterpay a merchant fee for each transaction (c. 4.2%, versus 1.5%-2.5% merchant fees typically paid to credit card processors). In return, retailers can expect a highly quantifiable uplift in sales:
So evidently incremental value is being injected into the system to the benefit of both retailers and customers. Now, value doesn’t just appear out of thin air and in this instance it is created by leveraging an unsuspected secret about how the world works – i.e. that conventional wisdom over-estimates the credit risks of Afterpay’s consumer demographic (especially after the introduction of some technology and clever process tweaks).
Afterpay’s transaction economics
Set out below is a break-down of Afterpay’s underlying unit economics. I have attempted to map this out against actual FY2017 1H numbers:
This seemingly insignificant c.2.5% transaction margin then gets multiplied approximately 12 times due to Afterpay’s short lending cycles, and voila we end up with an implied net ROCE that is greater than 30%!
So let’s look at the metrics above in turn.
We know that its transaction processing costs are very low because of its favoured treatment by significant shareholder / merger partner Touchcorp (in fact I query whether 0.8% effectively represents a subsidy – given Touchcorp in turn has to pay a transaction fee to its payment providers – e.g. Visa / Mastercard).
We also know that its transaction funding costs are negligible at this point in time given Afterpay has utilised equity funding exclusively to-date (and if the implied net ROCE is being achieved, raising debt should not be an issue).
So then the key metric that remain is Net Transaction Losses ratio. This is arguably the single most important metric in assessing the viability of Afterpay’s business model as it either validates or invalidates its unsuspected secret.
Net Transaction Losses Ratio
We start off by reviewing Afterpay’s definition of Net Transaction Loss ratio from its Prospectus in March 2016:
This definition was changed a few months later in Afterpay’s FY2016 reporting where the denominator has expanded from simply “gross payments due” to now including both “gross payments due” and “gross payments not yet due” (i.e “Underlying sales”):
The steep reduction in its Net Transaction Loss ratio therefore appears to be, at least in part, attributable to this change in definition (as per footnote below):
Perhaps the company felt that this new definition better reflects its transaction loss economics. The takeout here is that Afterpay is operating a business model with no precedents and a very limited history. So there are necessarily lots of moving pieces.
The graph below shows how the Net Transaction Loss was calculated for the FY2017 1H period:
Note in particular that c.$1m of Late Fees was offset against Bad Debt Expenses to effectively halve the Net Transaction Loss. However, it is unclear as to whether or not these are fees that have been received by Afterpay or are simply being accrued as the account goes into arrears (Afterpay’s revenue recognition policy states that late fees are recognised upon charge to customer at certain time points where late fee become applicable and are expected to be recovered.).
The question is ultimately what this Net Transaction Losses ratio looks like once Afterpay’s hyper-growth moderates. We can see below that the bulk of Afterpay’s $144.8m in underlying sales during 1H FY2017 would have been made towards the end of the accounting period due to its very steep growth trajectory:
Correspondingly, Afterpay’s trade receivables (i.e. loans outstanding) increased 5-folds from $7.2m at the end of FY2016 to $38.8m six months later. Its Net Transaction Loss calculation is thus highly dependent upon provisioning:
All of this is not to doubt Afterpay’s transaction economics but simply to highlight that, operating in a fluid hyper-growth environment, we need to recognise that there are subjective elements to calculating this very important metric (with the possibility of this subjectivity going either way).
Ultimately, investing in a start-up that is attempting to execute a brand new business model necessitates that you are comfortable investing in uncertainty – and with this risk comes tremendous potential rewards (and our economy can only advance when there are people willing to make such a trade-off).
The investment thesis in such scenarios can usually be distilled down to a singular question that needs to be answered. We can therefore make our lives easier by placing our focus on (1) identifying the metrics that answers this question; (2) dissecting and understanding them thoroughly; and then (3) continuing to monitor diligently for any material movements.
Note: The above article constitutes the author’s personal views only and is for entertainment purposes only. It is not to be construed as financial advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this article. Disclosure – I hold no positions in AFY at the time of publishing this article (This is a disclosure and NOT A RECOMMENDATION).
I don’t quite understand their model, even after this excellent write up.
I possibly smell something fishy. Subtle changes in narrative remind me of Enron.
It goes in the too hard basket for me.
Thanks for posting
Thanks Christian, it is also in the “too hard” basket for me!
This is the easiest credit available to certain consumer segments, but it can’t actually grow absolute demand, can it?
Sure it can bring forward consumption (like the “Lindy” example above), but you do that a few times and these fortnightly repayments add up and the consumer is back to living paycheque-to-paycheque.
The retailer definitely benefits as they can gain share from competitions who don’t offer Afterpay. Eventually though, as more merchants offer Afterpay or similar payment services, and as Afterpay’s customer growth plateaus, the incremental impact on the merchant’s sales growth will become mute. Will the merchant continue to happily cede a hefty 4.2% to Afterpay?
I can see the growth but I can also see what it might become at the end of the growth path. My simple take however doesn’t include competition (ZipMoney being another listed name, but there’d be international players as well) or markets beyond Australia.
Yes I think you bring up a good point – in my view AFY should be viewed more as a low-doc consumer lending company (that is enabled by technology) rather than a sexy “fintech” company. I think incremental demand is being generated via the provision of incremental credit into the system, but the key to its sustainability is whether or not the likes of “Lindy” can afford to pay back this credit ultimately. We do not yet have an answer to that question – it will show up in the Net Transaction Loss ratio at some stage.
Note also that for first time customers, AFY requires an upfront payment of the first instalment. So with so many first time customers coming on-board currently, this would have been quite favourable to AFY’s reported transaction economics.
And yes, AFY’s transaction economics (e.g. merchant fee percentage) will definitely be impacted by the likes of ZipMoney who has raised a whole bunch of money and competing aggressively.
The red flag, or should I say red flashing siren is the Net Transaction Loss chart. Why would you put two non comparable metrics next to each other, if not to “pretend” they are comparable.
Interesting article and very much my line of thinking.
I think there is one massive thing that is being missed by almost all onlookers/investors in this space.
The latent demand is actually an issue of cashflow.
There is a large segment of consumers that rely on paychecks to get by.
All current financing products for short-term financing / mezzanine financing or whatever you want to call it are very expensive. Unsurprisingly, the increase in sales achieved my merchants approximates to the annual cost of short-term financing. What afterpay is allowing is for this specific consumer segment to amortise larger purchases to smooth cashflows. That is all they are doing.
The knock-on effect however is huge- it genuinely increases cash in hand to people who don’t over-extend themselves on this new platform by 20% and by not having an interest component, actually allow their users to pay off their debts. There will be a segment of the market that will never pay and will be not credit worthy in the long run, but that is probably not most people. With spending velocity limits, short payback and low overall average order volume, as long as the algorithms are correct (and they will have internal data), there is no reason why the model should not work.
There is a reason that the overall retail spend is increasing 15-20% in retailers that take up Afterpay- this is the equivalent additional cost put into the system by short-term financing providers.
The winners are AfterPay, consumers and retailers….the losers are the short-term financing companies.
Had a meeting recently with a guy that runs a large online personal loan company and he brought up afterpay.
He is starting to see lots of examples of clients applying for loans with his company that already have payments to afterpay out of proportion to their income – he gave examples of people with $700 / week in income and $600 payments to afterpay
Afterpay are exempt from NCCP (National Consumer Credit Protection Act) because of the “point of sale” exemption, i.e. they can offer credit at point of sale without doing any analysis of the customers ability to repay. Companies like harvey norman rely heavily on the point of sale exemption to offer their “interest free loans” All afterpay do is check that the person has a credit card.
If this turns out to be happening on a large scale it presents two potential issues: 1) increasing credit losses 2) regulatory oversight from ASIC who have had their eyes on the point of sale exemption for some time.
It is always easy to build a loan book quickly by being lax in your credit policies.
Thank you for these very helpful insights James. I think you’ve hit the nail on the head – anyone can grow a loan book quickly by giving away free credit to whoever wants it. Ultimately though it’s always about whether you’re getting compensated sufficiently with respect to the risk you’ve taken on.
thanks james for that insight & thanks FindTheMoat for that alert. I’ll join all of you and put that in the too hard basket as well. This is certainly a site i look to for reference all the time.
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Here is another question – how does AFY price risk?
I.e. you would think that riskier customers pay more interest? But who pays AFY? And how does the pricing change?
Try to set up an account with Afterpay and you will find that they ask you practically nothing.
I find it difficult to understand AFY’s claim that there’s some magical smarts in the back end to assess credit risk. May be they are just piggybacking the credit card’s company due diligence.
If you don’t have the data input to begin with, no amount of sophisticated big data analytics will churn out meaningful or useful outputs.
Afterpay manages the risk three fold. They limit how much theyll lend you until they build up a view of your behaviour and they monitor and act quickly on any deterioration i.e by stopping further account activity.
Further, the incentives to encourage repayment are high as late fees stack up quickly.
The highest risk to afterpay is not credit but rather regulatory. If folded into nccp, ASIC will force afterpay to perform reasonable inquiry into the customer and also to change the hefty late fee structure. Both will have a significant impact on afterpays model.
Afterpay is also exempt to some degree from regulation to encourage competition (the sandbox) but at some point its size and success will draw govt attention.