Afterpay and Zip are 'too hot to hold': Morningstar

Buy now, pay later (BNPL) firms Afterpay and Zip both announced strong third quarter growth figures this month but are still "too hot to hold" says Morningstar equity analyst Shaun Ler.

Both stocks screen as significantly overvalued despite a considerable lift in Afterpay's fair value to $75 last month, and a modest lift in Zip's to $5.80 following the result.

Afterpay (ASX: APT) was last trading at a 55 per cent premium to fair value at $115. Zip Co's (ASX: Z1P) last close price ($8.02) represents a 38 per cent premium to the fair value.

On Zip, Ler believes investors are overestimating the company's long-term growth potential.

"Our valuation implies Zip will capture less share of total BNPL sales in North America (4 per cent), UK (3 per cent), and Australia and New Zealand (16 per cent), relative to Afterpay (21 per cent, 14 per cent and 58 per cent, respectively) by fiscal 2030," he says.

"Management is shrewdly on the right track of growth, but there are limits to the efficacy of its strategy."

Ler thinks Afterpay will continue to build a strong business by adding new customers and merchants at a rapid rate and increasing engagement – all things which are crucial to building a network-effect-based moat. But he says risks surrounding regulation, credit quality and competition are challenging the company valuation.

"To apply a moat, we would ideally need to see less-prescriptive regulation in overseas markets, such as its key growth region in the US; as well as competitive inertia among major incumbents even as APT continues to grow," he says.

Source: Morningstar

Zip: US business a standout but uneven growth

Digging into the result, Zip's top line growth figures were exceptional. Quarterly revenue jumped 80 per cent on the prior corresponding prior to $114.4 million. Quarterly transition numbers and volumes were also up 114 per cent and 195 per cent respectively. Global customers rose 88 per cent to 6.4 million. Ler says he expects Zip's growth to continue, especially in the US where Zip US's (Quadpay) revenue margins (7.1 per cent) are almost double Afterpay (3.9 per cent). However, he says growth is lumpy across the business.

In Australia and New Zealand, Zip has pursued a 'Pay Anywhere' model which allows its Zip Pay customers to shop at retailers that don't directly offer their service. This stands in direct contrast to Afterpay's model of partnering with selected retailers.

Ler says Zip's 'Pay Anywhere' is proving costly to adopt as revenue margins fall and arrears grow locally. Flaws in the model include the need for increased promotions, and growing credit exposure which requires levying additional fees. This, Ler says, exposes Zip to market share erosion from major player PayPal and CBA, and other BNPL products which are focused on portability and lower order value items.

"A Pay Anywhere operator like Zip can be caught between a rock and a hard place," Ler says.

"The lack of merchant partnership revenue and higher credit exposure - given the lack of control on shopping channel - means it needs to recoup these 'forgone profits' via levying fees elsewhere - such as account fees in Australia and New Zealand and convenience fees in the US.

"Consequently, Zip's BNPL products are overall more expensive, which could increase consumer friction and limit repeat usage."

Product comparison

Source: Company report, company announcements, websites

Ler says Zip needs to do three things to catch up to its biggest competitor:

Lower its fees
Provide discounts; and/or
Or increase its marketing spend - but more business means more credit risk.

"The rising arrears in ANZ (1.20 per cent versus 0.91 per cent in the first quarter) is evidence to this, and we expect bad debts to average 6 per cent of receivables - above fiscal 2020 - over the next three years in the region," he says.

"We also forecast Zip to spend more than 100 per cent of gross profits to drive growth (such as marketing) over the next two years, as incumbents bring their cheaper and equally-portable BNPL solutions to market."

Positives from the result include rising transaction margins for Quadpay "well in excess of 2 per cent" and quicker-than-expected reduction in funding costs in Australia and New Zealand.

Ler lifted Zip's fair value after incorporating this month's earnings announcement, time value of money, lower-than-expected funding costs in Australia and New Zealand, and higher long-term net transaction margins for Quadpay.

KEY HIGHLIGHTS (Q3 FY21)

Quarterly revenue $114.4m – up 80pc YoY
Quarterly transaction volume $1.6b – up 114pc YoY
Quarterly transaction numbers 12.4m – up 195pc YoY
Customers 6.4m – up 88pc YoY

One-size-fits-all regulation difficult

Afterpay's US business is also growing quickly. US-financed sales in March 2021 exceeded $1 billion, helping March quarter sales surpass the seasonally strong December quarter on a US dollar basis. Locally, underlying sales were up 48 per cent to $2.1 billion on the prior corresponding period.

Competition is rising from both BNPL players and the likes of PayPal and CBA. Last month, CBA unveiled its own BNPL. The product is available to CBA customers, available anywhere, with no additional costs to the businesses. Ler is unfazed by this announcement, noting Afterpay's sticky customer base.

Afterpay is also moving into CBA's territory, offering savings accounts to its users via Westpac later this year and a contactless virtual card.

"Afterpay has a network of loyal users whose repeat usage will be a strong force for earnings growth, likely helping it deliver a maiden profit in fiscal 2022," he says.

"These users are likely to be difficult to win over, with the growth in spend frequency, despite the proliferation of competition, a testament to this.

"The firm's evolution from a credit provider to a marketer and the next step to bank account provider, from second-half 2021, sets it apart from other plain-vanilla BNPL, including those from PayPal and CBA."

In the face of rising competition, Ler believes Afterpay can:

continue to add its share of new users
retain most of its users; and
increase engagement and transactions

"User growth and increasing engagement are key profit drivers," Ler says.

"The top 10 per cent of customers now spend 33 times per year, from 31 times in December 2020.

"ANZ is leading the charge (62 times) with other regions (US 23 times, UK 29 times) following a similarly impressive trajectory."

Ler believes Afterpay's initiatives to grow engagement on both sides of the user network - consumers and merchants - is likely to result in higher-quality growth relative to BNPL providers focused on just the consumer side of the network. This, he says, will support Afterpay's premium margins relative to most BNPL players.

"For example, financed sales per customer/merchant ($903 and $362,069 respectively) and repeat usage (around six times) over the year to March 2021 in the US are superior to "Pay Anywhere" operators like Quadpay (around $524 and $153,115 respectively)," he says.

Ler believes the risk of prescriptive regulation is low owing to Afterpay's fast repayments, low credit losses and small outstanding balances. He also believes the variety of BNPL models is making one-size-fits-all regulation difficult. However, risks remains.

"The case for more scrutiny increases as Afterpay grows in size, presenting uncertainty," he says.

"The potential for regulatory action, while we think it is unlikely for the foreseeable future, represents a risk and a contributing factor to our no moat rating."

Ler doesn't see regulation as a likely significant barrier to user growth. In a downside case, he says Afterpay could be required to perform credit checks, which could mildly slow uptake.

"However, BNPL firms (like Zip) are already able to swiftly complete credit checks at application, so we expect any impact to be modest," he says.

APT remains a major holding for several Australian-domiciled Australian equity active managers

Source: Morningstar.

Other and more present risks include the potential for merchant partners to surcharge BNPL fees in Australia or be asked to apply for credit broking in the UK. However, Ler imagines retailers would be inclined to bear these costs.

"Afterpay is not like a standard transaction business: it helps drive customers, and as such, the cost can be considered at least in part a marketing expense," he says.

Afterpay's fair value jumped 88 per cent last month on stronger growth expectations for the 10-year forecast period. For more details, see Ler's March note explaining the valuation change and detailing the company's outlook.

KEY HIGHLIGHTS (Q3 FY21)

Quarterly financed sales $5.2b – up 104pc YoY
Active merchants 85k – up 77pc YoY
Active customers 14.6m – up 75pc YoY