Morningstar has begun analyst coverage of Aussie buy-now, pay-later juggernaut Afterpay, describing it as overvalued and carrying a high-uncertainty rating despite its runaway success among millennials and its push into US and UK markets.

Morningstar analyst Chanaka Gunasekera has set a fair value estimate of $22 for Afterpay Touch Group (ASX: APT), which makes it a two-star stock.

High operating leverage, business risks and competition are among the reasons Gunasekera assigns the company a no-moat, high-uncertainty rating.

Afterpay merged with Touchcorp - which designed and built Afterpay's platform software - in June 2017 to create Afterpay Touch Group. It debuted on the ASX at $2.95 and at 3pm on Monday was trading at $31.38 – a rise of 963 per cent.

Afterpay has since expanded its operations to the US, UK and New Zealand. Its model works by charging retailers to offer customers interest-free instalment plans by splitting a purchase amount over four fortnightly instalments, available both online and in-store.

The service is free to customers who pay on time, with no interest and no contracts.

The model is straightforward. For example, you spot a $100 pair of shoes you want immediately but you can’t foot the bill. Afterpay steps in and pays the shoe shop $96 ($100 for the shoes minus a $4 fee).

It then recoups the money from the customer in four payments of $25 over a period of up to eight weeks. A missed payment incurs a $10 late fee, with a further $7 late fee added seven days after the payment is due if the payment is still unpaid.

The company primarily generates revenue from receiving a margin from the merchant. Afterpay pays the merchant the full purchase price immediately on the sale, minus this margin.

“The margin compensates Afterpay for accepting all non-payment risk, including credit risk and fraud by the consumer,” says Gunasekera, “and for encouraging consumers to buy greater dollar values and transact more frequently.”

Buy now, grow now

First, the upbeat outlook. Afterpay processed $2.2 billion of financed sales in fiscal 2018, which rose to $5.2 billion in fiscal in 2019.

Gunasekera forecasts this to rise to $20.5 billion by the end of fiscal 2022, which is consistent with management’s reaffirmed guidance of $20 billion-plus.

He says the growth should primarily be fuelled by its global expansion into the US and the UK. For instance, it has only been in the US for about 14 months, yet it has achieved $927.5 million in financed sales – a much faster growth rate than it achieved in Australia.

Its UK expansion is going even faster. After just 15 weeks of trading, its UK brand Clearpay has more than 200,000 customers – a faster growth rate than the US.

“Australia, the US and the UK represent a $6 trillion total opportunity and a $780 billion online opportunity,” Gunasekera says.

In Australia, Afterpay says it has more than 3.5 million customers – 1 in four millennials use it – and more than 25,000 merchants.

It is also a highly trusted source, according to surveys. A 2018 Roy Morgan Research survey found Afterpay had the highest net trust score of all major payments products used in Australia.

It scored an NTS of 61.1, outpacing payment giant PayPal (48.3), while the second-highest NTS in the BNPL category was fellow start-up digital provider ZipPay (37.5).

The combined boost in users and trust is helping Afterpay establish a network effect. The rapid increase in transactions allows the company to collect more data, which in turn helps it improve its user friendliness and relevance, Gunasekera says.

New features include “variable payment upfront”, which allows customers to pay a higher initial instalment, and “persistent logins”, whereby the customer can stay logged into the system for longer cross-border transactions.

High leverage, business risk and competition

Despite its expansion and the network effect of its customers and merchants, Afterpay is too early in its lifecycle to warrant an economic moat, says Gunasekera.  

Key challenges include low margins, more direct competition and regulatory scrutiny.

“Our modelling suggests only small changes to key drivers like financed sales growth, margins earned from merchants, receivable impairments and late fee revenue are needed to materially impact its return on invested capital and intrinsic value.

“This high operating leverage and the business risks it faces at the early stages of its life makes future sustainable earnings highly unpredictable."

Rivals loom

It also faces more direct competition, which may make it harder to grow financed sales at the same rapid rate and put pressure on the margins received from merchants.

Afterpay has grown largely without competitors, but others are catching on. FlexiGroup (ASX: FLG), for instance, recently combined its Certegy and Oxipay products into a new product humm.

“It is a more flexible BNPL product that services transactions from $1 to $30,000 and provides more payment options than Afterpay,” says Gunasekera.

“And FlexiGroup is introducing another BNPL product called Bundll. It will allow consumers to transact for free if they pay within two weeks and delay for two to potentially 12 weeks for a fee.” 

And then there are the international rivals such as Swedish provider Klarna, which has secured an exclusive partnership in Australia with the Commonwealth Bank (CBA: ASX).

“There is the potential for competition from a range of other disparate providers, including from new online and digital finance companies, more established payment providers like PayPal, non-bank financial institutions and banks.”

Afterpay has announced a tie-up with credit card giant Visa in the US, but details are yet to be revealed.  

Watchdog concerns

Another challenge is regulatory scrutiny, which Gunasekera expects to persist.

Afterpay is under investigation by Australian regulator Australian Transaction Reports and Analysis Centre, or AUSTRAC.

“AUSTRAC ordered Afterpay to appoint an external auditor to examine its compliance with Australia’s anti-money laundering and counter-terrorism financing legislation. 

“A key risk is if regulators order Afterpay to change its procedures, including enhancing security, to make transacting less user friendly and frictionless, resulting in lower growth and more costs.”