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From Australia's biggest deal to a share market bloodbath: Lessons from the BNPL fallout

Christine St Anne  |  18 Jul 2022Text size  Decrease  Increase  |  
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How the mighty have fallen. A little over a year ago, Afterpay announced its acquisition by Square in a deal worth $29 billion, the biggest in Australian history.

Fast forward to last week and a proposed merger between Zip (ZIP) and US-rival Sezzle (SZL) collapsed as investors soured on consolidation in the ailing buy-now-pay-later sector. Block (formerly Square) is down 73% since the Afterpay tie up was announced.

Initiating coverage in 2019, Morningstar argued Afterpay was still early in its lifecycle and was unlikely to turn a profit by fiscal 2021. Even as Afterpay began its phenomenal growth Morningstar warned shares were expensive relative to the fundamentals.

As the sector stumbles, we spoke to Morningstar BNPL expert Shaun Ler about the lessons for investors in the rise and fall of the sector.

Valuations matter, even for growth stocks

Ler remembers the number of investors who were willing to pay any price to jump on the BNPL bandwagon.

“Many investors were just chasing the momentum of their share prices without assessing the underlying risks,” Ler says.

In frothy markets investors tend to forget that valuations matter, he says.

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“We had advised against buying both Afterpay and Zip back in 2020-2021. Their market prices were valued off things like revenue or worse—transaction volumes—and simply did not reflect the cash flows they are expected to generate” Ler says.

As the industry confronts rising interest rates and impending regulation, company fundamentals and earnings matter again.

Focus on quality businesses

“Investors should focus on buying high quality business. Specifically, to BNPL, they need to understand the intricacies of different BNPL business models. Not all BNPL firms are equal. For example, Zip had more challenges around building scale, compared with Afterpay who had a first mover advantage and a cleaner value proposition and thus was able to gain share faster,” Ler says.

Investors continued to pile into BNPL stocks at lofty prices last year even as incumbents like PayPal and Commonwealth Bank launched competing products and concerns around regulation grew.

Paypal launched its “Pay in 4” product last July, with CBA following a month later with its BNPL competitor “StepPay”.

“Prospects of more competition and regulation are not new,” says Ler. “We had this information all the way back in 2020. But back then, the market simply dismissed those concerns as immaterial.”

Regulatory scrutiny sharpened in June when incoming Minister for Financial Services Stephen Jones flagged plans to bring BNPL businesses under existing credit product laws. He reiterated the point at the Informa Responsible Lending conference last week:

“And within this classification of 'credit products' I include BNPL,” Jones said. "This should not be controversial. If it walks like a duck and quacks like a duck, it's a duck.So let's have an end to the silly argument about whether BNPL is credit and get on with the next stage of growth for this emerging industry."

The Minister recognised BNPL’s legitimacy. Quoting statistics from The Australian Finance Industry Association’ showing there are 5.9 million active BNPL accounts, accounting for $11.9 billion of transactions per year.

“Australians are clearly responding positively to a new and innovative credit product. BNPL plays an important role in providing low cost and convenient credit to consumers. However, we must be mindful of the risks that may arise from innovation and ensure our regulatory frameworks remain fit for purpose in light of evolving technologies and business practices.”

A shrinking investable universe?

Despite the challenges facing BNPL companies, investors can find opportunities in this “new and innovative” sector by focusing on those firms differentiating themselves from the generic BNPL offerings increasingly offered by banks and payment processors, says Ler.

“There will be consolidation among BNPL firms,” he says. “Some could get acquired by larger firms. But some could also get competed away. Over the long term, the (BNPL) survivors who want to fight back and regain market share will need to differentiate their products either through finding niche markets or lend to people the banks are not willing to lend to.”

Dialing up credit risk can be mitigated by proper credit and affordability checks, something regulators will likely be supportive off, says Ler.

Surviving BNPL firms also need to carve out niche markets. For example, Humm (HUM) has a relatively niche strategy providing BNPL financing for larger order value items such as solar panels.

“It is crucial for these businesses to differentiate if they are to compete against larger players, like the banks and the Paypals of the world, that can afford to outbid you cost.

Investors’ focus needs to be on finding good franchises that can demonstrate a sustainable pathway to profitability.”

is communications manager at Morningstar Australia.

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