Afterpay: The Not Credit But Actually Retail Tech Company

Afterpay: The Not Credit But Actually Retail Tech Company

This article is opinion. While it relies on public information, it also makes use of judgements and guesswork. Readers should always do their own research and read my full disclaimer at the bottom.

Afterpay: The Not Credit But Actually Retail Tech Company

I like Afterpay. I think their product is great and management have belted it out of the park by removing all of the customer pain points. From the customer’s perspective, it is a revolution compared to previous systems – a point that I think the sceptics often overlook – and the company has deservedly grown at a cracking pace.

(I would also like to give a nod to the Afterpay social media account for handling criticism with aplomb, unlike some others we know…)

I have never had a position either way because I think the business model has weaker economics and I struggled to measure the risks, but I do think that it’s great for consumers, and you would have been crazy to short it so far. However, some recent things that I’ve seen have increased my scepticism considerably.

First is this video – hit play and watch 8 seconds, it’s already cued:

“We’re not a credit company, we’re very much a retail tech company.”

Perhaps this reflects how Afterpay views itself internally, as a retail innovator – a somewhat justified view. I understand that this is a low-significance comment in a puff piece (targeted at retail holders, though!), but if the valuation is anything to go by, Exec Director and ‘Group Head’ Hancock’s views are widely shared by the market.

From the perspective of an investor though, if you think that Afterpay is not involved in credit, you have rocks in your head. As somebody said to me recently:

“It’s essentially a no doc layby lender masquerading as a sexy fintech payments company”

While the product might not technically be a credit product, Afterpay has major credit-type risks and is clearly a credit company.

There is a Credit Suisse trading note (not from CS Research) doing the rounds at the moment opining that Afterpay is a lender that should be governed by responsible lending laws, which would require them to perform credit checks on customers. I suspect this is why Afterpay shares are getting sold off at the moment, and I reckon Credit Suisse probably just got itself crossed off the Afterpay capital raising Christmas card list.

CS also point out that Afterpay has a huge leg up on the competition because it is not required to conduct customer credit checks (David Hancock even states in the video that Afterpay has no direct competitors).

The person from CS – whom I suspect is currently neck deep in APT lawyers – also argues that there is somewhat of a grey zone for Afterpay’s ‘non credit status’, if you imagine that late fees basically = interest payments, given that 29% of revenue in 1H18 came from late fees.

If I understand aright, Afterpay is not required to perform credit checks because it doesn’t lend to the consumer or charge interest, it gives credit to the merchant and the consumer pays back Afterpay. There are no fees to the consumer if they pay on time, but there are fees if the consumer is late. Afterpay’s revenue comes from the merchant via a transaction fee plus around 4% of the merchant’s transaction value. Simply, Afterpay collects around 4% per transaction, but takes the risk that 100% of the transaction doesn’t get repaid.

This looks a lot like a payment platform where Afterpay provides a transaction service and earns a processing fee – which is what Afterpay would like you to believe – except that Afterpay also faces substantial default risk from its customers.

The lack of credit checks may be the basis for the ‘we’re not a credit company’ comment, although Afterpay says in its product documentation that it talks to credit agencies and it even has an Australian Credit License.

Obviously, the whole Afterpay business model is built on this premise. It has been so successful – to the point where Afterpay is now a verb – because it removes all the pain points from the customer experience. This picture is a case in point:

Retail tech, baby!

I think this is a hilarious ad and it captures Afterpay’s raison d’etre wonderfully. Afterpay stressed that this is advertising provided by the retailer, not Afterpay, and it has also been removed by the retailer because it doesn’t fit with Afterpay’s views on responsible spending.

Even if the Afterpay product does not require consumer credit checks, from an investment perspective, I think it is wise to be sceptical of this aspect of the business:

A loss of 0.7% appears low for this type of ‘facility’ (I say ‘facility’ because of course this is not a credit company). As findthemoat points out Afterpay ‘facilitates’ essentially a payment smoothing service. Still, I don’t think this loss ratio accurately reflects the risk that Afterpay is taking.

I’m not an accounting expert but I think it is probably fair to net off the late fees when measuring net transaction losses. However, the above analysis overlooks the percentage of Afterpay customers which are in arrears, and the degree to which rising late fees are masking losses:

	1H18 (‘pay later’ segment)	FY2017	FY2016
Revenue / (bad debts as % of revenue)	$37m (37%)	$22.9m (23%)	$1.38m (NM)
Receivables* / (bad debts as % of receivable)	$177.8m (7.6%)	$92.0m (5.7%)	$7.2m (NM)
Allowance for bad and doubtful debt (‘BDD’)	$13.6m	$5.3m	$0.006m
‘Other income’ (i.e., revenue from late fees)	$10.8m	$6.1m	$0.29m
Percent of revenue earned from late fees	29%	27%	21%

* = the $ of receivables that the debt is secured against. Is less than total receivables due to the Touchcorp business etc.

The percent of revenue earned from late fees appears to be rising and if you look at the bad and doubtful debt expense as a % of revenue it’s not hard to imagine one bad year wiping out more than a year’s worth of revenues and profits.

It’s not clear how many customers pay late fees, but ballpark:

$150 average transaction size.

$6 goes to Afterpay as fees (~4% base fee, which is Afterpay’s ordinary revenue).

One late fee = $10 (6.7%). This is recorded as ‘other income’. If the late fee is unpaid for a further 7 days = $7 fee (4.7%).

According to Afterpay’s 1H18 presentation, 90% of orders come from returning customers and those customers return an average of 8 times per year. The other 10% of orders are presumably from new customers (which are much riskier), but, assuming 100% of customers are returning, 8 visits multiplied by $150 average order size = $1200 underlying merchant sales annually. 4% of that is $48, which is Afterpay’s revenue.

Just roughly, if $48 is revenue and 29% of revenue is late fees = $13.92 in late fees. This works out to I guess around 1-2 late payments per customer per year, which does not sound unreasonable. Reversing this, 8 visits per customer and 1.5 million customers = 12 million transactions per year. $150 average order size x 12 million transactions = $1.8 billion in underlying merchant sales per year.

Afterpay reported underlying merchant sales of $918 million in the first half which is about $1.84 billion per year. My figures are just illustrative, and the Q2 run rate is >$2bn currently, but 1-2 late fees per customer per year appears to be in the right ballpark. I could easily be wrong on those calculations though so feel free to correct me.

Assuming my analysis is correct, while the bad debts and late fees are rising, 1-2 late fees per customer per year does not sound egregious. It does not appear as though Afterpay is repeatedly ‘facilitating’ to people in order to harvest fees from them, for example.

Borrowing short and lending short

On the plus side, short borrowing and lending terms allow Afterpay to tighten its facilitationing very quickly in a downturn or if losses spike. I noted the other day that the company has tightened its lending criteria repeatedly in the past 2 years:

Afterpay’s changed its credit terms for borrowers again. I should have screenshotted these, this is the fifth or sixth evolution in 18 months. $APThttps://t.co/6N7oqGt8ZG

— 10foot dog (@10footinvestor) March 14, 2018

In the event of a recession, Afterpay can tighten its lending criteria substantially virtually overnight and, while that won’t prevent it from taking losses, it will mitigate a lot of the risk. The NAB facility is secured against Afterpay’s receivables, but the debt itself could still be recourse to Afterpay, I could not determine that either way. Seaforth Ben has done some work on Afterpay through the credit cycle, which is very relevant here.

So is Afterpay a long? A short?

I wouldn’t bet against the product long term. I’m not sure if the business will ever have spectacular economics, but I recently described Afterpay to a friend as potentially becoming the ‘Netflix of credit’ or the ‘credit utility’ and I am guessing that that is where the company ends up – ubiquitous.

I don’t think you can make a strong case that Afterpay is a zero. Perhaps in the future once it gets more debt on its balance sheet, and if it gets hit by tail risks, but not in the foreseeable future.

It does however look as though both bad debts and the reliance on late fees are clearly rising, which is typically a signal of lower credit quality or more stressed borrowers. That said, and assuming I’m correct, 1-2 late fees per customer per year is not outrageous, and if it were ‘a feature rather than a bug’ of the model so to speak it generates a significantly higher return for Afterpay. There are definitely regulatory risks here though, and based on my regulatory research for on Thorn Group (I formerly owned shares) I would rate the likelihood of regulatory intervention in this sector a) higher than average and b) more likely to have a meaningful impact on revenues if it does occur.

Elsewhere I think Afterpay is currently being valued on multiples of revenue or revenue growth, which maybe problematic if it later becomes valued based on profits and the profits don’t meet expectations (I suspect they might not; future growth and availability of capital are important). I think the valuation is pretty optimistic for a business that needs a significant amount of capital.

I am leaning towards the short side at the moment and I think it might be possible to short Afterpay sometime in the next 18 months, especially if losses keep increasing, the valuation multiple starts to look shaky, or it has to raise capital. That’s a bit of a stretch, it certainly doesn’t look like a slam dunk short idea, but it’s something I’ll keep an eye on and will let you know if I figure it out.

I love the product, hate the economics of the business, and I’m pretty sceptical of the stock, but ultimately I can’t prove it has a very bright future or a very dark one. This is one I’ll be watching from the cheap seats for now.

I have no direct financial interest in any company mentioned. I own shares in a technology fund which may own shares in Afterpay but does not typically disclose its positions, so I am not sure if I have a relevant interest. This is a disclosure and not a recommendation. 

I have no relationship whatsoever with Afterpay, Group Head David Hancock, or with the people/organisations who facilitated the video.