How much higher can Buy-Now-Pay-Later stocks go?

As you’ve no doubt noticed, Buy-Now-Pay-Later (BNPL) providers, like Afterpay and Zip, are all the rage. But do their soaring share prices reflect their real value and future earning power? Or are we just witnessing the latest incarnation of tulip mania?

I sometimes wonder how we will look back on the rise of profitless growth stocks. Trading well above normal historic multiples, their very strong performance is tough to rationalise with fundamentals. Their booming prices seem to be the product of a speculative bubble. And BNPL providers in particular, such as Afterpay and Klarna, are, by no small measure, recipients of the broader irrational ebullience.

When Afterpay’s closing share price peaked at $92.48 in late August this year, its market capitalisation was $26.3 billion. This was remarkable for a number of reasons. Its market value had risen 2,500 per cent in three years and eight-fold since March. At that moment, Afterpay was then worth more than Cochlear and Sydney Airport combined, worth more than double Scentre Group – the operator of Australia’s Westfield malls, and worth 25 per cent more than Coles Group.

For a company generating revenue of just $230 million (compared to Coles’ $37.4 billion) and losing money, a $26.3 billion market capitalisation was an extraordinary achievement, and with today’s market capitalisation of $22 billion it remains Australia’s 16th largest listed company.

When a consumer purchases an item online or in store and chooses to use a pay later offer, they take the goods home and commit to the BNPL provider to paying off the item within an agreed timeframe to avoid penalties (Afterpay generates about 14 per cent of revenues from late payment penalties).  Meanwhile the BNPL provider pays the retailer a discounted price for the goods, say around four per cent. It’s essentially an inverted version of the old lay-buy system. The benefits are that the customer takes the goods immediately and the retailer doesn’t have to store the product.

According to a July survey from The Ascent, the avoidance of credit card interest is the primary reason for using a BNPL service for about 40 per cent of users. And according to Mastercard, three out of four first-time U.S. shoppers that adopted BNPL plan to continue use after the pandemic is over.

And so far, retailers have embraced the concept too as BNPL drives foot traffic and increases basket size. According to a survey by 451 Research, BNPL influenced the decision to purchase for a third of consumers aged 18-37. Their surveys also revealed that 40 per cent of merchants generating more than 50 per cent of sales online now offer payments by installment at checkout.

But Afterpay isn’t alone. The BNPL model is also offered by US-based Sezzle, Klarna and Zebit, Israeli-firm Splitit, New Zealand’s Laybuy, Affirm, Payright, and a host of other operators including FlexiGroup’s Humm and Bundll, and PayPal’s ‘Pay in 4.’ Indeed, payment giants, Visa and Mastercard (Quadpay) have also revealed products that can only be described as BNPL.

And according to Similartech, Afterpay may dominate the saturated Australian market in terms of representation online, but it is well behind elsewhere in the world. By way of example, Afterpay is mentioned on 28,710 websites while Klarna is seen on 46,033 websites. Meanwhile Klarna leads Afterpay on the world’s top 10,000 sites, the top 100,000 sites, the one million sites and the entire web.

Products like Afterpay, which allows consumers to purchase products with an interest-free, unsecured loan is one source of their advantage over credit card providers. The other is the contractual “no surcharge” agreement retailers enter with the likes of Afterpay that prevents the merchant passing on the additional cost to the consumer.  The law prevents credit and debit card providers from prohibiting a merchant passing on their costs to customers. Afterpay gains and advantage because it can market its offering as free to all customers who pay on time.

Importantly, the credit and debit card charges that merchants do pass on, amount to between 0.5 and 1.5 per cent. BNPL charges can be as high as seven per cent according to UBS.

If retailers continue to allow this asymmetric approach, they will end up strengthening Afterpay’s market power at the expense of credit card providers and ultimately deliver Afterpay and their ilk the ability to charge them even more.

For regulators and consumer-interest groups, the significant charges will ultimately result in higher retail prices for all consumers. And with BNPL offers most attractive to younger consumers without the money to pay for a product upfront, pureplay BNPL providers that only require superficial personal information might suffer most from regulatory scrutiny.

According to Roy Morgan, more than half of BNPL users are consumers under the age of 35.  But regulators also need to be mindful that wiping out BNPL could dent retail sales and adversely impact the discretionary consumer sector.

Nevertheless, the rising competition globally and the regulatory tightrope being walked by BNPL providers, combined with stretched market valuations, suggests investors need to tread carefully. It’s worth remembering that during the COVID-19 inspired sell off Afterpay’s shares fell 77.5 per cent.

The threats of increasing competition, rising regulatory risk and stretched valuations is already resulting in very wide valuation and price target dispersion among sell side analysts.  UBS reckons Afterpay’s shares are worth less than $30 while Morgan Stanley has had a price target of over $100.00.

And while there is no shortage of BNPL pure plays, those that are publicly traded are all listed in Australia. One might argue that the multiples considered normal by Australian investors are a joke to investors elsewhere. If they’re right, it may be worth ensuring you can look back on this moment in stock market history and laugh.

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