Consumer finance is like fashion. It needs to evolve to suit the taste of each generation of consumers. 20 years ago FlexiRent did well, 10 years ago Certegy captured a solid audience base. The current generation includes Afterpay and now Zip, which do not charge interest and integrate much more smoothly with online shopping and mobile devices.
Who is Zip?
Zip has a lot of potential if it gets it right. Zip Co. (Z1P) provides consumer finance in Australia through its two main products:
- Zip Money, an interest-free product that competes against FlexiGroup’s Certegy and HSBC’s interest-free offerings; and
- Zip Pay, a short-term instalment lending product similar to Afterpay.
The real opportunity is a product that can tightly integrate with the online shopping experience and fit the mobile economy. Credit card as a product is cumbersome to use online and on mobile. Furthermore, since the GFC, funding costs have reduced significantly while credit card interest has not, this creates a high profit margin ripe for disruption. The biggest potential for Zip (and Afterpay) is therefore to become a credit card replacement.
To capture this credit card replacement opportunity, Afterpay and Zip need to change their current products, pass the current ASIC review, launch new products and undergo more future scrutiny. But the price is worth it, Australia’s annual credit card spending is more than $300B, with $30B plus interest-accruing balances each month. If credit card replacement products can capture 10% of that, it is a $30B volume opportunity.
In finance, the brand is everything. Most merchants and consumers are not going to carry more than two similar solutions. This is why it is tough for a newcomer to dislodge their positions, once Afterpay and Zip have gained large acceptance. As long as both players can keep up with product innovation, they are in the prime seats to capture this multi-billion-dollar opportunity.
Better risk-return than Afterpay
While we admire the success of Afterpay and its stronger brand loyalty and growth potential in the USA, we consider Zip to provider better risk-return characteristics.
Based on various operational metrics, Zip the business is about 25-50% the size of Afterpay, but its valuation is only 10-20% the size. Furthermore, Zip’s products are a lot further progressed in the credit card replacement journey, while serving more day-to-day type of merchants, including grocery and bulky goods categories that may not work well with Afterpay’s existing high margin model. This early mover advantage may provide Zip with a lead in capturing the credit card replacement opportunity.
Like buying Xero in the early days?
This opportunity reminds us of Xero in the accounting software industry. Starting out as a lightweight entry-level solution, Xero was not taken seriously by the incumbents. But through solid execution, changing industry dynamics, and incumbents’ ignorance, Xero has become a globally significant business.
At this stage, Afterpay and Zip are considered niche products by the credit card incumbents, while the incumbents are embroiled in a Royal Commission investigation.
In such an environment, we wonder what good execution by Zip starting from today’s solid foundation could deliver over a five-year period. Of course, execution is everything, and we will continue to assess the development in this sector.
Weimin has close to 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.
I suspect this marketplace will fragment along demographic lines. The baby boomers (and older) are comfortable with credit cards, don't buy as much online, aren't on the leading technology wave to the beach and have time to 'pay as they always have'. Gen X and milennials are the reverse...they are the natural target of the Zip's and Afterpay's of the world. At the end of the day they will succeed by making the acquisition process easy and cost effective for both puchaser and merchandiser. I cannot see them capturing 10% of the marketplace in the short term...maybe 3 to 5 years out, perhaps.
How does Zip make money on interest free loans?
Justin - Zip and Afterpay both charge fees to the merchant as a percentage of the transaction value.
Z1P need to 10x their revenue to achieve a PE of 30, at current prices. It is more likely that they will go bankrupt than achieve this growth.
The devil, as they say, is in the detail. Never a truer spoken with respect to Z1P. Looking at the 1H2018 results we see that: - Revenue up 2.45x on PCP - Net loss up 2.45x on PCP - Revenue to loss ratio of 1.125 (1H2017) and 1.095 (1H2018). Getting worse. - Doubtful debt as a % of revenue: 29% (1H2017) and 38.7% (1H2018). Getting worse. - Salaries and employee benefits as a % of revenue: 32.5% (1H2017) and 46.3% (1H2018). Again worse! - EPS loss 1H2018 double PCP - Total assets up 47%. Total liabilities up 34%. Equity up 238% from a low base. Not a complete picture, but some relevant metrics. Casting forward to FY2019 let’s assume revenue of $50M and an earnings yield of 20%. Too ambitious. Too conservative? You decide. However, using that assumption we get earnings of $10M which is 30x current market cap. Assuming continued revenue growth of 30% and earnings yield of 20% we get $65M revenue FY2020 and $84.5M revenue FY2021 with earnings of $16.9M i.e. 18x current market cap. Blue sky ... maybe. On the other hand, it could be a long wait for investors.
Hmmm...this business model sounds like picking up pennies in front of bulldozers. I lend out $500 at 0% in exchange for an upfront payment of what? $10? So I'm on the hook for $490 to an unsecured borrower? What could possibly go wrong?
Zip Money's business model sucks. It's like a poor mans credit card, without the physical card......and you pay $10 p/m for the privilege of opening an account. I heard a story that's a great example of the difference in customer value between Zip and AfterPay, where a woman went into a retailer and asked if they had AP. The retailer said no, they support ZipPay and the customer then stood there for 15 minutes setting up an account and getting approved for the 'loan'. What a terrible customer experience! AfterPay is a totally different story. It deserves to be valued at a premium.