Should Investors Buy Now And Pay Later At The Price?

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If 2020 is to be remembered for anything other than the obvious, it’s the Big Bang of the BNPL sector. But is the market over-exuberant?

-BNPL not without risks
-New products provide opportunities
-Differing business models suggest differing outcomes

By Greg Peel

UBS has from the beginning been an outlier when it comes to broker views on the Buy Now, Pay Later (BNPL) sector, and specifically on local market leader Afterpay ((APT)). While UBS acknowledges the potential for BNPL, and more so now in covid-hit 2020, the broker stoically maintains the view that unlike most technology stocks, Afterpay’s is a very capital intensive business.

As the company grows its receivables book, every new customer acquired must be funded, reducing free cash generation.

UBS continues to believe the market is under-appreciating this headwind, and considered itself vindicated when back in July Afterpay raised $800m in new capital. While the broker has been moving its price target up over time, at a current $28.25 that target remains well below the current stock price ($102.79) and well below the average of the other FNArena database brokers.

The average of all six brokers covering the stock is $87.10. Take out UBS and that rises to $98.87 in a range from Macquarie (Hold) on $90.00 and Morgan Stanley (Buy) on $115.00.

Is BNPL new?

This writer has been asked more than once recently what is it about BNPL, specifically given Afterpay has risen from $3.00 to almost $100 in a mere three years. Isn’t it just “lay-buy” by any other name, which has been around for yonks?

Well, it depends what era you’re in. Back in the day, if you wanted to buy, say, a frock but you couldn’t afford it, the retailer could hold on to it while you made the payment in instalments. This was “lay-buy”. But to complicate the matter, in September a (Kiwi) company listed on the ASX called Laybuy Group ((LBY)) which offers exactly the reverse: buy now and pay it off in instalments over six months, ie BNPL.

If anything, today’s BNPL is more akin to the old “hire purchase”, where a product such as this writer’s family’s first colour television could be “rented” immediately but if all the payments were made, would be owned at the end. Or more simply, “pay day lending”, which has been around for some time but typically requires proof of income.

And how is BNPL any different to a credit card? Not a lot, if you pay your card off within the month, but credit cards are high-interest and typically used for larger purchases while BNPL is more attractive to young users for smaller transaction values, and…importantly… in an era in which you can buy a coffee with your phone, technological advancement makes it all so simple compared to hoops one had to jump through, forms filled out and approval sought back in the day.

You can however link your BNPL service to your credit card, but surveys suggests most users link to a debit card, and recently Afterpay signed a deal with Westpac ((WBC)) providing a link to one’s savings account, with the bank holding on to the deposits.

When you want to buy something on a whim, simplicity counts.

Speaking of surveys, UBS recently conducted its second BNPL survey, the first being in 2019.

Who uses BNPL?

The broker found 40% of 1000 respondents had used BNPL, up from 35% in 2019. That seems an extraordinary amount, but UBS points out that the survey was online, and thus represents more “connected” consumers more likely to use such technology. Respondents chose to do so and cannot be considered a representative sample set of the wider population.

Afterpay remains the most popular service.

Reasons cited for using BNPL centred on budgeting, flexibility and convenience, with a minority using it as credit (which presumably implies not paying off in time). 62% of Afterpay users surveyed visit websites directly and pay with Afterpay, 42% use search engines to search and pay with Afterpay, 24% purchased only using Afterpay's app, and 13% made Afterpay purchases via promotions.

It would be logical to assume most BNPL users are young and on low wages, living from paycheque to paycheque, but the survey found BNPL users were most likely to be not just employed, but own shares and investment properties. The users surveyed enjoyed an average income 28% higher than non-users.

The flipside, nevertheless, is most are also carrying debts and have been declined for credit cards.

At the lower end of the scale, 26% of respondents to the survey received JobKeeper this year and 18% JobSeeker, compared to 10%/10% for non-users. For those on JobKeeper, 60% believe they would have defaulted on BNPL if not for the support, and 40% for those on JobSeeker.

BNPL users were 3.5 times more likely to have accessed their super when permitted than non-users, and 40% of those said they used their super to repay BNPL balances.

The Risks

One risk UBS believes the market is overlooking with regard BNPL companies is the rather complex and as yet unresolved (review still ongoing) matter of payment surcharges. Some might recall, back in the day, paying by Amex or Diners and copping a 5% additional surcharge for processing.

Some payment processors have tried to ban merchants from applying any surcharge on customer purchases, thus putting the burden of the processing fee on the merchant in return for allowing customers to pay via their preferred service. The ACCC prohibits “no surcharge”, but also limits allowable surcharges.

In short, a merchant cannot apply a surcharge any greater than the merchant’s processing fee. It becomes confusing however, when it is understood not every payment processing service is included in such a “ban”.

To date BNPL services have not been included, but only because they were not around the last time the rules were set. The RBA is currently reviewing the issue and a draft review is due in early 2021.

UBS's survey found 67% of Afterpay users would no longer be users if they had to pay a 4% surcharge. Only 12% said they would continue to use the service, with 21% unsure.

Afterpay is a 100% BNPL business, exposed to merchant income. Rival Zip Co ((Z1P)) derived only around 40% of income from BNPL in FY20, UBS notes, and is more reliant on consumer income.

UBS sees regulatory risk (surcharges) for the sector as not priced in by the market. The broker also notes the sector has few barriers to entry, as evidenced by PayPal recently moving into the space, and suggests the risk of the likes of Visa, Mastercard and Amex following suit are again not priced into the market.

And then in simple terms, UBS believes the market is pricing in unachievable growth for Afterpay. On the broker’s calculation, the current share price implies some 60 million customers (there were about 10 million in FY20), or a combined 18%/15%/15% of the A&NZ/US/UK adult population, each spending around $3,850/year in Afterpay's current markets (roughly double A&NZ per customer spend in FY20) plus some 24 million customers spending around A$3,600/year in new markets.

So the broker has a Sell rating. The only Sell rating among FNArena database brokers (two Buys, three Holds and the one Sell). UBS sees less growth being priced into Zip, but also has a Sell rating, and is not alone (two Buys, three Sells).

Unlike Afterpay, for which UBS has the one standout contrarian target price, Zip attracts a more diverse range of target prices, from Macquarie’s (Sell) $4.95 to Morgans’ (Buy) $9.77. Such a range nevertheless highlights a wide range of views for this “new” sector.

Afterpay versus Zip

As noted earlier, Afterpay has recently teamed up with Westpac to provide for BNPL payments directly from a savings account. In addition to increasing consumer engagement and stickiness, Citi believes adding a savings account should be positive for Afterpay’s unit economics by lowering processing costs (if the savings account is used to fund Afterpay transactions) and lowering losses (better transaction data/history).

But Zip has also introduced a new product, called Tap & Zip, allowing Zip Pay customers to shop anywhere that accepts Visa. And let’s face it, where doesn’t? The product will also allow Zip Pay users to be added to Google and Apple wallets. Zip will monetise payments via “interchange” revenue on transaction volume processed on its cards (which is its surcharge equivalent).

These new offerings highlight the difference in positioning and revenue models between Afterpay’s and Zip’s A&NZ products, with Afterpay sticking to its non-credit & savings/budgeting positioning, while Tap & Zip allows Zip to compete more effectively with credit cards. Tap & Zip increases Zip’s proportion of revenue generated from the consumer (currently around 65%), Citi notes, and brings to the fore the debate regarding the durability of Afterpay’s merchant funded model versus Zip’s consumer funded model.

Outside of A&NZ, the US represents the larger opportunity for Afterpay’s savings account-linked model, but Citi questions whether the company has the scale. The US offers the bigger opportunity, both in terms of processing cost savings and incremental revenue from debit cards, given higher interchange rates. For instance, the broker notes, US debit card spending represents a US$41 billion revenue opportunity according to US point-of-sale software company Square.

However, Citi suggests, a key question is whether Afterpay has sufficient scale to compete with the likes of Square’s Cash App and Venmo services in the US.

Citi sees Tap & Zip as somewhat of a two-edged sword. The expansion of Zip’s virtual card offering to in-store as positive for volumes and purchase frequency given it can be used at any merchant irrespective of whether the merchant is integrated or not. However, the broker expects revenue growth to lag volume growth.

The revenue yield for Zip of this product will be lower given an interchange revenue yield of 40 basis points for a non-integrated merchant compared to 200 basis points for an integrated merchant. Then there’s the risk of Tap & Zip cannibalising existing in-store transactions.

From a consumer fee perspective, notes Citi, the key question is whether Tap & Zip increases the yield from an existing paying customer due to longer repayment periods, and/or converts current transacting customers who pay off balances without incurring the monthly account keeping fee to paying customers.

Yet, Tap & Zip will lower Zip’s processing costs, Citi points out, including online, for transactions via Visa.

Citi has a Sell rating and $6.55 target on Zip (last trade $6.05) and a Hold rating and $92.50 target on Afterpay. Note that Zip’s share price recently peaked at $8.20 on October 13 while Citi last updated on the company on October 19, so it’s possible an upgrade to at least Hold may soon ensue.

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