Afterpay and Zip: Don't be fooled by the pretenders
This time last year, we discussed Zip Co and Afterpay, comparing them to “buying Xero in the early days.” With Zip Co (ASX:Z1P) up 138% and Afterpay (ASX:APT) up 330%, the rate of their share price appreciation was clearly like Xero in the early days, so Livewire got in touch to ask for an update on the sector.
Our thesis for the Buy Now Pay Later (BNPL) sector was that customer preferences for consumer finance were changing, especially for millennials, who don't like credit cards or debt. Both Z1P and APT had a once in a generation opportunity to capture shifting spending pattern and build up a strong reputation for a sustainable business.
In the past 12 months, this trend of spending shift seems to have accelerated, with both Z1P and APT recording more-than-doubling of their membership numbers and transaction volume. At the same time, Australian credit card 'balances accruing interest' saw the first sustained decline in the past four years, even when the value of transactions has maintained its CPI-type growth rate.
As predicted in our original article, the BNPL sector attracted a number of regulatory reviews by ASIC and the Australian Senate and cleared them with flying colour. The muted regulatory response is a strong endorsement to the superior product offerings compared to the traditional consumer credits and the associated problems with a revolving credit balance model. These reviews provide a strong contrast to the revelations from the banking royal commission, where consumer trust of the big banks has waned.
As Z1P and APT expand rapidly and gain the trust of the millions of people, they have already captured a large part of these consumers’ share of mind. In the coming decade, Z1P and APT are in prime positions to capture an increasing share of millennials’ rising income and wealth. As discussed in our original article, we expect both Z1P and APT to launch new products to capitalise on these opportunities after the land-grab phase is finished.
Which ones to choose?
Afterpay has done an admirable job in executing the US opportunity while maintaining its growth rate and market leadership in Australia. APT just reported the best result we have seen, where both the gross and net bad debts have declined as a proportion of its turnover while reducing its reliance on late fees and keeping its revenue margin stable.
As we proposed earlier, consumer finance is a commodity business with a brand on-top. Afterpay being the largest player can derive the lowest cost of production, as evidenced by its new plan to lower interchange fees. A lower cost to produce puts Afterpay in a better position to withstand the upcoming price competition. With the strong start in the US and the UK to come, Afterpay is investing aggressively to maintain its growth rate even if the near term profit is depressed artificially, causing a high price to earnings multiple.
We think APT has the most near-term upside from here.
Zip Co has come a long way in the past 12 months to narrow its gap to the market leader. Z1P closed its technology gap with the launch of native mobile apps and a new brand relaunch to combine its Zip Money and Zip Pay products.
Z1P’s differentiated strategy to penetrate all credit card usage is making progress, as we have seen from the sign-up of a number of significant enterprise customers such as Target, Bunnings and Chemist Warehouse. However there are two areas that caused our concern. Firstly, is the weak revenue margin that is being perpetuated by winning bigger merchants with a discounted pricing business model, this will work against Z1P’s aspiration goal of 20% revenue yield. Secondly, Z1P is land-locked to Australia, falling behind in the neighbouring New Zealand market where Flexi Group has become a strong number two. While Z1P’s market cap is much smaller than APT, Z1P only has one market while APT has three markets to support its growth ambition. We think Z1P will do very well compared to the market but may lag behind APT.
What about the rest?
Other providers are emerging in the BNPL sector, which has heated up in the past 12 months. Flexigroup (ASX:FXL) has recapitalised and has a new CEO who is tilting the strategy toward BNPL.
Splitit (ASX:SPT) listed recently and a share price surge that seemed speculative. We are also hearing potential IPOs in this sector in the coming year.
A sector with so many new competitors would generally see two things happen: the top two operators derive the vast majority of the profit in this sector, and the new entrants putting price pressure that required scale and real differentiation to withstand.
As we have learnt in other sectors, first mover advantage in a generational shift is very powerful, being the first two players are vital to profitability.
A2 Milk and Bellamy’s in the infant formula space, Netwealth and Hub24 in the investment platform space are just two recent examples.
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Weimin has more than 10 years direct experience in the Australian small to mid-cap equity market honed over 3 years with Ophir Asset Management as a portfolio manager, and 7 years with Kosmos Asset Management as an analyst.