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Afterpay’s hangover?

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By Paul Rickard

The challenge for high-flying tech companies is that the market doesn’t really know how to value them, and as the hype develops about their “growth”, they become vulnerable to the inevitable hiccup. This looks like what has happened to a current market darling, Afterpay Touch Group (ASX APT).

After a spectacular run-up to a high of $8.16 in mid-January, which capitalised the company at a staggering $1.3 billion, the shares have come under pressure as concerns have been raised about the robustness of their risk management processes. Yesterday, the shares fell a further 5.7% to $5.60, following the release of a business update and details of the actions Afterpay is taking to address these concerns.
            

Afterpay (APT) – July 17 to April 18 (source: Commsec)

Afterpay’s business model

If you are not one of the 1.8 million Australians that use Afterpay, let me explain the proposition. It is quite simply the old “lay-buy” done electronically. Customers buy goods online or in store from their favourite retailer, receive those goods immediately, and pay Afterpay in four equal fortnightly instalments by credit or debit card. Afterpay pays the retailer up front, less a service fee of approximately 4%.

Shoppers don’t pay any interest or transaction fees, and buy goods that they may not have otherwise been able to purchase (lay-buy). If they miss a fortnightly payment, they are charged an initial “late fee” of $10, and then a further fee of $7 if it hasn’t been paid after 7 days.

Retailers get incremental sales and new customers, guaranteed up-front payment, zero fraud or credit risk (Afterpay assumes this) and, according to the marketing material, “increased basket size and repeat purchase rates”. There are now 14,000 merchants/retailers on board – up from 6,000 at the start of the financial year.

Turnover using Afterpay has surged, with underlying sales of $530 million in the quarter just completed (March 18), up 360% from $145 million in the corresponding period in FY17. For the 9 months, sales of $1.45 billion compared to $290 million in 2017 – up 500%.

But growth rates anywhere near these magnitudes are hard to sustain, and the inevitable slowing occurs as the base grows. The following table show’s Afterpay’s quarterly sales to March 18 and the growth rate compared to the preceding quarter.

Afterpay quarterly sales

On paper, the decline in the just completed March quarter of 3.8% looks pretty bad and was one of the reasons the market sold the stock down yesterday. Due to the impact of the Christmas peak shopping season, fewer trading days, and the timing of Easter, Afterpay’s performance wasn’t nearly as bad as it looks. Afterpay grew – it just isn’t growing at the same rate.

Afterpay didn’t help its own cause by not attempting to “adjust” for the seasonal factors, nor by describing it as “above system growth”, which conjures up images of single digit growth, rather than growth in the twenties or thirties.

Afterpay Touch also earns revenue from the “pay now” business (the Touch business it acquired in 2017) which services merchants directly. Of the Group’s $60.7 million in revenue for the first 6 months, 21% came from Touch and 79% from the Afterpay (“pay later”) business. Of the latter, 75% comes from the merchant fees and 25% through late fees.

Afterpay reported EBITDA before significant items of $12.1 million for the first half, and a net loss after tax for the first half of $0.7 million.

Risk concerns

As it has grown, Afterpay has come under fire from some consumer groups and industry competitors. Firstly, it hasn’t been verifying the identity of its customers and under age customers can purchase goods using Afterpay that they are not legally allowed to buy (eg. alcohol and other restricted items). Afterpay says that it will now implement an external ID verification service, but as at yesterday when I opened a “fake” account, this clearly wasn’t in place.

Next, Afterpay’s “late fees” have been described by some as exorbitant, which, depending on the transaction size, can represent a very high effective rate of interest. Afterpay says that over 90% of orders don’t attract a late fee, and 78% of customers have never paid a late fee. But, it is a material source of revenue – around 20% of net revenue in the first half.

Afterpay announced yesterday that it would cap late fees at 25% of the purchase order, with a maximum fee of $68 per order.

Finally, there is the question about whether Afterpay promotes responsible customer spending, and how, if at all, it should be regulated. Afterpay argues that customers cannot “revolve” (unlike a credit card), the very short duration of the payment cycle (4 payments every 2 weeks) means that bad debts are detected quickly and usage stopped, that it applies a repayment check for first time customers and that 85% of transactions are via a linked debit card.

Afterpay is not currently a regulated credit product under the National Credit Code and it maintains this hasn’t been challenged by any regulatory authority.

What do the brokers say?

Only two of the major brokers cover the stock. Morgans, who recently initiated cover, have a ‘hold’ recommendation on the stock with a target price of $6.34. Ord Minnett is more positive, with a ‘buy’ recommendation and a target price of $9.50. These were made prior to the yesterday’s trading update (source FN Arena).

In terms of Afterpay’s investment thesis, both see regulatory risks as being high, together with risks from an uptick in the bad debt cycle, competition and maintaining the sales momentum.

On a multiple basis, they have Afterpay earning 5.7c per share in FY 18, rising to 16.5c in FY19, putting it on a multiple of 98.9x FY18 earnings and 33.9x FY19 earnings. At $5.60, this is a PEG (price earnings to growth) ratio of 0.52

My view

Afterpay’s performance in attracting 1.8 million customers, 14,000 merchants and generating $200 million per month in customer turnover has been very impressive. It really has had a remarkable take-up.

While 99 times FY18 earnings looks like a pretty heady multiple, if the analysts are right about the growth in earnings by FY19, $5.60 is not an over the top price and is probably a reasonable entry level.

But it doesn’t look like the regulatory concerns will go away in a hurry, and the new measures, such as external ID verification and capped late fees, will put pressure on earnings. And if the growth rate is really starting to slow, or margins come under pressure due to competition, the gloss will go away from the Afterpay story.

For the brave. For the not so brave, no bargain yet.

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Published: Thursday, April 12, 2018


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