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).