Australia | Mar 04 2020
Afterpay requires a lot of confidence in its strategy as profitability is sacrificed for rapid expansion in new markets.
-Profitability likely delayed to FY22
-Is the market factoring in all the risks?
-Competition could force higher investment in marketing
By Eva Brocklehurst
Can Afterpay ((APT)) maintain its stellar rate of growth? Most brokers recognise and accept the company's strategy is to grow rapidly and geographically. Operating earnings in the first half were substantially below forecasts because of a material investment in marketing and technology that aims to accelerate growth in existing markets and expand the platform.
Macquarie assesses the business is scaling up well, with active customers up 135% in the first half and merchant numbers up 86%. Given varying levels of maturity, all the company's markets are performing well. The broker also expects marketing expenditure as a potential of total operating expenditure will rise.
Momentum looks set to continue and perhaps even accelerate further. Ultimately, Macquarie suggests, the company will need to convert its early leadership into a sustainable position and establish brand, marketing capability, global reach and cost efficiencies as well as partnerships.
Some of this is occurring already, with a minimal loss rate and a merchant margin of 3.8% that is holding up well. Early customer cohorts in home base Australia are now transacting at 23 times per year while customers in the US and UK are following a similar trajectory at the equivalent point in the cycle. An interesting statistic: the company states 5% of all millennials in the US have used the Afterpay service.
Afterpay delivered to expectations on a sales basis, and the transaction margin was also in line but a material step-up in costs and share-based payments drove a miss at the earnings line for UBS, which now expects profitability will move to FY22. UBS points out the cost base is more variable than the market likely appreciates and a significant and ongoing investment in marketing will be required.
Still, the broker considers the company's aspirational target of 9.5m customers by the end of FY20 is potentially conservative. Afterpay has also confirmed entry into Canada in FY20. Significant partnerships, including a deal with eBay Australia, are expected to come on board in 2020 as well as verticals in travel, health and entertainment.
Morgans believes the exceptional growth should be weighed against the higher investment required but remains of the view that penetration of offshore markets will create substantial upside over time.
Downside?
Was there anything not to like in the results? There was no update from the government financial intelligence agency, AUSTRAC, which is still considering the auditor's report while the company works on implementing recommendations from that report.
UBS suspects this could weigh on investor confidence. There is also ongoing uncertainty around a potential Californian investigation. Paradoxically, the broker points out, the more successful the company is the more likelihood it will attract regulatory scrutiny.
The main risks UBS envisages are whether the company can continue to prohibit merchants from surcharging and whether Afterpay could be considered a provider of credit in the future. All up, the broker believes the market is pricing in excessive growth for Afterpay without factoring in all risks.
Competition is also a threat, as there are low barriers to entry and it is relatively easy to replicate the company's product. Competition from other payment methods also mean the business is vulnerable, although first-mover status in Australasia has potentially created a defensive position in the home market. Specifically, Citi is concerned about PayPal, given its established merchant and consumer base.
Attractive Growth
Bell Potter, not one of the seven stockbrokers monitored daily on the FNArena database, considers the company's strategy in the US and UK is sound, as it leads to a network effect that has already been experienced in Australasia. The broker retains a Buy rating and raises the target to $52.50, envisaging higher customer numbers will outweigh a lower earnings profile.
Citi agrees that while the necessary future operating expenditure may be underestimated, the multiple growth levers in the business model are attractive. The broker forecasts a loss at the EBITDA level of -$2m in the second half and materially lowers margin forecasts. While this may bring into question the sustainability of margins, unit economics are expected to improve, as penetration and usage increases.
Wilsons, also not one of the seven, remains cautious about the competitive landscape and the market's valuation, believing the latter is incorporating significant US market share. The broker has a Market Weight rating and $34.41 target.
Morgan Stanley, on the other hand, finds the stock remains an attractive play on the disruption in global payments. Late fees are falling, revealing the customer experience is improving. The broker is confident pursuing market expansion is the right strategy at this point in the cycle.
The database has five Buy ratings and one Sell (UBS). The consensus target is $37.55, suggesting 6.7% upside to the last share price. Targets range from $18.20 (UBS) to $46.50 (Morgan Stanley).
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