Emma Rapaport: Hi, welcome to Morningstar. I'm Emma. We're joined today by Morningstar equity research's Shaun Ler to talk about one of the most talked about stocks on the ASX 200 this year, Zip.

Shaun, thank you for joining us.

Shaun Ler: Thanks, Emma. My pleasure.

Rapaport: Shaun, before we kick off, I want to get your response to this piece of research that's just come out from ASIC which shows that one in five people missed a buy now pay later payment in fiscal 2019. Were you surprised that that many people had missed payments?

Ler: Well, Emma, I would say that, first of all, users need to be very, very careful of using buy now pay later products because these firms are very, very skilled in marketing and branding. And perhaps, this also indicates the fact that many users still do not understand the true cost of using a buy now pay later product. Now, though not charging interest, we need to remember that buy now pay later players make up for this via a range of account fees, late fees, et cetera. There's no such thing as a free lunch in this world. Afterpay's late fees average about 14 per cent on (consumables) over the last three years. Zip's revenue use about 16 per cent, similar to credit cards. So, it, kind of, points towards buy now pay later products more being used as credit or as an avenue to spend more and potentially even kick the can down the road. So, I think, this points towards both users need to be aware of the nature of buy now pay later services and buy now pay later companies need to do a better job in marketing their products as the marketing tools. So, I mean, there's lots of things going on behind the scenes that we need to be aware about.


Rapaport: Do you think that ASIC or any other regulatory body will use this research to jumpstart regulatory change in the industry? Is there anything coming that you're worried about and can you just walk us through quickly what is already in the works?


Ler: So, there are numerous things in the pipeline. For example, the RBA is currently going through payments review which could see the no surcharge rule being scrapped and of course, there's also this constant debate on whether buy now pay later companies could be considered as credit and if they need to do so, they would need to be subject to responsible lending obligations and would need to go through a more stringent process while onboarding their customers, for example.


Now, look, we're sort of in quite a unique scenario. Just looking at the ASIC's report, it does point towards consumers being more high risk. But if you realize ASIC similar to the recent FinTech senate inquiry has stopped short of recommending any prescriptive regulations on buy now pay later players. So, the FinTech senate inquiry was arguing that the sector needs more innovation, you can't have a one size fit all approach. And ASIC also hinted towards more room for self-regulation. So, to me, if I can speculate, I would also think that buy now pay later—these products are sort of seen as necessary for the time being, it helps support the economy because they can help—because they have been proven to make consumers spend more sort of helping to help retailers under the changing retail landscape. So, regulators will no doubt be monitoring their loss rates and their arrears which so far have been quite good. So, I mean, things are still quite uncertain at the moment, but it does point towards the environment being slightly more benign rather than draconian.

Rapaport: So, you reinitiated coverage of Zip for Morningstar at the end of last month. You put a $4.50 fair value on the stock which places the stock at the moment in about a 2-Star territory, which means that you think that it's currently overvalued. Can you walk us through how you've reached that fair value for Zip?

Ler: Without being too detailed, all of this buy now pay later players share a very similar set of drivers that being population penetration, spend per customer, merchant margins, loss rates. So, definitely, I'm expecting things like population penetration and spend per customer to improve.

There's a lot of ways to value these buy now pay later companies nowadays. But just looking at—just trying to put things into perspective, Zip's share price has been quite volatile over the past six months. Now, taking the average of the top and the bottom over the past month or so gives us a price of about $6.60. Now, at $6.60 this assumes that Zip would either have higher net transaction margin than Afterpay and have a customer base close to the entire of Australia's population by 2030 or have the same net transaction margin as Afterpay and have a customer base close to the fourth of Australia and New Zealand's current population by 2030, each spending about $1,700. Now, I think that people are forgetting that Zip is a comparably more capital-intensive business. Its receivables book is higher risk. So, it needs to conduct credit checks which slows down customer additions and its key growth engine, QuadPay, is essentially more expensive buy now pay later product which lacks differentiation. So, to this end, while we assume that Zip's population penetration and spend per frequency to increase, we are not expecting them to grow as quick as what consensus in the market is factoring in. And because Zip's—for example, for QuadPay, its merchant margins also comparably higher, twice of Afterpay's in the US, so we are also expecting to see some compression in margins over there.

Rapaport: Great. Thank you, Shaun, for joining us today. If anyone wants to hear more about what Shaun thinks about Zip, he's got his initiation coverage of Zip up on Morningstar Premium. You can go there, download the report and read that.

Shaun, thank you very much for joining us today.

Ler: Thanks, Emma.