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.