Zip (ASX.ZIP) reaffirmed its fiscal 2027 cash EBTDA guidance of $340 million, despite a hit from an external fraud event in the US, higher US bad debts, and rising funding costs. First-quarter cash EBTDA rose 3% to AUD 65 million, or nearly 20% excluding AUD 10 million of fraud costs. Shares fell 29%.

Why it matters: US bad debts rose to 1.93% of transaction value, the top of Zip’s 1.5%-2.0% target. It is unclear how much is due to higher customer stress or recent customer growth. But we are not alarmed for now, as losses remain within the target range and are guided to decline in the second quarter.

  • Zip suffered from coordinated individuals opening accounts using legitimate credentials in the first quarter. The swift response to the fraud supports our view that Zip’s business model is resilient. Short loans and small initial limits that rise with a customer’s repayment record help Zip identify problems early, limit its exposure, and act quickly.
  • Tighter controls to contain fraud slowed US growth in July and August. But we see no lasting impact, with transaction value growth rebounding to 41% in September and momentum continuing into October. Still, fraud risk is now on investors’ radar.

The bottom line: We maintain our $3.50 fair value estimate for no-moat Zip. Shares are materially undervalued. We believe investors are overly pessimistic about the effects of recent headwinds on Zip’s future earnings potential.

  • We trim our long-term annual Australian customer growth forecast from 3% to 1.5% to reflect weaker customer trends. The modest earnings reduction is immaterial to our fair value estimate, though.

Bears say: Our valuation assumes US bad debts settle near the midpoint of Zip’s target range. If they remain at the top of the range over the long term, our fair value estimate would fall by about 15% to roughly $3.00.

Zip shares materially undervalued amid temporary fraud, credit, and funding headwinds

Zip has benefited from the growth of e-commerce and from those in younger demographics, who are either unable to access credit or view traditional credit cards as complicated and expensive. Signing up takes minutes, and the advantage of giving shoppers a way to smooth out expenditure has resulted in merchants reporting increased sales and fewer shoppers abandoning their purchases at checkout. Zip gets paid by merchants and customers. Integrated merchants that offer Zip as a payment option pay Zip a fee as a percentage of the purchase value, and when they use the Zip marketplace for promotions. Customers pay establishments fees, interest, monthly fees, and late fees. Customers tend to increase usage over time, as shoppers become more comfortable with the product, and Zip increases the customer’s credit limit based on strong repayment history. This results in larger average spending per customer, a trend we expect to continue.

Zip is the second-largest BNPL provider in Australia. Its Australian products differ from most peers as they are effectively revolving credit rather than fixed installments. While its terms and fees are more complex, Zip’s wider range of options appeals to shoppers. Having a longer average repayment period, the segment is more capital-intensive than some peers and cannot scale up as quickly, a fact Zip compensates for by supplementing merchant fees with customer account fees for most products. We expect Zip to maintain its dominant position in this mature market, albeit with moderate growth.

In the underpenetrated US BNPL market, Zip is growing fast with its simple installment financing model. Zip targets a potential market of 100 million people, of which it currently serves over 4 million. Its US customers are mainly near-prime and subprime consumers who are unable to obtain credit through traditional routes, like credit cards. Its US transactions are predominantly essential spending. In contrast, its large instalment-based competitors target more prime customers and focus more on discretionary categories. We expect Zip to be profitable in the long run in the US, as there is still significant room for e-commerce and BNPL adoption here.

Bulls say

  • Zip may scale fast in the US and build a strong enough network that it can maintain its market share in its target market for customers and merchants against larger BNPL providers.
  • Zip stands to benefit from structural trends, including an accelerated shift to e-commerce, increased adoption of smartphones and cashless payments, and a growing need among merchants for effective and data-driven marketing.
  • Over time, Zip may get better at refining its criteria for its ideal customer profile and can identify unsuitable customers earlier, thus reducing default rates.

Bears say

  • Stricter credit regulations on BNPL could make it tougher to sign new customers and impede the company’s revenue growth.
  • BNPL products are perceived as encouraging excessive spending and may attract increasing public and regulatory scrutiny, impinging on growth.
  • A weakening economy and labor market could increase default rates and affect profitability.

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